Journal of Regulation & Risk - North Asia, Volume II, Edition I, Spring 2010

Articles & Papers

Fed monetary and regulatory policy: lessons from the crisis Janet L. YellenThe post-crisis fix: regulatory or monetary policy remedies? Stephen S. Roach Risk orientation in regulation and supervision Patrick Raaflaub & Gabe Shawn Varges Regulation, supervisory lessons from Japan since the 1990s Kazuo UedaEnhancing cross-border regulation after the 2008 crash Richard NeimanWhat we thought we knew and what we didn’t know Olivier Blanchard, Giovanni Dell’Ariccia and Paolo MauroThe ‘business of bribery’ sparks anti-corruption drive Gavin SudhakarPublic or private accounting and the Sarbanes-Oxley Act Alex J. Pollock ‘Innumerate bankers, systemic idiocy & accounting standards’ Lord Adair TurnerLessons for the forex market from the global financial crisisMichael Melvin & Mark P. Taylor Exports and financial shocks: new evidence from JapanMary Amiti & David WeinsteinA case of mistaken identity: the illusion of ‘too big to fail’ Avinash Persaud

Journal of regulation & risk north asia

Volume II, Issue I, Spring 2010

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A5_JournlRegRiskNA_8Oct09.indd 1 09/10/2009 11:17:23 AM

Journal of Regulation & Risk North Asia 1

editor emeritusDr John Pattison

editorIan Watson

Chief sub-editorFiona Plani

Commissioning editorChristopher Rogers

editorial standards BoardDr Giovani Barone-Adesi, Dr Colin Lawrence, Luo Ping, Dr Patrick McConnell,

Dr Michael Ong, Dr John Pattison, William Ryback, Dr Kariya Takeaki, Simon Topping, Dr Peter Treadway, Lawrence Uhlick and Dr Lawrence White.

ContributorsDr Susan Ariel Aaronson, Mary Amiti , Olivier Blanchard, Prof Charles Calomiris,

Giovanni Dell’Ariccia, Prof Simon Johnson, James Kwak, Paolo Mauro, Michael Melvin, Richard Neiman, Avinash Persaud, Alex J. Pollock, Patrick Raaflaub, Stephen S. Roach, Gavin Sudhakar, Janet Tavakoli, Mark P. Taylor, Edwin M. Truman, Lord Adair Turner,

Prof. Kazuo Ueda, Gabe Shawn Varges, David Weinstein, Dr Janet Yellen. Design & layout

Lamma Studio Design Printing

DG3Distribution

Deltec International Express Ltdissn no: 2071-5455

institute of regulation and risk – north asia5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong Kong

Tel (852) 2132 9620 Fax (852) 3007 0229Email: [email protected]

Website: www.irrna.org JRRNA is published quarterly and registered as a Hong Kong journal. It is

distributed free of charge to governance, risk and compliance professionals in China, Hong Kong, Japan, Korea and Taiwan.

© Copyright 2010 Institute of Regulation and Risk, North AsiaMaterial in this publication may not be reproduced in any form or in any way

without the express permission of the Editor.

Disclaimer: While every effort is taken to ensure the accuracy of the information herein, the editor cannot accept responsibility for any errors, omissions or those opinions expressed by contributors.

INSTITUTE OF REGULATION & RISK NORTH ASIA

The Institute of Regulation & Risk North Asiais proud to present:

An Evening Dialogue withMr. Charles L. Evans

President and Chief Executive Officer Federal Reserve Bank of Chicago

5:15 PM – 10:00 PMTuesday, 30 March 2010

Grand Ballroom, Conrad Hotel, Pacific Place

5:15 PM Registration opens

6:15 PM Welcoming Remarks Ms. Au King-chi, Permanent Secretary for Financial Services and the Treasury Bureau, Hong Kong SAR

6:30 PM Some perspectives on regulatory reform Charles L. Evans

6:45 PM Regulating risk, a UK perspective Andrew Haldane, Executive Director, Financial Stability Bank of England

7:00 PM What happens after an end of quantitative easing: A Japanese Perspective?

Prof. Kazuo Ueda, Former member of the Policy Board

Bank of Japan

7:15 PM Break

7:30 PM Panel Discussion and Audience Q&A

Moderator: Robert Pringle, Chairman Central Banking Publications

Panelists: Charles L. Evans Andrew Haldane Prof. Kazou Ueda Stephen Roach, Chairman, Asia Morgan Stanley

8:45 PM Evening Meal & Beverages

10:00 PM End of Evening Dialogue


Volume II, Issue I – Spring 2010

ContentsForeword – Dr John Pattison 5Acknowledgments 7Q&A – Dr Janet Yellen 9Book overview – James Kwak & Simon Johnson 19Opinion – Janet Tavakoli 23Opinion – Susan Ariel Aaronson 27Debate – Prof Charles Calomiris 31Debate – Edwin M. Truman 47 ArticlesFed monetary and regulatory policy: lessons from the crisis 55Janet L. Yellen

The post-crisis fix: regulatory or monetary policy remedies? 61Stephen S. Roach

Risk orientation in regulation and supervision 75Patrick Raaflaub and Gabe Shawn Varges

Regulation, supervisory lessons from Japan since the 1990s 87Kazuo Ueda

Enhancing cross-border regulation after the 2008 crash 99Richard Neiman

What we thought we knew and what we didn’t know 107Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro

The ‘business of bribery’ sparks anti-corruption drive 113Gavin Sudhakar

Public or private accounting and the Sarbanes-Oxley Act 123Alex J. Pollock

‘Innumerate bankers, systemic idiocy & accounting standards’ 129Lord Adair Turner

Lessons for the forex market from the global financial crisis 141Michael Melvin and Mark P. Taylor

Exports and financial shocks: new evidence from Japan 147Mary Amiti and David Weinstein

A case of mistaken identity: the illusion of ‘too big to fail’ 153Avinash Persaud



An Evening Dialogue withDr. James Bullard

President and Chief Executive OfficerFederal Reserve Bank of St. Louis

5:30 PM – 10:00 PMMonday, June 14, 2010

The Willard Room, InterContinental Hotel, Tokyo Bay, Japan

5:15 PM Registration opens

6:15 PM Welcoming Remarks & Opening Address

Mr. Takatoshi Kato, Deputy Managing Director International Monetary Fund

6:30 PM Monetary policy and medium term inflationary risks: What should central banking monetary policy focus on: Inflation or deflation? Dr. James Bullard (Confirmed)

6:45 PM Monetary policy and the medium-term outlook for price stability Mr. Jurgen Stark, Member of the Executive Board European Central Bank

7:00 PM From insider to outsider: Coping with a financial meltdown — the good, the bad and the ugly Sir John Gieve, former Deputy Governor, Bank of England

7:15 PM Break

7:30 PM Panel Discussion and Audience Q&A Moderator: Robert Pringle, Chairman Central Banking Publications

Panelists: Dr. James Bullard Mr. Jurgen Stark Sir John Gieve Mr. Takatoshi Kato




Foreword

The papers in this edition of the Journal are from some of the leading practitioners of monetary policy, regulation and

supervision as well as those from academia and the financial sec-tor. They highlight a number of critical themes that will guide, or haunt, the financial world in coming years.

This edition demonstrates that the agenda for policy makers is both diverse and full. While work at the national level as well as the various Basel Committees, the Financial Stability Forum, the International Organization of Securities Commissions and many others progresses, the issues are complex, analytically diffi-cult and often without the historical data and experience on which

to repose confidence. This is well known. By default it places a heavy load on assessment of the challenges, balancing conflicts and making difficult judgments. This cannot satisfy all national interest groups let alone conflicts between countries, nor should it. But progress is being made. This may be halting at times as we will need to learn from experience in previ-ously uncharted areas.

A second theme is that within this financial house there are many rooms. The finan-cial crisis exposed issues in virtually every corner. However the financial world is networked. Some issues are separable, many are not. Thus making individual steps correctly is sensible. However the cumulative effects may not be. This is true of monetary policy as well as regula-tory issues. Once again we will need to rely upon judgment.

A third theme is that we are in a world of dramatic change for all participants, be they supervisors, central bankers, securities regulators or financial market players. If achieving financial reform and improved operating procedures for central banks are difficult, it will be equally challenging for those trying to operate in a new and uncertain world.

Finally, what is often an unstated theme is that operational risks will rise for all parties as the financial world attempts to adapt to a more demanding and critical environment. Supervisors have long commented that financial innovation is often followed by a predict-able round of losses as firms adapt to new businesses with an inadequate understanding and poorly designed controls. The risks this time are different, and hopefully declining but it remains true that institutions will need to adapt, from Boards of Directors through every layer of their organisations to a new world with higher standards and lower tolerances for errors.

Dr John Pattison Editor Emeritus

Institute of Regulation & Risk – North Asia


An Evening Dialogue withMr. Jurgen Stark,

Member of the Executive Board European Central Bank

5:45 PM – 10:00 PMTuesday, June 15, 2010

Grand Ballroom, Conrad Hotel, Pacific Place

5:15 PM Registration

6:00 PM Welcoming Remarks Arthur Yuen, Deputy Chief Executive Office, Hong Kong Monetary Authority (Invited)

6:15 PM What should central banking monetary policy focus on: Inflation or deflation? Dr. James Bullard, President & CEO, Federal Reserve Bank of St. Louis

6:30 PM Monetary policy and the medium-term outlook for price stability Mr. Jurgen Stark, Member of the Executive Board, European Central Bank

6:45 PM From insider to outsider: Coping with a financial meltdown — the good, the bad and the ugly Sir John Gieve, former Deputy Governor, Bank of England

7:00 PM Break

7:15 PM Panel Discussion and Audience Q&A

Moderator: Robert Pringle, Chairman Central Banking Publications

Panelists: Dr. James Bullard Mr. Jurgen Stark Sir John Gieve Mr. Takatoshi Kato, Deputy Managing Director International Monetary Fund




AcknowledgmentsTHE Secretariat of the Institute of Regulation and Risk – North Asia could not have published this edition of the Journal without a great deal of assistance and advice from professional associations, international monetary and finan-cial bodies, regulatory institutions, consultants, vendors and, indeed, from the industry itself.

A full list of those who kindly assisted would be impossible, but the Secretariat would like to thank: the Federal Reserve Bank of Boston; the Federal Reserve Bank of Chicago; the Federal Reserve Bank of New York; the Federal Reserve Bank of San Francisco; the State of New York Banking Department; the Ameri-can Enterprise Institute; The Peterson Institute, for International Economics; the Swiss Financial Market Supervisory Authority (FINMA); the International Monetary Fund; the Securities and Exchange Commission; the UK’s Financial Services Authority; the University of Warwick, Loughborough University; Co-lumbia University Graduate School of Business; George Washington University, the Baseline Scenario; FinReg21; Voxeu; World Scientific; Barclays Global Inves-tor; Morgan Stanley Asia; Blackrock; Sapling Solutions; Intelligence Capital and Tavakoli Structured Finance for their kind permission to reproduce material and articles from their respective publications and websites – much of which was revised for the purposes of this Journal.

Detailed comments and advice on the text and scope of contents from Prof Wil-liam Black, Robert Pringle, Dr Michael Ong, Dr Heong Wee Chong and Prof Charles Calomiris were invaluable; we are also grateful to Ian Watson and Fiona Plani of Edit24.com for their due diligence in setting out, editing and correcting the text.

Special consideration must also be given to Dr. John Pattison once more for taking time out from a hectic schedule to review all contributions within this Journal and engage actively with all those who submitted papers and articles.

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Q&A

Joblessness, price stability and quantitative easing

San Francicso Fed head, Dr Janet Yellen, and guests tackle awkward questions from

some of Hong Kong’s leading bankers.

ON the evening of November 17, 2009, some 400 guests assembled in Hong Kong to engage with Dr Janet Yellen, Sir John Gieve, Norman Chan and Jochen Sanio. Below is a transcript of the proceedings.

Robert Pringle: We are honoured to be joined by Mr Norman Chan, Chief Executive of the HKMA. It is a pleasure that he’s cho-sen to participate at this event – one of his first public engagements.

I would like to start this Q&A session by inviting Dr Janet Yellen to say a few words about the macroeconomic situation and outlook in the United States and the state of monetary policy of the Fed. To have a mem-ber of the FOMC here in Hong Kong, I think we should give her the opportunity, if she would be so kind, to say a few words about this first and then we can go into the ques-tion and answer session. Thank you.

Dr Janet Yellen: Thank you very much for that . . . I’ll try to be brief and we can take follow-up questions if you have some. Let me just summarise by saying that while it’s not yet official, the recession is probably

over and the worst downside risks to the US economy have subsided substantially. We’re all breathing a sigh of relief and I think we have a growing economy.

There are many things to fret about in terms of downside risk because some of the growth that we have seen during the last quarter, and probably through to the end of the year, rely on fiscal policy, a diminution of inventory liquidation, and some government programmes, like stimulus for auto pur-chases that are temporary. So one can won-der what will happen when some of these temporary impulses fade. Can the economy keep going on its own?

Savings rate growthI’m reasonably sanguine that the economy can and will continue to grow into next year. We’ve seen some strength in consumer spending, maybe more than I would have anticipated, given all the negative things that have happened to households. And while I think that the savings rate is going forward, American consumers will end up saving more and so consumer spending growth will be more sluggish than we saw in the

Journal of Regulation & Risk North Asia10

years leading up to the crisis. However, I’m reasonably optimistic that consumer spend-ing will return to growth and the housing market is beginning to recover. On the other hand, when I think how robust this recovery is likely to be, I’m not alone among forecast-ers in anticipating a recovery that is going to be slow. I think this is consistent with what we’ve seen in almost every country around the globe that’s experienced a financial crisis.

Stubborn jobless scenarioIt takes a long time for financial markets and institutions to heal, and that means a period of subdued growth. For example, in a new study out this morning, 41 professional fore-casters said that by the end of 2010 unem-ployment will still be above 10 per cent in the United States and so I think employment growth particularly will be very weak. On the inflation side, over the past year infla-tion has actually been negative, and the core inflation that we focus on has been around 1¼ per cent. To just tell you what this survey of pro-fessional forecasters thought in the poll, they anticipated core inflation would be running at the same rate – 1¼ per cent in 2010 and 1½ per cent in 2011 – and when they were asked to go through to 2013, their expecta-tion was that inflation would run at a very low rate. In fact, it was a down revision to just 1.8 per cent; so professional forecasters do not expect high levels of inflation at least in the next five years. My own view is that inflation is going to be quite subdued for a number of years and that reflects a great deal of slack in the economy and subdued infla-tion expectations.

So with respect to monetary policy, the

conclusion that the FOMC has drawn from this is that while there are no promises about what our policy will be, it depends on the state of the economy. We use language that says we can anticipate the economic condi-tions: low rates of resource utilisation, sub-dued inflation trends and stable inflation expectations are likely to warrant exception-ally low levels of the Federal Fund rate for the next extended period. I certainly share that view, but I also want to emphasise that we all understand very well that we cannot have an accommodative policy for too long and that once these conditions no longer prevail, it is a core responsibility of the Federal Reserve to preserve price stability.

And we are making sure right now that we have the tools, and not just one tool but many tools, which Chairman Bernanke has described as a ‘belt and suspenders’ approach. We don’t want to rely on just one tool. We want to make sure that we have more than enough tools to tighten mon-etary policy when the appropriate time comes. And though right now inflation is running a little bit below levels consistent with price stability, we don’t want inflation to pick up. We regard it as a core responsibil-ity that every FOMC member is committed to removing the accommodations we’ve put in place in a timely fashion, so that inflation doesn’t pick up.

Price stability pledgeI would like to give you just my own personal assurance that this is the Federal Reserve’s intention. I know a lot of people are con-cerned with fiscal policy in the United States and long-run budget deficits. And globally there is a connection between loose fiscal


policy and inflation, but you don’t see that correlation in advanced countries with inde-pendent central banks, and we regard it as our job [to keep a tight rein on inflation]. Of course, it is important to have a responsible fiscal policy, but regardless of what fiscal policy turns out to be in the United States, it’s the Federal Reserve’s job to ensure price stability and we take that as our core respon-sibility and our pledge to achieve that.

Robert Pringle: Thank you very much indeed, Janet. Now I suggest that in this ques-tion and answer session we start with some questions on the broad macro-economic outlook and the panel’s view of the monetary policy aspect of this evening’s discourse. We will then move on to ask questions about regulators, future banking regulations and so forth. If you can divide the questions into those two parts, I think it could be very help-ful to the panellists. And so without further ado, may I ask for the first question.

Norman Chan: Yes, thank you. I just want to comment on the point that Janet just mentioned about maintaining price stability in the US. Clearly this is the core mandate of the Fed, but I think you need to actually consider the threat to financial stability in this part of the world, of which we are more familiar, whether it’s inflation compared to asset bubble. I just want to share a point of observation that in Asia economies, Hong Kong included, we have seen a very massive inflow of funds. This is explainable by the very low global interest rates and is coupled to this huge amount of quantitative easing. I did take a look at the numbers this morn-ing and the Fed’s balance sheet expanded

by US$1.2 trillion, the other central banks by another $800 billion, representing altogether around $2 trillion of quantitative easing injected into the financial system. Of course, those measures were introduced with good reason, but the issue for all of us is the timing of the exit. There are other challenges about fiscal stimulus, whether you should exit, whether it’s sustainable in the medium term . . . but on the monetary side, I think that this is clearly a challenge for Asian economies. Because, with this very significant inflow of funds – it doesn’t matter in Hong Kong where we have no independent industry policy instruments – our hands are tied. Even in Singapore or Malaysia, where they have, in theory, a possible US dollar interest rate, they’re in a dilemma, because if they raise interest rates, they attract even more hot money coming in, betting on an appreciation of their currency against the US dollar, high interest rates and better economic prospects in the asset mar-kets. So the problem with Asia, at least in Hong Kong’s context, is the risk of an asset bubble forming in Hong Kong.

’A lot of money’Now we understand that to maintain low interest rates is necessary within a certain period of time, but the question that one really has to ask is to what extent is quantita-tive easing necessary? If it is necessary, is the amount right, is the dosage right, because $2 trillion is a lot of money. In the banking sys-tem it is high-powered money, it’s M zero, so what does that mean in terms of help-ing US economies and US households to repair their balance sheets, and how long do you allow them to do this? Looking at


it in another way, savers, depositors, all over the world are getting close to zero. In Hong Kong, I’m glad to say, I get 0.01 per cent on my deposits. Elsewhere, it is very low. The banks are now able to lend, even [for] mort-gages, at two or 2.25 per cent, a historic low. So housing has become very affordable and therefore a lot of families would like to think about maybe going into the housing market to buy a property. Indeed, housing has never been so affordable.

Quantitative easing policySo going back to this question of the poten-tial risk of an asset bubble forming, if this is to continue for a long period of time, it is a big challenge for us. And therefore the question that I address to Janet, is: To what extent is this quantitative easing necessary and how do you assess the kind of dosage that is both necessary and needed in terms of helping to achieve your original goals?

Dr Yellen: Well let me comment briefly and I’m sure the other members of the panel will want to comment as well. I would say that even if we had not used a quantitative eas-ing policy and had merely added enough reserves to the banking system to bring the Federal Funds rate down to zero, I believe that the impact of our monetary policy on Asia and on other countries, and on poten-tially provoking asset bubbles, would be the same. To my way of thinking – and you may have a different view – but the fact that we have purchased assets and expanded our balance sheet beyond the minimum level necessary to push the Federal Funds rate and short-term interest rates to zero, hasn’t added significantly to the very real pressures

you face and the forces you are acting on in terms of asset prices here. The reason that we engaged in quantitative easing – actu-ally we don’t use the term ‘quantitative eas-ing’, we prefer to call it ‘credit easing’ – is that we focused our attention particularly on the market for mortgage-backed securities. We thought that the spreads on mortgage-backed securities over long-term treasuries reflected breakdowns in financial markets in terms of causing risk spreads that were unduly high. We didn’t think that merely expanding our balance sheet would have very much effect, so we were trying to sub-stitute our own asset purchases in cases where we thought market functioning had diminished.I think when we tighten monetary policy – which we can do, for example, by raising the rate of interest that we pay on reserves – whether we contract our balance sheet or not, the impact on other countries, on Asia, on capital flows, will be identical. I did say in my prepared remarks that I think one of the things that monetary policy-makers should learn from this crisis is that we need to, at a minimum, monitor developments in asset markets, much more carefully than we did going into this crisis. I am well aware of the concerns you have here and that many Asian economies have, about the capital inflows.

Credit spread narrowsI also agree that low interest rates in the US are triggering capital outflows, but Asia is recovering more quickly than the United States, and it is logical that you would see more impact on your asset prices. We’re closely monitoring US asset prices, and I don’t want to say that I’ve got a wonderful


model that can tell us exactly what is a fair value for the stock market or any other asset price, but the kinds of rough indicators that we do have for valuations suggest to me that the US stock market is not massively over-valued. And when I look at credit spreads, they have narrowed dramatically and that is what we’re trying to accomplish.

But do I see credit spreads resulting in a narrowing so great that it suggests bubble-like conditions in US debt markets? No I don’t see that. I see levels that are typical or slightly higher than one would normally see in a deep recession. But I do think that you need to be aware of this, we all need to be aware, and in addition to monetary policy, we need to be prepared to deploy regulatory tools to address these imbalances.

Robert Pringle: Thank you so much for that very full reply, Janet . . . John?

Sir John Gieve: Just three points in response to Norman and Janet. Firstly, we’ve thrown everything at it because we thought there was a real risk that we were going into not just a recession but a depression. And it’s not been an operation, certainly in the UK, where we’ve known how much is enough. We just did everything we could in order to stop a downward spiral and obviously stopping this downward spiral is pretty important to Asia too, because you need our consumers.

My own view is that we’re coming to the end of adding to any quantitative easing. You will see that there’s been a deceleration in the US and the UK. I don’t know quite when it will come to an end, but I think that we’re coming to an end of that phase. The other point is that one way of responding, and

perhaps the market will respond, to print-ing money in the West and the changing of exchange rates. And of course that is nor-mally what would happen. But this isn’t happening, because that’s a part of your policy obviously here in Hong Kong; it’s also a policy of many countries around here and I think that the bigger pic-ture is . . . yes, it is possible that credit creation in the US will show up in asset price infla-tion at the other end of the world rather than in the US. That means that we’ve got to co-ordinate internationally and, at the moment, we’ve got each country essentially pursuing its own strategy in the light of what’s hap-pening in its own economy.

I’m afraid one lesson we should have learnt over the past few years is that we should be co-ordinating more, albeit at a time when it might be a bit uncomfortable for everyone.

Robert Pringle: Thank you very much. Jochen, do you have anything to add on this point?

Jochen Sanio: I’d feel quite comfortable if you don’t press me on monetary matters, which to me sometimes as a supervisor looks like a random walk, and that’s some-thing that is difficult to cope with. I think one thing that is sure for us is that the law of unintended consequence applies eternally and, as John just pointed out, in these mat-ters I think it’s still the old principle of eve-rybody on their own and then you have to look for the side-effects. You could ask me the question, which is among my half-dozen unanswerable questions. How can we react to this? I’m not an expert in the Hong Kong


market, but what I’ve been told here, within the past two days, to me as a laymen in this environment, it looks as if an asset bubble might be forming, to put it very mildly.

So what then is the supervisor’s answer to this? Of course it seems to be easy – you have to do everything to suppress this – but how do you do so? In my country, in a very liberal market economy, as a supervisor I have no right to substitute the business deci-sions of banks, although if you think they are totally wrong and might end up in a catas-trophe, then it’s very easy to say that we must watch very carefully.

We must play the old, very ancient soccer strategy of always keeping close to the one who wants to strike, which is not a very modern way of playing, but in the end we have to admit that our possibilities are rather limited. And then we must again do a cleanup operation. And that’s my night-mare . . . we’re always doing the cleanup operation!

Robert Pringle: Thank you very much. Let’s have one or two questions from the floor now. Thank you.

Stuart Winchester, RCM: It’s not clear to me how a capitalist system can function effectively with a zero interest rate policy, so I have an open question to the panel mem-bers. How can a capitalist system effectively work? We can look at Japan and see what a disaster Japan has become economically. But you go to Japan and obviously things are fine; but Japan is just not competitive anymore, which has broad implications for everyone. And so I’m just wondering, again addressing my question to the panel members: To what

degree can a capitalist system effectively function in a zero interest rate environment?

Robert Pringle: Who would like to take that one on?

Norman Chan: The answer is difficult. To me it is very difficult. Let’s say inflation is moder-ate and subdued – let’s say one per cent or 1.5 per cent – it’s a very respectable rate. But if interest rates are zero then you have negative real interest rates and therefore savers, who are by nature very prudent people and don’t want to take risks for many reasons such as liquidity, retirement, school fees for their children… They save up and deposit with banks via their short-term instruments and they take very little risk.

Switch to riskBut with zero interest rates, you’re actually punishing them and therefore they are sort of tempted or compelled to go into riskier assets. It could be stocks, it could be futures, it could be property. And therefore the theory goes that if you keep interest rates low, or zero for a long period of time, people would actually go out and switch their savings into riskier assets and therefore you may have a bubble.

So the question I have for Janet is: Maybe you have an asset, because yours is the big-gest economy in the world, so it’s crucial. It’s a question of not whether we have asset bubbles in Asia, it’s a question of the asset price level in the United States, sustained by very low-level interest rates. I would feel a lot happier – and you talk about no exuberance within this and that may well be right – but I would feel a lot more comfortable at the


current price levels (if) interest rates were at two per cent or three per cent for depositors. I don’t have a rigorous model to justify this kind of belief, but my gut feeling is that if you sustain a certain price level in the asset mar-ket and a close-to-zero deposit rate and two per cent lending rate, then I become very sceptical.

Dr Yellen: OK. Let me try to explain what it is that has motivated us to reduce our inter-est rate to zero. It’s exactly the same motiva-tion that Japan had when it became the first country since the Great Depression to find itself in this situation. Japan had such an enormous shortage of demand for the goods and services its economy was capable of pro-ducing that it had huge amounts of unuti-lised resources. That’s what we now have in the United States. We don’t have enough buyers lining up to buy the goods and serv-ices our economy is capable of producing.

Deflation dangerSo if all the workers were to be employed producing goods and services, and if facto-ries were running at normal capacity, utilisa-tion rates, as opposed to roughly the lowest capacity utilisation we’ve seen in the entire post-war period, would result in an enor-mous slack in real interest, and in our real economy. If we had not brought interest rates to exceptionally low levels, then infla-tion arguably might fall and continue to fall with such slack that we would have had deflation like Japan… an intensifying defla-tion that would be in contrast to the current negative real short rate of say1¼-1½ per cent.If we went into deflation we would end up with ever-increasing positive real interest

rates that would further and further dis-courage spending and cause the amount of slack in the economy to grow ever larger. We would then fall into the black hole of defla-tion. So why do we bring short rates to zero when long rates are by no means at zero lev-els? Because it is possible that an economy – in a condition such as ours, still suffering as it is from the housing bubble collapse and a weak financial system – has an equilibrium real interest rate that is actually negative; and for our economy to recover, at least for a time, this is a very abnormal situation. One would never expect in a capitalist economy to have negative real interest rates for a pro-tracted time. But could an economy, in order to recover, require negative real interest rates for a while? Yes, and were we not to lower it to zero, we would risk falling into a defla-tionary spiral.

Robert Pringle: Any more questions from the floor?

Luca Silipo, chief economist, Asia-Pacific, Natixis: I have a question that basically is built upon the former theme of capital movement and international capital movement and I think it is central. What Dr Yellen said about quantitative easing and the fact that even if we adjust assets to bring the Federal Fund target to around zero we would have had asset inflation here. This would have been particularly interesting and the question is a little bit provocative. But if this is the case, isn’t there then too much capital flowing internationally and isn’t there the need to restrain a little bit of this capital, because even if the fundamental power of domestic monetary policy can induce asset


bubbles on the other side of the world, then maybe there is too much. And then it’s not only the fault of the United States. I see these countries in Asia – I’ve been living here for a year-and-a-half now – still terrorised by external debt and I think there is less and less need for such ter-ror. It’s also the fault of these countries which do not sufficiently diversify assets at the dis-posal of international investors. An interna-tional investor which wants to invest usually has one choice and that is the stock market. So this, of course, leads to horrible allocation of savings in this country. So shouldn’t there be some kind of global control over raising capital? And the second question: Should those countries in Asia try to minimise bad allocations of savings by issuing or by giving more opportunities to investors to invest in something that they can control more, such as external debt? Thank you.

Robert Pringle: Thank you for your ques-tion. Many Asian countries have begun to put controls on various currencies and, in the West too, there’s a feeling of needing to ask the question of whether we are going to go back to a kind of earlier stage in banking where you have more credit controls and so forth. This kind of discussion is starting again all over the world. So would anybody on the panel like to respond to this question? No great enthusiasm? John’s going to have a go!

Sir John Gieve: Picking up on Robert’s point about whether or not we’re going to see a return to financial protectionism and capital constraints. The most striking thing about this crisis – which is very different from the 1930s crisis – is that I don’t think there is any

alternative model, and so we’re not going to see a return to general capital controls. There will be lots of changes in banking and the path on which we have been progressing for the past 20 years or so – which has resulted in a much more liberal product in terms of capital financial markets internationally – is leading to greater concentration in financial justice and a greater concentration in terms of manufacturing, resulting in big blows and interdependencies which are going to continue.

Few takers for bondsThat’s another reason why we need rather better international co-operation in dealing with it. On your other point, of whether it would be good if Asian countries should offer more bonds as well as equities, well, actually I think it’s been the policy of many Asian countries to try to promote a bond market. It’s not that they’ve been reluctant, but they haven’t found many takers, partly because so many sovereigns have had huge reserves and haven’t had to raise money and, on the whole, neither have companies. Companies have been able to raise equity so I think the problem, as I see it, is as much demand as it is fear on the part of the authorities.

Robert Pringle: Thank you very much. We’ve only got time for just two more ques-tions, I’m afraid.

Eugene Yip, Morgan Stanley: I have a ques-tion for Norman Chan. It is my understand-ing that interest rates are trending towards the level of growth in the economy, yet because of the US dollar/Hong Kong dollar peg, you cannot raise rates in Hong Kong


to match the level of growth. Clearly Hong Kong’s economy is more tied to China than the US. So if the US dollar/Hong Kong dol-lar peg is fuelling the asset bubble in Hong Kong, how do you justify use of the peg in the current environment?

Norman Chan: I think one has to be very careful. The peg has served Hong Kong very well since 1983. Financial stability is some-thing like your personal health. You don’t really appreciate it until you’ve lost it and therefore I would go back to the question about whether the peg has reached its time of life, whether it’s time to change and move on. Actually, I disagree with the idea. You therefore, from any economist’s point of view, have to look at empirical evidence. Have we fared very badly in terms of inflationary per-formance or so-called asset increases? I have just done a very recent check.

Sharp rise in rents The Hong Kong equity market – if you look at Morgan Stanley Asia, ex Japan and Hong Kong, compared with the Hang Seng Index, it has tracked very closely in the past 12 to 18 months. So our stock market is no more exuberant within its Asian peers, despite this very massive inflow of funds. Our book prices, yes, we have seen a very sharp increase in high rent – but so has Singapore, so has Korea, so has Malaysia to varying degrees.

So one cannot draw the conclusion that because our currency is pegged to the US dollar, that this is fuelling any asset bubble. Therefore I think there’s a potential risk of an asset bubble being formed at the moment, and of course we have other measures to

try to prevent this. For example the HKMA introduced not long ago a tightening of underwriting standards for the high rent of the property market in Hong Kong. We lowered the loan-to-valuation rate for the top end from 70 per cent to 60 per cent. We have also asked banks to be more diligent and vigilant in underwriting mortgage loans. Those measures are having some effect; it seems to be working and we continue to monitor the situation very closely. There will be instruments other than monetary policy tools to help us mitigate the risk of another bubble forming.

So I think, to answer your question, that it is highly justified for us to continue to maintain the linkage system.

Robert Pringle: Thank you. One final ques-tion please.

Philip Goeth, Deloitte: Thank you for this highly interesting evening. My ques-tion is: If you look at the trading desks, there is an old saying that some of us may know. I think it comes from the Las Vegas poker tables really … If you’re in trouble, double. And my question is, Sir John said something very extraordinary – he said that we’ve thrown everything at it. So my ques-tion to the Federal Reserve really is what if this doesn’t work? What is your Plan B for this leverage?

Dr Yellen: Well, you know, I think we have thrown everything we can at it. In the dark-est days of the crisis, just a little bit more than a year ago, I think the Federal Reserve was very inventive in terms of devising a whole range of tools that would restore liquidity to


markets and stabilise the financial system, and we’ve been very effective in this. Part of the reason that markets have recovered and the US economy is recover-ing is because of the extraordinary array of policies that, not just the Fed, but also gov-ernments – and not just in the United States but around the world – have thrown at the problem to avoid a repeat of the Great Depression. I do believe that we’ve used the tools that we have at our disposal. We are beginning to pull back on some of the liquidity facilities and to phase them out. You might think of that as the initial phases of an exit strategy.

Timely phase-outIndeed, many of the facilities we put in place were designed to be phased out and to become less attractive for market partici-pants to use, as markets began to heal. And as markets are beginning to heal, the usage of these facilities is declining, so we will phase them out over time as they become unnecessary. We have announced what the overall size of our so-called quantitative or credit easing programmes will be – that we will complete $1.25 trillion worth of pur-chases of mortgage-backed securities at our agency, as well as debt purchases.

We have no current plans to push those programmes further, so you might think of that as we’re continuing to make those pur-chases up to pre-announced limits. We’re not going to push them further. I do believe we’ll be successful in restoring economic growth and in gradually getting the US economy moving again.

If I could think of policies that would be effective to put in place that would bring

down the unemployment rate more rapidly than I anticipate it is going to be declining in the United States, if I knew how to do that, if the Fed could do it, I would certainly be inclined to consider further policy. But I really think that we’ve used the tools that we have, and so we don’t really have, in that sense, a Plan B. I think that what we’ve put in place is going to work and I’m very hopeful that we’re not going to need a Plan B.

Sir John Gieve: There wasn’t a Plan B, so it’s lucky that Plan A worked! But that was a reaction to a loss of confidence in the finan-cial markets particularly, which was certainly the first time in my lifetime, and I think that we’ve stopped a spiral into depression and we’ve restored some confidence in financial markets. The real problem, though, is in a short-term set of measures and the fact that there remain some big structural problems in our economies, which again will take time, in fact years to work through. And the restora-tion of household balance sheets and bank balance sheets is going to take years. But in all honesty, I don’t know that there was any-thing else to do a year ago when it was done, so it was lucky it worked!

Robert Pringle: Any other comments? Well, it forces me then to wrap up these proceedings. I would like on behalf of us all here at this gathering to thank the members of the panel, especially Dr Janet Yellen, for giving such very full answers to our ques-tions, and the other members, Sir John Gieve, Jochen Sanio, Norman Chan. Thank you for the honour of coming and participat-ing with us today. •


Book overview

13 Bankers: Wall Street’s coup d’état and next financial crisis

James Kwak & Simon Johnson present a brief summation of their highly acclaimed

critical study of Wall Street and DC.

What caused the french revolution? People have been arguing that ques-tion for centuries. since 1789, believers in the march of freedom and progress have seen the revolution as a victory of the principles of enlightenment over the superstition of the “ancien régime”.

Yet one precipitating cause of the revolts of 1789 was high grain prices caused by the poor harvests of the preceding year. Alexis de Tocqueville saw the Revolution as a col-lision between the rising aspirations of the middle class and the rigidity of the existing political structure. Karl Marx saw the over-throw of the aristocracy by the bourgeoisie, an ineluctable historical process driven by changes in the mode of production. The debate continues to this day, with each gen-eration giving its own answer to the ques-tion and interpretation of issues.

Major historical events are almost always over-determined. They are caused and shaped by multiple forces, many of which may be necessary for the event, but none of which is alone sufficient. The recent financial crisis is no exception. Today, the acute panic

of 2008-2009 has subsided; people no longer fear the imminent collapse of the global financial system as a whole.

Although the world economy still faces serious threats, we have moved from responding to the financial crisis to arguing about it. And this is not merely an academic discussion; each explanation of the crisis implies different policy lessons, and so the continuing debate over the crisis is inher-ently political.

Apportioning blame Several early books about the crisis focused on the key figures involved and the actions they took in the heady days of 2008; these narratives reflect the view that the decisions of key people are sufficient to explain what happened. However, many other explana-tions have been advanced. Some people blame the financial crisis on ‘global imbal-ances’ (code for China); on this theory, Chinese over-saving forced the United States to accept a flood of cheap money, which necessarily created a bubble.

The implication is that we need to pres-sure China to let its currency appreciate. A


few blame excessive government interfer-ence in markets, arguing that the housing bubble was caused by government-sub-sidised home ownership; they would like to see a smaller government role in the economy.

Much has been made of Wall Street’s recent innovations, which created the secu-rities and derivatives that were at the heart of the crisis; this explanation implies a need for greater government regulation. Some have noted that human beings have a pro-pensity for speculative bubbles and therefore perhaps there is nothing we can do to avoid them.

In 13 Bankers, myself and Simon Johnson focus instead on politics. We think that much of the recent financial innova-tion has been destructive; that lenders used exotic mortgage products to take advan-tage of homebuyers; that Wall Street bank-ers took advantage of their customers; that flawed compensation structures led banks to take on too much risk and, in short, that the US financial system became a dysfunc-tional, bloated, exploitative cancer on the American economy. We are no friends of Wall Street.

Greed like gravityYet we believe that in the analysis of causes and solutions, it is not enough to simply blame Wall Street. Greed is like gravity: it is always present, and you need account for it in your calculations. In the United States, the entity responsible for protecting the public interest is the government.

Failure to prevent the financial crisis – or the many problems that led up to it – was a failure of regulatory agencies, administration

officials, and Congress. This does not imply that we need less government, it implies that we need government to step up to its responsibility to protect the public interest.

Question of questionsBut the question remains: why did the gov-ernment fail us? The answer, we argue, is that the federal government came to see its interests as being aligned with those of the financial sector. The financial sector, or the megabanks at its pinnacle, became a new American oligarchy – in accordance with Aristotle’s view – a ruling economic elite.

In the United States over the past two decades, the titans of Wall Street did not themselves call the shots in Washington, but they had something that was, in many ways, even better – they convinced Washington policymakers that what was good for Wall Street was good for America.

They did this in part through lavish campaign contributions, but even more so through the revolving door, in which Wall Street veterans stepped into important government positions, and former regula-tors and officials became successful bank-ers. Finally, American culture (unwittingly) created a cult of the smart, hard-working, rich investment banker, beginning with Liar’s Poker, the first Wall Street movie, and Barbarians at the Gate.

By the first decade of this century, invest-ment banking was the career of choice for many top graduates of America’s leading schools, and up and down the East Coast it was nearly universally accepted that finance was not only good for financiers, but for society as a whole. This was the secret of Wall Street’s success; the banks disarmed


the government not through corruption, but through persuasion. Seduced by high finance, policymakers and regulators gave free rein to the creative imaginations of the bankers, setting the stage for both the bub-ble of the 2000s and the crash, the conse-quences of which we are still living through.So what is the solution?

If the cause of the crisis is essentially political, then the solution must also be a political one.

A return to anti-trust regulation A century ago, President Theodore Roosevelt launched the ‘trust-busting’ campaign that eventually brought down Standard Oil, the most dominant monopoly in the country at that time. In the process, he changed the conventional wisdom about economic con-centration, to the point where no one any

longer argues that monopolies are good for society or for the economy.

The solution to a concentrated financial oligarchy is to take the same trust-busting approach to the large banks that currently dominate our financial system. There has been much talk of the problem that certain banks are ‘‘too big to fail’’. We believe they should be broken up until they are no longer too big to fail.

This will require shifting the conventional wisdom away from the idea that finance is always good and that bigger is always better. This will take political leadership. Whether President Obama will rise to this challenge remains an open question. •

Editor’s noteInformation on purchasing 13 Bankers is at: www.13bankers.com

Hong Kong: +852 9144 5549email: [email protected]

Australia: +61 (41) 271 8715email: [email protected]

South Africa: +27 (82) 449 6333email: [email protected]

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Opinion

Wall Street and Congress hope you’re gullible: disappoint them

Tavakoli Structured Finance’s CEO Janet Tavakoli vents her spleen as bankers get

bonuses and the US gets the Great Recession.

if a driver, high on crack cocaine, crashed his speeding rental car into your house and killed your spouse, you would be outraged if law enforcers took bribes and gave the driver a pass on a blood test. if a judge merely fined the killer and then ordered you to pay the fine, you would appeal, wondering what had happened to justice. if the government then handed the same driver the keys to a bigger rental car and presented you with the bill, you would certainly protest.

How is it, then, that you have remained largely silent in the face of the same sort of behaviour by Wall Street and Washington? Bonus-seeking bankers careered off the right path and ran Ponzi schemes that nearly ruined our economy. Bureaucrats and elected officials bailed them out without demanding consequences. And bankers are revving up their engines again.

Taxpayers are asked to believe that over-borrowing by US consumers created a global financial crisis; this myth aids and abets Wall Street. The economy was nearly destroyed because banks borrowed massively, and

they borrowed many multiples more than they could afford. Wall Street pumped the Fed’s cheap money through financial ‘meth labs’ and deceptive financial vehicles ran over securities laws at top speed.

More than 20 per cent of mortgage loans – including what were originally considered to be sound loans – are underwater, meaning that the borrower owes more than the home is worth. Official unemployment numbers hover at around 10 per cent. If you include underemployment, this figure escalates to a whopping 18 per cent.

Destitute groupIn depressed areas where the nation’s poor-est reside (chiefly from minority groups); people have been hurt the most. In these areas, unemployment has soared past 30 per cent. For this largely destitute group, unem-ployment combined with underemploy-ment exceeds 50 per cent.

As US soldiers fought wars in Iraq and Afghanistan, Wall Street flattened Main Street. Our foreign wars drag on, while the US continues to battle a crippling recession back home.


Fraud by borrowers, fraud on borrowers and speculation by people who thought home prices would rise forever have all contributed to tarnish the mortgage lending industry. Yet this pales compared to the epidemic of predatory lending.

Predatory snipers committed financial murder as deliberately as British soldiers sold blankets contaminated by smallpox to Native Americans. Honest homeowners were systematically targeted and actively misled into bad mortgage products. Loans were presented as gifts, but these Trojan horse loans hid destructive risk. ‘Disclosures’ were seen as acts of malice.

When Wall Street packaged these loans and sold deceptive ‘investments’’, documents did not specifically disclose that the associ-ated credit ratings were misleading. If you know or should know that a car’s gas tank will blow up, you cannot use a misleading third-party consumer report as an excuse. Yet bonus-seeking bankers used this sort of excuse to get through a few more highly-paid bonus cycles before it all fell apart. Only the elite crowd of insiders prospered.*

Global Ponzi schemeThis was the most massive Ponzi scheme in the history of the global capital markets. US taxpayers became unwilling unsophisticated investors as we bailed out the financial sys-tem. We must hold Wall Street accountable for this fraud.

Banks that contributed to our economic distress are now heralded as geniuses inso-far as risk management is concerned… that is, after taxpayers saved them from ruin. Wall Street has so far escaped prosecution, and Congress gave it a faster and more powerful

car. Paul Volcker suggested reforms, and special interest groups lobbied successfully to make the same reforms essentially mean-ingless. His proposal to limit ‘proprietary’ trading – a small step in the right direction – has been thwarted by banks claiming that they engage in high risk trades on behalf of customers.

Washington seems to have already for-gotten that AIG came close to bankruptcy and nearly took the entire financial system down with it – because of Wall Street’s ‘cus-tomer’ trades. Both AIG insiders and Wall Street grew rich on bonuses based on a myth and taxpayers funded AIG’s US$180 billion bailout.

Bonus billions ‘myth’Wall Street now makes most of its ‘profits’ from high-risk trading, and rewards risk with huge bonuses. It has unfettered access to more of US taxpayers’ money than that of the combined history of the United States. Traditional banking suffers; it cannot gen-erate enough revenue to ‘justify’ massive bonuses. Bankers get billions in bonuses based on a myth and US taxpayers face a deeper recession and yet more risk.

Congress has protected Wall Street and passed on the costs to hard-working taxpayers. ‘Too-big-to-fail’ financial institu-tions are those that are too big to exist and it is past time to break them up. They cur-rently enjoy around $13 trillion of taxpayer-funded support, including tens of billions of Federal Deposit Insurance Corporation (FDIC) debt guarantees aimed at each of the too-big-to-fail banks and more than $2 trillion in nearly zero-cost funding from the Fed. President Obama has yet to condemn


Wall Street’s massive fraud, and Congress’ bailout methods have simply rewarded Wall Street’s malicious mischief. The House just passed a bigger bailout bill that will give the so- called too-big-to-fail Wall Street banks access to $4 trillion dollars the next time they trigger a crash in the economy.

Congress must start again from scratch, and give us real reform. Washington needs to get back in the driver’s seat, and voters need to make Congress steer straight this time by calling and writing to representatives and senators. •

Editor’s note Janet Tavakoli is the founder and President of Tavakoli Structured Finance, a Chicago-based firm that provides consulting services

to financial institutions and institutional investors. Ms Tavakoli has more than 20 years’ experience in senior investment bank-ing positions, trading, structuring and mar-keting structured financial products. She is a former adjunct associate professor of deriva-tives at the University of Chicago’s Graduate School of Business. A prolific author and media pundit, Ms Tavakoli wrote: Credit Derivatives & Synthetic Structures (1998, 2001); Collateralised Debt Obligations and Structured Finance (2003); Structured Finance & Collateralised Debt Obligations (John Wiley & Sons, September 2008). Her book on the causes of the global financial meltdown and how to fix it is titled: Dear Mr Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).


Reprints AvailableArticles & Papers

Issues in resolving systemically important financial institutions Dr Eric S. Rosengren

Resecuritisation in banking: major challenges ahead

Dr Fang Du

A framework for funding liquidity in times of financial crisis Dr Ulrich Bindseil

Housing, monetary and fiscal policies: from bad to worst Stephan Schoess,

Derivatives: from disaster to re-regulation

Professor Lynn A. Stout

Black swans, market crises and risk: the human perspective Joseph Rizzi

Measuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull

Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian Fahrholz

The ‘family’ risk: a cause for concern among Asian investors David Smith

Global financial change impacts compliance and risk

David Dekker

The scramble is on to tackle bribery and corruption Penelope Tham & Gerald Li

Who exactly is subject to the Foreign Corrupt Practices Act? Tham Yuet-Ming

Financial markets remuneration reform: one step forward Umesh Kumar & Kevin Marr

Of ‘Black Swans’, stress tests & optimised risk management David Samuels

Challenging the value of enterprise risk management Tim Pagett & Ranjit Jaswal

Rocky road ahead for global accountancy convergence Dr Philip Goeth

The Asian regulatory Rubik’s Cube

Alan Ewins and Angus Ross


Volume I, Issue III, Autumn Winter 2009-2010

ContactChristopher RogersGeneral Secretary

[email protected]


Opinion

A failure of credibility undermines future of the WTO

George Washington University academic Susan Ariel Aaronson calls on the global

trade body to bare its teeth to China.

is the Wto doomed? this column argues that the World trade organisation’s cred-ibility is waning and that to get it back it needs to rein in China’s erratic govern-ance. Beijing’s failure to enforce trade laws threatens the concept of mutual benefit that underpins the Wto. China is broken, and a broken China could break the Wto.

The year 2010 could be a daunting one for the WTO. Many observers believe it is con-demned to irrelevance if it does not find common ground among its 153 member states on the Doha Round – now in its 10th year. Many of these same countries bypass the WTO as they seek to expand trade. As an example, WTO members completed some 25 new preferential trade agreements in 2009, bringing the total of such bilateral or regional agreements to 186.

But the WTO’s most difficult challenge may be to discipline trade relations among China and other WTO member states. China today is now the world’s third-largest trading nation, the world’s largest recipient of invest-ment, the world’s fastest growing consumer

market, and the world’s leading provider of manufactured goods. China’s regulatory and trade practices can move global markets.

There is no doubt China’s growth has led to global growth. Chinese demand for raw goods and materials have created jobs. The World Bank notes that the efficiency and scale of China’s manufacturing has pushed down the price of many manufactured products relative to other goods and services (Commission on Growth 2009). Investors, consumers, and taxpayers have benefited from these developments.

Inadequate governanceBut China’s competitive advantage is to some degree based on its inadequate governance; its failure to enforce its own laws in a trans-parent, even-handed manner. As part of its accession to the WTO, however, China was required to enforce the rule of law through-out all of its territories. China’s political econ-omy has two key attributes: authoritarian governance and inadequate governance. At the national level, the Communist Party sets the rules, yet it is sometimes willing to ignore its international commitments in order to


maintain power. In addition, the Communist Party owns and operates or is tied to private enterprises in key sectors such as transport, energy and banking. Some have described the government as both a market competi-tor and referee.

China’s inadequate governance at the provincial level also reflects many factors including corruption, a lack of uniformity among rules, and arbitrary abuse of power. Local officials often have financial stakes in the same companies they are supposed to regulate.

Missing: the rule of lawThese officials sometimes ignore or circum-vent governmental mandates from Beijing. Finally, China has a culture of non-compli-ance, where bad actors set the norm, where laws and regulations are often ignored or unevenly enforced, and where many citizens and market actors don’t know or can’t obtain their rights under the law.

Inadequate Chinese governance is a trade problem because of the country’s dominance in global markets. Its failure to enforce the rule of law threatens the concept of mutual benefit that underpins the trade regime. China is broken, and a broken China could break the WTO.

On one hand, China’s leaders have tried very hard to comply with its WTO obliga-tions. China has changed many of its laws and met most of its market access commit-ments. On the other hand, it has yet to meet many of the obligations delineated in its pro-tocol of accession. European and American business groups investing in China believe that the country is becoming more interven-tionist and protectionist (European Business

in China 2009 and US China Business Council 2009).

WTO members deliberated a long time before they let China join the WTO. And they used the accession to hold China on a tight leash. The 2001 Protocol on the Accession of the People’s Republic of China (WTO 2001) explicitly calls on China to:

“apply and administer in a uniform, impartial and reasonable manner all its laws, regulations and other measures of the central government as well as local regulations, rules and other measures … pertaining to or affect-ing trade … China shall establish a mechanism under which individuals and enterprises can bring to the attention of the national authorities cases of non-uniform application.”

It also calls on China to ensure that:“those laws, regulations and other meas-

ures pertaining to and affecting trade shall be enforced.”

The rule of law was a key element of China’s accession agreement because trade policy-makers understood that how China was governed could distort trade.

Key trade issuesIn recent years, China has become infa-mous for its failure to enforce its own laws, whether those laws related to intellectual property, product or food safety, human rights, or employment.

In both its 2006 and 2008 Trade Policy Review at the WTO, member states lauded Chinese trade diplomats for their export prowess but also complained that China was not transparent, accountable, or sufficiently even-handed (WTO 2006, 2008). Nor could they trust Chinese statistics or assertions on enforcement related to key trade issues such


as product and food safety or intellectual property protection. Meanwhile, Chinese leaders argued that they are a developing country and thus deserve patience as they learn to govern effectively.

What can the WTO do?WTO members have the ability to encour-age China to address its inadequate govern-ance. They could begin by using the trade policy process more effectively to discuss the rule of law and how it distorts trade. And they could threaten a trade dispute on some aspect of inadequate governance. Under GATT Article XXIII, any country in the WTO is entitled to a “right of redress” for changes in domestic policy that systematically erode market access commitments even if no explicit GATT rule has been violated.

Such a “non-violation” complaint entitles the aggrieved party either to compensa-tion in the form of other tariff concessions to “rebalance” market access commitments or the complaining partner may withdraw equivalent concessions of its own.

Legal scholar Joost Pauwelyn, says: “In non-violation cases a WTO panel could, indeed, be called upon to refer to non-WTO rules . . . in its assessment of whether certain governmental measures, though not in violation of WTO rules, have affected the ‘legitimate expectations’ that could have been derived from a trade concession” (Pauwelyn 2003).

Hard to proveA trade dispute may not succeed because it would be hard to prove that market access was undermined by China’s failure to enforce its own laws and international

standards. But a multilateral approach would bring the issue to global attention and could move China to do a better job of educating managers, policy-makers, and workers on the importance of the rule of law.

China’s membership in the WTO has no doubt provided benefits for the people of the world. But China is exporting its inadequate governance. At the WTO, member states can work collectively to encourage China to change its behaviour. And in so doing, they may bolster the WTO. •

Editor’s note The publishers would like to thank VoxEU – www.voxeu.org – and Associate Professor Susan Ariel Aaronson for kindly allowing the Journal to reproduce this article in its entirety.

ReferencesCommission on Growth (2009), “The Growth Report: Strategies for Sustained Growth and Inclu-sive Development,” 93-94.European Business in China (2009), “Position Paper 2009-2010,” Executive Summary; USTR, National Trade Estimates Report.Pauwelyn, Joost (2003), Conflict of Norms in Public International Law: How WTO Law Relates to Other Rules of International Law, New York: Cambridge University Press, 456.US China Business Council (2009), “US Companies China Outlook,” Member Priorities Survey Results 9-13.WTO (2001), “Accession of the People’s Republic of China, Decision of 10 November 2001,” November.WTO (2006), Trade Policy Review China, Minutes of the meeting, April 19 and 21.WTO (2008), Trade Policy Review China, Minutes of Meeting, May 21 and 23.


Debate

Origins of the subprime crisis and regulatory imperatives

Columbia’s Prof Charles Calomiris blames lax Fed policies and government initiatives

for the 2008 financial implosion.

finanCial crises not only impose short-term economic costs, they also create enormous regulatory risks. the financial crisis that has been gripping the global economy for the past two years is already inspiring voluminous proposals for regulatory reform coming from all quarters. Previous financial crises – most obviously the great Depression – have usually brought in their wake significant financial regulatory changes.

Some crises breed sensible reforms. For example, in the United Kingdom, policy reforms in the 1850s and 1860s that changed the rules governing Bank of England assist-ance to distressed banks (effectively ending the bailout of banks during crises) had enor-mous consequences for incentives toward risk-taking, which stabilised the financial system dramatically; Britain had experienced severe banking panics in 1825, 1836, 1847, 1857, and 1866, but (with the exception of the upheaval in 1914 as the world prepared for World War I) none for more than a cen-tury afterward (Calomiris 2009a).

The Great Depression, in contrast, gave

rise to a raft of changes in bank regulations, most of which were subsequently discred-ited by economists and economic histori-ans as counterproductive and destabilising (Calomiris 2000). Since the 1980s, the US has been removing many of the regulatory missteps that arose out of the financial col-lapse of the Great Depression, by allowing banks to pay market interest rates on depos-its, operate across state lines, and offer a wide range of financial services and products to their customers (which has diversified banks’ sources of income and improved the efficiency of bank services to clients).

Permanent policies It is worth remembering how long it took for unwise regulatory actions taken in the wake of the Depression to be reversed. Indeed, some regulatory policies introduced during the Depression – most obviously, deposit insurance – will likely never be reversed, despite the fact that financial economists and economic historians regard the adverse incentive consequences of deposit insurance (and other safety net policies) as the pri-mary source of the unprecedented financial


instability that has arisen worldwide over the past 30 years (Barth, Caprio and Levine 2006, Demirguc-Kunt, Kane, and Laeven 2009).

A major lesson of the regulatory response to the Great Depression (and many other post-crisis policy reactions), therefore, is that unwise policy reactions to crises can have very long lives and very large social costs.

Bad thinking, ulterior motivesUnwise reactions to crises have two sources: bad thinking about the sources of crises, and ulterior (politically captured) motives of “reformers” (which, to some extent, thrive because of a lack of general understanding of the true causes of crises). It is important, therefore, in the interest of shaping desirable reform, to get our story straight about what happened to cause the recent crisis.

In my discussion, I will focus on the United States for the simple reason that the US was the place where the earliest, larg-est and most persistent shocks originated, namely the problems in the intermediation of subprime mortgage risk. That is not to say that the US was unique in its high-risk, high-leverage binge from 2002 to 2007; many other countries (including, for example, the UK, Iceland, Spain, Ireland and Hungary) have also suffered from their over-exposure to risk during that period. However, I would argue that without the US’s uniquely large subprime shock, the global financial cri-sis and its severe macroeconomic conse-quences for the world would have been mild and short.

Why the focus on subprime shocks? After all, US and global banks ultimately face losses on virtually all kinds of loans. While that is true, the losses on other categories

of assets were smaller and came later in the cycle (because they reflect the endogenous economic consequences of the shocks that originated in subprime, as for example, the losses in credit card lending).

In other words, this was not just a world-wide asset price bubble, or a US asset price bubble; it was first and foremost (although not exclusively) a US subprime credit-driven housing bubble. That particularity requires an explanation.

Furthermore, everyone was not equally exposed to subprime losses (or to losses more generally), and any attempt to come to grips with the causes of the subprime crisis that does not explain this cross-sectional varia-tion is incomplete. JP Morgan Chase, Bank of America, Deutsche Bank, Goldman Sachs, Morgan Stanley, Barclays, and Credit Suisse had relatively small exposures to subprime; indeed some of these institutions benefited in some ways from the crisis, either because they were able to buy competitors at low cost (e.g. JP Morgan’s acquisition of Bear Stearns), or because their competitors disappeared.

Utter disasterIn contrast, for the financial firms with large subprime exposures – Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, Merrill Lynch, Citibank, and UBS – the cri-sis was an utter disaster that forced them either [1] to be placed in bankruptcy or conservatorship (Fannie Mae, Freddie Mac, and Lehman Brothers), [2] to be acquired by private firms (Bear Stearns, Merrill Lynch), or [3] to receive heavy assistance from govern-ments to survive as independent firms (AIG, Citibank, and UBS). The stories about the origins of the subprime


shock that are being told are not all the same, and some popular stories do not withstand scrutiny. For example, some critics point to allegedly obvious incentive problems inher-ent in the “originate and distribute model” that led to the failure of securitisation as an intermediation strategy technology.

Credit card alternativeThe problem, we are told, is that securitisa-tion permits sponsors to have too little skin in the game. But two facts belie that view. First, sponsors actually retained large amounts of the subprime debts that they issued (and have the losses to show for it). Second, secu-ritisation, per se, did not fail. Credit card secu-ritisation, an alternative product to subprime mortgage backed securities (MBS) for con-sumer-finance based securitised debts, has operated reasonably well for three decades. It maintained fairly normal deal flow until September 2008, when all financial trans-actions shrank dramatically, and in recent months it has recovered along with other financial flows.

Others point to rating agencies as the culprits for the crisis. But here again, there was not uniformity in behaviour. For over a decade, research has noted that ratings of securitised debts tend to be inflated relative to corporate debts, so there is evidence of a general inflation of ratings for securitised products. But during the financial crisis, the severe errors in rating methodology that produced grossly overstated ratings were specific to subprime-related securities.

When searching for explanations for these and other facts about the origins of the US subprime crisis, something else should be kept in mind. This was a banking crisis, not

just a wide-ranging financial crisis. The his-tory of banking crises – that is, financial col-lapses in which banks are severely exposed to loss – provides helpful guidance of where to look for explanations. Macroeconomic factors, including monetary policy laxity, are generally associated with financial booms and busts, but they don’t explain banking crises; when one looks specifically at banking crises, these macroeconomic circumstances are not sufficient conditions to produce a banking crisis. Banking crises typically result from severe microeconomic distortions, often relating to government subsidisation of risk (Calomiris 2009a).

In summary, when coming to grips with the origins of the current global financial crisis, one should: [1] place this banking cri-sis in the broader context of the history of banking crises, which suggests an emphasis on microeconomic distortions in incentives toward risk; [2] explain the particular origins of subprime related risk-taking in the US and its timing; [3] explain why some, but not all, large financial firms had taken on large subprime risks; and [4] explain the break-down in the ratings process for subprime related securitised debts, but not other debts.

Predictable error, or bad luck?The default risk on subprime mortgages was substantially underestimated in the market during the subprime boom of 2003-2007 (Calomiris 2009b). One starting point for explaining the origins of the subprime crisis is to ask whether the large losses and huge underestimation of risk that occurred in the pricing of subprime-related securities was the result of identifiable and predictable errors or, alternatively, just bad luck. Recent


academic studies describe in detail the faulty assumptions that underlay the mas-sive securitisation of subprime mortgages and related collateralised debt obligations (CDOs).1 It can be difficult to establish the ex ante unreasonableness of any assumptions. Nevertheless, in the case of subprime securi-tisations, it is not so difficult.

Facts ignoredSome facts known to everyone in advance of the subprime collapse were simply put aside in the modelling of risk. In retrospect, the two most important errors of subprime risk modelling were: [1] the assumption that house prices would

not fall (an especially important assump-tion, given that subprime MBS was much more sensitive to house price assumptions than normal MBS, as dis-cussed further later), and

[2] the assumption that ignoring “soft” infor-mation and allowing lending through “no-docs” or “low-docs” mortgages based entirely on Fair Isaac Corporation (FICO) credit scores would not result in significant adverse selection in the pool of no-docs and low-docs mortgages. In other words, the models wrongly

assumed that a mortgage with a 600 FICO score and with proper documentation of employment was roughly as good as a mortgage with a 600 FICO score with no documentation.

According to recent research by Rajan, Seru and Vig (2008) each of those two mod-elling errors was of roughly equal impor-tance in production of the massive shortfalls of performance in subprime mortgage port-folios. Without those assumptions there

would have been no subprime debt crisis. And yet, those assumptions were obviously unreasonable on an ex ante, not just ex post, basis during the subprime boom, as they contradicted both logic and experience.

What was the basis for assuming that house prices would never fall? Subprime was a relatively new product which grew from humble beginnings in the early 1990s and remained small even as recently as 2003, after which it took off, roughly tripling in 2004 and peaking in 2006 and early 2007.

Subprime risk models based their stress tests, including their house price stress tests, on a short period of “lookback.” For some variables in the models (say, interest rates) that may have been a reasonable practice, given the short track record of the product, but it was not reasonable to base projections of the possible paths of housing prices on a 10-year retrospective history of house price change.

Reasonable assumptionDoing so meant that modellers relied on the experience of housing prices as demon-strated during the 2001 recession to gauge the potential downside for the housing mar-ket – this was the only recession in their lim-ited sample. It was also a unique recession from the standpoint of the housing cycle – the only recession in US history in which housing price growth was sharply positive.

Other prior recessions show a very dif-ferent pattern. Would it not have been more reasonable to assume in 2003-2007 that the next recession might see a flattening or a decline in housing prices, which was the rule rather than the exception?

Indeed, some risk managers were


worried that the US was overdue for a housing price decline, partly because of the extremely positive performance of the 1990s and early 2000s. David Andrukonis, a risk manager at Freddie Mac, recognised in his April 5, 2004 letter to a superior that the reli-ance of underwriters on house price appre-ciation to “bail out” subprime lenders was

based on a false extrapolation of the past into the future: “We are less likely to get the house price appreciation we’ve had in the past l0 years to bail this programme out if there’s a hole in it.”2

By “this programme” he was refer-ring to the proposed entry of Freddie Mac into no-docs lending on a large scale. The

Figure 2. Federal Funds Rate and Inflation Targets

Figure 1. Real Federal Funds Rate


assumption that no-docs mortgages would have the same risk as well-documented mortgages with similar FICO scores defied economic logic and the experience of the mortgage market with no-docs products in the 1980s, and Mr Andrukonis weighed in to discourage his superiors from entering this product area in 2004.

No-docs, low-docs mortgagesHe reminded them that “in 1990 we called this product ‘dangerous’ and eliminated it from the marketplace.” No one listened. The growth in subprime originations from 2004 to 2007 was meteoric, and was accompanied by a significant deterioration in borrower quality due to the growth in no-docs and low-docs mortgages. The heavy weight of no-docs mortgages in subprime portfolios after 2004 largely reflected the decisions of Fannie Mae and Freddie Mac (the 800-pound gorillas in the mortgage market) to enter massively into purchases of no-docs subprime MBS in mid-2004, over the strong objections of their risk managers who pointed to large adverse-selection consequences from doing so, and those objections were specifically based on the experience they had with no-docs mort-gages in the 1980s.

Not only did lenders know better from their own experience, but using simple eco-nomic theory, the consequences of no-docs lending were predictable. If a mortgage lender hangs out a shingle saying that he will ask no questions but the FICO score, then he will attract (“adversely select”) peo-ple who know that their FICO scores are about to deteriorate. The three primary rea-sons for consumer defaults are the loss of a job, a severe health problem, and divorce. All

of those three events are generally known to the borrowers long before their conse-quences show up in the FICO score; only by doing proper due diligence can a lender detect these problems before they show up in the FICO score. Banks that do not perform such due diligence will predictably “adversely select” lower quality borrowers.

Even more remarkably, subprime and Alt-A originations for late 2006 and early 2007 continued at peak levels despite mounting evidence beginning in mid-2006 that hous-ing prices were flattening (which had predict-ably disastrous consequences for subprime portfolios), and evidence of unprecedented performance problems beginning to occur in existing portfolios, which were discussed openly by the ratings agencies.

Flight from subprime Josef Ackerman, the CEO of Deutsche Bank, in a speech given at the European Central Bank in December 2008, said that Deutsche Bank fled the subprime market in mid-2006 in reaction to these obvious signals of poten-tial problems. Professor Gary Gorton of Yale, in his oral comments at the August 2008 Kansas City Federal Reserve Bank’s Jackson Hole Conference described the continuing high-volume of originations in 2006 and 2007 by Merrill, UBS, and Citibank in light of the obvious problems brewing in the hous-ing market as “shocking.”

As Gorton (2008) emphasises, the core assumption on which subprime lending had been based was the permanent apprecia-tion of home prices. By the middle of 2006, that assumption was being disproved, and no one – least of all the rating agencies – seemed to care.


The rating agencies did notice the prob-lem; they just did not react to it. According to Fitch’s (2006) extremely negative discussion of subprime prospects in December 2006, the environment became increasingly nega-tive after the first quarter of 2006, as reflected in the fact that “the number of sub-prime downgrades in the period between July and October 2006 was the greatest of any four-month period in Fitch’s history for that sec-tor” (up to that point).

Fitch correctly predicted that “the sensi-tivity of sub-prime performance to the rate of HPA [home price appreciation] and the large number of borrowers facing scheduled payment increases in 2007 should continue to put negative pressure on the sector. Fitch expects delinquencies to rise by at least an additional 50 per cent from current levels throughout the next year and for the general ratings environment to be negative, as the number of downgrades is expected to out-number the number of upgrades.”

Feverish paceNevertheless, in the midst of all this negative news, the originations continued at a fever-ish pace, and not until the middle of 2007 did these serious problems become reflected in any significant (albeit still inadequate) changes in modelling assumptions by the ratings agencies.

The predictable risk-taking mistakes of financial managers were not the result of random mass insanity; rather, they reflected a policy environment that strongly encour-aged financial managers to underestimate risk in the subprime mortgage market. Risk taking was driven by government policies. Four categories of government error were

instrumental in producing the crisis: First, lax Fed monetary policy, especially from 2002 through 2005, promoted easy credit and kept interest rates very low for a protracted period. As I have already noted, the history of banking crises teaches us that, while mon-etary policy laxity by itself is not a sufficient condition for generating a banking crisis, it is frequently a contributor to aggravating bad decision making by empowering bad deci-sion makers with easy credit (Bordo 2009, Calomiris 2009b).

Sharp deviation As Figure 1 shows, the history of post-war monetary policy has seen only two episodes in which the real Fed funds rate remained negative for several consecutive years; those periods are the high-inflation episode of 1975-1978 (which was reversed by the anti-inflation rate hikes of 1979-1982) and the accommodative policy environment of 2002-2005.

As Figure 2 shows, the Federal Reserve deviated sharply from its “Taylor Rule” approach to setting interest rates during the 2002-2005 period; Fed funds rates remained substantially and persistently below the lev-els that would have been consistent with the Taylor Rule.

Not only were short-term real rates held at persistent historic lows, but because of peculiarities in the bond market related to global imbalances and Asian demands for medium- and long-term US Treasuries, the Treasury yield curve was virtually flat during the 2002-2005 period, implying extremely low interest rates across the yield curve. Accommodative monetary policy and a flat yield curve meant that credit was excessively


available to support expansion in the hous-ing market at abnormally low interest rates, which encouraged overpricing of houses.

Political pressuresSecond, numerous government policies spe-cifically promoted or subsidised subprime mortgage-related risk taking by financial institutions (Calomiris 2009b, 2009c). Those policies included: (a) political pressures from Congress on the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, to promote “affordable housing” by investing in high-risk subprime mortgages; (b) lending subsidies via the Federal Home Loan Bank System to its member institutions that promoted high mortgage leverage and risk; (c) FHA Home Loans (FHA) subsidisa-tion of high mortgage leverage (nearly zero down payments) and high borrower default risk; (d) government and GSE mortgage foreclosure mitigation protocols that were developed in the late 1990s and early 2000s to reduce the costs to borrowers of failing to meet debt service requirements on mort-gages, which encouraged risky mortgage borrowing by forcing originators to rene-gotiate delinquencies rather than foreclose (these new protocols were associated with a substantial reduction from the mid-1990s to the early 2000s in the probability of foreclos-ure occurring conditional on 90-day delin-quency) and, almost unbelievably, (e) 2006 legislation that prohibited so called “notch-ing,” which encouraged rating agencies to relax their standards for measuring risk in subprime securitisations. All of these govern-ment policies contributed to encouraging the underestimation of subprime risk, but the politicisation of Fannie Mae and Freddie Mac

and the actions of members of Congress that encouraged reckless lending by the GSEs in the name of affordable housing were arguably the most damaging of microeconomic policy actions leading up to the crisis.

In order for Fannie Mae and Freddie Mac to maintain their implicit (now explicit) gov-ernment guarantees on their debts, which contributed substantially to their profit-ability (with good cause), they believed that they had to cater to the political agendas of their supporters in Congress. In the context of recent times, that meant making a huge amount of risky subprime loans (Wallison and Calomiris 2009).

Fannie Mae and Freddie Mac ended up holding US$1.6 trillion in exposures to these toxic mortgages, which constitutes half of the total non-FHA outstanding amount of toxic mortgages (Pinto 2008). Calomiris (2008) argues that it is likely that absent the involvement of Fannie Mae and Freddie Mac in aggressive subprime buying beginning in 2004, the total magnitude of toxic mortgages originated would have been less than half its actual amount, since Fannie and Freddie crowded in market participation more than they crowded it out.

Prudential regulatory failureTheir entry into no-docs mortgages in an aggressive way in 2004 was associated with a tripling of subprime originations in that year. In mid-2006, when housing price weakness led others like Goldman Sachs and Deutsche Bank to pull back, Fannie and Freddie continued to make markets in subprime securities which produced a dis-astrous prolongment of peak-level deal flow well into 2007.


Third, prudential regulation of commer-cial banks by the government has proven to be ineffective. That failure reflects (a) fun-damental problems in measuring bank risk resulting from regulation’s ill-considered reliance on credit rating agencies assess-ments and internal bank models to meas-ure risk, and (b) the too-big-to-fail problem (Stern and Feldman 2004), which makes it difficult to credibly enforce effective disci-pline on large, complex financial institu-tions, such as Citibank, Bear Stearns, AIG, and Lehman Brothers, even if regulators detected that those institutions have suffered large losses and that they have accumulated imprudently large risks.

The risk measurement problem has been the primary failure of banking regulation, and a subject of constant academic regula-tory criticism for decades. Bank regulators utilise various means to assess risk, depend-ing on the size of the bank. Under the sim-plest version of regulatory measurement of bank risk, subprime mortgages have a low asset risk weight, of 50 per cent that of com-mercial loans, even though they are much riskier than most bank loans. The more com-plex measurement of subprime risk (applica-ble to larger US banks) relies on the opinions of ratings agencies or the internal assess-ments of banks and, unsurprisingly, neither of those assessments is independent of bank management.

Underestimating riskRating agencies, after all, are supposed to cater to buy-side market participants (i.e. banks, pensions, mutuals and insurance companies that maintained subprime-related asset exposures), but when their

ratings are used for regulatory purposes, buy-side participants reward rating agencies for underestimating risk, as that helps the buy-side clients avoid regulation. Many observers wrongly believe that the problem with rating agency grade inflation of securitised debts is that sellers of these debts (sponsors of secu-ritisations) are the ones who pay for ratings; on the contrary, the problem is that the buy-ers of the debts want inflated ratings because of the regulatory benefits they receive from those inflated ratings.

Buy-side client influenceRating agencies had no incentive to construct realistic models or respond realistically to bad news relating to subprime instruments for a simple reason: their buy-side clients did not want them to. Institutional investors managing the portfolios of pensions, mutu-als, insurance companies and banks contin-ued to buy subprime-related securitisation debt instruments well into 2007.

Even the banks that sponsored these instruments (and presumably had the clear-est understanding of their toxic content) continued to retain large amounts of the risk associated with the subprime MBS and CDO securitisations they packaged, through purchases of their own subprime-related debts and credit enhancements for sub-prime conduits.

Were the bankers who created these securitisations and retained large exposures for their banks related to them, and other sophisticated institutional investors who bought subprime-related securities, aware of the flawed assumptions regarding housing prices and no-docs mortgages that underlay the financial engineering of subprime MBS


by ratings agencies? These assumptions were widely publicised as part of the proc-ess of selling the securities. Did they object? Apparently not.

Someone else’s moneyWhy did these bank investors create such risks for themselves and other institutions, and why did sophisticated institutional inves-tors buy these overpriced securities? The obvious answer is that asset managers were placing someone else’s money at risk, and earning huge salaries, bonuses and manage-ment fees for their willingness to pretend that these were reasonable investments.

Rating agencies gave legitimacy to this pretence and were paid to do so. Investors may have reasoned that other competing banks and asset managers were behav-ing similarly and that they would be able to blame the collapse (when it inevitably came) on a surprising shock. The script would be clear and would give plausible deniability to all involved. “Who knew? We all thought that the model gave the right loss assumption! That was what the rating agencies used.”

Plausible deniability was a co-ordinating device for allowing asset managers to par-ticipate in the feeding frenzy at little risk of losing customers (precisely because so many participated). Because asset managers could point to market-based data and ratings at the time as confirming the prudence of their actions on a forward looking basis, they were likely to bear little cost from investor losses.

In short, the regulatory reliance on ratings magnified a pre-existing agency problem on the buy side of the securitised debt market. Asset managers willingly invested too much

in risky assets because of an incentive con-flict or “agency problem,” and rating agen-cies, and the regulators that relied on their ratings, were their willing (fee-receiving) accomplices. If asset managers had informed their clients of the truth – that the supply of good investments in risky assets has been outstripped by the flood of financial sav-ings, and that consequently, the risk-reward trade-off did not warrant further investment in risky assets – then asset managers would have been required to return money to cli-ents rather than invest in risky assets.

Low risk, low feesPresumably the money would then have ended up in bank deposit accounts or other low-risk (and low-fee generating) invest-ments. Returning the money to investors under these circumstances would have made investors better off (given the poor return to bearing risk), but it would have made asset managers worse off, since man-agement fees earned grow in proportion to the amount of funds invested in risky assets. Managers faced strong incentives to benefit themselves at their clients’ expense.

To what extent is it plausible to argue against this view by pointing to the novelty of securitisation products (subprime MBS, CDOs, etc), which may have made inves-tors and rating agencies unable to gauge risk properly in advance of the crisis? As I have already noted, data and logic available prior to the crisis showed that key assumptions regarding the possible path of home prices and the adverse-selection consequences of no-docs mortgages were unrealistic.

Furthermore, the novelty of a securitisa-tion product, in and of itself, should be an


indicator of a need to adjust estimates of risk upward. Experience suggests that rating agencies have frequently underestimated the risks of new products and only adapted their behaviour after major credit or fraud events occur, and this shows that their risk measures and controls for new products tend to be inadequate.

Experience prior to the subprime collapse (in credit card securitisation, in delinquent consumer account receivable securitisa-tion, and in other areas) has shown that the learning curve related to underestimation of risk can be steep. Decades of experience with steep learning curves in new securitisation products indicates yet another reason that properly incentivised institutional investors should have been cautious about the new, fast growing markets in subprime mort-gages and CDOs.

Indeed, it is particularly revealing to con-trast the measurement of subprime risk with the measurement of risk in the much older credit card securitisation business. In credit card securitisation, even during the sub-prime crisis, market participants paid close attention to the identities of originators, to their performance in the past, to the compo-sition of portfolios, and to how compositions changed over time, and originators were rewarded with greater leverage tolerances for “seasoned” receivables with good track records.

In contrast, until the middle of 2007, the ratings of subprime portfolios (based largely on the unrealistic expected loss assump-tions) seem to have been extremely insensi-tive to changes in borrower quality, product type (which is correlated with unobservable aspects of borrower quality), or the state of

the housing market. And there was dra-matic new entry into subprime origination in 2004-2006 by fly-by-night originators; these new entrants offering new, riskier products to new customers seem to have been able to raise funds under more or less the same low loss assumptions as old originators who offered older, lower-risk products. The princi-ples learned over 20 years in the credit card securitisation business were thrown out the window when rating subprime-related securitisations.

Supply and demandThis account does not place the primary blame for the mispricing of risk on securi-tisation sponsors (the sell side) or on rating agencies. After all, sponsors were only sup-plying what asset managers of their own institutions or outside buyers were demand-ing. The rating agencies were also doing what the investors wanted – going through the mechanical process of engineering con-duit debt structures, and rating them, based on transparently rosy assumptions.

Rating agencies were not deceiving sophisticated institutional investors about the risks of the products they were rating; rather they were transparently understating risk and inflating the grading scale of their debt ratings for securitised products so that institutional investors (who are constrained by various regulations to invest in debts rated highly by Nationally Recognised Statistical Rating Organisations) would be able to invest as they liked without being bound by the constraints of regulation or the best interests of their clients.3

Many observers wrongly attribute rat-ing agencies’ behaviour to the fact that


sponsors, rather than investors, paid for the ratings. But that fact was not relevant; sponsors and investors alike knew what was going on, and if the investors had not wanted the models to be misspecified and the ratings to be inflated, then the ratings agencies would not have built such faulty models and would not have generated such inflated ratings. Ratings inflation and model misspecification of subprime-related securitised debts was demand-driven, and thus would have occurred if the buy side had paid for ratings.

‘Moral hazard’ problemThe too-big-to-fail problem relates to the lack of credibility of regulatory discipline for large, complex banks. For large, complex banks, the prospect of failure is considered so potentially disruptive to the financial system that regulators have an incentive to avoid intervention. The incentives that favour “forbearance” and/or explicit govern-ment assistance ex post can make it hard for regulators to ensure compliance ex ante. The too-big-to-fail problem magnifies the so-called “moral-hazard” problem of the gov-ernment safety net; banks that expect to be protected by deposit insurance, Fed lending, and Treasury-Fed bailouts, and believe that they are beyond discipline, will tend to take on excessive risk, since taxpayers share the costs of excessive risk on the downside.

The moral hazard of the too-big-to-fail problem was clearly visible in the behaviour of the large investment banks in 2008. After Bear Stearns was rescued by a Treasury-Fed bailout in March, Lehman Brothers, Merrill Lynch, Morgan-Stanley and Goldman Sachs sat on their hands for six months

awaiting further developments (i.e. either an improvement in the market environment or a handout from Uncle Sam).

In particular, Lehman Brothers did lit-tle to raise capital or shore up its position. But when conditions deteriorated and the anticipated bailout failed to materialise for Lehman Brothers in September 2008 – showing that there were limits to Treasury-Fed generosity – the other major investment banks immediately either became acquired or transformed themselves into commercial bank holding companies to increase their access to government support.

Fourth, government regulations limit-ing who can buy stock in banks have made effective corporate governance within large banks virtually impossible, which contrib-uted to the buy-side agency problems within banks that took large subprime risks. Hedge funds and private equity funds have tradi-tionally been barred from controlling bank holding companies.

Pension funds, mutual funds and insur-ance companies are limited by regulations to only own small stakes in any public firm, including banks. Given the importance of the incentives that come from ownership concentration in enforcing effective corpo-rate governance, these regulations make the managers of large banks virtually immune to effective challenges from sophisticated shareholders.

Lax corporate governance allowed bank management to pursue investments that were in the long run unprofitable for stock-holders but were very profitable to manage-ment in the short run, given the short time horizons of managerial compensation sys-tems. When stockholder discipline is absent,


managers are able to set up the manage-ment of risk within the firms they man-age to benefit themselves at the expense of stockholders. An asset bubble (like the sub-prime bubble of 2003-2007) offers an ideal opportunity; if senior managers establish compensation systems that reward subordi-nates based on total assets managed or total revenues collected, without regard to risk or future potential loss, then subordinates are incentivised to expand portfolios rapidly during the bubble without regard to risk.

Senior managers then reward them-selves for having overseen that “successful” expansion with large short-term bonuses, and ensure they cash out their stock options quickly so that a large portion of their money is safely invested elsewhere by the time the bubble bursts. This review of the four areas in which government policy contributed to the financial crisis makes no mention of deregu-lation. During the 2008 election, many can-didates (including President Obama) often made vague claims that “deregulation” had caused the crisis. That claim made no sense; involvement by banks and investment banks in subprime mortgages and mortgage securitisation was in no way affected by the deregulation of the past two decades.

Cushioning effectIn fact, deregulation cushioned the financial system’s adjustment to the subprime shock by making banks more diversified and by allowing troubled investment banks to stabi-lise by becoming, or being acquired by, com-mercial banks (Calomiris 2009b). Since the election, President Obama and other erst-while critics of “deregulation” have changed their emphasis, and now properly focus on

failures of regulation, rather than deregula-tion, as causes of the crisis.

The severity of the crisis may seem para-doxical given the limited size of the subprime market. Roughly $3 trillion in non-FHA subprime mortgages were outstanding at the time of the crisis, and ultimate losses on those securities are likely to be roughly $600 billion.4 Why did this limited loss cause such widespread havoc throughout global finan-cial markets? The answer to that question revolves around liquidity risk.

Liquidity riskThe shocks of financial loss are magnified when the distribution of loss is hard to ascer-tain. This “asymmetric-information” problem produces a widespread scramble for liquid-ity throughout the financial system, which causes suppliers of credit to refuse to roll over debts, and causes interest rates on risky secu-rities and loans to rise dramatically, reflecting not only the fundamental credit risk in the system, but also the illiquidity of the mar-kets. This scramble magnifies losses and the risk of financial failure far beyond what they would have been if it were easy to identify exactly who suffered from the fundamental exogenous shocks giving rise to the crisis.

As Gorton (2008) shows, the complexity of subprime-related securitisations contrib-uted greatly to the inability of the markets to identify the distribution of loss in the system, once the crisis began. That inability reflected the complex design of the distribution of cash flows in the various securitisations, the multiple layers of securitisation, and the sen-sitivity of securitisation portfolios to uncer-tain changes in housing prices.

The sensitivity of subprime mortgage


valuation to housing prices was particu-larly problematic because subprime securi-ties payouts had been based on scenarios that only envisioned rising housing prices, which made it especially difficult to project payouts in a declining housing price environment.

Liquidity vs. expected lossSchwarz (2009) devises an innovative means of distinguishing between the exogenous effects of fundamental loss expectations and the endogenous effects of the scramble for liquidity in explaining the widening of credit spreads during the crisis. Liquidity risk is captured by mar-ket factors unrelated to default risk (e.g. spreads on sovereign bonds of different liquidity), and credit risk is captured by dif-ferences between banks in the rates they paid in the interbank market (abstracting from changes in the average interest rate and, therefore, from the common effect of liquidity risk). She finds that roughly two-thirds of the widening of credit spreads was attributable to liquidity risk.

Conclusion Loose monetary policy and global imbal-ances explain the timing of the subprime crisis, but like other severe banking crises historically, microeconomic government policies that distorted the risk-taking deci-sions of financial institutions were crucial necessary conditions for causing the crisis. The microeconomic policy errors enumer-ated above that caused the subprime cri-sis relate to the fundamental design of the financial system – housing finance policy, prudential regulatory policy, and corporate

ownership rules relating to large banks – all of which have been the subjects of substan-tial academic research prior to the recent financial crisis.

It is therefore no surprise that cred-ible solutions to these problems have been identified by financial economists who write about public policy, and those pro-posals are reviewed elsewhere (Calomiris 2009b, 2009c, 2009d, 2009e). Successful reform must begin with the recognition that major flaws in policy and regulation have existed for decades and that these flaws must be addressed if we hope to avoid a repeat of the recent crisis. •

ReferencesBarth, James R., Gerard Caprio, Jr., and Ross Levine (2006).

Rethinking Bank Regulation Till Angels Govern, Cambridge: Cam-

bridge University Press.

Bordo, Michael D. (2009). “The Crisis of 2007: The Same Old

Story, Only the Players Have Changed,” Working Paper, Rut-

gers University.

Calomiris, Charles W. (2000). US Bank Deregulation in Histori-

cal Perspective: Cambridge University Press.

Calomiris, Charles W. (2008). “Statement Before the Com-

mittee on Oversight and Government Reform, United

States House of Representatives,” December 9, 2008.

Calomiris, Charles W. (2009a). “Banking Crises and the Rules

of the Game,” NBER Working Paper 15403, October.

Calomiris, Charles W. (2009b). “The Subprime Turmoil:

What’s Old, What’s New, and What’s Next,” Journal of Struc-

tured Finance, Spring, 6-52.

Calomiris, Charles W. (2009c). “Financial Innovation, Regula-

tion, and Reform,” Cato Journal, Winter, 65-92.

Calomiris, Charles W. (2009d). “Prudential Bank Regulation:

What’s Broke and How to Fix It,” in Reacting to the Spending

Spree: Policy Changes We Can Afford, edited by Terry L. Ander-

son and Richard Sousa, Stanford, CA: Hoover Institution

Press, 17-34.


Calomiris, Charles W. (2009e). “The Debasement of

Ratings: What’s Wrong and How We Can Fix It,” Work-

ing Paper, Columbia Business School.

Demirguc-Kunt, Asli, Edward Kane, & Luc Laeven, Editors

(2009). Deposit Insurance Around the World, MIT Press.

Ellis, Luci (2008). “The Housing Meltdown: Why did it Hap-

pen First(?)/Only(?) in the United States?” Working Paper,

Bank for International Settlements.

Fitch Ratings (2006). “2007 Global Structured Finance Out-

look: Economic Sector-By-Sector Analysis,” Dec.

Gorton, Gary (2008). “The Panic of 2007,” in Maintaining

Stability in a Changing Financial System: Symposium Sponsored by

Kansas City Federal Reserve, 131-262.

International Monetary Fund (2008). Global Financial Stability

Report, 2008

Keys, Benjamin J., Tanmoy K. Mukherjee, Amit Seru, and

Vikrant Vig (2009). “Did Securitisation Lead to Lax Screen-

ing? Evidence from Subprime Loans,” Quarterly Journal of

Economics, forthcoming.

Mason, Joseph R., and Joshua Rosner (2007a). “How Resil-

ient Are Mortgage Backed Securities to Collateralised Debt

Obligation Market Disruptions,” Working Paper, Louisiana

State University.

Mason, Joseph R., and Joshua Rosner (2007b). “Where Did

the Risk Go? How Misapplied Bond Ratings Cause Mort-

gage Backed Securities and Collateralised Debt Obliga-

tion Market Disruptions,” Working Paper, Louisiana State

University.

Pinto, Edward J. (2008). “Statement Before the Commit-

tee on Oversight and Government Reform, United States

House of Representatives,” December 9.

Rajan, Uday, Amit Seru, and Vikrant Vig (2008). “The Failure

of Models that Predict Failure: Distance, Incentives and

Defaults,” Working Paper, London Business School.

Schwarz, Krista (2009). “Mind the Gap: Widening Risk

Spreads Explained By New Measures of Credit and Liquid-

ity,” Working Paper, Wharton School.

Stern, Gary H., and Ron J. Feldman (2004). Too Big To Fail:

The Hazards of Bank Bailouts, Washington, D.C.: Brookings

Institution Press.

Wallison, Peter J., and Charles W. Calomiris (2009). “The

Last Trillion-Dollar Commitment: The Destruction of

Fannie Mae and Freddie Mac,” American Enterprise Insti-

tute, Journal of Structured Finance, Spring, 71-80.

End notes1 Mason and Rosner (2007a, 2007b), International Mon-

etary Fund (2008), Ellis (2008), Keys, Mukherjee, Seru,

and Vig (2009), Rajan, Seru, and Vig (2008), and Calo-

miris (2009b).

2 Calomiris (2008).

3 Calomiris (2009e) shows that ratings shopping – the

practice where originators of subprime-related securi-

tisations get a preview of rating agencies’ views before

choosing which ones to permit to rate their debts –

produced a race to the bottom among agencies. It is

important to recognise that in order for rating shop-

ping to result in a race to the bottom in ratings, that

race must be welcomed by the buy side of the market;

ratings shopping will not benefit the sell side without

the co-operation of the buy side. If institutional inves-

tors punish the absence of good rating agencies in an

offering (by refusing to buy or by paying a lower price,

when a reputable rating agency is excluded from rat-

ing a securitisation), then would-be ratings shoppers

would have no incentive to exclude reputable rating

agencies. Thus, the fact that ratings shopping tends to

exclude relatively reputable rating agencies and leads

to low quality and inflated ratings implies that the buy

side favours a ratings shopping process that results in

low-quality, inflated ratings.

4 Because of creative accounting practices by Fannie

Mae and Freddie Mac, which disguised the true size of

their subprime mortgage exposure, it was not widely

known until roughly September 2008 that Fannie Mae

and Freddie Mac held half of the total subprime expo-

sure, or that the total amount of subprime exposure

was so high (Pinto 2008, Wallison and Calomiris 2009).

Thus, prior to mid-2008, the general perceptions of

total exposure and expected loss were even lower.

H O W WA S H I N GT O N FA I L E D A M E R I C A

W I L L I A M M . I SA AC with P H I L I P C . M E Y E R

SENSELESS PANIC

F O R E W O R D B Y P A U L V O L C K E R


Debate

Root causes of the subprime crisis: What broke?

Peterson Institute’s Edwin M. Truman argues that agreement is necessary if an-

other financial crisis is to be avoided.

in the fall of 2009, the federal reserve Bank of Chicago, in conjunction with the World Bank, organised its 12th annual symposium – The International Financial Crisis: Have the Rules of Finance Changed? a number of academics, central bankers, economists and government advisers delivered a series of lectures and papers focusing on the origins and consequences of the financial crisis and remedies to mitigate against further occurrences. the previous paper, by Charles W. Calomiris, gave one perspective on the origins of the subprime crisis which the Peterson institute for international economics’ edwin M. truman fundamentally disa-greed with. Below is an edited transcript of Mr truman’s discourse.

Mr truman …It is is a pleasure to partici-pate once again in an International Banking Conference at the Federal Reserve Bank of Chicago.

Charles Calomiris wrote in his article (see previous paper in this journal): “It is important, therefore, in the interest of shap-ing desirable reform, to get our story straight

about what happened to cause the recent crisis.” I agree and would add that doing so is equally important with respect to other lessons that should affect policies but might not necessarily rise to the level of reforms requiring Congressional action, for example monetary policy.

Multiple points of viewThere is no paucity of potential candidates who postulate the root causes of the crisis of 2007-09. The number is probably larger than the four or five presented in Calomiris’ article, or the four or five largely implicit in the Mussa chapter, and less than the 10 or 12 presented in the Baily-Elliott chapter. However, the intersection of these lists of causes is essentially a null set aside from a common theme of the housing boom.

These observations illustrate the reality that even today, more than two years after the crisis broke in August 2007, and essen-tially there is no agreement about the root causes. This is unfortunate if we want to learn the lessons and apply this learning to policy reform; but it gives me free reign in my commentary.


Conventionally, the identified causes of the global financial crisis that has affected the world economy and financial system for two-plus years fall across four broad categories:

Failures of macroeconomic policies, which have three sub-categories: monetary and fiscal policies, global imbalances, and a housing boom;

Failures of financial-sector supervision and regulatory policies and practices, which have innumerable sub-categories;

Excesses of poorly understood financial engineering innovations, which have several sub-categories; and

Excesses, or imprudence, of large private financial institutions, in particular those with a global reach.

In the first category of macroeconomic policies, Calomiris includes lax US monetary policy and global imbalances that flattened the US yield curve.

To blame or not to blameBaily and Elliott, largely absolve Federal Reserve policies, but don’t absolve global imbalances. Baily and Elliott, also include government policies that encouraged a boom in housing construction. Calomiris is less explicit under the macroeconomic heading.

Mussa does not absolve the Federal Reserve and other central banks, but his only mention of global imbalances is to note that the US imbalance was declining in advance of the crisis. He mentions housing as well.

In the second category (supervision and regulation), Calomiris includes four items: • US government policies to promote sub-

prime risk taking;

• Excessive reliance on credit rating agencies;

• US too-big-to-fail policies; and• US government policies to limit stock

ownership. Calomiris is less clear about the relevance

of the fourth item, but I assume he is hinting at a limitation on outside influences relating to corporate governance.

Too-big-to-fail policiesBaily and Elliott agree on the first two of Calomiris’ items, but as far as I could tell they do not agree on the third and fourth. They add, by my count, five items in this category: (1) a general erosion of lending and regula-

tory standards, (2) flaws in the originate-to-distribute

model, (3) lack of a US comprehensive supervisory

system, (4) mark-to-market accounting, and (5) inadequate capital cushions.

Mussa explicitly focuses on the too-big-to-fail policies in his concern about moral hazard in the wake of the crisis and implic-itly as a contributor to the crisis, but I suspect that his indictment is not fully consistent with Calomiris. He also, in passing, refers to financial excesses. However, he basically traces the causes of the financial crisis to the business cycle and to financial sector devel-opments over several decades that got ahead of the regulators.

Three specificsIn the third category (financial engineer-ing), Calomiris includes the liquidity risk and complexity associated with new instruments that contributed towards uncertainty in the


system. Baily and Elliott do not entirely disa-gree, but they point to three specifics: (1) the new securitisation model, (2) excessive leverage, and (3) credit insurance.

Mussa does not mention this category beyond a few oblique hints.

In the final category (behaviour of large financial institutions), Calomiris and Baily and Elliott are together in citing poor risk management practices, but do not entirely agree on the reasons. Mussa shares the view that imprudent risk taking was involved. For the record, Calomiris pays more attention to compensation policies and practices; the word does not appear in the first part of the Baily-Elliott chapter or in Mussa’s chapter.

In the context of an international bank-ing conference, my major criticism of these analyses, with the limited exception of Mussa’s chapter, is that they treat what is clearly a global financial (and economic) cri-sis as if it was solely a US event caused by US regulatory and policy failures.

Apportioning the blameMuch of the rest of the world would like to believe that the US deserves full blame for the crisis. Perhaps it does, but simply being the epicentre is not the same as being the sole cause. I remain to be convinced that policies elsewhere in the world were irrel-evant to the crisis.

Baily and Elliott do note that housing prices rose rapidly in many countries and state that this fact points to a global driver of what happened, which they hint had some-thing to do with low interest rates. However, when they come to discussing low interest rates, they do not blame the Federal Reserve

(or other central banks). They do cite global imbalances, but only in connection with flattening the US yield curve. Moreover, the drivers of the US crisis in the Baily-Elliott list of causes, as well as in the Calomiris list, are almost exclusively US-centric in that other jurisdictions did not share most of the short-comings that they identify, such as the tax deductibility of mortgage interest payments.

So what do I think? What is my narrative for the root causes of the crisis?

Supervisory sinsMy view, in contrast to the conventional sto-ries, to a substantial degree, macroeconomic policies in the United States and the rest of the developed world were jointly responsi-ble for the crisis although they had help from supervisory sins, largely of omission.

In the United States, fiscal policy con-tributed to a decline in the US saving rate, and monetary policy was too easy for far too long, thereby fuelling the global credit boom. In Japan, the mix of monetary and fiscal poli-cies distorted the global economy and finan-cial system; here again monetary policy was too easy for too long, also fuelling the fires of the global credit boom. In recent years, many other countries also had very lenient mone-tary policies and included other Asian coun-tries, energy and commodity exporters and, in effect, a number of countries within the Eurozone, as well as the United Kingdom and Switzerland.

Design flawsThe impressive accumulation of foreign exchange reserves by many countries distorted the international adjustment process and took some pressure off the


macroeconomic policies of the United States and other countries. However, I am among a minority of economists who believe that the phenomenon of global imbalances played little or no role in causing the economic and financial crisis. Instead, the imbalances and the crisis were jointly caused by flaws in the design and implementation of macroeco-nomic policies and the resulting global credit boom.

I won’t argue this point in great detail, but I would cite two facts:

First, we have witnessed at least two other periods of large global imbalances; those of the late 1970s and 1980s – they did not lead to the extent of financial excesses like what we have more recently experienced.

Second, the ‘global savings glut’ hypoth-esis is a flawed analysis; not only was it in reality a dearth of global investment, as was demonstrated by the IMF staff at the time, but in addition the analysis focused, in its simplest form, on net inflows and on gross official inflows. In fact, on average over the period 2002 to 2007 official inflows to the United States were less than 25 per cent of total gross inflows.

Peak yearsThe peak years were 2003 at 32 per cent and 2004 at 26 per cent – before the boom year of 2005. Moreover, the Chinese current account surpluses (the net flow to the rest of the world which is the relevant metric in terms of the savings glut) were only $69 billion and $161 billion in 2004 and 2005 respectively.

The rest of China’s reserve accumulation in gross terms amounted to a recycling of capital inflows. The net savings from China amounted to about three per cent of global

net savings in the latter year.1 It is a stretch of the imagination to think that a flow of net saving of this size added significant down-ward pressure on the US and other yield curves around the world that could not have been resisted by central banks.

Baily and Elliott are careful not to blame the foreigners for our problems, which is more than I can say for many other US observers and officials past and present. However, their basic argument, and that of Calomiris with regard to the influence of capital inflows, though common in the lit-erature generally, lacks a factual or analytical base.

Worldwide housing boomWe do not know what would have hap-pened if global imbalances had been smaller; the presumption is that US interest rates would have been higher, starting with the federal funds rate. I would think that it therefore follows, if the foreigners can push US interest rates down or up, the Federal Reserve should have been able to push them up as well.

We had a global credit boom; monetary policies have something to do with credit booms, with the size of balance sheets, and with ‘aggregate liquidity’ using the Baily-Elliot terminology. The credit boom did not just fuel a housing boom in the United States, but also contributed towards housing booms in many other countries, some to a greater extent than in the United States.

However, in addition to housing booms, the credit boom fuelled significant increases in the prices of equities and many other manifestations of financial excess. We are not talking here about pricking bubbles; we are


talking about fuelling a global credit boom and about the associated pricing of risk.

Benign conditionsFinancial-sector supervision and regu-

lation, or the lack thereof, also played a role in the crisis. But the many sins of omission and few sins of commission were commit-ted over several decades, not primarily over the past 10 years. As is reported in the Mussa chapter, they started in the 1960s. Moreover, without the benign economic and financial conditions that prevailed in the wake of the dot-com boom, and the associated belief that ‘this time it is different’, this crisis would have taken a different form.

As Calomiris hints, benign conditions lead to lax lending and credit standards, just as night follows day. In principle, financial-sector supervision could have helped to curb the excesses, but it did not do so in the United States or in many other countries around the world.

Shadow bankingIn some cases, notably including the United States but also elsewhere, regulation and supervision were simply incomplete. The rise of what is now known as the shadow financial system had been going on for decades in many countries: money mar-ket mutual funds, special purpose invest-ment vehicles, hedge funds, private equity firms, etc. In many cases, these entities were highly leveraged and/or used short-term funding to finance longer-term invest-ments contributing to Mussa’s “inherent instabilities.”

We saw a gradual shift in financial inter-mediation from traditional banks to other

types of financial institutions that were less well capitalised and subject to less close supervision. Traditional banks gradually, but radically, transformed their business models in order to compete with the less-regulated institutions. The global financial system became overleveraged; the US financial sys-tem in particular but not exclusively. When confidence finally and fully drained from the system, funding dried up and financial insti-tutions collapsed.

New forms of financial engineering were part of the story, but innovation has been a feature of domestic and international finance for decades. In many cases, the asso-ciated innovations were poorly understood, resulting in a failure of risk recognition, which is a necessary precondition for good risk management.

Imprudence at largeFinancial engineering helped to distort incentives facing financial institutions and contributed to the market dynamics once the crisis got underway, but this was not the cause of the crisis or a major root cause.

Finally, some words relating to the imprudence of large private financial insti-tutions, in particular those with global reach; we can agree that they were impru-dent in many dimensions. Size has been a problem, and the sheer complexity has led to decisions to rescue particular institutions in whole or in part. However, the global scope of the operations of these institutions was not a major contributing factor to the crisis per se.

In my view, the two major sources of the global financial crisis of 2007-09 were failures in macroeconomic policies together


with financial supervision and regulation. I would assign principal blame to failures in macroeconomic policies by a small mar-gin, which is more blame than is assigned by most observers, including the authors of these presentations.

I do not see this as inconsistent with the view that there were structural flaws in national and global financial regulatory and supervisory systems, which had been build-ing for a number of years, that need to be addressed in the wake of the crisis. It may well be that a crisis of this magnitude was necessary to uncover those flaws. Whether they would have been revealed without the macroeconomic failures is debatable.

Final thoughtsDrawing upon over three decades of expe-rience with financial crises in this country and around the world, I would add one final thought. The only other global economic and financial crisis of the post-World War II period was the crisis in the early 1980s, centred on 1982. In many respects, that cri-sis was also made in the United States. US macroeconomic policy mistakes produced rip-roaring inflation and an extended period of negative real short-term and long-term US dollar interest rates that fuelled a global credit boom; in particular by extending credit to emerging market economies.

In late 1979, the Federal Reserve finally began to address the problem of US infla-tion. We had a brief six-month recession associated with a flirtation with credit con-trols. The recession was followed by a brief 12-month recovery and expansion, before we plunged back into recession in mid-1981 and this lasted 16 months. It is likely that

the National Bureau of Economic Research (NBER) will date the most recent recession as only slightly longer, perhaps 18 months, from December 2007 to June 2009. The US recession of 1981-82 coincided with a global recession centred on 1982; global growth that year was less than one per cent.

Nineteen-eighty-two was the year that the global debt crisis broke out. The debt cri-sis was the consequence of the reversal of US financial conditions from negative real inter-est rates to positive rates – macroeconomic causes – and the excesses of international bank lending in originating loans and syn-dicating them to smaller banks around the world.

By the end of 1982, most international banks located in the United States and those within other major industrial coun-tries were insolvent on a mark-to-market basis. However, fortunately at the time, the secondary market in sovereign loans was underdeveloped. In the wake of the debt crisis, blame was heaped upon the interna-tional banks for causing the crisis through reckless lending.

Volatile mixA number of reforms were instituted, includ-ing the US requirement that syndication fees be spread over the life of loans and the capi-tal standards that were agreed later in the decade stemming from the Basel I Accord. In many respects the crisis of the early 1980s was a lot like this crisis, including the fact that the global financial system was blamed for the crisis and came under tremendous strain. Its causes included principally a volatile mix of macroeconomic and financial supervisory and regulatory components. •

Fed monetary and regulatory policy: lessons from the crisis 55Janet L. Yellen

The post-crisis fix: regulatory or monetary policy remedies? 61Stephen S. Roach

Risk orientation in regulation and supervision 75Patrick Raaflaub and Gabe Shawn Varges

Regulation, supervisory lessons from Japan since the 1990s 87Kazuo Ueda

Enhancing cross-border regulation after the 2008 crash 99Richard Neiman

What we thought we knew and what we didn’t know 107Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro

The ‘business of bribery’ sparks anti-corruption drive 113Gavin Sudhakar

Public or private accounting and the Sarbanes-Oxley Act 123Alex J. Pollock

‘Innumerate bankers, systemic idiocy & accounting standards’ 129Lord Adair Turner

Lessons for the forex market from the global financial crisis 141Michael Melvin and Mark P. Taylor

Exports and financial shocks: new evidence from Japan 147Mary Amiti and David Weinstein

A case of mistaken identity: the illusion of ‘too big to fail’ 153Avinash Persaud

JOURNAL OF REGULATION & RISK NORTH ASIA

Articles & Papers


Regulation

Fed monetary and regulatory policy: lessons from the crisis

San Francisco Fed’s Janet L. Yellen, et al1 calls for an end to the monetary and regula-tory dichotomy that exists at the Fed’s heart.

in this paper, i will try to lay out some broad themes concerning the implica-tions of the financial crisis for regulatory reform and monetary policy. My com-ments are my own and do not necessarily reflect the views of my colleagues in the federal reserve.

In the past, monetary and regulatory poli-cies have generally been viewed as separate domains with distinct objectives. The pri-mary focus of monetary policy has been on attaining the macroeconomic goals of low inflation and a stable economy. In the United States, these goals find their expression in the Federal Reserve’s dual mandate of maximum employment and price stability. By contrast, regulatory policy has generally pursued sig-nificantly different ends: protecting the safety and soundness of individual financial institu-tions and reducing systemic risk.

Of course, monetary and regulatory policies do not exist in total isolation and the Federal Reserve, an institution with responsibilities in both domains, has long recognised some important linkages. For example, it’s clear that the effectiveness of

monetary policy and the performance of the macroeconomy depend greatly on main-taining a stable and healthy financial system. And a sound economy makes the work of regulators much easier because economic downturns put considerable stress on the financial system. In addition, the insights we derive from our supervision of bank-ing organisations are helpful in formulating monetary policy. And the economic analysis that underpins monetary policy improves our understanding of the risks confronting financial institutions. Nonetheless, policy-makers have generally viewed monetary and regulatory questions as separate disciplines, and we have designed our strategies and carried out our policies accordingly.2

Important implicationsThe painful events of the past two years have fundamentally challenged this dichotomisa-tion of monetary and regulatory policies. It is no longer obvious that setting policies to sta-bilise the economy on the one hand and to safeguard the financial system on the other can be cleanly separated – either in concep-tion or implementation.3 This experience has


important implications for both monetary and regulatory policy. Here I will focus on the conceptual issues, leaving aside vital ques-tions concerning implementation, such as the appropriate division of authority among different regulatory bodies – a subject that is under discussion in the United States.

Regulatory responsibilitiesLet me start by considering our regulatory responsibilities. Government agencies have long practiced micro-prudential supervision and regulation – that is, oversight of individ-ual financial institutions aimed at preserving their safety and soundness. Indeed, micro-prudential supervision – including on-site examinations, surveillance, guidance, regu-lations, and enforcement – is the first line of defence against systemic risk. The crisis has taught us valuable lessons on how to strengthen supervision going forward.

For example, we need to develop stronger and more effective capital and liquidity standards, strengthen our oversight of risk management practices, and insure that compensation arrangements do not create incentives that could compromise safety and soundness.4 In the United States, we also gleaned important insights on how to improve our consolidated supervision of bank holding companies through this year’s stress test of the 19 largest banking organi-sations, as part of the Supervisory Capital Assessment Program.

Horizontal institutional reviewsWe intend to make such horizontal insti-tutional reviews involving multidisciplinary teams an important component of our supervision going forward. Currently, we are

conducting a horizontal assessment of inter-nal processes for evaluating capital adequacy at the largest US banking organisations and will shortly undertake a similar horizontal review of incentive compensation practices.

Overall, the crisis has exposed serious deficiencies in our micro-prudential regu-latory structure. We clearly need to address gaps, such as inadequate authority or tools to properly supervise the so-called shadow banking system, including major investment banks, non-bank lenders, and vital financial insurance providers such as AIG.

Finding the balanceA broad consensus exists that we need to make these changes. But, it is critical to rec-ognise that carrying bigger sticks as micro-prudential supervisors entails tradeoffs between stability and efficiency – between managing systemic risk and cultivating a fertile environment for economic growth. Admittedly, we may well have been operat-ing far off the optimal tradeoff curve in recent years!

Still, in designing a new regulatory framework, we must be aware that stronger capital standards that reduce leverage might hamper the flow of funds to businesses and households in ways that could impede investment and consumption. Of course, finding the right balance is an immense challenge. To strike that balance between stability and growth, we should examine what other policy weapons should be in our arsenal. Perhaps the most important are in the area of macro-prudential oversight, which we increasingly understand is an essential complement to micro-prudential supervision.


Now, what exactly does macro-prudential supervision entail? To me, it means identify-ing and correcting behaviours and structures in financial markets that create excessive risk before they mushroom into something that threatens the entire financial system. This requires real-time collection and analysis of data from a wide variety of financial institu-tions and markets, the deployment of tools to mitigate the inherent pro-cyclical tenden-cies of financial markets, and new resolution powers to deal with the failure of any institu-tion that poses a threat to financial stability.

Macro-prudential supervision takes a very different perspective than its micro-prudential sibling. It’s akin to caring for an entire ecosystem rather than individual trees. It is targeted at spillovers and exter-nalities that contribute to systemic risk even when they don’t directly harm individual institutions. An example is an investment strategy that is highly positively correlated across institutions.

Herd mentalityTaken in isolation, each institution may appear to be adequately managing liquid-ity, capital and exposure to risk. But, when many large institutions invest in the same class of assets, a downturn in that asset class can cause a rush to the exits as everyone tries to sell at the same time. That’s exactly what happened in 2007 and 2008 in the markets for mortgage-related securities, with disas-trous effects that we know too well. In the worst case, correlation can feed contagion that spreads across the globe as institutions seek to rapidly deleverage and protect liquid-ity. This presents a regulatory challenge of the first order:

How are we to measure and safeguard against such highly correlated investment strategies? Research is under way now to provide some answers.5 One promising strategy is to implement a system that would require banking organisations to build capi-tal buffers in good times that could be run down under stressful conditions.

Such a system could serve as an auto-matic stabiliser, mitigating the buildup of lev-erage in booms and the destabilising impact of broad-based deleveraging in downturns.

Macro-prudential supervisionOther practices may also be ripe for macro-prudential supervision. They include pro-cyclical underwriting standards, shortcomings in the provision of liquidity and credit risk protection during crises, and payment and clearing systems.6 For example, markets for over-the-counter derivatives, including credit default swaps, lack the stabilising mecha-nisms associated with central exchanges.7

A key issue in macro-prudential super-vision concerns the too-big-to-fail problem of systemically important financial institu-tions. A number of approaches have been suggested to limit the systemic risk from large, interconnected financial institutions. These include capping the size of these insti-tutions, moving some activities to exchanges or clearing firms, requiring them to hold more capital, and reducing their odds of failure by requiring them to hold debt that automatically converts to equity in a crisis situation. It is also essential to devise effec-tive means to resolve large, highly intercon-nected financial institutions in an orderly manner to minimise the damage to the financial system.


In the United States, the Federal Deposit Insurance Corporation uses a well-tested and highly effective procedure for resolving commercial banks and thrifts. But, for non-depository financial institutions, the stand-ard bankruptcy process is all that’s available. We’ve seen that the mere hint a financial institution is headed for bankruptcy can set off a run, depriving it of vital short-term funding and leaving it incapable of paying creditors. As recent events attest, in the cases of systemically important institutions, the end result can be market turmoil, cascading declines in valuations, and panic.

Management roleMacro-prudential supervision has the potential to lower systemic risk and thereby create a more secure financial system that will contribute to macroeconomic goals as well. But, monetary policy may also play a role in managing systemic risk. One notable feature of boom-and-bust cycles has been highly pro-cyclical leverage at primary deal-ers, such as investment banks.

Recent research by Tobias Adrian and Hyun Shin suggests that monetary pol-icy affects these cycles in asset growth.8 Specifically, they find that periods when monetary policy is “tight” relative to the pre-dictions of an estimated Taylor rule are asso-ciated with weaker growth in holdings of repurchase agreements by primary dealers.9 By contrast, “easy” monetary policy is associ-ated with rapid increases in financial institu-tion balance sheets that can add to systemic risk.10 These results suggest that monetary policy could play a role in restraining unde-sirable swings in leverage and, by extension, reduce systemic risk. In particular, interest

rate cuts in a time of market disruption can be effective at stopping a deleveraging cycle from turning into an uncontrolled crash. And higher rates than called for based on purely macroeconomic conditions may help forestall a potentially damaging buildup of leverage and an asset price boom.

This raises the broader – and very con-tentious – issue of whether monetary policy should seek to lean against poten-tially dangerous swings in asset prices. The answer is far from clear, because the use of monetary policy for these ends necessarily compromises the attainment of other macr-oeconomic goals. Because such use of mon-etary policy is costly, high priority should be assigned to developing regulatory tools to address systemic risk.

Even so, the crisis of the past two years has prompted many of us to re-examine the widely held view that monetary policy should respond to asset prices only to the extent that they influence the anticipated trajectories of inflation and unemploy-ment. Further research into the connections among monetary policy, the banking and financial sectors, and systemic risk is needed to help answer this question.11

In summaryIn summary, the events of the past few years compel us to re-examine many of our long-held ideas and practices in both monetary and regulatory policy. I am gratified that researchers around the world are looking hard at these questions. In addition, I am encouraged by the sense of purpose and co-operation exhibited by my colleagues at cen-tral banks, governments, and international organisations in their efforts to develop


policies that will help us avoid the kind of crisis we have just experienced. Thank you. •

End Notes1 I would like to thank John Williams and Sam Zucker-

man for assistance in preparing these remarks.

2 At times, the connections between monetary policy

and regulation have become more apparent. For exam-

ple, the abolition of Regulation Q in the United States

had a direct bearing on how monetary policy affected

the economy and the appropriate monetary policy

response to shocks (see Mauskopf 1990).

3 See Shirakawa (2009) for further discussion on this.

4 See, for example, Crockett (2009) and Tarullo (2009)

for discussions of these issues.

5 See Caruana (2009), Adrian and Brunnermeier (2009).

6 See Bernanke (2009) and Dudley (2009) for further

discussion of these and related issues of macro-pru-

dential regulation.

7 See Duffie and Zhu (2009) for an analysis of the prob-

lems with clearing credit default swap contracts.

8 See Adrian and Shin (2008a).

9 Taylor (2007) describes a different channel, but comes

to the same conclusion that monetary policy can con-

tribute to undesirable booms and busts.

10 See Adrian and Shin (2008b, 2009). They find evidence

that asset growth is linked to housing construction.

11 Increasingly macroeconomists are incorporating bank-

ing and financial frictions in their macroeconomic mod-

els. See, for example,Curdia and Woodford (2009) and

Gertler and Karadi (2009).

ReferencesAdrian, Tobias, and Markus K. Brunnermeier. 2009.

“CoVaR.” Federal Reserve Bank of New York Staff Report

No. 348 (August).

Adrian, Tobias, and Hyun Song Shin. 2008a. “Liquidity, Mon-

etary Policy, and Financial Cycles.” Federal Reserve Bank

of New York Current Issues in Economics and Finance 14(1,

January/February), pp. 1-7.

Adrian, Tobias, and Hyun Song Shin. 2008b. “Financial Inter-

mediaries, Financial Stability, and Monetary Policy.” In Main-

taining Stability in a Changing Financial System. Kansas City,

MO: Federal Reserve Bank of Kansas City, pp. 287-334.

Adrian, Tobias, and Hyun Song Shin. 2009. “Money, Liquidity,

and Monetary Policy.” American Economic Review: Papers &

Proceedings 99(2), pp. 600-605.

Bernanke, Ben S. 2009. “Financial Reform to Address Sys-

temic Risk.” Speech at the Council on Foreign Relations,

Washington, DC, March 10.

Caruana, Jaime. 2009. “The International Policy Response

to Financial Crises: Making the Macroprudential Approach

Operational.” Remarks at the Federal Reserve Bank of

Kansas City Symposium, August.

Crockett, Andrew. 2009. “Rebuilding the Financial Architec-

ture.” Finance & Development 46(3, September), pp. 18-19.

Curdia, Vasco, and Michael Woodford. 2009. “Credit

Spreads and Monetary Policy.” Federal Reserve Bank of

New York Staff Report 385 (August).

Dudley, William C. 2009. “Some Lessons from the Crisis.”

Remarks at the Institute of International Bankers Member-

ship Luncheon, New York City, October 13.

Duffie, Darrell, and Haoxiang Zhu. 2009. “Does a Central

Clearing Counterparty Reduce Counterparty Risk?” Rock

Center for Corporate Governance at Stanford University,

Working Paper No. 46 (July).

Gertler, Mark, and Peter Karadi. 2009. ‘A Model of Uncon-

ventional Monetary Policy.’ Manuscript, New York U (April).

Mauskopf, Eileen. 1990. “The Transmission Channels of

Monetary Policy: How Have They Changed?” Federal

Reserve Bulletin 76(12, December).

Shirakawa, Masaaki. 2009. “International Policy Response to

Financial Crises.” Remarks at the Federal Reserve Bank of

Kansas City Symposium, August.

Tarullo, Daniel K. 2009. “In the Wake of the Crisis.” Speech

at the Phoenix Metropolitan Area Community Leaders’

Luncheon, Phoenix, AZ, October 8.

Taylor, John B. 2007. “Housing and Monetary Policy.” In

Housing, Housing Finance, and Monetary Policy. Kansas City,

MO: Federal Reserve Bank of Kansas City, pp. 463-476.


Regulation

The post-crisis fix: regulatory or monetary policy remedies?

Chairman of Morgan Stanley Asia, Stephen S. Roach, discusses the probable imposition

of macro-prudential regulations.

unDer the auspices of the us Congress, the newly constituted financial Crisis inquiry Commission (fCiC) held its first hearings in Washington on January 13-14 this year. established by Congress in the aftermath of the bankruptcy of lehman Brothers, its function is reminis-cent of congressionally-sponsored hear-ings held in 1932 by the so-called Pecora Commission.

As was the case some 78 years ago, the current generation of Wall Street captains was grilled on the specifics of the Great Crisis of 2008-09. Like earlier times, this high-pro-file exchange could well be a key to driving legislation that could shape the US financial system – and an asset and debt-dependent US economy – for generations to come.

Twin concernsThe early betting is that post-crisis remedies will be concentrated in a new approach to regulatory oversight – specifically the impo-sition of new “macro-prudential” regulations aimed at the twin concerns of systemic risk and financial stability. While this approach

undoubtedly has considerable merit, it may not be enough to prevent another crisis from occurring in the not-so-distant future. In my opinion, also needed is a major reworking of the mandate that guides the role and con-duct of monetary policy.

Specifically, the addition of a finan-cial stability mandate could go a long way in forcing central banks to face up to the destabilising perils of asset bubbles and the imbalances they have spawned in the mix of global saving as well as on the real side of increasingly asset-dependent economies.

No silver bulletThere is no quick fix in a post-crisis world – no silver bullet that would inoculate an ever-changing world from the next inevita-ble crisis. However, the world can surely do a much better job of crisis prevention that it did in the free-wheeling decade before the onset of the sub-prime crisis in the summer of 2007.

Significantly, it should avoid a backward looking fix that addresses the problems that gave rise to this most recent crisis. A myopic approach would invariably miss the excesses


that sow the seeds of the next crisis. Instead, the post-crisis fix needs to be as broad-based and comprehensive as possible – in essence, throwing out a big net that would limit as many destabilising risks as possi-ble. The broad fix should both contain both regulatory reforms and a new approach to monetary policy. Only then, will there be a meaningful chance for a safer and sounder post-crisis world.

Glass-Steagall resurrection?Where the Washington debate ends up is anyone’s guess. Right now, the regulatory approach has the upper hand. A resurrection of a Glass-Steagall type separation between the commercial banking function and riskier capital market activities is certainly a possi-bility. Senators McCain and Cantwell have introduced such a proposal – in essence, repealing the decade-old Gramm-Leach-Bliley Act (also known as the Financial Services Modernisation Act of 1999). This effectively repealed the original Glass-Steagall framework.

Meanwhile, none other than former Federal Reserve Chairman, Paul Volcker, has offered a similar proposal that would offer full government backstop support (i.e. deposit insurance and lender of last resort access) to the utility-like commercial bank-ing functions of deposit gathering and lend-ing – but no such support to the proprietary and speculative capital market activities of financial institutions.

The Volcker proposal, which has now been formally endorsed by the Obama administration, is very specific in arguing that commercial banks be prohibited from involvement in proprietary trading, hedge

funds and private equity activities. In that key respect, it is the functional equivalent of Glass-Steagall II.1

Fostering stabilityA re-instatement of Glass-Steagall-like restrictions on the US financial system is one example of a new “macro prudential” approach to regulatory policy that seems to have gained favour in the current post-crisis debate. The goal of such proposals is to put regulations in place that foster stability of the system as a whole. The inference is that the former approach on “micro-prudential” regulations, which were directed at the sta-bility of individual institutions, could lead to investor herding and other counter-produc-tive trends that could be destabilising to the broader financial system.

Other macro-prudential proposals under active consideration include counter-cyclical capital provisioning for banks which would require a build-up of reserves in a boom and less onerous capital requirements in a down-turn, as well as proposals to revamp bonus-driven compensation schemes of Wall Street executives and risk-takers.

Asleep at the switchThe so-called resolution authority to unwind failed financial institutions is another option in the macro-prudential tool-kit – aimed, in this instance, at the critical moral hazard implications of large financial services firms that have become “too big to fail.”

The problem with fixating post-crisis remedies on a macro-prudential regulatory solution is that it ignores the 800-pound gorilla that is also in the same room – mis-directed monetary policies. Yes, regulators


were asleep at the switch in the Era of Excess. So, too, were their political overseers in the US Congress. But the Federal Reserve was hardly an innocent bystander. Excessive monetary accommodation, beginning in the late 1990s, was a conscious outgrowth of the Greenspan-Bernanke view that monetary policy should not be used to prevent asset and debt bubbles and the distortions they foster in the real economy.

Standard argumentInstead, the Fed believed that it had both the power and the wisdom to use monetary policy to clean up the post-bubble carnage. The breadth and depth of the current crisis and recession draws that presumption into serious question.

Yet this remains a very contentious issue in the current macro-policy debate. For Ben Bernanke, the debate goes to the heart of his macro-philosophy – not just as a cen-tral banker but also as an academic before he came to Washington. In an early 2010 speech, Bernanke reiterated his long-stand-ing view that blame for the current crisis rests on the laxity of regulatory oversight rather than on inappropriate monetary policy.2 He underscored the standard argument that monetary policy is too blunt an instrument to deal with asset bubbles – despite the fact that bubble-related distortions on the real side of the US economy ended up engulf-ing nearly 80 per cent of the GDP (personal consumption and residential construction, combined).

When imbalances in the real economy are that large, reliance on the blunt instru-ments of macro-stabilisation policy might not be such a bad idea after all. In my view,

it is not a question of either/or. While some macro-prudential proposals have consid-erable merit, the role of monetary policy during and after this crisis also needs to be examined very carefully. I reject the sug-gestion that post-crisis remedies should be outsourced to regulators. The US financial system post-crisis needs to strike a balance between better regulation, more disciplined monetary policy, and more responsible political oversight. Prudential regulation of financial institutions – whether it is macro or micro – still involves very specific judgment calls affecting the performance of individual companies. While such intervention may be appropriate at times, it is not a substitute for more disciplined monetary policy.

Whatever the balance between the two avenues of control of the financial system, it would be dangerous to put too many eggs in the same basket. While some macro-pru-dential proposals have considerable merit, the role of monetary policy during and in the aftermath of this crisis also needs to be examined very carefully.

The past is historyAs the body politic comes to grips with America’s post-crisis carnage, it must also take a long hard look in the mirror. The fail-ures of the political oversight function were yet another weak link in the increasingly unstable pre-crisis equation. With these considerations in mind, it is important to stress that any post-crisis fix be framed in the context of a comprehensive and forward-looking approach.

By contrast, the narrow and backward-looking approaches of the past are doomed to failure – and to the painful likelihood


of yet another crisis in the not-so-distant future. The experience of the past 10 years underscores how difficult it is to break the habit of monetary accommodation in bubble-dependent economies. Each suc-cessive post-bubble shake-out has required increasingly looser monetary policy. The only way out of this vicious circle is a judi-cious and highly disciplined “exit strategy” – in this case, the unwinding of the unprec-edented monetary stimulus that was put in place to arrest the great crisis and recession of 2008-09. Unlike the fairly mechanis-tic withdrawal of the special liquidity (and capital) injections of quantitative easing that have been put in place in the past year and a half, there is nothing neat and easy about a post-crisis normalisation of the pol-icy interest rate.

That’s not to say that central banks are lacking in the tools and skills to restore benchmark interest rates to pre-crisis con-ditions. The issues in this case boil down to judgment and will – specifically, political will. That’s because the policy rate holds the keys to the kingdom of the financial system – and the support that system provides to the real side of the global economy.

Asymmetrical issuesIn my opinion, the biggest risk to the exit strategy remains an asymmetrical response pattern of the policy interest rate – quick to slash in a downturn, a crisis, or as a result of a post-bubble shake-out, but slow to normal-ise in the subsequent healing and recovery. The post-equity bubble profile of the US federal funds rate in the early part of this

FED FUNDSDATE TARGET

January 2001 6.50%December 2001 1.75%

Reduction 475 bpsNumber of Cuts 11 over 12 monthsAverage Reduction 43 bpsSpeed Per Month -40 bps

June 2004 1.00%June 2006 5.25%

Increase 425 bpsNumber of Hikes 17 over 24 monthsAverage Increase 25 bpsSpeed Per Month +18

bpsAugust 2007 5.25%December 2008 0 to 0.25%

Reduction 500 to 525 bpsNumber of Cuts 10 over 17 monthsAverage Reduction 51 bpsSpeed Per Month -30

bps

Figure 1. The Asymmetries of Fed Policy


decade is perhaps the best – and most rel-evant – illustration of this bias. Over the 12 months of 2001, the benchmark short-term interest rate was cut 11 times from six per cent to 1.75 per cent by a total of 425 basis points; it was then reduced by another 75 bps to one per cent in two additional instal-ments by mid-2003.

A year later, with its mission presumably “accomplished,” the Fed embarked on the road to post-bubble normalisation – taking the funds rate up in 17 separate incremen-tal instalments of 25 bps per move – from one per cent in June 2004 to 5.25 per cent in June 2006. This underscores the asym-metrical biases of the Fed’s post-bubble reaction function. Once the normalisation process finally began in mid-2004, it took the US central bank twice as long to bring the policy rate back to its appropriate post-bubble setting as it did to slash the funds rate

in the aftermath of the bursting of the equity bubble. Putting it another way, the speed of the normalisation – averaging out to 18 basis points per month over a 24 month interval – was less than half the speed of the easing – an average of 40 basis points per month over a 12 month period (see Figure 1).

Check the numbersThis asymmetry was justified by two key considerations – persistently low inflation and the ongoing fragility of a post-bubble jobless recovery. In retrospect, the delayed normalisation was not without serious unin-tended consequences.

As seen through the lens of the real fed-eral funds rate, it meant that the US central bank maintained an extremely accommoda-tive policy stance long after the emergency of the post-bubble shakeout had run its course (see Figure 2).

Source: Haver Analytics, Morgan Stanley Research

-8

-4

0

4

8

12

16

20

24

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

% Morgan Stanley ForecastNominal Fed Funds Rate, %Real Fed Funds Rate, %Average of Real Fed Funds Rate over 1970-2006

Figure 2. The Fed’s Policy Rate


Notwithstanding the ex post justifica-tion for monetary accommodation in recent years, the numbers speak for themselves: Since 2000, the real federal funds rate has been less than its long-term average of 1.9 per cent in all but one year. Over this same period, the real funds rate has been less than zero about half the time.

Fuelling the bubblesIn the decade just ended, for whatever rea-son, the Fed ran the most accommodative monetary policy since the 1970s – hardly a comforting precedent. Notwithstanding the recent contentions of Ben Bernanke, it’s hard to believe that the Era of Excess leading up to the Great Crisis didn’t draw considerable sustenance from such easy money.

With the benefit of hindsight, it now appears that the Fed’s asymmetrical reac-tion function kept US monetary policy in a highly accommodative stance well into 2006. In my view, that played a key role in fuelling the next round of even larger bub-bles – twin bubbles in both the property and credit markets.

Unfortunately, the same movie appears to be running in the current cycle. Going into the bursting of the subprime bubble in the summer of 2007, the federal funds rate stood at 5.25 per cent. Then, beginning in September of that year, it was slashed to its current level of near “zero” in 10 separate moves over a 17-month period. And now the Fed – once again citing sustained low inflation and a shaky post-crisis economic recovery and now making explicit refer-ence to an “indefinite” period of monetary accommodation – is sending very clear sig-nals of another delayed normalisation. With

a striking sense of déjà vu, America’s central bank has once again been quick to ease aggressively – hardly surprising in the midst of the great crisis and recession – but equally reluctant to restore policy settings to pre-crisis norms.

This approach can, and has been repeatedly justified by a risk manage-ment approach to monetary policy. After all, history demonstrates that the bursting of asset and credit bubbles typically takes a lasting toll on the real side of underlying economies. As a result, central bankers have opted repeatedly to err on the side of cau-tion in implementing normalisation strat-egies in the context of fragile recoveries of post-bubble economies. At the same time, this rationale is very much at odds with the “emergency” feature of aggressive crisis-driven policy responses.

This raises the key question of the post-trauma reaction syndrome: If extraordi-nary circumstances cause policy rates to be slashed to unusually low levels, once those same circumstances have been resolved and the emergency is effectively over, then why shouldn’t there be an equally prompt sus-pension of the emergency measures?

‘Earning’ prosperity Putting this in another way – if the US economy is in a weak recovery as the Fed seems to be indicating, shouldn’t the policy rate at least be set at weak-recovery levels? Given the long lags of monetary policy, such forward-looking concerns seem especially relevant. This critical balancing act lies at the heart of the asymmetries of discretionary monetary policy adjustments.

There is another key factor that drives the


asymmetrical post-crisis reaction function of central banks – the desire to foster a steep yield curve that then enables crisis-torn banks to “earn” their way back to prosper-ity. By allowing, if not encouraging, banks to play the spread between rock-bottom short-term borrowing rates and higher yielding intermediate and longer-term market-based investments, central banks can accelerate the healing of earnings-constrained finan-cial institutions. In the US, the Fed discov-ered this approach in the early 1990s in the aftermath of the savings and loan crisis; it was even more effective in boosting earn-ing for beleaguered banks in the aftermath of the bursting of the equity bubble in 2001 and 2002.3

However, the bank earnings subsidy of a steep yield curve is hardly without cost in the broader macro sense – especially if it tempts central banks to stay too easy for too long in a recovery and sets up asset dependent economies for yet another fix from the next bubble.

New policy mandateIt is a key aspect of the moral hazard dilemma – providing banks with the comfort that the central bank will do everything in its power to allow surviving post-crisis financial institutions to earn their way back to recov-ery. Unwinding the yield curve subsidy is yet another critical consideration in evaluating the efficacy of the asymmetrical post-crisis pattern of the policy interest rate.

This financial crisis has unmasked some of the most serious policy blunders by central banks since the 1930s. While the so-called sub-prime crisis and the severe global reces-sion it spawned have many culprits, none

have been more derelict in carrying out their responsibilities than the custodians of the financial system. Any post-crisis fix must address this glaring fault head on.

Ideological debateAdding a “financial stability” provision to the policy mandates of central banks would go a long way in avoiding this type of problem in the future. Notwithstanding a predict-able outbreak of post-crisis remorse, central banks simply cannot be relied upon to break bad habits on their own. Experience sug-gests that they have a hard time saying “no” to the siren song of the latest untested theory that is invariably concocted to explain away asset and credit bubbles. Recent history is lit-tered with false claims of those in denial over the twin perils of asset bubbles and macro imbalances.

Discretionary policy-making has failed in this important respect. It got caught up in an ideological debate over the risks of bub-bles and imbalances. Such temptations can only be avoided by more of a rules-based approach – specifically by a financial stabil-ity mandate that is hard-wired into the legal obligation between central banks and the body politic. This is especially the case for America’s Federal Reserve – long the most powerful central bank in the world, yet at the same time, the one monetary authority that played the greatest role in condoning and nurturing the Era of Excess that nearly brought the world to its knees.

Over the past 75 years, the US Congress has intervened on several occasions to refo-cus America’s monetary authority, and now needs to do so again. For example, Fed policy blunders are widely viewed as central


to the Great Depression. In response, the Employment Act of 1946 was enacted; this required the Fed to aim its policy arsenal toward avoiding a repetition of the massive unemployment that occurred in the 1930s. Then came the double-digit inflation of the 1970s – another outgrowth of poor mon-etary policy – and the Congress passed the Humphrey-Hawkins Act 1978 (more for-mally known as the Full Employment and Balanced Growth Act 1978), which added price stability to the Fed’s mandate. Now, after a decade of asset bubbles and related saving and current-account imbalances, the Congress needs to step in again – this time adding “financial stability” to the Fed’s exist-ing dual mandate.4

How would this work? Like full employ-ment and price stability, the concept of financial stability is very much open to inter-pretation. One thing it should not entail would be setting price targets for key asset markets. Instead, financial stability criteria should reflect a combination of quantitative asset pricing and valuation metrics, together with an assessment of asset-related linkages to the expansion of debt and the risks of imbalances in the real economy.

‘Bow to the wind’There were few doubts of an equity bubble in the late 1990s, or more recently of a con-fluence of property and credit bubbles. Nor were there any doubts that such bubbles had important spill-over effects into the real side of the US economy.

Should such situations arise in the future, as they undoubtedly will, a financial stabil-ity mandate would require the central bank to “lean against the wind” – in effect, setting

its policy rate higher than price stability and/or full employment mandates might oth-erwise require.5 In such frothy climates, the monetary authority would also be required to exercise greater regulatory discipline to manage the capital adequacy of financial institutions, as well as the leverage of return-seeking borrowers.

Policy rate powerCentral bankers typically object to this approach. Both Ben Bernanke and Alan Greenspan have argued that the surgi-cal precision of regulatory policies is more appropriate to deal with asset bubbles than the blunt instrument of the policy interest rate. In the end, it may not be a question of either/or – but more a strategy of using both.

Regulatory action – to say nothing of the central bank’s bully pulpit – can send an important message to market participants. But the policy rate is a far more powerful enforcement mechanism. The point is not to prick every bubble that arises but to inter-vene when excesses in asset markets give rise to dangerous distortions to the real side of asset-dependent economies.

And that, of course, was precisely the case in the period leading up to the sub-prime crisis, when bubble-dependent US consumption and homebuilding activity ended up surging to nearly 80 per cent of total GDP. In such instances, using the blunt instruments of monetary policy to arrest the outsize excesses of bubble-prone economies is both appropriate and desirable.

Yes, such pre-emptive moves could well entail a “growth sacrifice” – an economy that would grow slower than a more free-wheel-ing approach might otherwise suggest. But


the growth that would be sacrificed was artificial from the start. Moreover, if handled correctively – namely, early enough – such a sacrifice need not entail a recession. The resulting growth shortfall would be far pref-erable to the severe downside of wrenching post-bubble adjustments in financial mar-kets and asset-dependent economies such as those that are now playing out. A financial stability mandate offers a far more robust framework than the current ad hoc scheme for evaluating the hows and whens of the exit strategy. Under the prevailing asymmet-rical approach that plays to the downside of post-bubble growth and inflation risks, exit strategies are invariably delayed – thereby setting the stage for yet another round of ever-mounting excesses.

Under a financial stability mandate, there would undoubtedly be more symme-try to the exit strategy – forcing the authori-ties to weigh the perils of asset and credit bubbles against the costs of the growth sac-rifice. That may well mean a more rapid nor-malisation of monetary and fiscal policy than previous policy regimes might have oth-erwise suggested. While that is not exactly a riskless approach in today’s fragile post-crisis climate, I believe it is worthy of serious consideration.

Global implicationsThe financial stability mandate would also empower central banks to take on the new and important responsibility of systemic risk regulators. This is one of the new areas of focus in the post-crisis debate on which there is a broad consensus. The key here, like in so many macro issues, lays in execu-tion – specifically, the mechanisms by which

systemic risks are identified, addressed and appropriate measures implemented.

In essence, systemic risks are all about spill-overs – across financial institutions, asset markets, financial products, and econ-omies. By definition, no one central bank can address these complications alone. It would be like putting pressure on one end of a water balloon. In an increasingly interconnected world, systemic risk regulators all need to be on the same page in this critical aspect of policy formulation and implementation. To do otherwise runs the risk of a fragmented approach to global risk management and regulation – creating market-specific oppor-tunities for “regulatory arbitrage” that could well end up exacerbating global imbalances.

New framework neededRecent G-20 summits in London and Pittsburgh suggest that global leaders want to get serious about establishing a new glo-bal policy and regulatory architecture. If that were the case, then collaborative consulta-tions between national authorities in the area of systemic risk assessment would be an important place to start.

Yet it is not enough to discuss systemic risks periodically at high-profile meetings such as G-20 summits. A new framework needs to be established that explicitly incor-porates international policy co-ordination into the global architecture. Such an effort may well require a global systemic risk man-ager to co-ordinate the surveillance and early warning responsibilities that would mitigate systemic risks.

This functionality should reside in an international organisation – either the Bank for International Settlements (BIS) or the


International Monetary Fund (IMF). But it should be delegated to the professional staff of the BIS or the IMF who would then need to be insulated from any pressures from their politically-selected boards of directors. This could be an important transformational step for the G-20 – converting the rhetori-cal flourishes of periodic communiqués into ongoing operational capabilities.

Contentious issueA robust global architecture demands noth-ing less if the world is ever to cope with sys-temic risks and the global imbalances they spawn. The global implications of the post-crisis exit strategy have recently become an increasingly contentious issue of debate. That’s especially the case these days in devel-oping Asia, where liquidity driven surges in equity and property prices are worrisome, to say the least.

This has sparked yet another global blame game. Asians pin the excesses on reckless liquidity injections made in America and Europe. The West blames it all on Chinese currency policy. While there is some validity to each line of reasoning, the dispute goes back to the deep-rooted global imbal-ances that lie at the heart of this crisis.

This is a classic example of why a glo-balised world needs global policy-making architecture. The G-20 cannot take on responsibility for avoiding crises without having a clear understanding of how to manage post-crisis exit strategies.

A failure to address the global dimen-sions of a financial stability mandate would be a major impediment for global rebalanc-ing. Yet that’s exactly the direction the world is headed. National governments are now

hard at work in crafting their own individual approaches to global issues.

This mismatch reflects a dangerous presumption – that the best global policies are the sum of the best national policies. Nothing could be farther from the truth.

A new and expanded policy mandate is not a sure-fire fix for all that ails a post-crisis world. Nor is it an inoculation against future crises. But it is an important step in the right direction. In the rush to regulatory reform, the vengeance of a polarising populism has fixated on the compensation of risk takers as the major post-crisis remedy. Yet it will take far more than that to create a sounder finan-cial system.

Risk-taking was excessive, not just because of misaligned bonus incentives, but also because the prices of leverage and risky assets were set far too low by misdirected central banks. New proposals for pay guide-lines, regulatory consolidation, or counter-cyclical capital provisioning will work only if they are set in the context of the clearly defined goals and principles of financial stability.

Learning the lessonsLearning the lessons of this crisis is an exer-cise in shared responsibility. Like the rest of us, regulators, politicians, and central banks hardly deserve special dispensation from a critical reappraisal. In the end, they must be held accountable for their failed stewardship of the financial system. They allowed the bedrock of policy discipline to be supplanted by the ideology of self-regulation – the very last thing that increasingly complex financial markets and asset-dependent economies needed. Never again should the authorities


have such open-ended discretion. I have argued that the rules-based approach of a new financial stability mandate for central banks and regulators must be a key ele-ment of the post-crisis financial architec-ture. At the same time, I would be the first to concede that the ideological corruption of financial stewardship was a symptom of the ever-seductive excesses of the growth of the political economy.

In what has been dubbed the ‘Era of Excess’, this was premised on the mistaken belief that financial engineering – namely, using a credit bubble to borrow against a property bubble – could create a new and lasting period of vigorous growth in the glo-bal economy. It’s easy to blame the United States but the entire world was more than delighted to go along for the ride.

Insatiable appetiteYes, bubble-dependent American consum-ers led the way on the demand side of the equation. But export-dependent econo-mies in Asia and even Europe were equally delighted to sustain their growth impera-tives by producing the goods that fed the insatiable appetite of the American con-sumer. Nor was there much of a complaint from resource-dependent economies in the Middle East, Australia, New Zealand, or Canada.

It was the ultimate virtuous circle – one that unfortunately depended on the folly of virtual consumption and the reckless policies that spurred such excesses.

In short, this crisis arose out of the timeworn quest for a shortcut to economic growth. It didn’t have to happen. I categori-cally reject the “inevitability excuse” – the

notion that the world has once again been engulfed by the proverbial 100-year tsunami.

This all too convenient justification is nothing more than a cop-out by those who were asleep at the helm during the Era of Excess. Yes, cycles of fear and greed date back to the inception of the market economy. And those powerful animal spirits were very much at work this time, as well.6

Micro remediesBut I take strong issue with the apologists who claim that little could have been done to avoid the devastating repercussions of the so-called subprime crisis. Instead, there is compelling reason to hold the stewards of the financial system – especially those in Washington as well as those on Wall Street – accountable for much of the blame.

In free-market systems, the body politic renders the ultimate judgment on matters of governance. The emphasis above has been on monetary policy and, specifically, on a new mandate for central banks. That is not meant to take the place of other regulatory reform proposals that have been offered in recent months. But as the debate now unfolds, I worry that too much attention is now being focused on micro remedies – ignoring the macro issues that have come to a head in this wrenching period of crisis and recession.

Cultural extremesIn that same vein, politicians and policy makers face a number of other key macro challenges. The choice between the quick fix and the heavy lifting of global rebalancing is especially critical. It is tempting to recre-ate the old strain of economic growth that


got the world into serious trouble in the first place.

Why not, for example, let Americans go back to excess consumption and the Chinese revert to saving and exporting? After all, as many argue, both societies are culturally inclined toward those extremes. I don’t buy that logic for a second, but I cer-tainly concede that there is a compelling political expediency in maintaining such a status quo.

Nor should politicians be let off the hook in seeking artificial insulation from mount-ing economic pressures through trade fric-tions and protectionism. These risks are particularly worrisome in the current climate. Ultimately, it boils down to a choice between the collective interests of globalisation and the self-interests of “localisation.” In times of prosperity and low unemployment, bellig-erence on trade policy can be dismissed as political posturing.

Policy blundersBut with exceptionally high unemploy-ment in the aftermath of a severe recession and a weak recovery, politicians are likely to remain under serious pressure to protect increasingly beleaguered workers. The risks of protectionist policy blunders are espe-cially worrisome in the aftermath of the Great Crisis. Only through a better under-standing of globalisation – especially today’s strain that is now bearing down on long-sheltered white-collar knowledge workers – can the body politic avoid such dangerous temptations.7

In the end, we can’t delude ourselves into thinking that the lessons of this crisis rest solely in new rules and regulations. They are

a necessary – but not sufficient – condition for a more robust post-crisis architecture. Our problems also have a very important human dimension – namely, they are an outgrowth of the poor judgment that was endemic in a reckless era of self-regulation.

By purging the governance of the sys-tem of untested and misdirected ideological biases, the authorities will be much better positioned to avoid the dangerous interplay between asset bubbles and global imbal-ances in the future.

Political visionNo, I do not harbour the illusion that such steps will banish the threat of financial cri-ses in the future. But to the extent the body politic rises to the occasion, the inevitable next crisis should be far better contained than this one.

This raises the biggest question of all: Do politicians have the vision and the courage to look beyond their normal short-term hori-zons and make the tough choices that could provide a longer-lasting cure for a crisis-torn world? This could well be the biggest test of all for us all in the aftermath and recovery from the recent crisis.

This is not an impossible task. It takes focus and a rigorous analytical framework to pull it off – and, yes, the courage to incur enormous political risk. I remember all too well the widely presumed impossibility of curing the Great Inflation of the late 1970s and early 1980s.

Only way outPolicy makers and politicians were utterly convinced that inflation was deeply entrenched in the institutional fabric of the


system – a system that appeared unwilling to pay the price for the cure. Paul Volcker begged to differ. And with great courage, he led the assault that broke the back of inflation.

It will take a similar approach – and an equally heroic leader – to face up to the imperatives of the exit strategy. A failed exit strategy that is compromised by the political economy of growth only risks another – and even more serious – crisis in the future. The growth sacrifice of an early exit is the only way out.

It must be managed wisely and judi-ciously – and with great sensitivity to the innocent victims of this crisis and recession. It is time to break the daisy chain of asset and credit bubbles – and the global imbal-ances they spawn. If we fail, there may not be another chance.

Volcker’s ‘symbolic’ roleThe prominent role of Paul Volcker in the post-crisis policy debate is symbolic of what appears to be a basic flaw in the American strain of the political economy of growth. Volcker’s assault on inflation some 30 years ago occurred only because the US body politic said “enough.” Through passage of the Humphrey-Hawkins Act of 1978, the Fed then had the political cover it needed to focus on price stability as an explicit objective of monetary policy.

The single mandate, which up until then had focused and aligned policy towards the objective and achievement of full employ-ment, needed to be modified in response to a major shock to the system – runaway inflation. Yet there is nothing in the current dual mandate of America’s central bank

that provides comparable political cover for an assault on asset and/or credit bubbles and the imbalances that they spawn in the real economy. The mandate shaping US macro policy is seriously in need of a major reworking.

Brave new eraWith a new mandate would come a new compact between Wall Street and Washington. And that is long overdue. In the brave new era of self-regulation, the scale and complexity of Wall Street turned out to be a breeding ground for destabilising sys-temic risks.

The policy and regulatory pendulum now needs to swing the other way. And there is good reason to believe that this proc-ess in now under way. But there is always a risk that the post-crisis response will be too extreme, shackling the US financial system and ultimately hobbling American competi-tiveness. Wall Street still excels in providing effective tools for credit intermediation that are essential to productivity-enhancing allo-cation of capital. This role needs to be pre-served at all costs.

While Wall Street deserves its fair share of blame for the Great Crisis, so does Washington. Predictably, politicians, policy makers, and regulators were all delighted during the boom. Equally unsurprisingly, they are not so thrilled with the bust and consequent fallout.

Recipe for instabilityYet the populist blame game offers little in the way of a constructive remedy. A more basic realisation is needed: growth for the sake of growth is a recipe for instability at


best and disaster at worst. In the Great Crisis of 2008-09, the world came very close to the once unthinkable worst-case scenario.

That takes us to that undeniably sticky point where the rubber must meet the road in the post-crisis era: Recognition of the pos-sibility of a growth sacrifice – whether it is an outgrowth of inflation control or financial stability – must be incorporated more explic-itly into political economy of growth.

That remains the most critical challenge in the aftermath of the Great Crisis and Recession. And it defines the fulcrum on which Wall Street and Washington will need to take a careful look at new approaches to both regulatory and monetary policy.

A more sustainable financial system – to say nothing of a more stable and safer global economy – demands nothing less. •

Editor’s note The publisher would like to thank Morgan Stanley Asia and the Reserve Bank of India for allowing the Journal of Regulation & Risk North Asia to print an edited version of this paper, originally presented by Stephen S. Roach, on February 12, 2010, at the bank’s conference in Mumbai, the theme of which was: “Challenges for Central Banks in the Context of the Crisis”’.

References1 See remarks by Paul A. Volcker before the Statutory

Congress of the European People’s Parties in Bonn, Ger-

many, December 9, 2009, as well his testimony before

the Banking, Housing and Urban Affairs Committee of

the US Senate on February 2, 2010.

2 See Ben Bernanke, “Monetary Policy and the Hous-

ing Bubble,” speech before the Annual Meeting of the

American Economic Association, Atlanta, Georgia, Janu-

ary 3, 2010. Bernanke was even more explicit in making

this point in an extended interview with the editors of

Time that accompanied his recent selection as ‘person

of the year’. The Fed Chairman said: “I don’t think that

monetary policy was a particularly important source of

the crisis.” See www.time.com December 16, 2009.

3 This shows up very clearly in the income statement

of US banks over the 1999 to 2002 period. Over that

time frame, loan-provisions for FDIC-insured commer-

cial banks surged from $21.8 billion in 1999 to $48.2

billion in 2002; however, that $26.2 billion increase in

loan write-offs was more than offset by a $44.4 billion

increase in net interest income from $192 billion in

1999 to $236.4 billion in 2002. This earnings buffer was

very much an outgrowth of the Fed’s post-equity bub-

ble yield curve steepening tactics. In the current cycle,

it is much more of an uphill battle. While yield curve

steepening helped boost net interest income by $16.7

billion in 2008, that was more than offset by a $95 bil-

lion spike in loan-loss provisions from $57.4 billion in

2007 to $152.4 billion in 2008.

4 Not surprisingly, the US Congress has now weighed

in with a major legislative initiative that would, in effect,

punish the Federal Reserve for its dereliction of duty in

the years leading up to the Great Crisis. While the bill

proposed by US Senator Christopher Dodd, Chairman

of the Senate Banking Committee, would strip the Fed

of much of its existing regulatory authority, it does not

address the need for a financial stability mandate in shap-

ing monetary policy decisions.

5 See William R. White, “Should Monetary Policy Lean

Against Credit Bubbles or Clean Up Afterwards?” Based

on remarks made at the monetary policy roundtable at

the Bank of England on September 30, 2008.

6 See George A. Akerlof and Robert J. Shiller, Animal Spirits:

How Human Psychology Drives the Economy, and Why

It Matters for Global Capitalism, PrincetonU Press 2009.

7 See Stephen S. Roach, “Perils of a Different Globalisa-

tion” in The Next Asia: Opportunities and Challenges of

a New Globalisation, Wiley 2009.


Regulation

Risk orientation in regulation and supervision

FINMA’s Patrick Raaflaub & Gabe Shawn Varges* detail how the new Swiss supervi-

sory authority is setting its priorities.

rarelY does a supervisory author-ity have an opportunity to rethink its fundamental mission and approach. this is an opportunity which we at the financial Market supervisory authority (finMa), switzerland’s new integrated financial services regulator, are currently having and which we highly value.

The materialisation of this opportunity is taking three main forms: First, how do we define who we are and what we wish to accomplish? Second, what do we expect of the companies that we supervise? Third, how do we go about carrying out our regu-latory and supervisory work?

A common theme in each of these areas is risk, as we will demonstrate in this article. While by itself not a complete guidepost, risk serves as a key driver in shaping our approach, our priorities, and our expecta-tions of what the companies that we super-vise should be doing.

Given the importance of financial serv-ices in the Swiss economy,1 the question of how best to regulate and supervise the sec-tor has long been of central interest among

local industry players, politicians and the public. A variety of considerations – among others a desire to configure a well-posi-tioned supervisory authority that is more able to deal with cross-sectoral issues and with more complex and internationally active players – led to the approval of the recommendation to put under one roof the banking/securities, insurance, and money laundering authorities.2 Previously, these authorities were separate even though good co-operation existed among them.

Twist of historyIt is an interesting twist of history that the idea for a combined Swiss regulator came together increasingly during a time when financial markets were under severe strain following the collapse of the overleveraged ‘new economy’ in the 2001-2003 period and that the resulting product (FINMA) came into existence in the middle of another financial crisis.3 Indeed, FINMA’s birth in January 20094 coincided with the intense activity being pursued in many jurisdic-tions, including Switzerland, to stabilise financial markets following the failures at


Lehman Brothers, AIG, and other financial institutions. In Switzerland, major efforts became necessary to address capital and other weaknesses at one of its two largest banks, a task which straddled precisely the months immediately prior and following the inception of FINMA.

‘What if’ questionsWhile the seeming coincidence indicated above may have taken time away from some items on our ‘first 180 days to-do-list’ – such as optimising our organisational structure5 – it also served to symbolically remind both us as regulators and the mar-ketplace of why robust, well-prioritised supervision is indispensable. During this time we often remarked that one element of a supervisor’s role is to imagine what could go deeply wrong with a given market, product or seemingly solid financial institu-tion. Being conscious of the ‘way down’ part of the potential downside is not a sign of pessimism. It is a reflection of being realisti-cally aware of the full risk spectrum.

Beyond the more formal techniques of stress testing and scenario planning, this mindset also helps the supervisor to ask the tough ‘what if’ questions, probing into the improbable all while recognising that little economic gain can be had without an appropriate degree of risk taking. We think this is a healthy outlook, one which we hope more boards of directors and control functions of companies are adopting.

Setting prioritiesOne matter is the formal powers and tasks that an enabling law provides a supervisory authority. Another matter and, in some ways

of even more importance, is defining, con-sistent with such mandate, the authority’s strategic goals and priorities for addressing the immediate and long-term risks of the industries and companies it oversees. An equally critical task is fashioning the archi-tecture, governance, managerial approach, and culture that will help the supervisor execute and deliver on its goals.

While Article 5 of the law governing FINMA broadly sets out its formal brief,6

FINMA is given considerable room to deter-mine how it will operate. This is consistent with FINMA’s status as an independent institution established under public law. This status not only allows FINMA to set its priorities and make its supervisory deci-sions free from political influence but gives it functional and financial independence7,

including the ability to determine required resources, recruit staff, and set compensa-tion. The latter is critical to be able to attract and retain quality staff with the right skills and experience.

As an integrated supervisor, FINMA’s scope is expansive. This is both a chal-lenge and an advantage. FINMA supervises banks, insurers, stock exchanges, collective investment schemes, securities dealers and other financial intermediaries. The broad nature of this remit means that FINMA must cast its eye across a large landscape, be attentive to a plethora of issues simultane-ously, and appropriately deploy resources.

The breadth of FINMA’s mandate is also a plus. Not only does it lead to oppor-tunities for leveraging horizontally and for otherwise optimising supervisory resources, but it provides FINMA with a more com-plete view of the financial marketplace.


We believe this is particularly valuable in light of the increasing interdependencies across borders, markets, sectors, and even products. Indeed, prudential oversight can be hampered when regulators see only a corner – their corner – of the playing space. We are finding that being under one roof is helping us ‘scope out’ the full field and to identify and harness the interplay of its various players. While some might call this a macro view, we prefer to simply call it a better vantage point for the whole market and for each constituent component.

Checks and balancesTo help us advance our mission, and do so in accordance with the principles of good governance, FINMA’s structure com-prises an independent Board of Directors (all external, non-executive members), a Director or CEO and an Executive Board. The members of the Board of Directors are appointed (and terminated if necessary) by the Swiss Federal Council. The Director is appointed (and terminated if necessary) by the FINMA Board of Directors with the Swiss Federal Council having the right to object on both counts.

The appointment and dismissal of the other members of the Executive Board require the approval of the FINMA Board of Directors. Each of these elements is part of checks and balances integral to FINMA’s governance, as is the fact that FINMA is ulti-mately accountable to the Swiss Parliament and is subject to external audits from the Swiss Federal Audit Office.8

An initial and vital task for FINMA’s Board of Directors and Executive Board was to articulate FINMA’s strategic direction.

In 2009, seven strategic goals were set. The considerations behind these priorities are touched on later in this article. It is worth pointing out that a foremost objective – and one facilitated by FINMA being a new insti-tution – was to set the right tone as we pon-dered where we wished to be many years down the road and what should be the key multi-year drivers.

Market stability, integrityOne clear theme emerged: to be able to address the formal goal of protecting “creditors, investors and insured persons”, FINMA should give, above all, attention to the stability and integrity of the market and the financial system. We felt that to better protect each individual creditor, investor and insured person, FINMA in conjunction with the Swiss National Bank and other important government agencies has to help increase systemic stability and the crisis-resistance of the financial market and its major players. Therefore, limited resources could be prioritised where possible toward this goal, rather than toward more individu-alised, but less systemically impactful activi-ties, such as direct handling of consumer complaints or consumer education.9

Several years from now we would hope to be in a position of higher prudential effectiveness, with better economic and risk analytical capabilities. We feel that these along with our more traditional skills and tools could help us better understand the market context in which our supervised companies operate and identify earlier eco-nomic risks that they may cause, they may transmit, or of which they may become victims. Taking the recent financial crisis as


an example, it would have been helpful for regulators worldwide to have had a deeper grasp of the complexity behind the various linkages surrounding AIG (and Lehman Brothers) and the risks that these repre-sented. Even without going into the detail of what is precisely being measured, the IMF’s depiction below of these10 provides a good sense of the complexities.

In better understanding the market, we feel we will also be in a better position to devise smarter tools and to calibrate more exactingly when and how intensely to use them. Our long-term goal is not more but

more effective and efficient regulation and supervision. This does not mean that we will neglect any responsibility given to us by law. Nor does it mean that we will not give attention to problems at an individual com-pany level or focus only on large companies.

What it does mean is that we will increasingly give more proportional and risk-adjusted attention to a matter by taking into account the size, intensity and dura-tion of its potential impact on the market or on important sectors of the market. This includes looking for material risks but also for smaller risks that together could come to

Figure 1 A Diagrammatic Depiction of Co-Risk Feedbacks


constitute a material risk. A risk focus is not a one-dimensional search for single colos-sal threats. It necessarily includes looking for dependencies and correlations among risks of all sizes since these could combine to also create significant exposures.

Core expectationsBeing better aware of what we expect of ourselves also helps us to fine-tune our expectations of those we supervise. While there are various ways to express this, the following summarise core expectations which encompass a good deal of what is behind FINMA’s various regulatory and supervisory initiatives:

[1] Avoid engaging in any activity for which you do not know or understand the risk. For us the key pre-condition here is not models or technical prowess; rather, it is cor-porate culture. Having a risk-aware culture that allows for open discussion on risks and opportunities and for challenging as needed is an essential ingredient for avoiding taking risks unawares or, as the saying goes, `on a wing and a prayer’.

As the recent financial crisis has shown, another key factor is active oversight of risk by the Board of Directors. As the highest gov-ernance organ of the company, the Board of Directors should set the tone for prudent risk taking, for exercising due diligence, and for ultimately saying no to risks whose contours or implications are not well understood.

The Board of Directors should be part of the discussions regarding risk propensity and tolerance and should formally define or approve the firm’s risk appetite. It should also ensure that this becomes part of the

risk policy which needs to be communi-cated widely within the organisation and on which employees should be regularly trained. Another expectation of companies that we supervise is that they have sound remuneration systems. We do not, nor think it wise, to regulate the size of remuneration, but we do require the Board of Directors of our large companies to ensure that remu-neration: a) does not create incentives to inappropriate risk-taking, b) is subject to proper governance, and c) is properly risk-adjusted.11

We give great weight to remuneration systems as we are aware that highly enticing financial incentives can sometimes trump culture and even controls. The prospect of a high bonus can, if only subconsciously, make a risk seem less risky and ultimately compromise the objectivity of risk assess-ments. In our circular on remuneration we specifically require Board of Director leadership on compensation as well as the involvement of control functions in the design, implementation, and monitoring of the overall compensation system. This is intended to create a healthy check vis-à-vis management. Conflicts can arise when those who stand to gain the most from a remuneration system craft and administer it without adequate oversight or controls.

[2] Don’t pursue any activity for which you are not equipped to effectively manage the risk. While the will to act sensibly on risk is important, will by itself is insufficient. A company may be aware of a risk but still be unprepared to properly manage it, or it may overestimate its capacity to manage it.12 For


example, the recent financial crisis showed that some companies were not fully aware of the risk of investing in subprime mortgages or CDS. It also demonstrated that some companies were aware of the risk but were not in a position to hedge, reserve against, or otherwise manage it. In some instances this was due to the company not fully under-standing the forces that could affect the value of these instruments, not appreciating how far these investments could fall, or overesti-mating their company’s ability to counteract or cope should such a fall occur.

Skills, tools and resourcesTherefore, we expect the companies we supervise to be equipped to manage risk by making continuing investment in the devel-opment and maintenance of the right skills, tools and resources as well as the right gov-ernance and controls. This includes:• having properly positioned, authorised,

and resourced risk and other control functions;

• ensuring that the identification of risks is early and thorough;

• communicating identified risks on a timely basis to the right persons and company structures consistent with a sound governance process – this includes ensuring that the Board of Directors is promptly informed of mate-rial risks and takes necessary action;

• ensuring that the assessment, modelling and decision on each risk is objective and sound; takes into account a healthy measure of remote probabilities, includ-ing through proper scenario and stress testing; is not only quantitative but sup-plemented by appropriate qualitative

considerations; takes into account the long-term interest of the company;

• taking steps to effectively manage the risk, not just to catalogue and observe it (a weakness we sometimes per-ceive among certain risk management functions);

• testing periodically the design and oper-ational effectiveness of risk systems;

• having robust controls in place to reduce the chance of deviation from agreed-upon risk measures occurring without necessary governance approval, includ-ing that of the Board of Directors for potentially material risks;

• ensuring that appropriate action is taken in respect of personnel, no matter how senior, who disregard risk, compliance or other important company policies.

[3] Don’t look at any risk in isolation …search for interconnectedness. As stated earlier, supervisors need to increase their ability to see the larger context of risks and spot earlier possible linkages among seemingly disparate risks. So too do com-panies. This kind of ‘connecting the dots’ requires concerted effort and has to be sup-ported by proper reporting and assessment systems.

The ability to spot linkages rests on having an enterprise-wide view so as to know what other parts of the company are doing and which risks each is taking or is exposed to (failure to do this prevents, among other things, proper measuring of risk concentrations, as happened at some companies during the recent financial cri-sis where subsidiaries or units had expo-sures in the same product area or to the


same counterparty without each knowing this or without this being fully grasped at the group or headquarters level). It also includes understanding the correlation of the various categories of risks and taking into account company-specific but also industry and market-wide risks.

Connecting the dots also means having the capacity to effectively aggregate all risks to form and keep an up-to-date total risk picture faced by a company. This is critical for decision-making. Without it a singular risk may appear acceptable, but when such risk is examined in light of the aggregate risk picture it may show that accepting it would tip adversely the total risk-reward scale. This also highlights the importance of hav-ing a well-defined (and Board-approved) risk appetite and risk limits.

[4] Learn from past mistakes but also invest more effort anticipating the risks to come. To a supervisor there is nothing more dis-heartening than to see a company repeat previous errors or misjudgments. This can occur when identified shortcomings are not followed by prompt remediation and lessons-learned type of training. It can also happen when earlier missteps are forgot-ten as a result of changes in the company’s Board of Directors or senior management. In this respect control functions play a special role as they usually have more continuity and are therefore better positioned to help prevent corporate amnesia.

Look to the futureBut while the past is an important refer-ence point, rapid changes in the social, technological, economic, climatic, and legal

environments necessarily require equal focus on what lurks over the horizon. Some risk management functions may tend to overweigh already known risks at the expense of not doing enough to consider what might still come. A company asking itself questions such as those outlined below can help ensure that it is also positioned for understanding tomorrow’s, not just yester-day’s risks: Does our company have a dedi-cated emerging risks group? How robust are its analyses in identifying trends and future threats in all relevant areas? Are the necessary functions and people represented on such body so as to have as many angles as possible with regard to the future land-scape? What percentage of our risk efforts is dedicated to identifying and preparing for emerging risks? How much time does the Board of Directors spend in this area? What forward-looking risk indicators do we have in place? Are our company’s business strat-egy, risk appetite, and risk management resources adjusted early enough in antici-pation of emerging risks?

Risk as a ‘prioritiser’A risk approach also helps FINMA carry out its regulatory and supervisory work. The risk focus not only helps prevent that a major threat, current or future, is missed; it is of benefit also as a prioritisation tool for managing. It can help order agendas and facilitate discernment of difficult choices in the face of competing needs.

As indicated earlier, FINMA is working to make headway on the challenge of how to regulate and supervise more effectively and more efficiently. This forces us to seek a bal-ance between prevention and enforcement


and between principles and more concrete rules where needed. Principles create more flexibility at the potential cost of less predict-ability, while rules create more predictability at the potential cost of unnecessary rigidity and possibly more burden on companies. In tackling these challenges, we have found that a risk-guided approach helps us make better decisions on the trade-offs involved. It is also contributing towards shaping pol-icy responses on three specific fronts: the what, the who, and the how in respect of regulation and supervision.

The ‘what’Increasingly, we are using a risk approach to help define specific areas that merit super-visory and, if needed, regulatory attention. Some examples of these are: activities that may be particularly susceptible to causing or transmitting market-disrupting or mar-ket-distorting risks or to being subject to such risks; capital adequacy and solvency; liquidity risk; funding and credit risk; invest-ment risk; cross-border risk; overall market, operational and other important risks.

The risk approach is also allowing us to look at more qualitative areas such as the soundness of the basic business model and strategy of a company; company prepared-ness on crisis management and contingency planning (for various market scenarios and even for any potential winding down of any of its businesses); and the quality of stew-ardship of the company, including a strong Board, capable managers, and effective control functions

The ‘who’The risk approach is also helping us with

the “who” question. On which institutions should we focus our attention?

The main goal of this is not to create any hard-and-fast lists but to move more in the direction of using our time and resources on any institution in closer proportion to its risk significance. Factored in are many ele-ments, such as the sector and activities in which the institution is active, its size and financial significance, its complexity, and its overall risk profile. The risk profile may be influenced not only by the kinds of risks the company takes but how prepared it is to manage such risks.

This type of approach is allowing us to set certain priorities. For example, we are giving heightened focus to institutions that are of such magnitude that their instability or failure could have major or even systemic economic impacts; groups, conglomerates, and other particularly complex companies; companies involved in particularly risky products or markets, including on a cross-border basis; companies that repeatedly come uncomfortably close to the minimum capital or other financial regulatory stand-ards; and companies displaying material weakness in governance or deficient risk management or control systems.

As we advance further, we hope to be able to refine further our approach to more reliably capture, for example, those compa-nies showing patterns of financial instabil-ity or which could pose a concentrated risk such as by having a particularly high market share in a key market segment.

The ‘how’Finally, we are finding that the risk approach is also helping us define priorities


with regard to the ”how”, i.e. the ways and means by which we should regulate13 and supervise. This may be expressed as clusters of efforts. These clusters are: • Calibrating the nature, frequency and

intensity of supervision. This relates to predicating any important supervisory activity on the risk profile of the company in question, its complexity and other fac-tors discussed earlier. It involves adjust-ing accordingly the supervisory activity, its timing, and its degree of intensity. It also includes endeavouring to supervise economic activities of similar nature and similar risk in a more consistent way, whether the activity is located within a banking or an insurance entity. As risks shift, this approach permits more a tai-lored and nimble response and quicker shift of focus.

• Deploying the right tool from a wider arsenal of tools. This is about aiming to match more closely a tool with the per-ceived problem or need. For example, there may be a need to better monitor companies, to more forcefully enforce, to cover regulatory gaps, or to induce cer-tain conduct among companies. Each of these types of needs necessitate careful review in order to select the most appro-priate tool.14 The range of tools include risk rat-

ing companies and using tiering or peer schemes to monitor or analyse compara-tively similarly-positioned companies; vari-ous quantitative and qualitative reporting requirements, assessments and stress-test-ing, some designed to help provide a type of early-warning radar;15 focused risk dialogues with companies; sensitising and encouraging

companies to better self-govern and volun-tarily pursue ‘best practices’; rules and guide-lines, such as those related to compensation, where mere encouragement may not suffice; inspections and audits (some of which may be outsourced to third parties); warnings and sanctions, such as suspension or withdrawal of the right to operate.

Another important aspect of the “how” relates to two areas: internal and external leveraging and networking. As suggested earlier, the very conception of FINMA as an integrated regulator rests on the premise that integration can facilitate leveraging of resources. In FINMA’s 14-month existence we have found that being integrated is of value not simply to optimise resource usage and increase cost efficiency but also to cross-fertilise internal know-how and explore areas where greater supervisory or regula-tory consistency across sectors could bring value. We are using mixed project teams staffed with members from the various areas we supervise. We aim to make our work on the supervision of groups more cross-secto-ral. Our effort on the so called ‘too-big-to-fail challenge’16 looks at banks and insurers. Our commitment to governance and risk man-agement is demonstrated through having put in place senior-level FINMA-wide func-tions for each of these areas.

Feedback and ideasLeveraging and networking is also criti-cal for FINMA at an external level. This takes the form of close co-operation locally with Swiss governmental and supervisory authorities, such as the Swiss National Bank and our Federal Department of Finance. It also includes working with industry groups,


academia, and many others who can supply us feedback and ideas.

Another critical external dimension to our work is our international efforts. We are keenly aware that global and regional chal-lenges cannot be resolved solely by national solutions. We also know that in order to be effective, the development of international standards requires the active participation of national regulators and that a national regu-lator stands to improve its own performance by learning from what regulators in other countries are doing.

An essential component of FINMA’s strategy is therefore to contribute to key international bodies and initiatives on a pri-oritised basis. We are active members and in some cases hold leadership positions on expert task forces and committees of inter-national bodies such as the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, the International Organization of Securities Commissions, and the Joint Forum. Equally importantly, we pursue close co-operation with regional bodies, such as the European Union and its various bodies, and with specific countries through regular bilateral dialogues. These efforts helps FINMA to develop a more complete understanding of the risk picture regionally and globally and of the tools and remedies available to regula-tors in this regard.

Conclusion As an integrated regulator, FINMA is still young but our experience so far suggests we have embarked in the right direction. Being new and being one team under one roof is helping us to rethink, reform, and advance

our mission and our work. We are finding that having a risk focus is invaluable for mak-ing better decisions in respect of the institu-tions we supervise and the ways to optimise our work as a supervisor.

Some insights that our predecessor authorities already had gained – such as the imperative of having a true consolidated view of groups and conglomerates – have been reinforced during our first 14 months of operation. Other newer insights have emerged, such as a deeper appreciation of the need (a) to be earlier aware of material risks building up in the financial system or moving across borders and (b) to look at risk not only on company-by-company basis but on a basis that aggregates the risks of indi-vidual companies and seeks to spot trends, commonalities, and potential impacts on critical parts of the market, on the financial system as a whole, or on public trust and confidence.

If we can improve the above capabili-ties – all while continuing carefully selected activities from a more traditional supervisory approach – we feel that we will be better able to fulfil our responsibilities to custom-ers, shareholders, and other relevant stake-holders of the companies we supervise. We will also advance further toward meeting another responsibility we are given by law, namely contributing to “the general func-tioning of the financial markets” and “the competitiveness of Switzerland as a financial centre”.17 •

End notes* Mr Raaflaub is CEO of FINMA. He holds a Doc-

torate in Economics and Political Science. Mr. Var-ges is Head of Governance of FINMA. He holds


M.A. and Juris Doctor degrees and is an Attor-ney-at-Law. Photograph by Edouard Rieben.

1. Banking and insurance represent about 11 per cent of the Swiss GDP and five per cent of employment. Assets of Swiss banks and insur-ers are some 8.9 times the level of GDP. Source: OECD, Economic Surveys, Switzerland, Vol. 2009/20, December 2009, Supplement 2, p. 59, referring to figures as of end 2008.

2. The bodies merged were the Swiss Federal Banking Commission (SFBC), founded in 1934; the Federal Office of Private Insurance (FOPI), founded in 1874; and the Anti-Money Laundering Control Authority, founded in 1997.

3. Two main taskforces were involved in formulating recommendations. The first (the Zufferey Expert Group) offered numerous new regulatory and organisational options and completed its work in November 2000. One option considered was integrating the then existing supervisory authori-ties. A second taskforce (the Zimmerli Expert Group) was commissioned by the Swiss Federal Council in November 2001. This group delivered its recommendations in three instalments in 2003, 2004 and 2005.

4. Parliament approved the Federal Act on the Swiss Financial Market Supervisory Author-ity (FINMASA) on June 22, 2007. The Federal Council ratified the implementing provisions for FINMASA on October 15, 2008, with the Act entering into full force on January 1, 2009.

5. This is a task on which we continue to work, though we were able by September 2009 to already achieve one milestone: streamlining the management structure and reducing the number of members on the Executive Board to improve decision-making and achieve other efficiencies.

6. FINMA’s purpose is described as “protecting creditors, investors, and insured persons and ensuring the general functioning of the financial

markets.” Article 5, Act on the Swiss Financial Market Supervisory Authority, 2007.

7. Financial independence is also furthered by the fact that FINMA does not receive state money. It covers 100 per cent of its expenses through fees and assessments paid by supervised entities under a “user pays” principle.

8. FINMA also has its own internal audit and com-pliance functions, and has now created FINMA-wide governance and risk management functions.

9. Supervisors in some jurisdictions which have tended to devote a disproportionate part of their time and resources to these kinds of indi-vidualised efforts are now facing various kinds of pressures, including the possibility of losing responsibility for prudential oversight.

10. The illustration is from the International Mon-etary Fund, “Assessing the Systemic Implications of Financial Linkages”, Global Financial Stability Report, April 2009.

11. Switzerland was one of the first countries to act in response to the April 2009 Financial Sta-bility Board Principles for Sound Compensation Practices. FINMA issued a draft remuneration circular for public comment already in June 2009. The final version of the circular was issued in October 2009 and came into force on January 1, 2010. In 2010 FIMMA is focusing on super-visory activity to advance and monitor company preparation for implementation of the Circular, which is fully required as of January 2011. For others institutions it is recommended that they take into account the principles of the Circular for their remuneration practices as best practice guidelines.

12. A recent FINMA survey would suggest that some financial institutions may tend to be more optimistic about their overall risk, as well as gov-ernance, preparedness than a more objective assessment would support.


13. Specific regulatory elements in place or being contemplated by FINMA on the banking, securi-ties and insurance sides are beyond the scope of the present article.

14. Some of these supervisory instruments are set out in Articles 29-37 of the Act on the Swiss Financial Market Supervisory Authority, 2007.

15. Examples of this include our tools for stress test-ing on the banking side, the Swiss Solvency Test for insurers and the Swiss Qualitative Assess-ment. The latter is currently limited to insurers. See “Governance, Risk Management, and Internal Controls at Swiss Insurers: Observations from the first Swiss Qualitative Assessment”, February 1, 2010 on www.finma.ch

16. The term refers to efforts being pursued

at various international organisations as well as in some countries to identify each of those financial institutions which are of such size or economic significance that it would be difficult for national or interna-tional authorities to allow it to go bankrupt or otherwise fail for fear of major damage to the local or international financial system. The efforts include contemplating possible measures to help prevent any such failure, to reduce the impacts if a failure were to occur, and to prepare for a more orderly wind-down should the viability as an on-going concern of any such institution become compromised.

17. Article 5, Act on the Swiss Financial Market Supervisory Authority, 2007.

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ContactChristopher RogersGeneral [email protected]

Articles & PapersIssues in resolving systemically important financial institutions Dr Eric S. RosengrenResecuritisation in banking: major challenges ahead

Dr Fang DuA framework for funding liquidity in times of financial crisis

Dr Ulrich BindseilHousing, monetary and fiscal policies: from bad to worst

Stephan Schoess,Derivatives: from disaster to re-regulation

Professor Lynn A. Stout Black swans, market crises and risk: the human perspective

Joseph RizziMeasuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian FahrholzThe ‘family’ risk: a cause for concern among Asian investors

David SmithGlobal financial change impacts compliance and risk

David DekkerThe scramble is on to tackle bribery and corruption

Penelope Tham & Gerald LiWho exactly is subject to the Foreign Corrupt Practices Act?

Tham Yuet-MingFinancial markets remuneration reform: one step forward Umesh Kumar & Kevin MarrOf ‘Black Swans’, stress tests & optimised risk management

David SamuelsChallenging the value of enterprise risk management

Tim Pagett & Ranjit JaswalRocky road ahead for global accountancy convergence

Dr Philip GoethThe Asian regulatory Rubik’s Cube




Journal of Regulation & Risk North Asia

147

Legal & Compliance

Who exactly is subject to the

Foreign Corrupt Practices Act?

In this paper, Tham Yuet-Ming, DLA

Piper Hong Kong consultant, examines the

pernicious effects of the FCPA in Asia.

The US Foreign Corrupt Practices

Act (FCPA), has its beginnings in the

Watergate era, when the Watergate Special

Prosecutor called for voluntary disclo-

sures from companies that had made

questionable contributions to Richard

Nixon’s 1972 presidential campaign.

However, these disclosures revealed

not just questionable domestic payments

but illicit funds that had been channelled

to foreign governments to obtain business.

The information led to subsequent investi-

gations by the US Securities and Exchange

Commission (SEC) which revealed that

many US issuers kept “slush funds” to

pay bribes to foreign officials and political

parties. The SEC later came up with a voluntary

disclosure programme under which any cor-

poration which self-reported illicit payments

and co-operated with the SEC was given

an informal assurance that it would likely

be safe from enforcement action. The result

was the disclosure that more than USD$300

million in questionable payments (a mas-

sive amount in the 1970s) had been made

by hundreds of companies – many of which

were Fortune 500 companies. The US legis-

lature responded to these scandals by even-

tually enacting the FCPA in 1977.

There are two main provisions to the

FCPA – the anti-bribery provisions, and the

accounting provisions. Both the SEC and the

US Department of Justice (DOJ) have juris-

diction over the FCPA. Generally, the SEC

prosecutes the accounting provisions and

the anti-bribery provisions as against issuers

through civil and administrative proceedings

whereas the DOJ prosecutes companies and

individuals for the anti-bribery provisions

through criminal proceedings.

The anti-bribery provision

The FCPA’s anti-bribery provision makes it

illegal to offer or provide money or anything

of value to foreign officials (“foreign” mean-

ing “non-US”) with the intent to obtain or

retain business, or for directing business to

any person.

Anything of value can include sponsor-

ship for travel and education, use of a holi-

day home, promise of future employment,

discounts, drinks and meals. There is no


163

Risk management

Of ‘Black Swans’, stress tests & optimised risk management Standard & Poor’s David Samuels outlines the positive benefits of bank stress testing on the bottom line.It is a big challenge for banks to build

a robust approach to managing the risk of worst-case stress scenarios that, almost by definition, are triggered by apparently unlikely or unprecedented events.

However, solving the problem of identi-fying the risk concentrations and dependen-cies that give rise to worst-case outcomes is vital if the industry is to thrive – and if indi-vidual banks are to turn the lessons of the past two years to competitive advantage. Banks that tackle the issue head-on will

be lauded by investors and regulators in the coming years of industry recuperation and, most importantly, will be able to deliver sus-tained profitability gains. Meanwhile, banks that are well placed to take advantage of the consolidation process need to be sure they can understand the risks embedded in the portfolios of potential acquisitions. To improve enterprise risk management

and strengthen investor confidence, we think banks can take the lead in three related areas:

Better board and senior executive over-sight and control of enterprise risk man-agement; re-invigorated stress testing and

downturn capital adequacy programs to uncover risk concentrations and risk depend-encies, and; applying these improvements to drive business selection – for example, through performance analysis and risk-adjusted pricing that takes stress test results into account.

Top-level oversightBuilding a more robust and comprehensive process for uncovering threats to the enter-prise is clearly, in part, a corporate govern-ance challenge. The board and top executives must have the motivation and the clout to scrutinise and call a halt to apparently profit-able activities if these are not in the longer-term interests of the enterprise or do not fit the intended risk profile of the organisation.

But contrary to popular opinion, improv-ing corporate governance is not just a ques-tion of putting the ‘right’ executives and board members in place and giving them appropriate incentives. For the bank to make the right deci-

sions when they are difficult, e.g. when business growth looks good in the upturn, or when risk management looks expensive



Regulation

Regulation, supervisory lessons from Japan since the 1990s

Former BoJ Policy Board member, Kazuo Ueda, details significant changes to Japan’s

regulatory environment in recent years.

the regulatory and supervisory struc-ture of Japan’s financial industry has been a fairly simple one. until the late 1990s, most regulatory and supervisory functions belonged to the Ministry of finance (Mof). following widespread criticisms, fiscal policy and financial administration was separated.

The Financial Supervisory Agency (FSA) was established in June 1998 and since then has been in charge of inspection and super-vision. Furthermore, drafting of laws and other rule-making functions concerning the financial system were moved from the MoF to the FSA in July 2000. Similarly, the plan-ning and execution of measures directed at crisis prevention and containment went to the FSA after disbandment of the Financial Reconstruction Committee.

One exception to this structure is that the FSA delegates the surveillance of secu-rities and financial futures markets to the Securities and Exchange Surveillance Commission. The transfer of the finan-cial regulatory responsibility from the MoF to the FSA has created one substantive

change regarding financial crisis resolution. The FSA, unlike the MoF until 1997, cannot make independent decisions on the use of public money for resolving financial crises.In order to fill the gap, a committee headed by the Prime Minister – the Financial Crisis Management Council – now exists to make decisions on the use of exceptional measures involving fiscal resources during a financial crisis. I will return to this point later.

Broader interpretationIn addition to the FSA, the BoJ has carried out inspections (on-site examinations) of the financial institutions that have current accounts with the BoJ. The BoJ law stipu-lates that the bank can enter into contracts with financial institutions to carry out on-site examinations in order to fulfill its objective of the maintenance of financial system stability. The BoJ seems to interpret the role of inspec-tion more broadly. The BoJ (2004) states that: “The Bank conducts on-site examinations and off-site monitoring of financial institu-tions that hold current accounts with the Bank, so that it can assess their business operations and financial condition, and,


where it is necessary from the perspective of maintaining financial system stability, urge institutions to make improvements. The Bank uses the information it acquires to improve the payment and settlement sys-tem, and to better understand the financial intermediary function of financial institu-tions when conducting monetary policy.”

Off-site monitoringIt is noteworthy that non-bank financial institutions such as securities companies, money market dealers and securities finance companies have accounts with the BoJ and are thus more likely, than in the case of the absence of transactions with the BoJ, to obtain lender of last resort status from the BoJ. The practice of regular on-site exami-nations and the possibility of LLR lend-ing have provided the BoJ with significant power to collect a diverse range of informa-tion on financial institutions through off-site monitoring.

After the burst of the stock price and land price bubble in the early 1990s, the Japanese financial system experienced serious stresses for more than a decade. The bad loan-related losses of depository institutions amounted to about 110 trillion yen; some 20 per cent of GDP. As a consequence, many banks, secu-rities and insurance companies went under.

Of the 110 trillion yen losses of deposi-tory institutions, the government took a loss of 10.4 trillion yen and the banks assumed the rest. This in turn meant writing down bad loans out of current profits and provi-sion of financial assistance to debt holders of insolvent banks by the Deposit Insurance Corporation of Japan (DICJ) that collected insurance premiums from banks.

The government injected capital to 57 financial institutions – 12.4 trillion yen, of which at the time of writing about 75 per cent has been returned. The government also created programmes to purchase assets from financial institutions; the purchases amounted to approximately 10 trillion yen and most of this has been recovered when factoring in the inclusion of capital gains.

In the early 1990s the government, effec-tively the MoF, employed a scheme whereby healthy financial institutions could take over troubled ones by providing financial assist-ance from the DICJ that was within the payoff cost of troubled financial institutions. As the crisis turned more serious in the mid- 1990s, it obviously became difficult to find financial institutions capable of taking over those in trouble. Consequently, the govern-ment decided to establish bridge banks to which private banks and the BoJ provided capital.

Safeguarding depositsIn 1995, in order to contain depositor fears about the health of financial institutions, the government also announced the policy to protect all deposits. Furthermore, again in 1995 the government decided to use tax-payers’ money to resolve the crisis emerging with a group of non-bank financial institu-tions called Jusen (special housing loan cor-porations). The government also took the decision to use taxpayers’ money to resolve problems with credit unions. At this stage, however, the use of public money was not extended to larger financial institutions. In general, public opinion was fiercely opposed to “assisting” financial institutions.

In the autumn of 1997, the failure of a


medium-size securities company, Sanyo Securities, triggered a panic in Japan’s finan-cial system and led to the failure of three other financial institutions in the same month. Public opinion quickly reversed and turned in favour of using public money for resolution of the financial crisis.

Public moneyThe government decided to use pub-lic money to resolve problems concern-ing larger financial institutions by injecting capital. Despite the initial round of capital injection, which was in total 1.8 trillion yen to 21 banks, stresses in the financial system did not dissipate and the Long-term Credit Bank of Japan and Nippon Credit Bank faced serious attack by the market. In 1998, the government decided to temporarily nation-alise these banks and injected a second round of capital, amounting to 7.5 trillion yen, to 15 large banks in early 1999. Stresses continued into the early 2000s, but finally with significant bad loan write-downs and economic turnaround, the financial system finally began to emerge from the crisis in the mid-2000s.

In response to the normalisation of the financial system, the government discontin-ued the programme to protect all deposits. Since 2005, protection by deposit insurance has been confined to transactions bal-ances and other deposits (up to 10 million yen). Separately, in order to cope with sys-temic risks, the government established the Financial Crisis Management Council that consists of the Prime Minister, the Minister of Finance, Commissioner of the FSA, the Chief Cabinet Secretary and the BoJ Governor. The Prime Minister, after discussions at the

council, determines if exceptional measures – such as capital injection, to full protection of all liabilities, and temporary nationalisa-tion of financial institutions – are necessary to contain potential systemic risks. As a result, the BoJ involvement in crisis manage-ment is now in principle confined to lending to solvent but illiquid financial institutions, lending to financial institutions receiving public support based on the decision of the Prime Minister, and lending to DIC with government guarantee.

What can we say about the performance of Japan’s regulatory structure, then, in light of the history of Japan’s financial system and regulatory response during the past two decades?

To begin with, it may be appropriate to discuss why regulators were unable to check the formation of a stock and land price bub-ble, especially, the land price bubble. After all, the MoF possessed huge power to influence the behaviour of Japanese financial insti-tutions; it was effectively supervising and monitoring all financial institutions.

Uneven deregulationThere is a view that blames the uneven pace of financial deregulation that had taken place in Japan since the late 1970s. Large sales of government debt and other forces led to significant liberalisation of the bond market, while liberalisation of retail deposit rates and the availability of other financial instruments lagged behind. Large compa-nies left banks and went to the bond market to raise funds, but deposits continued to flow into banks. Rigorous separation of banking and securities businesses remained in place. Banks competed fiercely for loans. An easy


way out was to focus on land and equity-related loans. While these factors appear to go some way toward explaining the forma-tion of the bubble, it still leaves unanswered the failure of the regulatory authorities to check the growth of real estate and equity-related lending at an early stage.

Failure to prevent bubblesHoshi and Okazaki (2002) point out that while the MoF was aware of the growth of these loans, it was more worried about ris-ing real estate prices and the consequences for income distribution than the possibility of financial instability arising from the possible burst of the bubble. The MoF did ask finan-cial institutions to slow down real estate lending in 1985. Since 1986, the MoF had ordered financial institutions to report regu-larly on real estate related loans. In 1987 at the request of the MoF, financial institutions agreed to voluntarily contain the growth of such loans. But lending and the rise in prop-erty prices continued. It appears that the MoF did not employ strong enough policy measures.

Aggravating the situation was a Japanese version of the “shadow banking system.” Banks lent huge amounts to non-bank financial institutions which in turn lent to residential and commercial real estate related projects. Included among these were the so-called Jusen, special housing loan companies that started as entities specialis-ing in residential mortgage loans but later expanded business to the extension of com-mercial mortgage loans. As the MoF’s guid-ance to contain the rise in real estate related lending became tougher, financial institu-tions increasingly lent through the shadow

banking system. During the mid-1990s, banks and insurance companies lent 13 tril-lion yen to seven Jusens, of which six trillion yen became non-recoverable. Lending by banks and insurance companies to other non-banks was even larger at around 50 trillion yen. A significant portion of this was also channelled into real estate related loans.The MoF was surely aware of the situation, but once again did not crack down on the problem.

The bank inspections failed to find major problems with bank behaviour. After its fis-cal year 1988 inspection – in which the MoF emphasised the significance of its activities as they were seen to place importance on risk management by financial institutions – the MoF concluded that “on the whole, credit risk is prudently and properly man-aged.” However, financial institutions had enormous exposure to the property market.

Non-bank lending effectAs has been argued, in addition to direct lending by banks to real estate and construc-tion companies there were indirect expo-sures through non-banks. Furthermore, significant portions of loans in general were backed by land as collateral. Neither the reg-ulator nor financial institutions seem to have taken the trouble to calculate the vulnerabil-ity of financial institutions to changes in land prices. Kumakura (2008) points out that the director of the BoJ’s inspection department warned in 1986 that financial institutions’ lending was too concentrated within a small number of industries. However, there is no sign that such a concern led to significant action by the BoJ.

Japan’s experience during this period is


an example of the difficulty of taking proper care of tail risks. After all, with the excep-tion of 1974, land prices in Japan had never declined in the post-war period.

Any statistical analysis that relied on past data would have placed a negligible prob-ability to the possibility of significant land price declines. It was not easy for inspec-tors to warn of such risks of declines in land prices. In the end, the manifestation of a “tail risk” hit the Japanese financial system extremely hard.

MoF dictatThe MoF did employ a very strong weapon in March 1990 when it ordered banks to limit the growth of loans to the real estate indus-try to the growth of total loans. This appears to have exerted strong negative effects on property prices, but probably came too late and may have made the downturn in land prices overly severe.

During all this, the question that needs to be asked is what was the BoJ doing on the monetary policy side? As is almost always the case with large bubbles; this bubble turned on easy monetary policy. Responding to the deflationary effects on the economy of yen appreciation in the mid- to late 1980s, the BoJ lowered the discount rate five times from 5.0 per cent to 2.5 per cent between January 1986 and February 1987. In its economic outlook report in the sum-mer of 1987, the BoJ noted that “we have to be very cautious about the risk that the rise in asset prices (which is supported by easy monetary conditions) will jeopardise income equality and the health and stability of the economy in the long run.” The BoJ, how-ever, started the process of raising rates only

two years later – in May 1989 and by August 1991 moved the discount rate up to six per cent. As with the MoF’s policy of restricting credit to the real estate sector, the BoJ’s rate increases seem to have come a little too late and the absolute size of the rate increases may have been too large.

To summarise, both the MoF and the BoJ recognised the relationship between easy monetary conditions and rising asset prices. They seem however, to have been fairly opti-mistic about the long-term upward trend of asset prices. In other words, they were a captive of “this time it’s different” psychology.Even when they worried about this, as in the BoJ’s case in 1987, they did not take decisive action at an early stage.

It also appears that either the depart-ments within the MoF and the BoJ in charge of bank inspection were not equipped with ways to assess, measure, investigate, research and model systemic risks; and when they became concerned as the situation deterio-rated, their views were not effectively used in macroeconomic policy-making as the risks became more apparent and tangible.

Period of inactionIn retrospect, the mid-1990s can be seen as a period when the authorities could have acted more decisively and promptly to resolve the emerging financial crisis but failed to do so and allowed the vicious cycle between a dys-functional financial system and a stagnating economy to play itself out.

Looking at the BoJ, one is struck with the slow speed with which the BoJ recog-nised the effects of the deterioration in the financial system on the economy. The Nikkei 225 declined by more than 50 per cent by


October 1990. The fall in the index of urban land prices only emerged more in 1992, but the BoJ must have known the state of the property market at a much earlier stage. Looking at the BoJ’s economic reports, how-ever, one does not find reference to the nega-tive effects of the balance sheet deterioration of financial institutions on the economy until the fourth quarter of 1993.

Failure of the hawksAnecdotal evidence suggests that the pru-dence wing of the BoJ was more concerned about the state of the financial system and a possible vicious cycle between the finan-cial system and the economy. However, this did not seem to have affected the monetary policy wing before it became too late.

On the MoF’s side, the key issue was the delay in the decision to use public money to resolve the financial crisis. As previously explained, the absence of the decision to use taxpayers’ money until the mid-1990s led to the reliance on “taxes” on financial institu-tions and for the BoJ to construct schemes to address bad loan problems and naturally limited the scope of such operations.

A significant turning point came when the deterioration of the balance sheets of Jusen became very apparent in 1995. The banking bureau of the MoF was still work-ing on the assumption that no taxpayers’ money could be used to address the situa-tion. Powerful lobbying activities by agricul-tural banks that would have been hit hard without the use of public money forced the budget bureau to make a decision to use 685 billion yen in taxpayers’ money to resolve the situation. Non-transparency in the process of decision-making was criticised harshly by

the public and this made it even more dif-ficult to use taxpayers’ money further for the resolution of the crisis.

The amount decided upon was too small to address the problems of the entire finan-cial system. More importantly, the decision was not quite made with a view to resolving the crisis but rather to cater to the interests of a specific segment of the financial industry. This seems to have reflected the superior-ity of the fiscal policy wing of the MoF over the financial regulatory wing at the time and provided an example of the risk of having a financial regulator within a fiscal authority.

Stresses in the financial system became even more serious in the late 1990s and led to the closure of many financial institutions. A clear trigger of all this was the failure of Sanyo Securities in November 1997.

Karube and Nishino (1999) provide a detailed account of the process in which attempts to bail out Sanyo all failed. I would like to focus on the decision by the BoJ to not extend an LLR loan when Sanyo failed.

Sanyo’s defaultSanyo declared bankruptcy on November 3. The BoJ had known in advance that this would create a default in the interbank market. Of course, such information was made available through on-site and off-site examinations and through a wide range of market intelligence as the central bank. According to Karube and Nishino (1999), the BoJ’s Financial and Payment System Department was worried about sys-temic risk implications of Sanyo’s default. The Credit and Market Management Department, however, thought differently. Sanyo was a small player in the interbank


market and the amount of default would accordingly be small. Any spill-over effect of the default that might arise could be coun-teracted by the BoJ’s fund provision. After all, Japan was undergoing the Big Bang of the financial system and the market needed to take care of itself. The BoJ made no seri-ous move to extend an LLR loan to protect creditors of Sanyo. In a discussion on the legal aspects of the scheme to close Sanyo in the Tokyo District Court, when the chief judge asked if it was not appropriate to use LLR, the BoJ clearly said it was not.

Serious problemsSanyo’s default was in fact small – one bil-lion yen in the call market and 8.3 billion yen in the JGB repo market. For a few days the market remained calm. In the second week of November, however, market rates started to move up (see Fig. 1, page 96) and financial institutions that were perceived to have some serious problems no longer were able to borrow in the market. On November 14, a city bank – Hokkaido Takushoku Bank – was unable to meet the reserve requirement.

On November 16, the decision was made to transfer key businesses of Hokkaido Takushoku to Hokuyo Bank. The BoJ decided to provide an LLR loan to Hokkaido Takushoku until the transfer was complete.

Sanyo’s default in the repo market spilled over to Yamaichi Securities, which now found it difficult to raise funds in the repo market. This firm went down on November 24 and on November 26, Tokuyo City, a regional bank also went under. In both cases the BoJ provided LLR loans.

The discussion within the BoJ on whether or not to provide an LLR loan to Yamaichi as

described by Karube and Nishino is very interesting.

Key members of the BoJ were still scepti-cal of the view that a bankruptcy of a secu-rities company could be a systemic event. They also worried about the possible effect of such a loan on the balance sheet of the BoJ if it defaulted. In the end, the then governor, Yasuo Matsushita, decided to provide a loan.

It now seems clear that the default of Sanyo Securities was a systemic event. Despite its close dealings with securities companies and market intelligence, the BoJ was unable to correctly foresee what was to come. Again, it seems that it is not enough to be close to the market. One needs to be able think about all sorts of interconnectedness, interdependencies and relationships within the broader financial system.

Having said this, I would add that it was a good thing that the BoJ had the power to provide LLR loans to securities companies. As I later argue, had the liabilities of Yamaichi Securities not been protected, its bankruptcy would have created a serious stress in the international financial system.

More orderly approachIt has to be said that had the Bank of Japan rescued Sanyo’s creditors, the outcome may not have been that different. Many of the financial institutions that went down would have gone down anyway. But the proc-ess could at least have been slightly more orderly.

There have certainly been many mer-its for the participation in the resolution scheme of failing financial institutions of the central bank that has good intelligence on the market; that is, there is a positive


externality for a central bank to combine monetary policy-making and financial stability responsibilities.

Resolute actionDespite the initial hesitation to extend an LLR loan to Yamaichi, once the decision was made it was well executed. The emergency liquidity assistance by the BoJ was carried out via Fuji Bank. This was because Fuji was a main bank for Yamaichi and held accounts for the entire Yamaichi group, not just Yamaichi itself. Such a decision was made possible by the BoJ’s close knowledge of the structure of transactions in the market. More importantly, the BoJ explained carefully to the global financial community – especially overseas authorities – the consequences of the liquidity assistance for global credi-tors to Yamaichi; the overall intention of the assistance would be an orderly unwinding of the existing positions and that the Japanese authorities would bear any losses incurred from Yamaichi’s failure.

Long-Term Credit Bank of Japan (LTCB), which was temporarily nationalised in October 1998, was more active in the glo-bal financial market. It had a huge presence in the interbank and derivatives markets. Market participants feared that the nation-alisation of LTCB might constitute an event of default in the contracts of transactions in these markets. If so, serious turmoil could have developed in the markets. The BoJ worked closely with ISDA and explained to the market that loans from DICJ would cover all possible losses in the markets. As a result, disruptions in the market were avoided. The BoJ assumed a similar role in the case of the failure of Nippon Credit Bank in December

1998. To summarise, after Yamaichi’s fail-ure, the BoJ understood well the systemic risk implications of the failure of these large financial institutions and the BoJ’s moves during the resolution of the failures seemed to have kept international repercussions at a minimum.

There remains a key question concern-ing the BoJ’s involvement in financial stabil-ity issues; has it been useful for monetary policy decisions? The information generated about the BoJ’s involvement in financial sta-bility issues has been an important factor in the Bank’s monetary policy decisions. The results of on-site examinations of financial institutions are regularly reported to the pol-icy board. Results of the interviews carried out by BoJ staff with financial institutions and non-financial firms are brought to the attention of the board.

Monthly reports When banks experience serious liquid-ity problems, as in the period 1997-2003, board members are informed of the amount of daily deposit outflows from the banks.Since the early 2000s, the prudence wing of the BoJ has reported monthly to the board on the state of the financial system, cover-ing such topics as the capital adequacy ratios of financial institutions, their funding liquid-ity risk and the exposure to interest rate and stock price risks. Since 2006, the Financial Stability Report has been published twice a year, immediately prior to publication of the board’s bi-annual economic outlook.

Some examples will be discussed later. The BoJ lowered the policy rate by 25 basis points on September 9, 1998. The minutes of the board meeting on that day show that


board members were significantly influ-enced by the state of the financial system. Thus, a member noted that “financial institu-tions were adopting stricter screening criteria for firms’ borrowing of operating funds and firms had become nervous about extending trade credits.”

Cautious lending attitudesAnother member expressed the view that “the availability of funds to small firms was limited due to the cautious lending attitude of financial institutions. ”Turning to mone-tary policy, one member argued for a reduc-tion in the policy rate by saying that “a credit crunch was observed in some parts of the economy,” and suggested that “the Bank’s injection of ample funds into the markets would relax the cautious attitude of financial institutions.”

Hopefully, such remarks reveal that members had access to information on mar-kets and financial institutions beyond what can be inferred from movements in inter-est rates and other asset prices. It is hard to judge, however, whether such information on the state of the financial system affected members’ economic outlook and hence affected monetary policy, or had direct effects on monetary policy.

With the decision to lower the policy rate to 0.25 per cent, the BoJ started to seri-ously feel the constraints created by the zero lower bound on nominal interest rates. As a result, the BoJ increasingly moved into the area of what people now call credit easing. Needless to say, implementing credit easing policy properly requires substantial knowl-edge of the state of the financial system. It also becomes rather hard to distinguish

monetary policy from policies to maintain financial stability. One example where the knowledge of the market has affected the BoJ’s operations is the BoJ’s heavy reliance on fund provision in the term markets. This was certainly necessary during the quantitative easing period, but already in late 1998 the BoJ supplied huge amounts of term funds in an attempt to reduce term premiums gen-erated by stresses in the financial system.

Similarly, in response to the re-emergence of term premiums in the second half of 2007, the BoJ was one of the first central banks that increased term fund supplying operations on a large scale.

On the other hand, despite inputs from staff close to the financial system, the BoJ’s economic outlook did not seem to have reflected the severity of the global financial turmoil as early as one would have liked. Although the BoJ’s economic outlook report flagged the risk of serious deterioration of the global financial system and its effect on the global economy, it did not turn very bearish until October 2008.

More difficult jobThe Financial Stability Report was unable to forecast what was to come, even as early as spring 2007. However, it was pointing out the risk of increases in real estate non-recourse loans as early as in 2005, which needs to be commended in the light of what subsequently happened. Have international considerations made the job of the MoF/FSA/BoJ more difficult? It is to be argued that on a number of fronts they certainly have.

There is first the level playing field issue between domestic and foreign finan-cial institutions. Since the late 1980s, the


regulators have taken pains to persuade Japanese banks to increase their capital adequacy ratios on the one hand and, on the other, endeavoured to prevent the interna-tional minimum capital requirements from becoming excessively high for Japanese banks. Consideration of the pro-cyclicality problem of capital regulation might have meant lowering the minimum requirements for Japan during its financial crisis. However, such a possibility does not seem to have been pursued in earnest. The challenge facing the authorities has become worse with the cur-rent crisis, but this is probably not the best occasion to go into the issue in more detail.

Equal treatment of domestic and foreign financial institutions within the domestic market is also not straightforward. During Japan’s financial crisis, foreign securities companies in Japan were asked to join the

securities company version of DIC, the Japan Investor Protection Fund, but refused to do so and established a separate fund. It was not until 2002 that the two funds merged.

Systemic risks now easily transcend national boundaries. As explained in the previous section, the BoJ tried hard to explain and to work together with interna-tional authorities to contain the international repercussions of the failure of Japanese financial institutions in the late 1990s.

Serious instabilityDuring the past two years, Japan’s financial system experienced serious instability as a result of the global financial turmoil. This was so, despite minimal participation of Japanese financial institutions in the global credit market binge. Financial stresses travelled through the money market, the corporate

Money Market Rates in Tokyo

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bond/CDS markets, the equity market, and even the JGB market and the property mar-ket. The spillovers mainly came through par-ticipation of foreign financial institutions in these markets. The BoJ and the government have used a number of measures to contain such stresses. I would point out that given the spillovers which took place in the mar-kets, prompt policy moves were necessary and that involvement of the BoJ was crucial for their containment.

During Japan’s financial crisis, its finan-cial institutions experienced serious diffi-culties in borrowing in US dollars. The LLR function in this case was partially fulfilled by the MoF who lent its international reserves to financial institutions. The BoJ also played a role by lending yen in the term market which financial institutions swapped into dollars. The terms of the swap were extremely unfa-vourable for many Japanese financial institu-tions, obliging them to substantially curtail international operations.

In the context of the current crisis, finan-cial institutions around the world experi-enced similar difficulties. The currency swap market became dysfunctional. The Fed was obliged to step in as an international lender of last resort. Such a framework is useful, but it is unclear how formal it should be. The roles assumed by authorities will not be symmetric because the market or govern-ments would be in need of a global vehicle currency or at least some international cur-rency . . . and not just any currency.

Which currency will be in demand should depend on the situation and whether authorities want to step in; it should also depend on the nature of the problem. What is necessary seems to be the willingness

among global authorities to exchange infor-mation and step in when necessary. Japan’s experience during the past two decades sug-gests there are lessons to be learnt concern-ing the relationship between the structure of financial regulation/supervision and the outcome of policies.

Moral of the taleBeing an integrated regulator does not mean that it is a good systemic stability regulator. There are always loopholes and the regula-tor must be able to think in systemic stability terms. It is difficult to discern the long-term trend of asset prices. It is also not easy to identify ex ante triggers of systemic risks; being alert to systemic stability issues does not guarantee good performance.

There is a huge gap between recogni-tion of risks and policy action to improve the situation. Having a systemic stability regula-tor within a fiscal authority runs the risk of financial stability policy objectives subordi-nated to fiscal policy objectives or a wider political interest. The information the central bank collects from its interaction with mar-ket participants as an implementer of mon-etary policy is useful for spotting emerging vulnerabilities in the financial system and for the resolution of crises. And having strong financial stability responsibilities allow the central bank to collect huge amounts of information on financial institutions and the market.

Such information can be used to main-tain financial stability, for forming economic outlook or, more directly, for monetary policy. But central banks have not yet established a formal approach to using such information optimally on any of these three fronts. •


Cross-border regulation

Enhancing cross-border regulation after the 2008 crash

New York State’s banking watchdog Richard Neiman calls for closer worldwide

supervisory co-operation.

in the wake of the financial crisis, an effective framework for cross-border supervision of financial institutions has become an even more compelling imperative. financial and technologi-cal innovation has rapidly facilitated interconnected global markets, but our supervisory infrastructure has failed to keep pace.

The idea of one supranational global regulator – whether a dream come true or a nightmare – is still only imaginable. So how should we move forward as an international community? What strategies will best pro-mote financial stability through cross-border supervision that is conducted primarily by national regulators? I believe the answer is threefold: (1) Harmonisation of standards, with appropriate flexibility to address local situations; (2) Co-operation in examina-tion and enforcement activities, including expanded use of supervisory colleges; and, (3) Expansion of the resolution process, to pro-vide for the orderly unwinding of systemi-cally significant non-bank financial firms.

Before elaborating on these points, I will

briefly discuss the dual banking system in the US and the scope of state supervision. The dual banking system that consists of complementary state and federal oversight is one of the unique aspects of the US frame-work for financial services regulation; this directly impacts cross-border issues. This dual supervisory system may seem like a very interesting approach, especially if you are coming from a country with a more cen-tralised model. In the course of US history we have found a unique equilibrium in dual oversight that confers the benefits of both a centralised and a decentralised structure.

Institutional partnershipsClose interaction with local regulators at state level provides benefits to financial institutions, especially those with unique business models such as community banks, private/niche banks, or foreign banking organisations that in turn facilitate inter-national trade. In New York, we charter just over 100 domestic banks and supervise these institutions in partnership with either the Federal Deposit Insurance Corporation (FDIC) or the Federal Reserve. Twenty of


our banks are members of the Federal Reserve System, including industry lead-ers such as the Bank of New York Mellon, Goldman Sachs, M&T Bank and Deutsche Bank. With this diverse supervisory per-spective and a well-established partnership with the Federal Reserve Bank of New York, it is no coincidence that New York State also licenses most of the foreign bank-ing organisations operating in the US. We supervise 137 foreign branches, agencies and representative offices, with more than US$1.6 trillion in assets – which is almost 90 per cent of the nationwide assets held by foreign banking organisations.

State level regulationThe New York State Banking Department (Banking Department) also regulates a broad range of institutions, including com-mercial banks, credit unions, mortgage bankers and brokers, licensed lenders, sales finance companies, money transmitters and cheque cashers. It should be noted that the US insurance industry is regulated at state level. In fact, the various states oversee a wider mix of institutional types than does the federal government, which is primar-ily limited to the supervision of depository institutions. This breadth gives the states a distinctive perspective on market trends and reform principles that cut across the finance industry.

I provide this perspective not just as a state banking superintendent. I started my career with the Office of the Comptroller of the Currency (OCC) and worked exclu-sively for national banks. I am involved at national level in the regulatory reform process as a member of the Congressional

Oversight Panel for the $700 billion Troubled Asset Relief Program (TARP) which issued a Special Report on regulatory reform in January 2009.

Substantial reforms are anticipated both in the US and internationally. However, the task is so complex that we risk losing momentum. Both nations and international bodies must not lose the will and urgency to reform the financial system in order to move towards the imperative for implementation of more effective supervision of international firms.

A critical first step in enhancing cross-border supervision relates to standard-set-ting. Greater harmonisation of standards will help to eliminate both the potential for international regulatory arbitrage by which institutions could seek the most lax regu-latory environment, or be used in certain jurisdictional havens for criminal use of the financial system.

The goal is laudable, but convergence in rule-making embodies tension between the benefits of uniformity and the need for flex-ibility, as regulators must fulfill their respon-sibility to respond appropriately to local conditions. This tension can be, but need not be an obstacle; in fact, it can even be a cata-lyst for progress.

Setting uniform standardsThe US experience of this tension through the state-federal dynamic has ultimately been a creative force. While progress has not been strictly linear, there is a clear trend in terms of the structured flexibility of states to act at the local level in the con-text of mutual accountability with state and federal partners. This has led to improved


industry standards nationwide. The most recent example relates to consumer protec-tion and the scope of federal pre-emption, as in certain circumstances federal law may override state law. The federal chartering agency, the OCC, took an overly broad interpretation of pre-emption in 2004; this in effect exempted the largest banks in the country from complying with higher state consumer protection and anti-predatory lending laws. It has taken action by the US Supreme Court in order to restore balance which I anticipate will be further clarified by legislation.

New national baselineBut this aberration in state-federal relations that was provoked by the OCC’s sweep-ing pre-emption policy is the exception that proves the rule: there is an appropriate zone for local authorities to set standards above a national floor and those local standards, once tested, may in turn become the model for a new national baseline. The states were correct in detecting the emerging subprime mortgage problem and were the first to take action through anti-predatory lending laws and landmark settlements.

Over decades, state leadership relating to consumer protection issues has led to improved national standards for the finan-cial services industry with regard to product disclosure and protection of home equity. Results like this demonstrate that it is worth the effort of engaging in this dialectic proc-ess, whether it is state-federal or among international partners.

On the international stage, a compelling example of the benefits as well as the practi-cal limitations of harmonising standards can

be seen in the implementation of the Basel II capital framework. I thoroughly support the effort to establish international capital stan-dards, but progress on this issue will come about in stages. If we take two steps forward but one step back we will still be making progress. In the case of Basel II, the financial crisis has made clear that the FDIC was cor-rect in taking one step back and insisting on retention of the leverage ratio for the US.

What was sometimes misinterpreted as intransigence has now become an occa-sion and opportunity to refine Basel II. Far from frustrating international progress, this appropriate use of regulatory discretion by a national supervisor actually re-invigorated the work of creating even more effective international capital standards, which helps to ensure that we will reach our shared goal of a more stable banking system.

When entering into international agree-ments, the ultimate question for jurisdictions with high standards is the degree to which a partial relaxation of those standards in the adoption of a uniform baseline would contribute to a local increase in safety and soundness, through the reduction of risks stemming from other jurisdictions where uniformity would result in increased rigor.

Timely case in pointIn other words, if more and less robust regu-latory regimes meet somewhere in the mid-dle in setting a new common supervisory framework, is it still a net gain in terms of risk reduction for those who agree to technically lower the bar? The question of whether the US should abandon the leverage ratio for the sake of greater uniformity in the adoption of Basel II is a timely case in point.


The issue is further complicated by the fact that determining whether such a net gain in risk reduction is produced involves a qualitative and not just a quantitative judgment. The same supervisory stand-ards on paper could be more or less effec-tive in reducing risk and promoting stability depending upon the quality of execution. The right standards need to be paired with robust examination and enforcement activi-ties that are co-ordinated among home and host supervisors.

Examination and enforcementHere I return to the concept of mutual accountability. As with intra-national co-ordination, effective home-host supervision is dependent upon it. In the US the flexibility that states have in order to create, examine, and enforce local laws and rules affecting the finance industry is structured through mutual accountability to other states and to federal regulatory counterparts. This struc-ture does not imply that any of the individ-ual supervisors held within this covenant of accountability is inadequate or incapable of the task of sole supervision.

Rather, it is an affirmation that multiple regulators bring a much needed diversity of perspectives to complex issues in the rapidly evolving financial services market place. Just as multiple judges are used in the Olympics to achieve a fair score for competitors, mul-tiple regulators yield better results in setting a robust framework for the examination process.

In the US, state-chartered depository institutions are subject to dual regulation by either the Federal Reserve or the FDIC. Independent non-depository institutions

such as mortgage bankers and brokers are solely supervised at the state level. But the states co-operate in setting licensing and examination standards for this diverse sec-tor through the Conference of State Bank Supervisors (CSBS). There is something akin to positive peer pressure in this colle-gial gathering of state regulators that is very effective, and effective especially in the sense of accountability in the implementation of agreed principles.

With most state-licensed branches of foreign banks in the US, intrastate co-ordi-nation is critical to minimise overlap and reduce burden for foreign banking organi-sations with activities that cross state lines. For over 10 years, the states, through CSBS, have had in place agreements, both between states and state-federal, for nationwide co-ordination in the supervision and examina-tion of foreign banking organisations. These agreements are important in streamlining the oversight process. However, more could be done to reduce burden for foreign banks operating in multiple states.

Harmonising proceduresI could envision additional flexibility for state-licensed foreign branches to oper-ate under ‘home state rules’, similar to the arrangements extended to domestic banks that are chartered in another state. While national legislation would be required to fully implement this, there is much that the states can do through CSBS and using their own initiative. I am in the process of holding such discussions within California – another state that has a large foreign bank presence – in order to explore opportunities to harmo-nise licensing procedures.


The same type of co-operation that we are striving for in the US between states and the federal government should hold true at international level: we need to strengthen mechanisms of accountability for operational efficiency and vigilant supervision. That is precisely what nations are doing under the auspices of the G-20 and the International Monetary Fund (IMF). On the front lines of bank examinations we need to more fully realise the potential of supervisory colleges to enhance the quality of supervision.

Key functionsSupervisory colleges are working groups composed of the relevant regulators of an international banking organisation, co-ordi-nated by the home country supervisors. Key functions of a supervisory college include information sharing, assessment of cross-border risk exposures, co-ordinated inspec-tions and examinations. This supervisory co-operation is increasingly important as banking organisations continue to organise their operations along business lines with the result that risk management for a New York activity may be located in the home office.

While supervisory colleges cover institu-tions with a range of risk profiles, this cross-border market surveillance is particularly significant in identifying and responding to emerging systemic risks.

The existence of the supervisory college does not eliminate the need for, or prevent individual regulators within the college from establishing parallel mechanisms for co-operation such as bilateral agreements and memorandums of understanding. In New York, we have close to 20 agreements in place

with regulators from around the world and we have developed very strong supervisory relationships with those home countries. In fact, supervisory colleges may be formed as an outgrowth of bilateral agreements; the college then creates an additional forum in which sub-groups of supervisors can form new international connections and focus on concerns common to their markets. This flexibility is one of the benefits of the super-visory college structure.

The flexibility of supervisory colleges and similar voluntary oversight bodies is well-suited as a first response mechanism to evolving challenges in supervision. Areas in which mechanisms for formal oversight are yet to be fully established include, for exam-ple, the over-the-counter (OTC) derivatives market. The OTC derivatives market will benefit from this oversight structure which can be implemented immediately. The process of developing a formal supervisory structure for the ‘shadow banking’ system also benefits from early learning which will develop and emerge from new voluntary oversight structures.

Bid for transparencyCurrently, 41 supervisory bodies from 15 countries participate in the OTC Derivatives Regulators Group (the Group). The Group is discussing how to regulate central coun-terparties and data repositories and dialogue includes the specific types of information that should be requested of data repositories in order to assist with regulation of the mar-ket or market participants.

Data repositories for credit default swaps and trades will bring more transparency to the market and help to assess counterparty


exposures. Sub-groups have also been formed to focus on issues of particular rele-vance to the individual supervisors’ missions. I am proud of the early lead New York has taken in chartering one of the first clearing-houses and the trade repository for credit default swaps; our participation in the Group will further inform our mission as well as the movement to promote standardisation and disclosure for this diverse market.

Supervisory collegesSupervisory colleges are also the appropriate approach for co-ordination among jurisdic-tions with disparate legal and supervisory structures that would hinder more formal and binding approaches to cross-border supervision. For example, I considered it critical to personally attend the supervisory college in China earlier this month. New York has recently licensed branches of the Industrial and Commercial Bank of China, China Merchants Bank, and the China Construction Bank.

These are the first branches of banks from mainland China to open in the US in over 17 years and reflect the growing trade between our countries and New York’s role as a hub for global finance. The non-bind-ing, although still effective mechanism of the supervisory college is the best practical fit for engaging with supervisors from jurisdictions such as China that have legal systems and other dynamics that are very different from those in the US

EU co-operationI appreciate that some believe the non-binding nature of the supervisory college is a critical weakness in the concept – its Achilles

heel. Views on the efficacy of supervisory colleges are also relevant to the debate in Europe regarding the creation of expanded EU-level authority. I do not believe it is an either/or choice; supervisory colleges can provide a complement to increased co-oper-ation through EU regulatory bodies.

Proposals to develop EU-wide supervi-sion that go beyond existing bodies which focus primarily on co-ordination, also amount to a dual banking system and raise issues that are similar to state-federal con-cerns in the US.

Harmonisation of rules and consistency in the supervisory approach across the EU will need to be accomplished while recog-nising the responsibility of member coun-tries to protect their residents. When diverse economies need to work together for the good of the region, some form of dual over-sight appears to be the natural outcome. We can learn from each other in finding the optimal balance.

Resolution authorityAnother area in which an optimal structure is needed is the resolution process for inter-national firms. I would like to focus on the issue of creating a resolution authority in the US for systemically significant non-banks.

When faced with the failure of Lehman Brothers, the government found itself with-out the regulatory structure to ensure the orderly unwinding of the firm. The market uncertainty provoked by the Lehman bank-ruptcy is still evident. Bankruptcy proceed-ings have a tendency to exacerbate market destabilisation triggering call provisions that upend contractual arrangements that could otherwise have remained in place, and


simply do not provide sufficient means to ensure interim operations.

The Obama Administration and mem-bers of Congress are supporting various proposals to expand resolution authority for systemically significant institutions, such as bank holding companies, insurance com-panies and other non-banking financial organisations.

While the process of regulatory reform in the US covers many fronts, the resolution authority issue is one of the most central. It is a key to approaching the thorny problems of the moral hazard – ‘too big to fail’ and dem-onstrates the inter-connectedness of inter-national financial conglomerates.

Detractors characterise expanded reso-lution authority as a permanent bailout approval for large firms, with the attendant moral hazard concerns. The opposite is true; a proper resolution method demonstrates that large firms will be allowed to fail. It would also provide a way to assess firms that are outside the FDIC deposit insurance pro-gramme for implementation of a new form of insurance premiums commensurate with the external risks they present to the finan-cial system.

This would provide additional protec-tions against the need to put taxpayer dollars at risk. This is far superior to an ad hoc use of public funds in times of economic distress and helps to counter pro-cyclical trends.

‘Living wills’Some have suggested ‘living wills’ as a solu-tion to the resolution of systemically signifi-cant firms. In a living will, the firm outlines how it would conduct an orderly unwinding of operations. Such an exercise has value for

a firm as a compliance discipline, especially in identifying and aggregating counterparty risk and other contingent liabilities.

While I support the concept of a living will as part of a firm’s contingency planning – much like the liquidity contingency plan-ning mentioned previously – it is an insuf-ficient safety net in the event of a systemic financial panic.

ConclusionEffective cross-border supervision has been described from the domestic perspective; coming from a state like New York with a broad international presence, I would offer the following conclusions:

First, the progress of regulatory reform, including the creation of new or expanded authorities to manage systemic risk is criti-cal – but architecture alone is not a panacea. There are no structural shortcuts to effective oversight. Countries with diverse regulatory frameworks were all deeply impacted by the recent financial crisis.

Second, there is a continuing role for non-binding regulatory bodies. Strengthening the quality of these mechanisms should be our primary focus, given the reality of diverse legal structures among jurisdictions that can hinder more formal associations. Structures such as supervisory colleges have great potential as market surveillance tools and as stepping stones to forge closer international ties and greater convergence in standards and supervisory protocols.

And finally, no system, no protocol will result in quality oversight of the diverse and increasingly interconnected global financial markets apart from mutual accountability and trust between supervisory partners. •


Macroeconomics

What we thought we knew and what we didn’t know

The IMF’s Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro, outline a new macroeconomic policy framework.

the crisis of 2008 has forced economic policymakers to react in ways not antici-pated by the pre-crisis consensus on how macroeconomic policy should be con-ducted. in this paper, the authors review the main elements of the pre-crisis con-sensus, identify those that were wrong, and outline possible contours of a new macroeconomic policy framework.

The Great Moderation (Gali and Gambetti 2009) lulled macroeconomists and policy-makers alike in the belief that we knew how to conduct macroeconomic policy. The cri-sis clearly forces us to question that assess-ment. In a recent IMF Staff Position Note (Blanchard, Dell’Ariccia and Mauro 2010, which includes a bibliography), we review the main elements of the pre-crisis con-sensus; we seek to identify what elements were wrong and what tenets of the pre-crisis framework still hold; and we take a tentative first pass at the contours of a new macroeco-nomic policy framework.

To caricature: we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as

inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints limiting its usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy frame-work. Admittedly, these views were more closely held in academia; policymakers were more pragmatic. Nevertheless, the prevailing consensus played an important role in shap-ing policies and institutions.

Central bank prioritiesStable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This resulted from the repu-tational need of central bankers to focus on inflation rather than activity and the intellec-tual support for inflation targeting provided by the New Keynesian model. In the bench-mark version of that model, constant infla-tion is indeed the optimal policy, delivering a zero output gap, which turns out to be the best possible outcome for activity given the imperfections present in the economy. This “divine coincidence” implied that, even if


policymakers cared about activity, the best they could do was to maintain stable infla-tion. There was also consensus that inflation should be very low (most central banks tar-geted two per cent inflation).

Monetary policy focused on one instru-ment, the policy interest rate. Under the prevailing assumptions, one only needed to affect current and future expected short rates, and all other rates and prices would follow. The details of financial intermediation were seen as largely irrelevant. An exception was made for commercial banks, with an emphasis on the “credit channel.” Moreover, the possibility of runs justified deposit insur-ance and the traditional role of central banks as lenders of last resort. The resulting distor-tions were the main justification for bank regulation and supervision. Little attention was paid, however, to the rest of the financial system from a macro standpoint.

Keynesian glory daysFollowing its glory days of the Keynesian 1950s-’60s, and the high inflation of the 1970s, fiscal policy took a back seat in the past two-three decades. The reasons included scepticism about the effects of fiscal policy, itself largely based on Ricardian equivalence arguments; concerns about lags and political influences in the design and implementation of fiscal policy; and the need to stabilise and reduce typically high debt levels. Automatic stabilisers could be left to play when they did not conflict with sustainability.

Financial regulation and supervision focused on individual institutions and markets and largely ignored their macr-oeconomic implications. Financial regula-tion targeted the soundness of individual

institutions and aimed at correcting market failures stemming from asymmetric infor-mation or limited liability. Given the enthu-siasm for financial deregulation, the use of prudential regulation for cyclical purposes was considered improper mingling with the functioning of credit markets.

The decline in the variability of out-put and inflation led to greater confidence that a coherent macro framework had been achieved. In addition, the successful responses to the 1987 stock market crash, the LTCM collapse, and the bursting of the tech bubble reinforced the view that mon-etary policy was also well equipped to deal with asset price busts. Thus, by the mid-2000s, it was not unreasonable to think that better macroeconomic policy could deliver, and had delivered, higher economic stability. Then the crisis came.

Core inflation was stable in most advanced economies until the crisis started. Some have argued in retrospect that core inflation was not the right measure of infla-tion, and that the increase in oil or hous-ing prices should have been taken into account. But no single index will do the trick. Moreover, core inflation may be stable and the output gap may nevertheless vary, leading to a trade-off between the two. Or, as in the case of the pre-crisis 2000s, both inflation and the output gap may be sta-ble, but the behaviour of some asset prices and credit aggregates, or the composition of output, may be undesirable. When the crisis started in earnest in 2008, and aggre-gate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further. But the zero


nominal interest rate bound prevented them from doing so. Had pre-crisis inflation (and consequently policy rates) been somewhat higher, the scope for reducing real interest rates would have been greater.

Markets are segmented, with specialised investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when some inves-tors withdraw (because of losses in other activities, cuts in access to funds, or internal agency issues) the effect on prices can be very large. When this happens, rates are no longer linked through arbitrage, and the pol-icy rate is no longer a sufficient instrument.

Drawbacks exposedInterventions, either through the accept-ance of assets as collateral, or through their straight purchase by the central bank, can affect the rates on different classes of assets, for a given policy rate. In this sense, whole-sale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks.

The crisis has returned fiscal policy to centre stage for two main reasons. First, monetary policy had reached its limits. Second, from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact despite implementation lags. The aggres-sive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more “normal” fluctuations – in particular lags in formulat-ing, enacting, and implementing appropriate fiscal measures. The crisis has also shown the

importance of having “fiscal space,” as some economies that entered the crisis with high levels of government debt had limited ability to use fiscal policy.

Financial regulation contributed to the amplification that transformed the decrease in US housing prices into a major world economic crisis. The limited perimeter of regulation gave incentives for banks to cre-ate off-balance-sheet entities to avoid some prudential rules and increase leverage. Regulatory arbitrage allowed some financial institutions to play by different rules from other financial intermediaries. Once the cri-sis started, rules aimed at guaranteeing the soundness of individual institutions worked against the stability of the system. Mark-to-market rules, coupled with constant regula-tory capital ratios, forced financial institutions into fire sales and deleveraging.

If the conceptual framework behind macroeconomic policy was so flawed, why did things look so good for so long? One reason is that policymakers had to deal with shocks for which policy was well adapted. For example, the lesson from the 1970s that, with respect to supply shocks, anchoring of expectations was of the essence was well understood when the price of oil increased again in the 2000s. Success in moderat-ing fluctuations may even have sown the seeds of this crisis. The Great Moderation led too many (including policymakers and regulators) to understate macroeconomic risk, ignore tail risks, and take positions (and relax rules) which were revealed to be much riskier after the fact. The bad news? The crisis has shown that macroeconomic policy must have many targets. The good news? It has also reminded us that we have


many instruments, from “exotic” monetary policy to fiscal instruments, to regulatory instruments.

It will take some time, and substantial research, to decide which instruments to allocate to which targets. It is important to start by stating that the baby should not be thrown out with the bathwater. Most of the elements of the pre-crisis consensus still hold. Among them, the ultimate targets remain output and inflation stability. The natural rate hypothesis holds, at least to a good enough approximation, and policy-makers should not assume that there is a long-term trade-off between inflation and unemployment. Stable and low inflation must remain a major goal of monetary pol-icy. Fiscal sustainability is of the essence, not only for the long term, but also in affecting expectations in the short term.

Questions for economistsThe crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in nor-mal times, in order to increase the room for monetary policy to react to such shocks? Are the net costs of inflation much higher at, say, four per cent than at two per cent, the current target range? Is it more difficult to anchor expectations at the former? Achieving low inflation through central bank independ-ence has been a historic accomplishment.

Thus, answering these questions implies carefully revisiting the benefits and costs of inflation. A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimise the likelihood of deflation, even if this means

incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, on the Fed’s mind in the early 2000s, is one we must return to.

Part of the debate about monetary policy, even before the crisis, was whether the inter-est rate rule, implicit or explicit, should be extended to deal with asset prices. The crisis has added a number of candidates to the list, from leverage to measures of systemic risk. This seems like the wrong way of approach-ing the problem. The policy rate is a poor tool to deal with excess leverage, risk taking, or apparent deviations of asset prices from fun-damentals. A higher policy rate also implies a larger output gap.

Other instruments are at the policymak-er’s disposal – call them cyclical regulatory tools. If leverage appears excessive, regula-tory capital ratios can be increased; if liquid-ity appears too low, regulatory liquidity ratios can be introduced and, if needed, increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be increased. If monetary and regulatory tools are to be combined in this way, it follows that the traditional regulatory and prudential frameworks need to acquire a macroeco-nomic dimension. This raises the issue of how co-ordination is achieved between the monetary and the regulatory authorities. The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macro-prudential regulators.

The crisis has forced central banks to extend the scope and scale of their traditional role as lenders of last resort. They extended their liquidity support to non deposit-taking


institutions and intervened directly (with purchases) or indirectly (through acceptance of the assets as collateral) in a broad range of asset markets. The argument for extend-ing liquidity provision, even in normal times, seems lucid. If liquidity problems come from the disappearance of deep-pocket private investors from specific markets, or from the co-ordination problems of small investors as in traditional bank runs, the central authority is in a unique position to intervene.

Policy implicationsA key lesson from the crisis is the desirabil-ity of fiscal space to run larger fiscal defi-cits when needed. In future, the required degree of fiscal adjustment (after the recov-ery is securely under way) will be formida-ble, in light of the need to reduce debt while swimming against the tide of aging-related challenges in pensions and health care. Still, the lesson from the crisis is that target debt levels should be lower than those before the crisis.

The policy implications for the next dec-ade or two are that, when cyclical conditions permit, major fiscal adjustment is necessary and, if economic growth recovers rapidly, it should be used to reduce debt-to-GDP ratios substantially, rather than finance expenditure increases or tax cuts. The recipe to ensure that economic booms translate into improved fiscal positions is not new, but it acquires greater relevance as a result of the crisis. Medium-term fiscal frameworks, credible commitments to reducing debt-to-GDP ratios, fiscal rules (with escape clauses for recessions), and transparent fiscal data can all help in this regard.

Discretionary fiscal measures come

too late to fight a standard recession. Can we strengthen and improve the automatic stabilisers? A distinction is needed here between truly automatic stabilisers – those that imply a decrease in transfers or increase in tax revenues when incomes rise – and rules that allow some transfers or taxes to vary based on pre-specified triggers tied to the state of the economy. The first type of automatic stabiliser comes from the com-bination of rigid government expenditures with an elasticity of revenues with respect to output of approximately one, from the existence of social insurance, and from the progressive nature of income taxes. The main ways to increase their macroeconomic effect would be to increase the size of gov-ernment, make taxes more progressive, or to make social insurance more generous. However, these reforms would be war-ranted only if they were based on a broader set of equity and efficiency objectives. The second type of automatic stabiliser appears more promising.

On the tax side, one can think of tem-porary tax policies targeted at low-income households, such as a flat, refundable tax rebate, a percentage reduction in a taxpayer’s liability, or tax policies affecting firms, such as cyclical investment tax credits. On the expenditure side, one can think of temporary transfers targeted at low-income or liquid-ity-constrained households. These taxes or transfers would be triggered by the crossing of a threshold by a macro variable. •

Editor’s noteThe publishers thank VoxEU – www.voxeu.org – and the IMF for allowing the Journal to reproduce this paper.


Compliance

The ‘business of bribery’ sparks anti-corruption drive

Management consultant Gavin Sudhakar of Sapling Solutions argues the effectiveness

of current global FCPA regulations.

Due to the recent global financial crisis, risk management and compliance moni-toring has been the top priority of regu-latory enforcement officials. trends have shown that punishing wrongdoers with hefty penalties and re-aligning the fCPa regulation during crisis periods will lead to a reputable american brand and regain confidence in the global market.

In the ‘’business of bribery’’ it is not uncommon to influence human behaviour for a favourable outcome by means of finan-cial incentives. In a global competitive capital market, multinational organisations have used bribery as a means of promoting firms’ interests for centuries. On the other hand, individuals have used bribery as a commer-cial necessity to conduct day-to-day busi-ness across the globe.

This article argues the effectiveness of the enforceable legal framework used by devel-oped countries across the world to combat bribery as an illegal offence. In particular the Foreign Corrupt Practices Act (FCPA) in the United States has been used as a bench-mark to argue several points pertaining to

its practical applicability in the current global economy.

In late 1977, after the Lockheed Corporation bribery and Watergate cor-ruption scandals, President Jimmy Carter signed the FCPA into law.1 As the first nation to enact an anti-bribery statute, it was the intent of the US Congress to criminally prosecute corporations and individuals that bribe foreign officials when engaging in business dealings. In 1988, under the global demands of the Organisation for Economic Co-operation and Development (OECD) Convention, President Ronald Reagan amended the FCPA to include foreign com-panies which, as “domestic concerns’’, com-mit an offence under US jurisdiction.

Wider scopeIn 1998, President Clinton signed the International Anti-Bribery and Fair Competition Act by further amending “FCPA liability (criminal and civil) to include foreign nationals, foreign business and public inter-national organisations (such as the United Nations, the International Committee of the Red Cross, various international


development banks, and the World Health Organisation) that while in US territory, do any act in furtherance of a prohibited payment”.2

After 22 years of initial enactment of the FCPA statute, this article critiques its practi-cal applicability and argues its timeliness and effectiveness. In conjunction with the OECD global initiative against bribery of foreign public officials in international busi-ness transactions,3 we provide several sound recommendations for consideration by the US legislative branch and legal agencies. In addition, through relevant legal case analy-sis, the article also recommends a clear and consistent FCPA global compliance frame-work as a guideline for multinational cor-porations and individuals that operate in a highly competitive global market.

Quick, dirty solutionGenerally, compliance departments are poorly staffed, with limited access to finan-cial resources and training. Companies view FCPA violations as a “business of nexus and routine governmental action” to promote its presence in developing nations and emerg-ing markets. Management often takes the view that the negative publicity, penalties and legal fees associated with FCPA viola-tions outweigh its huge profits by bribing foreign officials. It appears to be a “quick and dirty solution” for a new market entry or to increase the firm’s footprint in existing markets.

In the fear of losing market share, little if any due diligence is done when partnering with third party vendors. There are mini-mal internal controls to monitor employees, especially marketing and sales teams, for

FCPA violations. Training internal employees on FCPA appears to be optional rather than a mandatory compliance requirement.

Confusing, vagueFrom the standpoint of FCPA statute devel-opment, companies view the language of FCPA as confusing, vague and also subject to individual interpretation. Companies are forced to answer to both the US Department of Justice (DoJ) and the US Securities and Exchange Commission (SEC) for the same violations under different applied standards. The due diligence requirements for compli-ance and ethics standards applied by the DoJ and SEC are vague, with too many loopholes and short on timely judicial guidance.4

The accounting provision requirement standards applied under this statute by both the DoJ and SEC are unclear when it comes to “good faith effort” in balancing between subsidiaries and internal control. On the other hand, accounting irregularities in bribery, violating book and records require-ments, appear to remain an acceptable norm in-country business practice. Having a “wilful blindness” to bribery and fiduciary duties seems to be the trending strategy that multinational companies have opted for as opposed to taking a self-risk assessment approach in day-to-day business transac-tions to promote a sustainable global oper-ating model.

Individual reactions to the FCPA statute appear to take the stance that “this is a green field market and bribing foreign officials is an exception for routine governmental action.” Further, few are unaware of the existence of the FCPA statute, which is mainly due to lack of knowledge and training. In the midst of


acquiring business contracts, the name of the game appears to be “doing whatever it takes to get the contracts binding.” Individuals seem to react to FCPA as a “nuisance” and the notion that “let’s worry about any vio-lation and penalties when, and if, we get caught in wrongdoing.”

Being on the right side of the bargain, the price-to-pay and the timeline also seem to be a major factor in wrongdoing. In addition, the notion seems to be “it’s a foreign land with in-country corruption and a legal sys-tem to worry about rather than domestic US agencies’ rules and regulations.”

Tantamount to pornThese FCPA reactions seem to be a reso-nating behaviour pattern across all country jurisdictions when it comes to operating in or entering emerging markets. Given the lack of awareness, training and moral con-science, these reactions are tantamount to porn and will resonate for many decades to come.

This section on case law analyses the recent FCPA enforcement against global corporations and individuals, and sets the stage to uncover the legal standards applied by the enforcement agencies in prosecuting violators. FCPA cases related to corporations will be analysed as well as subsequent cases relating to individuals. In addition, this sec-tion will uncover the fundamental reasoning behind US federal FCPA enforcement activi-ties and relate to core reasoning due to lack of robust compliance and ethics policies and procedures.

In recent years, FCPA federal enforce-ment actions against global corpora-tions have generated public and private

awareness by showing the importance of the statute against white-collar crime (as illustrated by US v. Kellogg Brown & Root LLC (KBR) & Halliburton Company.5) The complaint states that between the years 1995 to 2004, “senior executives at KBR and others, devised and implemented a scheme to bribe Nigerian government officials to assist in obtaining multiple contracts worth over $6 billion to build liquefied natural gas (LNG) production facilities on Bonny Island, Nigeria.”

In order to conceal the illicit payments, KBR and its members formed a sham joint venture with a UK agent and a Japanese agent. In addition, this joint venture was used to “funnel illegitimate fees” to Nigerian government officials. KBR as a part of this allegation pleaded guilty to the scheme “to violate the FCPA by authorising, promising and paying bribes to a range of Nigerian government officials, including officials of the executive branch of the Nigerian gov-ernment, NNPC officials, and NLNG offi-cials, to obtain the EPC contracts. KBR also pleaded guilty to four counts of violating the FCPA related to the joint venture’s pay-ment of tens of millions of dollars in “con-sulting fees” to two agents for use in bribing Nigerian government officials.”6

Guilty pleaHalliburton, as the parent corporation of KBR, pleaded guilty to failing to have ade-quate internal controls, in particular for working with third-party venders, foreign sales agents and the FCPA statute. In addi-tion, it failed to detect, deter or prevent KBR’s violations and continued to make pay-ments to “agents” with numerous books and


records and false information. According to company policies, Halliburton’s legal depart-ment’s due diligence investigation of its for-eign “agents” lacked any specificity regarding the agent’s roles and responsibilities. Halliburton’s third-party due diligence pol-icy also lacked governance and clear trans-actional documentation, specifically in terms of books, records and vendor management, which is a clear violation of the FCPA statute.

Poor due diligenceKBR/Halliburton’s reluctance to main-

tain a robust compliance monitoring pro-gramme and, in the absence of clear and consistent books and records, (its) policies along with poor due diligence procedures in managing third-party vendors, were the main factors leading to FCPA enforcement. In the case of United States v. Siemens AG,7 the SEC charged Siemens Aktiengesellschaft (Siemens AG), a German global corpora-tion, with FCPA violations for lack of a FCPA compliance programme, internal financial controls and adequate books and records. As a part of plea agreements with DoJ/SEC, Siemens AG, without admitting or denying culpability, “agreed to pay a US$448.5 million fine and Siemens Argentina, Bangladesh, and Venezuela each agreed to pay a $500,000 fine, for a combined total criminal fine of $450 million.”8

Siemens made at least 4,283 corrupt pay-ments between March 2001 and September 2007, worth more than $1.4 billion, to gov-ernment officials in Africa, the Americas, Asia, Europe and the Middle East. An addi-tional 1,185 payments, totalling $391 million, were alleged to have been used for commer-cial bribery and embezzlement.

According to court documents presented as evidence in this case, DoJ/SEC claims that despite incorporating a group/regional com-pliance programme, Siemens employees lacked adequate resources and had minimal training and supervisory controls regard-ing compliance roles and responsibilities. In addition, Siemens’ compliance policies and procedures lacked guidelines in conducting due diligence processes on its consultants and agents.

Despite the many “red flags” reported by outside legal and audit committees with respect to FCPA compliance and serious vio-lations, Siemens senior management took a “blindfold” approach to the issue without taking affirmative action to audit recom-mendations. In addition to the foregoing, “there were extremely limited internal audit resources to support compliance efforts.

All of these factors undermined the improved policies because violations were difficult to detect and remedy and resources were insufficient to train business people in anti-corruption compliance.”

Compliance monitorDue to the lack of operational compliance governance shown by Siemens senior man-agement in mitigating this compliance pro-gramme, the issue led to many additional FCPA enforcement actions. By pleading to these allegations, “Siemens AG agreed to retain an independent compliance monitor for a four-year period to oversee the con-tinued implementation and maintenance of a robust compliance programme and report to the company and the Department of Justice on its progress. Siemens AG also agreed to continue to co-operate in full with


the Department in ongoing investigations of corrupt payments by company employees and agents.”

In recent years, trends have shown that harsh criminal and civil action has been taken against individuals who “knowingly’’ violate FCPA statutes. As the individuals are always responsible for corporate actions, governmental moves against individuals remain at the highest standards.

Bribery, kickbacksAs illustrated in the United States v. Albert Jack Stanley (KBR), UK Citizens, “former officer and director of KBR pleads guilty to foreign bribery and kickback charges in a scheme to bribe Nigerian govern-ment officials in order to obtain contracts.”9 Stanley, 65, who worked under former US Vice- President Dick Cheney when the lat-ter headed Halliburton, admitted that he paid approximately $182 million in bribes to Nigerian government officials as a part of contract negotiations.10

In a two-part criminal count against him, Stanley was charged with, 1) conspiracy to violate the FCPA and, 2) conspiracy to com-mit mail and wire fraud. He was sentenced to seven years in prison and ordered to pay $10.8 million in restitution” in a plea-bar-gain agreement in connection with KBR-Bonny Island projects in Nigeria. Under this kickback bribery scheme, “Stanley hired the consultants to help Halliburton and its predecessor firms arrange deals to build LNG projects not only in Nigeria, but also in Egypt, Yemen and Malaysia.

From 1991 to 2004, the consultants directed a total of $10.8 million of the pro-ceeds back to Stanley through a Swiss bank

account.” By pleading guilty through a plea agreement with the DoJ, Stanley agreed to fully co-operate with the Department in an ongoing investigation.

In the case United States v. William J. Jefferson,11 the former US Congressman from New Orleans was sentenced to 13 years in prison for bribing Nigerian offi-cials and using his official power to “solicit bribes”. In a trial by jury and based on case details, Jefferson was convicted for using “his influence and his power to enrich himself and his family.” Jefferson unsuc-cessfully appealed to the Supreme Court on November 13, 2009, which upheld his conviction and sentence. This case sets the legal standard and the precedence that no individual, including government elected officials, is above regulation in terms of the FCPA statute.

Legal trends show that the agencies are increasing prosecutorial actions aggressively against individuals and corporations. The emerging legal trends in standards applied by the governing courts in punishing wrong-doers are articulated in jury instructions such as the case of United States v. Green.12

Element of conspiracyTaking the approach of applying FCPA stat-utes as a globally applicable legal standard and framework as a means of combating bribery, the standard applied by US courts in enforcing this statute is defined by the element of conspiracy. The courts have instructed the jury by defining the term “conspiracy” as a “kind of criminal partner-ship” in the context of violating the FCPA statute and the government has to prove its prima facie case beyond reasonable


doubt. Despite several conflicting admin-istrative viewpoints within and among the enforcement agencies, the release of the DoJ’s report provides a few guidelines to upcoming trends in FCPA enforcement. This forthcoming disclosure by individuals and corporations to the DoJ-Attorney General’s (AG’s) for opinion have proven to be some-what helpful specifically during mergers and acquisitions dealings in protecting the reputation of the American brand. In 2009, the DoJ released only one such opinion (in September) with respect to a request from a medical device manufacturer.13

Political initiativesIn light of the recent global financial cri-sis, the US Congress has taken a tougher stance in proposing to implement a “super regulatory” framework to regulate the capi-tal market. Using the FCPA statute as a glo-bal benchmark, the intent of Congress is to restore the reputation of the American brand and promote confidence in US business by punishing wrongdoers.

Based on recent case law and the stand-ards applied using FCPA statutes, it is clearly evident that this intent is more of a political initiative rather than one which will ensure major regulatory change in the conduct of business internationally.

History has clearly shown that since the inception of the 1977 FCPA statute, there has been limited participation and action by Congress to promote the true value of this statute. Due to lack of unanimity in the glo-bal fight against bribery by government offi-cials, Congress’ true legislative intent appears to be lost in the midst of mere political party differences. These differences are the main

reasoning for Congress’ bipartisan view on FCPA regulation as not being an integral part of US foreign policy. Congress’ regula-tory actions should consider both domestic and foreign policy in order to consistently apply the FCPA statute. In a globally com-petitive marketplace, a recent trend that has emerged is that FCPA regulation has created unfair business competition, particularly towards the American business community.

If the intent of Congress is to promote a fair and competitive environment in order to prosper in the international market and bring a true reputation to the American brand, its policy towards punishing entre-preneurship and innovative business activity needs to be reconsidered.

Through trends observed in recent legal cases, there seems to be a major discon-nect between the Export-Import (Ex-Im) Bank funding activities, regulatory oversight and reporting suspicious activities to the law enforcement officials. Congress needs to reconsider the overall banking import-export governance and amend the Banking Import-Export Regulation to include clear reporting channel requirements in Ex-Im Bank financial activities specific to monetary transactions related to FCPA statute.

On the judicial side of this argument, FCPA regulation and enforcement lacks clear authority lines across the Secretary of State, Secretary of Defence, State of Treasury, DoJ, AG, SEC, FBI, Economic Affairs, National Security Agency and many other govern-mental agencies. Due to conflicting complex policies and procedures adhered to by these agencies, recent legal trends have shown that FCPA enforcement activities are elabo-rate, expensive and time-consuming. Even


though violation of “domestic concern” may be investigated and prosecuted only by the DoJ, SEC and DoJ FCPA, investigative teams lack the necessary funding and resources.

Due to lack of resources, bandwidth, cor-rupt bureaucratic systems, sufficient foreign in-country law enforcement support and constant changes in the political climate, many of these investigative activities may take months and years to actually achieve punishment of wrongdoers. Given the com-plex nature of these multinational, parallel country investigations, trends have shown that FCPA enforcement activities are often settled with a quick plea bargain.

Penalty for briberyEven though the hefty penalties imposed in recent cases seems to indicate the sever-ity of FCPA violation, lack of judicial author-ity in the cross-border white collar crime jurisdiction are the main challenges FCPA enforcement authorities face in sophisticated business transactions. In clear and compel-ling cases, enforcement officials must have the authority to enforce forfeiture of the assets as a penalty for acts of bribery. Having cross-border foreign government officials and in-country law enforcement personnel, as well as proactive support in information sharing, will certainly expedite FCPA inves-tigative processes.

Long way to goEven though the OECD Conversion initia-tive in global bribery regulation has shown many in-country bribery policy changes, recent trends demonstrate the OECD’s lack of authority in imposing strong-arm practices, clear enforcement standards and

governance. As such, OECD Conversion only consists of 30 member countries; it has a long way to go in reaching out to the emerg-ing countries to realise its true objective.

The trends indicate it is clear that the flow of official bribery-related activities are driven from the developed to developing nations. With poor economic frameworks, such as, lifestyle, wages and moral standards, devel-oping countries are forced to accept bribery as a means of quick enrichment.

The OECD faces a major challenge in addressing these real political issues in order to find a common working ground and to bring developing countries into line with the intent of its core objectives. In the near future, OECD will have a major role to play in bringing about regulatory changes against global bribery.

With adequate member support among national world leaders, substantial finance and resources, the OECD anti-bribery global framework initiative will enhance the impor-tance of the FCPA statute and promote com-petitive advantage in the business market.

Strong corporate ethics and compliance frameworks are the minimum requirement for a sound FCPA compliance programme. Without true commitment and support from senior management teams, compliance monitoring controlling tools’ systems will fail to detect and apply corrective measures in a reasonable manner. Taking a blindfold approach by senior executives and board members to FCPA regulation, as seen in the KBR and Siemens cases, will lead to further FCPA prosecutions and contribute to the development of negative reputation along with unnecessary and harmful publicity.

It is the fiduciary duty of corporate


officials to maintain the corporate culture, clear and consistent compliance policies and procedures in line with the statute and regu-lations. Policies and procedures may need fine tuning periodically based on changes to the regulations, government actions and in-country laws. Implementing a global compli-ance team that works closely with regional compliance teams in monitoring and con-trols as necessary will lead to a stronger, more robust compliance framework.

Team accountabilityWith the support of in-house international counsel and external counsel, global com-pliance teams should be held accountable in initiating, monitoring and maintaining FCPA compliance and ethics programmes. As the trends are moving in the direction of increased governmental FCPA enforce-ment activities, compliance teams should undertake necessary due diligence to audit and fine tune the compliance programme to mitigate potential risk. Through periodic internal investigations and testing of internal controls, compliance teams should identify “red flags” and regulatory compliance gaps through risk assessment and take appropri-ate actions by ensuring that country focused investigation is sensitive to the culture.

Entrepreneurial spiritHaving a robust global compliance frame-work to promote free, honest and com-petitive behaviour in the global market will provide support necessary to regain the essence of the true American entrepreneurial business spirit. With dedicated, fully-funded and empowered compliance resources, and strong management voices, the FCPA

compliance programme will promote cor-porate governance and a proper “code of conduct” by offering innovative products and services in a competitive global market.

When it comes to the “business of nexus” quid pro quo, having clear and consistent global FCPA compliance policies and pro-cedures is absolutely critical in third party vendor business dealing. Recent trends have shown that third party due diligence in vendor management, contract negotiations, domestic and foreign agents, and distribu-tors’ relationship monitoring in the merger and acquisitions environment, remains a challenging compliance task. The “tone on the top” and the middle management organisation culture will need to promote zero tolerance towards bribery in day-to-day business dealings.

Having a “right to audit” clause in third party contracts will strengthen and empower the due diligence process and facilitate the ability to enforce observance of contractual obligations according to the FCPA compliance policies and procedures. Sub-contracting and private party business relationships must not be approved without proper endorsement from corporate compli-ance officials.

Regional sales management and mar-keting teams must adhere to the FCPA compliance policy and procedures; this will be facilitated by the application of manda-tory FCPA training. Having an international, independent in-house and an external auditing team to monitor and report irregu-lar activities to the compliance offices for further investigation and mitigation will pro-mote a risk aversive compliance culture in a cost effective manner.


Knowing your customer and third party vendors in business dealings will certainly help in monitoring and controlling corrup-tion in accordance with FCPA regulations. In addition, having diagnostic tools, facilities and protection for “whistleblowers” and web interface tools will also help identify compli-ance issues and enable resolution or the abil-ity to discipline wrongdoers in a reasonable manner according to the compliance policy and procedures.

Sustainable relationshipsEven though some of these advanced tools and techniques face challenges in new busi-ness dealings, specifically in emerging mar-kets, they have proven to be a good resource for sound risk management. There is suf-ficient proof to suggest that the existence of a right compliance toolset, sound business acumen-ship and risk aversive investigative techniques will aid in building sustainable business relationships. Training employees and vendors on FCPA regulation as a part of the compliance programme will enhance the quality of detecting, avoiding and man-aging conflicts of interest in key business transactions. Proactive due diligence and monitoring have shown to be very effective ways to enable compliance with FCPA regu-lations and to gain credibility and account-ability with regulators.

Enhanced credibilityUsing the DoJ’s FCPA opinion procedure effectively and in a timely manner, specifi-cally in merger and acquisitions dealings, will support a proactive due diligence process. The trends have demonstrated that plea and deferred prosecution agreements in FCPA

violation is effective in resolving compliance issues in an expeditious way. Working in conjunction with agencies to mitigate com-pliance gaps has enhanced credibility with regulators.

In addition, the cost-benefit in plea agreement outweighs the legal costs and reputation risk. In recommendation, vol-untary disclosure in FCPA violation is the best strategy in both the short and long run. Identifying and reporting conspiracy ele-ments to FCPA enforcement officials will promote a strong accountable compliance organisation.

The trends have illustrated that operating in high risk countries, specifically in emerg-ing markets, is a major challenge to the com-pliance and ethics programme. Knowing the local anti-bribery statute, jurisdictions issues and market barriers will aid in planning con-tingencies in high risk countries as a market entry. Implementing the FCPA compliance training in a timely fashion and ensuring good governance to monitor will help in operating in these countries.

Consistent complianceProviding consistent compliance commu-nications and setting clear policy rules and guidelines will aid the promotion of the code of conduct. Fine tuning the compliance pro-gramme in accordance with local anti-brib-ery laws, managing the overall programme from a global perspective will provide better ability to control and monitor.

Finally, coming to the “grease or facilitat-ing payment” in these countries which are considered normally as “business of nexus”, care should taken in such payments, spe-cifically, if payments are made to influence


foreign officials to award new or existing contracts.

Under these circumstances it needs to be emphasised that such payments are in viola-tion of FCPA regulations. However, it is legal if these payments are a normal in-country practice which has no barring towards influ-encing foreign officials but to expedite the contract performance process. In addition, care should be taken to record such pay-ments accurately and timely in the corpo-rate books and records. Payments should be audited periodically for compliance and “red flags” reported to the appropriation compli-ance committee for further action.

Moral conscienceIn the end, an individual’s moral responsi-bility in dealing with corruption is a choice, not a business necessity. As long as suppli-ers are willing to violate FCPA regulation by bribing foreign officials, buyers are available in abundance. Even though FCPA regula-tion applies only to the suppliers, giving and taking bribes is one’s personal decision. In the midst of short-term enrichment, human greed dictates wisdom which in turn leads to hefty life penalties.

The FCPA is a powerful tool that the agencies will continue to use in an effort to stop individuals who seek to further their own business interests through bribes paid to foreign officials.

Given the one-way path in bribery, indi-viduals may need to reconsider options and protect their personal brand before making hasty decisions. Having a moral conscience in business dealings will lead to a strong rep-utation, mutual respect and a credible legacy for generations to cherish. •

References1 See: PBS.com – Corruption in the Crosshairs (His-

tory of International anti-bribery legislation), April

17, 2009 SSRN: www.pbs.org/frontlineworld/stories/

bribe/2009/04/timeline.html

2 Amendment to Int’l Anti-Bribery Act of 1988 SSRN:

library.findlaw.com/1998/Dec/1/130472.html

3 Organisation for Economic Co-operation and Devel-

opment SSRN: www.oecd.org/

4 The Foreign Corrupt Practices Act by J.Ndumbe

Anyu, ISBN: 978-1424157021

5 SEC v. Halliburton Co, & KBR, Inc, CA No. 4:09-

399, SSRN: www.sec.gov/litigation/complaints/2009/

comp20897.pdf

6 KBR, Inc Pleads Guilty to FCPA, DoJ Press Release

– February 11, 2009 SSRN: www.justice.gov/opa/

pr/2009/February/09-crm-112.html

7 USA v. Siemens, December 12, 2008, Case No.

1:08-cr-00367-RJL SSRN: www.whitecase.com/files/

upload/fileRepository/Alert_WhiteCollar_FMD_

Siemens_FCPA_121608_addendum_2.pdf

8 Siemens Pleads Guilty to FCPA, DoJ press release

– December 15, 2008 SSRN: www.justice.gov/opa/

pr/2008/December/08-crm-1105.html

9 Propublica.org on KBR Exec’s Plea Widens Probe

– September 9, 2008 SSRN: www.propublica.org/

feature/kbr-exec-plea-widens-probe-909

10 KBR, Inc – Jack Stanley Pleads Guilty to FCPA, DoJ

Press Release – Sept. 3, 2008 SSRN: houston.fbi.gov/

dojpressrel/pressrel08/ho09032008.htm

11 Congressman William J. Jefferson Jail Sentence under

FCPA, DoJ Press Release – November 13, 2009

SSRN: www.justice.gov/opa/pr/2009/November/09-

crm-1231.html

12 USA v. Gerald Green & Patricia Green – Case No.

CR 08-59-GW SSRN: www.mediafire.com/ ?yfwn-

wddyymy

13 DoJ FCPA Opinion Procedure Release Request

SSRN: www.justice.gov/criminal/fraud/fcpa/opinion/

2009/ 0901.html


Compliance

Public or private accounting and the Sarbanes-Oxley Act

The AEI’s Alex J. Pollock casts a sanguine eye over SOX and the huge and costly

bureaucracy that was spawned in its wake.

it is seven years since the passage of the sarbanes-oxley act. as it fades into history, we ought to be able to gain some perspective on the efficacy and effects of the act. for example, as newt gingrich asked: “is it consistent with the factors that make for a successful, energetic, growing, entrepreneurial society?”

There are three sets of photos in my office which often amuse visitors. They depict three pairs of distinguished, serious gen-tlemen. One pair is Senator Smoot and Congressman Hawley, authors of the infa-mous Smoot-Hawley Tariff of 1929. The sec-ond pair is Senator Garn and Congressman St Germaine, authors of the Garn-St Germaine Act, which served to make the 1980s savings and loan collapse much worse. The third pair is Senator Sarbanes and Congressman Oxley. My motto for the three sets of paired photos is: “It seemed like a good idea at the time.”

What did it achieve and what do we know about the Sarbanes-Oxley Act? We know it succeeded in creating a vast bureaucracy and enormous associated costs.

We know it succeeded in creating a finan-cial bonanza for the partners of accounting firms; it was the most profitable thing that ever happened to them. We know it suc-ceeded in creating a vast effort around iden-tifying risk, documenting, and managing risk and risk factors.

But what was the result? In a recent study by Ernst & Young, The Future of Risk, an E&Y partner is asked: “Is there too much risk management going on now? Are there so many processes and complexities that the actual process of mitigating and assessing risk get in each other’s way and are counter-productive?” The partner replied: “That was a key finding.” Yes, that’s where we are.

Of course we know that despite all the Sarbanes-Oxley risk, efforts did not mitigate the tremendous financial bubble and bust that has emerged over the past few years. With that in mind, I asked two informal advisers of mine – both of whom are very knowledgeable and competent managers in the area of mortgage finance – what they thought about the outcome of the imple-mentation of the Sarbanes-Oxley Act. One of them, a specialist in hedging and related


accounting issues, wrote to me: “The mort-gage meltdown has proven that Sarbanes-Oxley had absolutely no impact on corporate behaviour. Any improved investor confi-dence was sorely misplaced, as we can see.”

Then he listed a number of examples of which we are all aware: New Century, GMAC, Fannie Mae, Freddie Mac, IndyMac, Washington Mutual, Wachovia Bank, Countrywide. Note these are all or were public companies, all subject to the processes and structures that Sarbanes-Oxley requires.

He went on to say: “Besides doing Sarbanes-Oxley reviews, the big four accountants were busy reviewing securiti-sation models. They would opine as to the mathematical accuracy of the models but not as to the assumptions. Well, you couldn’t audit the securities you were reviewing because of the need created by Sarbanes-Oxley to separate consulting from auditing.” This is his peroration: “Where was Sarbanes-Oxley? Supporters of Sarbanes-Oxley should be required to point out at least one success story. I can’t think of one.”

‘Big impact’I shared that with another colleague, who is a talented operating manager in finance and mortgages. He wrote back: “Dave’s mis-taken when he says Sarbanes-Oxley had no impact. It had a big impact: keeping manag-ers focused on trivial mechanics and inves-tors focused on the bogus management assessments of risk that were the volumi-nous output of the trivial mechanics which are still occupying loads of managerial time.”

And Dave replied: “Well, it’s hard to disa-gree. In this case, no one gained anything other than the accounting firm partners,

as previously mentioned. No loss was pre-vented so it was all a big waste of time and money signifying nothing.”

Something else we know about Sarbanes-Oxley is that it succeeded in creat-ing a huge emphasis on the notion of “inde-pendence”. Independence sounds like a fine idea, but independence just for the sake of independence is, in my view, a rather dan-gerous notion.

Sobering factThis includes independence relating to boards of directors of companies, and also in government-sponsored bodies, spe-cifically the Public Company Accounting Oversight Board (PCAOB) and the Financial Accounting Standards Board (FASB). I will suggest that Sarbanes-Oxley over-empha-sised the idea of independence and woefully under-emphasised, or didn’t even factor in, the centrality of knowledge and the applica-tion of knowledge to problems.

In retrospect, it is a sobering fact that the votes passing Sarbanes-Oxley were 99 to 0 in the Senate of the United States and 423 to 3 in the House of Representatives. If you add these two together, that gives you 522 votes in favour from the elected representatives of the American people, and three opposed. These votes make me think of a story from General Motors when it was one of the greatest companies in the world, and at the time run by Alfred P. Sloan.

At a management committee meet-ing one day, Sloan said: “We’re all agreed?” Everybody said “yes”. Sloan: “No one is opposed?” Everybody said “no”. Sloan: “No worries or dissent?” Everybody said “no”. According to the story, Sloan’s conclusion


was: “Then we’re going to table this question until we can get some wholesome disagree-ment and maybe we’ll know what we are doing.” Similarly, perhaps we should worry whenever the Congress is so uniformly in favour of something, especially in the wake of a political panic.

What was the Congress trying to achieve with the Sarbanes-Oxley Act? Here is what Senator Sarbanes said in his address to the Senate when the bill was about to be passed: “It is becoming increasingly clear that some-thing has gone wrong, seriously wrong, with respect to our capital markets. We confront an increasing crisis of confidence that’s eroding the public’s trust in those markets.” So Sarbanes-Oxley was passed to establish “confidence” and “trust” — did it achieve its objective? From the perspective of the sub-sequent bust and panic of 2008-09, Senator Sarbanes’ idea of what the Act would achieve needs no further comment.

A matter of faith?Further as to the purpose of Sarbanes-Oxley, at that time Senator Enzi said: “My hope is that this new oversight structure will renew the faith that the public has in auditors and in the financial statements that they help to prepare.”

Personally, I don’t feel too much “faith” in auditors or accounting, nor do I wish to have such faith. I think most auditors are honest, hardworking people who make mis-takes like everybody else makes mistakes. Inevitably, the mistakes are sometimes very large. Accounting mistakes and scandals are nothing new. The profession of auditing and accounting has often been in serious trouble over the decades. They were in trouble in the

1930s, 1950s, 1960s, 1970s, 1980s and, once again, in the 2000s. So I don’t know why we should be surprised by their travails or wish to feel too much “faith” in auditors.

‘Enron of the day’“Here are some specifics of their history: After the stock market bubble of the 1920s, accountants were charged with producing deceptive and misleading financial state-ments. In 1938, there was a massive upheaval – the Enron of the day – the McKesson & Robbins accounting scandal, “greatly embarrassing the profession.” About this, an accounting journal noted: “Like a tor-rent of cold water, the wave of publicity has shocked the accountancy profession into breathlessness.”

In the 1950s, the accounting profession was subjected to a “barrage of criticism.” In 1967: “Now all at once there are more than 50 lawsuits pending against the major accounting firms which handle 80 per cent of the US auditing business of listed compa-nies, charging irregularities and negligence. With equal suddenness, a barrage of public criticism has landed on the profession.” The later 1960s were called “a period of “unprec-edented stress” for accounting.

Then in 1970 came what was until then the largest bankruptcy in history, the Penn Central Railroad. We might call that today a “systemically important railroad.” Its failure and the subsequent panic in the commercial paper market naturally called into question the effectiveness of the auditors. By the later 1970s, highly publicised bankruptcies were creating calls for government intervention in the accounting profession. In the 1980s, the major accounting firms were entangled in


the savings and loan collapse and were the object of numerous Congressional hearings.

It is hard to find any extended period in which accounting has not found itself in some kind of hot water. The answer has always been, “more rules” and “independ-ence” – and yet the problems continue.

Let us turn to the notion of “inde-pendence” relative to boards of directors. Of course, there was a very large push in Sarbanes-Oxley for independence. I sug-gest we need to think about the difference, or perhaps the balance, between independ-ence and knowledge. Naturally, we want people to be independently minded; how-ever, if you have a very independent mind, but you don’t know much about the topic, what good is your independence?

Part-time directorsMore than 130 years ago, Walter Bagehot in Lombard Street wrote A Description of the Money Market; this book, which I consider to be the greatest ever written on banking, pointed out the problems with boards. The fundamental problem is that directors are, by definition, part-timers with the company and management is full time.

Ask yourself this question: “Who knows more? Somebody who works on some-thing one day every two months, or some-body who works on something 10 hours a day every day? Bagehot posed this problem: How can the board ever know as much as management? The only way they could is if they were themselves full time, in which case they would cease to be the board.

I discussed this issue some time ago at an AEI conference; the problem of manage-ment and boards and knowledge versus

independence. A very successful retired CEO of a Fortune 100 company said: “Yes, from the point of view of the CEO, the ideal board is 100 per cent independent directors except for the CEO.”

Authority vs expertiseHe continued: “That’s the board I’d like to have! I’d be the only one who actually knows anything and I’d be able to do what-ever I want.” This brings me to a quote from Senator Gramm. Senator Gramm voted for Sarbanes-Oxley, but he had this to say dur-ing the discussion:

“For the record, I submit that in the approach of this bill, we are probably going too far in putting people in positions where they’re going to have massive unchecked authority when they have no real expertise in the subject area.” I think that was a fair comment.

Now let us turn to government-spon-sored bodies. Over the years at AEI financial conferences, you will have heard a lot about government-sponsored enterprises like Fannie Mae and Freddie Mac. We also need to address government-sponsored bodies like the PCAOB or the FASB. When you apply the notion of independence to such bodies in an unbalanced way, as Sarbanes-Oxley did, you create organisations subject to few or no checks and balances.

It was a key point of Sarbanes-Oxley, for example, to create an independent funding source for the FASB, which is essentially a tax levied on all public companies, so they wouldn’t have to worry about whether peo-ple think they are worth it. The same kind of funding tax was set up for the PCAOB. It seems to me that the fundamental


Madisonian precept (managerial responsi-bility) we all ought to live by is that nobody should be fully independent. Everybody should be subject to checks and balances. Here is a good example of what hap-pens with such mistaken independence: so-called “fair value” or “mark to market” accounting.

There is no doubt whatsoever that this kind of accounting in a panic makes the panic worse and drives the financial system down. This would not be a surprise to any-body who has ever thought about it. In 1999, for example, Paul Volker said: “Marking to market can be a great recipe for accelerating crises.” He was right and we have just expe-rienced it in the panic of 2008-09.

In my view, fair value accounting is con-ceptually flawed and not a very good theory. But even if you like the theory, you cannot deny that it drove the panic closer and closer to the edge of the cliff. When collapse was threatening, Congress finally did intervene and forced the FASB to overrule itself.

Hand-wringing criticismThis was subject to some handwringing crit-icism: “Oh dear, you overruled the experts,” but anybody who really believes in democ-racy and in checks and balances ought to see this as a very good step. The elected repre-sentatives of the people had to defend the people from the theoretical accountants.

The second thing that helped overrule fair value accounting was that the Federal Reserve and the Treasury Department invented public “stress tests” for large banks. I think this was a magnificent piece of political theatre. A key point of the stress tests is they completely ignored and bypassed fair value

accounting, and made it irrelevant. When the accountants were checked and balanced in this dual fashion, by Congress and by the stress tests, last spring, financial markets started to recover. The fact that the market recovery closely followed these events may not indicate causality, but it may. In any case, the capital markets recovered.

Act ‘deeply flawed’The FASB has since counter-attacked, want-ing to expand fair value accounting even further. If they succeed, it will make us even more vulnerable to future panics. I repeat my conclusion that nobody should be fully independent. Everybody should be subject to checks and balances. Therefore, a funda-mental assumption or ideal of Sarbanes-Oxley is deeply flawed.

Let me come to the PCAOB and its dubi-ous constitutional standing. Is this a private or a government body? It is neither. It was set up as a hybrid to avoid two sets of disciplines. The market discipline of being fully private was avoided, so also was the discipline of being a government body, the processes of appointments and appropriations, the appa-ratus of being part of the government.

This avoidance of both disciplines was fully intentional on the part of the creators of Sarbanes-Oxley. As mentioned, PCAOB is supported by what is functionally a tax on public companies, and it is obviously a regu-latory body. But (like FASB) it claims that it is “private”.

My view is that PCAOB should have to decide; it shall be public, a part of the government with all that implies, or it shall be private with all that implies — it cannot be both. •


Accounting standards

‘Innumerate bankers, systemic idiocy & accounting standards’

The FSA’s Lord Adair Turner takes issue with some senior bankers’ views on book-

keeping standards across the industry.

in an article in the Financial Times on December 15, 2009, Martin taylor, former Chief executive of Barclays Bank, argued that the core cause of the financial crisis was that ‘the system was brought down because bankers could not count’ and ‘because there was no measure of cash flow to tell them that they were idiots’ in their assessments of income.

The article was reported as an attack on innumerate bankers; in fact it was an attack on accounting standards and on the way in which they are applied. Indeed, there have always been bankers concerned about exist-ing accounting approaches. Ahead of the crisis, there were both bankers and some boards of banks worried about how low their commercial loan loss provisions had to be to comply with accounting standards.

They were low because few commer-cial customers were behind with payments, so that there were very few observable facts to suggest potential loan impairment. Following the most recent boom period, with warning signs beginning to flash across the world economy, judgment suggested

that future loan losses might well be higher. However, accounting standards are designed to reflect today’s already observable facts – and to limit the role of judgment as to future possible events.

Whether that should be the case is now subject to intense debate, with two very dif-ferent points of view.

Among bank prudential regulators and central banks there is a belief that existing bank accounting standards were among the factors contributing to the crisis, inducing procyclicality in credit provision and pric-ing. In addition, there is a demand that bank accounting standards must reflect the con-cerns of prudential regulators. This is accom-panied by the belief that banks are different, and therefore accounting standards need to recognise and accommodate this.

If truth be told . . .However, among many securities analysts and investors and among some account-ing standards setters, the belief remains that accounts exist for investors and not for regu-lators, that they must tell the ‘truth’ as it exists at one particular point in time, and that any


influence of prudential regulators on bank accounting standards could be a Trojan horse for a wider politicisation.

This tension exists even within the regu-latory community. Around the table of the Financial Stability Board (FSB), the pruden-tial regulators and central banks are par-ties that are most convinced that banks are different and that the setters of accounting standards must listen to us. Conversely, the pure securities regulators tend to be more sympathetic to the ‘accounts are for inves-tors’ philosophy. Indeed the tension exists within the accounting standards-setting bodies, thereby contributing to the compli-cating of progress towards the convergence of international accounting standards. The International Accounting Standards Board (IASB), under the leadership of David Tweedie, has been sympathetic to the idea that it must be involved in close dialogue with the prudential regulators. The Financial Accounting Standards Board (FASB) has been more wedded to the ‘accounts are for investors only’ philosophy, and to the philos-ophy that in their accounting, banks should be treated no differently from anybody else.

Simultaneous failureSo are banks really that different and a special case in ways relevant to accounting standards? If so, in what ways, and what should we do about it?

Obviously in one crucial way banks are different from – say – retailers, hoteliers, manufacturers, mining companies, airlines, and we have seen that difference illustrated dramatically over the past two years. Bank system failures – the simultaneous failure of many banks – can plunge the whole world

economy into recession. Bank failures can be a key cause of economic recession as opposed to a consequence of the failure of companies in other sectors. Two principle reasons are put forward, the first general to all financial markets and to all financial firms which act as principals rather than intermediaries; the second specific to banks and bank-like institutions as a sub-set of the financial services industry.

Future valueFinancial instruments link the present to the future; they have value in markets which are inherently intertemporal. Bananas are worth what they sell for today: their mar-ket clears today, balancing today’s suppliers and today’s buyers. But a loan or an equity contract has value today determined by events still to happen in the future and by a changing set of other opportunities to trade future for present value via other financial instruments.

That complexity means that the prob-lems of market imperfection are more severe in the market for financial contracts than in other markets. There are far greater asym-metries of information between buyers and sellers, and a greater influence of imperfect principal/agent relationships. This means that perceptions of value can be highly volatile. Indeed, it introduces not just risk but in the terms in which Frank Knight and Keynes1

used it; inherent uncertainty as to the value of, say, an equity claim on the future. At any instant, there may be a price at which an equity will sell in small quantity, but that price can change radically and rapidly in the face of self-fulfilling changes in perception. And


it will be a quite different price if many peo-ple simultaneously influence one another in their decision to sell.

Inherent uncertainty over how to value long-term and contingent assets and lia-bilities introduces specific problems and complexities into the regulation and the accounting of all financial institutions, both for insurance companies as much as banks. But banks in two key respects are also cru-cially different even from other financial institutions in both their riskiness and their importance.

First, because of the maturity transfor-mation function they perform, lending over the longer term than their liabilities. It is an important function of considerable social value: it results in a term structure of interest rates more favourable to long-term invest-ment than would otherwise pertain; and it enables householders to enjoy the financial planning benefits and assurance of owing long-term liabilities (typically mortgages) but owning short-term assets (deposits). It is an extremely risky activity and one where the risks are inherently collective rather than individual2.

Crucial driverSecond, the fact that banks extend credit to the real economy, and that volatility in the extension of credit to the real economy (in both quantity and price) is one of the most crucial drivers of macroeconomic volatil-ity. Banks are different because swings in credit supply – irrationally exuberant sup-ply and over capacity in the upswing and then sudden withdrawal in the downswing – matter far more to the macro economy than irrationally exuberant over supply and

contraction in, say, airline capacity or internet entrepreneurship. It is therefore a combina-tion and interaction of three factors which make banks different:• Inherent uncertainty of the present value

of future financial claims;• The maturity transformation function;• The fundamental role which credit

extension plays as a driver of macroeco-nomic volatility.

Complex accountsInsurance companies embody the first of these features, but not all three. They are faced with complex and difficult-to-interpret accounts: they need to be regulated for rea-sons of customer protection but the collective action of insurance companies together is not a key driver of macroeconomic instability.

For these reasons we have prudential regulation of financial firms, in particular of banks. For these reasons prudential regula-tion of banks (unlike that of insurance com-panies) requires a close co-ordination with the ‘lender of last resort’ functions of central banks, and in the future will need to entail a joint central bank/prudential regulator approach to macro-prudential through-the-cycle regulation focused not just on the vulnerability of individual institutions, but on the total system as a whole3.

This need for a systemic macro-pru-dential approach lies behind the regulatory policies now being developed by the interna-tional Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). These include:• Higher capital and liquidity require-

ments overall, designed not merely to make individual institutions sound, but


to improve the resilience of the overall system.

• Crucially, counter-cyclical capital require-ments to build up capital buffers in good years so that they are available to absorb losses during recessions.Such policies are quite different from

those which we apply in other sectors of the economy. In non-financial sectors we do not have prudential regulation at all; in insur-ance, we have prudential regulation focused on the sustainability of the individual institu-tion, but not focused on the macroeconomic impact of all insurance companies together.

Therefore, the key question is not whether banks are different; they are and we are already designing prudential regulations to better reflect that fact. Instead the ques-tion for today is whether this difference has implications for bank accounting or whether it should be reflected solely in prudential regulation.

Loss implicationsTwo aspects of bank accounting in

particular could be relevant to the macro-prudential and macroeconomic factors that make banks different. First, the treatment of loan losses within the banking book, the way in which we capture, or fail to capture, present or future potential loan losses aris-ing from credit default. Second, the valu-ation approach in the trading book (and other items which are mark-to-market), the recognition of unrealised gains or losses in general, but in particular in more illiquid securities.

In both these areas, there is a strong case that the present accounting treatment contributes to the problem of procyclicality.

On the banking book side, the current IASB accounting treatment requires banks to rec-ognise the implications for potential loan losses of events which have already occurred, such as failures to make interest or principal payments.

Dramatic variationsHowever, this also requires them only to

recognise such known events, not to antici-pate possible or probable future events. This necessarily implies that loan loss provisions will vary dramatically through the economic cycle, and means that in good years income will be declared which does not reflect the average future loan losses likely to arise from loans being put on the books.

As a result, this accounting treatment can contribute to a cycle of self-reinforcing responses which tends to exacerbate the vol-atility of credit extension and of the economic cycle, both on the way up and the way down.

In the upswing (figure 1), the incurred loss model produces low figures for loan loss, boosting measured bank profits and flattering lending margins through three transmission mechanisms that can stimulate the procyclical effect of an increased quantity and lower price of credit. These include:• high bank profits bolstering capital ratios

and thus increasing lending capacity;• high apparent margins on lending gen-

erating competition for lending volume, and declining loan spreads; and

• high banker bonuses, paid out on the basis of high measured profits, to rein-force banker confidence and propelling the desire for greater achievement in order to earn equivalent bonuses in the subsequent year.


Seen together, this can drive further credit extension at fine spreads, initially improv-ing economic prospects and firm finances, and further reducing apparent indicators of potential loan loss. However, with the exces-sive lending that this will tend to generate and inevitably produce a set-back (figure 2), and with each of these factors operating in reverse in the downswing:• bank capital and lending capacity is

depleted; and• lending at existing prices is apparently

suddenly less profitable, driving reduced willingness to lend and increased lend-ing spreads.Meanwhile, on the trading book side,

the accounting approach requires banks to value assets at ‘fair value’4. Wherever possi-ble this means a ‘mark-to-market’ approach – the assets valued at what they could be sold for in a market on the day on which the accounts are struck.

Factual approximationWhen this is not possible, management and auditors are essentially led to infer what the market price would be if it existed, through the use of indirect information inputs such as reference to other relevant prices, or to models which use other relevant prices as inputs.

The rationale of this approach is that it reflects a set of facts – the facts, or the near-est approximation of the facts, of the price for which the assets could be sold, if sold at the balance sheet date. In some cases this approach is unavoidable; in some ways this is valuable, as I’ll return to this shortly. It clearly creates dangers of procyclicality both on the way up and the way down, but the

effects are even stronger and more disrup-tive than in the case of the banking book, as a result of the particularly procyclical tenden-cies of securitised credit extension.

When credit is extended in a securi-tised form (figure 3), with the market price of credit clearly visible from trading in credit securities, there is an inherent risk that credit supply and pricing can be subject to self-reinforcing herd effects.

‘Animal spirits’ The originators of and investors in credit treating the market level of credit or credit default swap (CDS) spreads as indicators of credit risk and consequently appropriate credit pricing. In an upswing this feeds a ris-ing price of credit securities, falling spreads, increased origination and a self-reinforcing willingness to invest in credit securities; or indeed to lend on balance sheet.

That cycle in turn can be reinforced, how-ever, by the use of fair value approaches to the valuation of assets in the trading books of banks and to the calculation of profit and loss. Rising values generate apparently high profits and swell the capital basis, which can support either more trading activity or increased on-balance sheet lending. And those effects may be reinforced by behav-ioural and confidence effects, to use Keynes’ words, the ‘animal spirits’ of bankers’ paid high bonuses on unrealised and potentially illusory profits.

Figure 4 illustrates a set of interlocking cycles which can then switch dramatically into reverse once confidence is lost. This points to:• falling security prices exacerbated by illi-

quidity and lack of confidence;


• bank balance sheets impaired by trading losses which may well reflect an over-shoot of rational equilibrium values; and

• rising credit and CDS spreads feed-ing through to dramatically increased assumptions on the fair price of credit, whether extended in a securitised or on-balance sheet form.

Harmful procyclicalityTherefore, I believe it is clear that the current accounting treatment in both banking and trading books can contribute to a harmful procyclicality in profits and in credit extension in both its securitised and unsecuritised form. Therefore, the issue is not whether there are problems – there are – but whether changes to accounting standards can help address them, or whether we simply need to recog-nise the problems and offset them through other levers such as countercyclical and liquidity standards. It may be that there are problems here, exacerbated by accounting treatment; no feasible alternative account-ing treatment exists which would help solve these problems without creating others.

In trading books in particular, there are many instruments for which there is no fea-sible alternative to a fair value approach. It is almost impossible for derivative contracts to be dealt with in any other fashion. Concepts of historic cost, nominal value or incurred loss cannot help us gauge the economic substance of the risks inherent in a derivative contract.

There is certainly a case for being a bit cynical about some of the criticisms of fair value which broke out in the period of the market downturn, but only in that period. As credit securities prices fell in 2008, many bankers expressed concern about

unrealistically low market values in illiquid markets, and demanded greater freedom to shift assets from a fair value to a historic cost/hold to maturity/incurred loss account-ing basis. These concerns would have had greater credibility if the same bankers had complained about the potential adverse consequences of the over-valuation of assets in conditions of the irrational exuberance of 2006 and early 2007.

Any changes which make it easier for banks to shift assets between categories in the face of changing circumstances will feed concerns that problems are being disguised or hidden. In late 2008, uncertainty about the value of ‘toxic assets’ and a lack of transpar-ency about how values had been measured by different banks, were major factors that eroded market confidence.

Dangerous credoEqually, the idea that all problems would go away if only there were total transparency and rigorous mark-to-market accounting, extending, according to the credo of true believers, to banking book loans as well as trading book securities is, I think, quite wrong and dangerous. Belief in this credo is sometimes based on a fallacy of composition, a failure to distinguish between the impact of a policy on the competitive advantage of one bank relative to others, and the systemic impact of that policy applied universally. For instance it is asserted and may well be the case, that banks which applied a very strong daily mark-to-market philosophy in their internal risk management were better placed than others to navigate the crisis, more flex-ible in rapidly closing out loss-making posi-tions, rather than holding on in the hope


that something positive would emerge. It is quite possible for that to be true, and at the same time for it to be true that a system of universally applied and totally transparent mark-to-market accounting would increase the volatility of prices, and increase the vola-tility of credit extension. What is good for one bank seeking to compete with others can be harmful in its systemic effect.

Highway to despairThe fundamental problem we face is that there are no definitive ‘facts’ about value – but that value in financial markets is con-tingent on specific circumstances and on the action of all other participants. For an individual bank selling slices of its indi-vidual portfolio in conditions where the actions of other banks can be considered as independent, mark-to-market account-ing provides meaningful facts and a useful management discipline. If all banks tried simultaneously to sell all or a significant proportion of their assets, the facts become quite different.

A fully transparent system of across the board mark-to-market accounting could simply increase the speed with which self-reinforcing assumptions about appropriate value generate cycles of irrational exuber-ance and ultimately despair. Market prices can be subject to self-reinforcing momen-tum and herd effects as much in highly liq-uid, technically efficient and transparently accounted markets, as in inefficient and untransparent ones. Herd and momentum effects in credit markets (whether loans or credit securities) will cause more harm to the macro economy than similar irra-tional movements in equity prices5. So in

summary as regards the trading books:• There is no alternative to mark-to-mar-

ket accounting for some instruments. Mark-to-market valuation provides information which shareholders should logically value.

• Freedom to switch accounting approaches to hide problems can be dangerous.

• But conversely there can be systemic problems of increased volatility if mark-to-market accounting is applied widely.

Therefore, what should we do about trading book risk and trading book and related accounting? The Financial Services Authority (FSA) believes the answer must be a combination of regulatory and accounting reform, each aiming to ensure that a distinc-tive trading book approach is used only for activities where it is clearly appropriate.

Fundamental reviewOn the regulatory side, this entails higher capital requirements against trading books; some changes to the trading book capital regime have already been agreed by the BCBS, and will be implemented by January 1, 20116. In addition, among the BCBS’s most important agenda items for the year ahead is a fundamental review of the trading book capital regime going back to the basic question of why and in relation to what spe-cific activities, is it justifiable to have a differ-ent and lighter capital requirement against an asset held for trading as against one held to maturity? The result is likely to be much higher capital requirements for any assets which are, or under conditions of stress might become, illiquid.


Meanwhile on the accounting side, the way forward requires a parallel look at the appropriate coverage of fair value approaches to the definition of profit or loss, ensuring that fair value gains or losses affect profit and loss (P&L) only where instru-ments are liquidly traded, and are likely to be liquidly tradable in almost all circumstances.

In the trading book, the crucial issue is not therefore a simple yes or no as regards ‘fair value’, or mark-to-market yes or no, but rather what should be included in trad-ing books whether this be for regulatory or accounting purposes.

Turning to the banking books, the prob-lem – as Martin Taylor defined it in his arti-cle – is that we have ‘spreads that take no account of default probabilities’ and therefore interest income recognised with inadequate allowance for the loss probability is always inherent whenever a loan is placed on the books. The fundamental issues are therefore: how to ensure that banks adequately antici-pate the probable and even the improbable but possible future in their pricing decisions and capital adequacy levels? Should this anticipation also be reflected in published accounts?

Anticipating the futureOne possible approach would be to leave accounting as it is and concentrate entirely on prudential regulation and, in particular, on two changes. First, ensuring that Basel II is implemented in a way which does indeed anticipate the future, rather than reflecting only the recent past in a procyclical fash-ion. In principle that is what it was always meant to do. Capital requirements within the advanced internal ratings-based (IRB)

approach are meant to anticipate potential economic losses, and therefore to reflect analysis of the economic losses which might arise for different categories of loans; look-ing forward into an uncertain future and informed by a history of the losses which have arisen for that category in the past, in bad times as well as in good.

Dearth of historic dataIn reality, however, Basel II’s implementation has often been focused on procyclical point-in-time estimates, in part because some banks have lacked adequate data relating to past historic loss experience. We need to shift to a through-the-cycle approach, and the FSA is working with firms to achieve this end.

A second parallel approach is neces-sary to add a clearly countercyclical regula-tory capital requirement, in order to build up capital buffers in good times to allow draw-down in bad. That too is a key priority within the redesign of the global capital adequacy system now being debated by the BCBS.

We could decide to make only these regulatory changes and to leave account-ing unchanged. The FSA believes that there would be considerable merit in changing the current accounting approach to loan loss provisioning – seeking both to address some of the behavioural implications aris-ing from unrealistically high declared profits, and indeed seeking to provide investors with a more realistic picture of underlying profit.

The case in favour of a step in that direc-tion has already been accepted by the IASB, which is now consulting on a new version of its impairment (provisioning) requirements which would require loans on balance sheet to bear an expected loss provision throughout


their lifespan, rather than recognising losses solely according to the existing incurred loss approach. In principle, this approach has merit, but the devil is very much in the detail and, in particular, in the detail of how ‘expected loss’ will be calculated.

If it is calculated by reference to current market expectations of future losses, there is a danger that the new approach could actu-ally be more procyclical than the past. In extremis, if ‘expected losses’ are calculated by reference to the market prices and spreads of traded credit securities, then an expected loss approach to the banking books becomes a form of mark-to-market by another name, potentially increasing rather than reducing procyclicality.

Conversely, if, as prudential regulators would generally prefer, expected loss is cal-culated by reference to judgments about future possible losses informed by past experience or by formulae which link pro-visions to broad indicators of likely future credit problems (such as the pace of credit growth on which the Spanish dynamic pro-visioning approach is based) some investors might have concerns about these judg-ments, whether made by the management or by the regulator, are based on fact and are understandable and transparent.

Ideal preferenceSo in the detailed design of the expected loss approach, the IASB may still face the inher-ent trade-off between the divergent and incompatible demands placed on accounts, investor concerns that they should reflect currently verifiable facts, and the prudential regulators’ concern that they should inform the market about underlying economic

reality and possibility, and should not con-tribute to procyclical credit extension.

Faced with that trade-off between diver-gent aims, the FSA’s ideal preference would be to provide not one but two separate lines of account information on loan loss provisions.

Separate linesThe existing line, as now based on the facts of already incurred credit impairment events; and a separate line, based either on a formula, as in Spain, or on the judgments of management, challenged by regulators, together with the details, basis and ration-ale for that judgment extensively disclosed. Two separate lines and extensive disclosure, we believe would provide better information to investors than either the current incurred loss line or any one ‘expected loss’ based line could ever provide. If instead we proceed with one ‘expected loss’ line, the disclosure of supporting information to enable investors to understand the assumptions made will be important.

However, at least in the US, it is often reported that ‘investors’ are strongly opposed to any divergence from existing standards, and indeed that they continue to be attracted to the extension of ‘fair value’ accounting to which FASB appears still to be devoted. At first sight, this attachment to fair value accounting appears strange. It is not clear why it was in the interest of investors to be told in spring 2007 that the credit securities held by the US or UK banking system were worth hugely more than they appeared to be worth just a year later. Examined in another way, the logic of the ‘investor’ perspective, or at least the perspective of the agents who


make decisions on behalf of investors (i.e. hedge funds, pension fund managers, etc) is clearer. Because the fund managers acting for end investors (if not the investors them-selves) may be logically more interested in precise and non-judgmental information as to the relative economic position of differ-ent firms, than in judgmental information; which, while capturing important aspects of aggregate economic reality, is likely to create more opportunities for cloudiness – non-transparency – in inter-firm comparison.

This clearly illustrates that the interests of investors (or at least of fund managers) and of prudential regulators (and of sound mac-roeconomic management) may diverge. We need to find ways of serving both interests.

Indeed, once again it illustrates the fun-damental problem with which we are strug-gling in accounting for financial services companies in general but for banks or near banks in particular: which is, under the con-ditions of inherent uncertainty that governs financial contracts – contracts which link the present to the future – there is no one ‘truth’, no one set of ‘facts’ relevant to all decisions and decision makers, but several truths and several facts.

Double-edged swordIt is true that the value at which one indi-vidual firm can liquidate part of its portfolio at a particular point in time is best given by the mark-to-market value. It is also true that if all firms try to liquidate a large proportion of their portfolio simultaneously, the mark-to-market value will not be obtainable. A transparent system of mark-to-market accounting, with fluctuating and transparent prices, may tend to induce the very collective

behaviour which makes the measured mark-to-market value cease to be true.

In formal economic terms, there are mul-tiple and unstable equilibria, and the extent to which the equilibria are unstable is itself influenced by the nature of information flows about market values.

Fundamental challengeSimilarly, and turning to the banking books:

It was true that at the end of 2006 and even 2007 that the number of business bor-rowers behind with their payments in many banks’ commercial loan portfolios was very low, and that is a fact that investors might legitimately want to note, providing infor-mation both about the idiosyncratic position of each bank relative to other banks, and about the point in the cycle.

It is also true that when a bank puts on loans during periods of rapid economic and credit growth and general market confidence, the measured loan losses then observed will have a systematic tendency to understate the average subsequent resulting loss.

The fundamental challenge of bank accounting is therefore to provide good information in an environment where the idea that there is one measure of value, one ‘economic reality’, is a chimera, a sub-set of the wider intellectual delusion that has attempted to construct economic theory and policy on the assumption that markets are always rationally equilibrating and that mar-ket prices are by definition ‘correct’.

And that does make banks different – not of course in absolute terms but to such a degree that different considerations must influence the development of bank account-ing standards than are taken into account


in other sectors of the economy. Clearly, for other companies as well as banks, asset val-ues can vary between normal and distressed times: if all retailers went bankrupt simulta-neously the liquidation value of their stocks would be quite different from that observed in the accounts. In reality, retailers do not all get into trouble simultaneously; and no other sector of the economy is remotely comparable with banking in its capacity to be a driver of economic volatility rather than a victim of it.

There is no other sector about which Martin Taylor would have reasonably argued that accounting played an important con-tributory role in provoking general sectoral collapse and macroeconomic recession.

Special relationshipBanks are different because they mat-ter more, because they can do more harm. That’s why we regulate and supervise their business but do not regulate the business of retailers, hoteliers or manufacturers. That’s why there is a special relationship between the banking system and central banks as lenders of last resort. That’s why we worry a lot about ‘too big to fail’ considerations. And that’s why prudential regulators, central banks and economic policymakers have a vital interest in the decisions of accounting standard setters on bank accounting stand-ards, which does not apply between regu-lators and accounting bodies in any other sector of the economy. •

References1 The classic statement of the distinction between

risk and uncertainty is Frank Knight Risk, Uncer-tainty and Profit (1921). See also J.M. Keynes

Treatise on Probability (1921) and The General Theory (1936)

2 Note that one consequence of this function and the activities which go with it – funding with short term deposits and interbank loans and holding liquid assets which can be sold to meet unexpected outflows – is that the measurement of “cash flow” is close to meaningless for banks. As Martin Taylor says, when banks have question-able measures of accounting income “there is no measure of cash flow to tell them that they are idiots.” But that is not because they have per-versely failed to use obviously available cash flow measures (for example those required under International Accounting Standard 7: Statement of Cash Flows), but rather that these cash flow measures are inherently less useful in the bank-ing sector than in non-financial sectors of the economy.

3 See Bank of England: The Role of Macro-pru-dential Policy: A discussion Paper (November 21, 2009)

4 International accounting standards (IAS 39) require use of fair value measurement for items held for trading for all derivatives, and for “avail-able for sale” assets. In certain specified circum-stances, preparers of accounts may elect to measure other positions at fair value under the “fair value option”.

5 See The Turner Review: A regulatory response to the global banking crisis (FSA, March 2009), pages 42-44 for the argument that irrational herd and momentum effects (to which all liquid traded markets are inherently susceptible) are likely to cause more macroeconomic harm in securitised credit markets than in equity markets.

6 Basel Committee on Banking Supervision: Guidelines for computing capital for incremental risk in the trading book and proposed revisions to the Basel II market risk framework.


Foreign exchange

Lessons for the forex market from the global financial crisis

Blackrock’s Michael Melvin and Warwick University’s Mark P. Taylor argue the case

for enhanced market stress indicators.

the timing of the subprime crisis that became the global crisis is well known. its impact on the foreign exchange mar-kets has been much less discussed. this column fills that void. its findings sug-gest that foreign exchange portfolio man-agers could have protected their portfolio by an appropriate risk control strategy using market stress indicators.

The crisis in the foreign exchange (FX) mar-ket came relatively late. In the early summer of 2007, it was apparent that fixed income markets were under considerable stress. Then, in July 2007 the dominoes began to fall as supposedly market-neutral equity port-folios suffered huge losses and it was com-mon to hear talk of a five (or larger) standard deviation event, reflecting the failure of traditional financial risk analysis to capture systemic effects.

Foreign exchange market participants watched these other markets with grow-ing trepidation. Their fears were realised on 16 August 2007 when a major unwind of the carry trade occurred and many currency market investors suffered huge losses. We

thus date the beginning of the crisis in the foreign exchange market as August 2007.

An efficient way to visualise the various stages of the crisis in the currency market is provided by the returns to the so-called “carry trade,” a popular foreign exchange investment strategy of taking long positions in high-interest rate currencies financed by short positions in low-interest rate curren-cies. Figure 1 (overleaf) displays a standard carry trade index over the crisis period.

Flight to qualityBeginning in August 2007, the first wave of the subprime crisis hit the foreign exchange market as losses in equity and fixed income portfolios spilled over as portfolio managers deleveraged and liquidated winning posi-tions, including their currency positions.

November 2007 saw credit problems increase as firms found it increasingly dif-ficult to issue commercial paper, and there was a flight to quality in which yields on US Treasury securities fell substantially. Investors shed risk from their portfolios, including for-eign exchange investments.

Risk appetite fell again in March 2008 as


rumours of Bear Stearns’ imminent demise began to circulate. The orderly rescue and sale of Bear Stearns to JP Morgan Chase restored some stability to the market. The market came to believe that there is a “too big to fail” doctrine, so that counterparty risks were perceived as manageable going forward. Then, in September 2008, this confidence-building exercise was undone as Lehman Brothers was allowed to fail, as pol-icymakers began to worry about the moral hazard implications of bank rescues.

Lehman Brothers’ failure imposed huge losses on many of their counterparties who were unable to collect on obligations owed them. Post-Lehman, there was a dramatic fear across the market as to where losses hid and who might be next to go under. Institutions were monitoring counterparty

exposures more carefully than ever and some institutions, considered more at risk than others, found their client base shrinking.

Risk, volatility and transaction costsThe failure of Lehman added a new dimen-sion to perceptions of risk. Post-Lehman exchange rates experienced unprecedented levels of volatility and FX transaction costs rose dramatically.

When market makers provide liquidity to the market, they assume inventory posi-tions in currencies as a result of their trades. The greater volatility, the greater risk they face from holding positions. As a result, the bid-ask spread rises to compensate them for this risk.

In the fall of 2008, FX spreads wid-ened dramatically (Table 1, below). In the

Figure 1. Deutsche Bank Carry index


pre-crisis period, the spread on a two-way price quoted by a market-maker to a hedge fund might be in the range of 4 “pips,” e.g. an offer to buy dollars at 1.1525 Swiss francs each or to sell dollars at 1.1529 Swiss francs. During the post-Lehman crisis period, the spread widened to at least 16 pips.

Forward delivery spreadsIn the worst of times, spreads on particular currencies were at least 400 per cent wider than normal times. In addition, there were times in the fall of 2008 when it was difficult to trade at all in normal sizes.

Even more dramatic than the spot spreads was the widening that occurred in spreads for forward delivery. Table 1 also contains data on indicative spreads for three-month swap (i.e. forward minus spot) quo-tations. In the pre-crisis period, swap spreads on the US$-Swiss franc would be around 0.4 pips; post-Lehman, they were about 15 pips.

The cost imposed by the financial crisis has resulted in a legislative and regulatory reaction to rein in risk-taking and specula-tive behaviour. One effort has been attempt-ing to reduce compensation at banks that have accepted government assistance. In

one instance, a UK bank paid no bonuses for 2008. This government reaction to the crisis is not surprising, but it is doubtful that those setting the rules fully understand the impli-cations of the changes they are forcing on the financial industry.

The losses experienced by financial insti-tutions did not come from foreign exchange trades, imposed compensation restrictions treat the foreign exchange function the same as other areas of the bank. We expect bank employees to respond in a predictable man-ner to a changed incentive structure. Since compensation is severely limited compared to the past, the risk-return tradeoff has changed in a manner that is probably con-sistent with public policy; less incentive to take risk results in less risk taking.

Good two-way pricesFor example, in the foreign exchange mar-ket, market-making dealers are expected to provide liquidity to their counterparties and then manage the risk of their positions while earning a profit for their banks. Competition across banks resulted in tight spreads and a willingness to provide good two-way prices for large trade size. This willingness to bear

Table 1. FX bid-ask spreads for $50 million, in pips

Pre-crisis 2007 Period Post-Lehman crisis Period

Spot 3-mo swap Spot 3-mo swap

EUR-USD 1 0.2 5 10

GBP-USD 3 0.3 12 12

USD-JPY 3 0.2 12 10

USD-CHF 4 0.4 16 15

AUD-USD 4 0.4 20 20

USD-CAD 4 0.3 20 30

NZD-USD 8 0.5 40 10


risk on the “sell-side” was beneficial to the “buy-side” bank clients. In fact, given the large spreads reported in Table 1 and the large volume of trading that occurred in 2008, bank profits from foreign exchange were very large.

Predictable implicationIn the aftermath of the crisis, dealers are charging wider spreads and dealing in smaller amounts than in the past. This will lower the bank’s risk exposure but impose greater costs on banks’ clientele: non-bank financial institutions, corporate customers, governments, central banks, international travellers, and others who benefit from liquidity and risk-management services pro-vided by banks.

A predictable implication of the public policy response to the financial crisis is to lower liquidity and raise the risks and costs associated with non-bank currency trades. The “buy-side” faces greater costs associated with currency trading along with greater vol-atility of exchange rates. It should be more difficult for non-banks to transfer their cur-rency risks to a bank than in the past, while the non-bank entities face greater risk in the foreign exchange market than they used to. It is not clear that there is a net gain to society from these changes.

One practical issue that arises concern-ing the crisis in the FX market is whether FX portfolio managers could have protected their portfolio by an appropriate risk con-trol strategy. In order to illustrate such a strategy without recourse to proprietary methods, we constructed a global financial stress index that is similar in many respects to the index recently proposed by the IMF

(2008). The index is a composite variable built using market-based, publicly available indicators in order to capture four essen-tial characteristics of a financial crisis: large shifts in asset prices, an abrupt increase in risk and uncertainty, abrupt shifts in liquid-ity, and a measurable decline in banking system health indicators.

In order to ascertain whether an extreme value of the financial stress index has been breached, we subtract off a moving-average mean and divide through by a moving-average standard deviation. The result then gives a measure of the how many standard deviations the index is away from its time-varying mean. As seen in Figure 2 (opposite page), the global financial stress index crosses the threshold of one standard deviation above the mean for most of the major cri-ses of the past twenty years or so, including the 1987 stock market crash, the Nikkei/junk bond collapse of the late 1980s, the 1990 Scandinavian banking crisis, and the 1998 Russian default/LTCM crisis.

Brief lull in indexThe 1992 European exchange rate mecha-nism crisis is less evident at the global level. Most interestingly, however, the global financial stress index shows a very marked effect during the recent crisis. Mirroring the carry unwind in August 2007, there is a brief lull in the index as it drops below one stand-ard deviation from its mean before leaping up again in November 2007 to nearly 1.5 standard deviations from the mean.

The global financial stress index then breaches the two-standard devia-tion threshold in January 2008 and again in March 2008 (coinciding with the near


collapse of Bear Stearns). With the single exception of a brief lull in May 2008, when index falls to about 0.7 standard deviations above the mean, it remains more than one standard deviation above the mean for the rest of the sample, spiking up in October to more than four standard deviations from the mean following the Lehman ebacle in September.

We simulated the returns an investor could have earned from investing naively in the Deutsche Bank Carry Return Index and the returns from investing in the index in normal periods and closing out the position in stressful periods when the FSI exceeds a value of 1. Over the entire 2000-2008 period studied, the naïve carry strategy yields an information ratio of -0.3 (the annualised return divided by the annualised standard deviation of returns) while the risk-control-led carry strategy yields a ratio of 0.69. Over the more recent 2005-2008 period, the naïve information ratio is -0.66 while the risk- controlled information ratio is 0.31.

In this regard, we see that the financial stress index and similar market stress indica-tors may have practical potential to add value to foreign exchange investments.2 •

Footnotes1 We look at the same group of 17 developed countries

as in the IMF study but, in contrast to the IMF analy-

sis, we built a ‘global’ financial stress index based on an

average of the individual country indices. See Melvin &

Taylor (2009);

2 This is likely to be true even after allowing for transac-

tion costs and implementation lags – see M&T (2009).

ReferencesIMF (2008), “Financial Stress and Economic Downturns,”

World Economic Outlook: Chapter 4, 129-158.

Melvin, Michael and Mark P. Taylor (2009), “The Crisis in the

Foreign Exchange Market,” CEPR Discussion Paper 7472,

September (forthcoming in the Journal of International

Money and Finance special issue on the Global Financial

Crisis, December 2009).

New York Fed (2009).”Timelines of Policy Responses to

the Global Financial Crisis.”

Figure 2. Global financial stress index


Trade finance

Exports and financial shocks: new evidence from Japan

New York Fed’s Mary Amiti and Columbia University’s David Weinstein show how

bank health impacts global trade.

Can the drying up of trade finance help explain the recent collapse in exports relative to output? using firm-level data, this article examines the effect that trade finance had on exports during the Japanese financial crisis of the 1990s. it suggests that the direct effect of declining bank health on exports caused at least a third of the decline in Japan’s exports at the time.

One of the most striking features of the most recent global financial crisis is the collapse in international trade – a fact highlighted by Richard Baldwin in a recent Vox ebook, The Great Trade Collapse.

Figure 1 (overleaf) plots the ratio of real world exports to real gross domestic prod-uct (GDP) for a sample of the world’s largest economies. This illustration shows the decline in world exports was much greater than the decline in world GDP. Between the first quarter of 2008 and the first quarter of 2009, the real value of GDP fell 4.6 per cent while exports plunged 17 per cent – a decline of US$761 billion in nominal terms. Moreover, this decline in exports was much larger than

standard gravity and macro models of trade would have predicted given the changes in supply, demand, and relative prices (see Chinn 2009, Campbell et al 2009, Levchenko, Lewis, and Tesar 2009a, OECD 2009).

Why the collapse in trade?Several authors have argued that trade finance may have been partially responsible for the remarkable fall in trade (Auboin 2009 and OECD 2009). However, most empirical work relating to trade finance has been ham-pered by the lack of information regarding the institutions providing the finance and what was happening to domestic sales at the same time [e.g. Bricogne et al (2009), Levchenko, Lewis, and Tesar 2009b, Mora and Powers 2009 and Chor and Manova 2009].

Hence, the mixed findings of these stud-ies which are in addition, hard to interpret because a clear link cannot be identified between changes in financial conditions and changes in exports and the inability to address the question of whether financial shocks affect exports more than domestic sales as is suggested in Figure 1 above. The role that trade finance played has come as


a surprise to most academic economists, as trade finance is almost completely ignored by the academic literature. Most interna-tional models assume international payment settlement markets function perfectly.

In a new paper (Amiti and Weinstein 2009) we argue that a potentially important reason why most macro and trade models

have failed to predict the dramatic collapse in world exports is due to their simplistic modelling of the role of the financial sector in international trade. It is suggested that in order to understand how trade responds to financial crises, it is necessary incorporate ‘financial accelerators’ as used by Bernanke, Gertler, and Gilchrist (1999) that specify

Figure 1. Quarterly movements in the ratio of world exports to GDP, 1995-2009

Source: This figure was constructed using national sources: Australia, Australian Bureau of Statistics; Belgium, the Banque Nationale de Belgique; Canada, Statistics Canada; France, National Institute of Statistics and Economic Studies; Germany, Deutsche Bundesbank; Hong Kong, Hong Kong Census and Statistics Department; Italy, Istituto Nazionale di Statistica; Japan,Cabinet Office; Netherlands, Centraal Bureau voor de Statistiek; Norway, Statistik Sentralbyra;South Korea, Bank of Korea; Spain, Instituto Nacional de Estadistica; Sweden, Statistiska Centralbyran; Switzerland, State Secretariat for Economic Affairs; Taiwan, Directorate General of Budget, Accounting and Statistics; United Kingdom, Office of National Statistics; and United States, Bureau of Economic Analysis. The set of countries accounted for 66% of world GDP and 68% of world exports in 2008.


why export flows are likely to be hard hit by financial shocks.

To understand the central role played by finance in international trade, we need to begin with what textbooks on international financial management refer to as “the fun-damental problem with international trade”. How do firms guarantee payments across international borders? (See, for example, Bekaert and Hodrik 2007.)

International trade differs from domestic trade in two fundamental ways:1) International trade is typically riskier

than domestic trade. While firms often know how to work domestic legal sys-tems for dealing with payment defaults and delays, frequently it much more difficult for firms to collect payments in foreign countries even if foreign legal systems are fully functional.

2) The added shipping times associated with international trade often mean that inter-national transactions take two months longer to conclude than domestic trans-actions. This imposes additional working capital requirements on exporters.

Working capital loansAs a result of these added risk and work-ing capital needs, exporters typically turn to banks and other financial firms to han-dle payments. Exporters benefit from these arrangements because financial firms typi-cally assume all of the importer’s default risk and also provide working capital loans.

The importer also benefits because this eliminates the need for cash-in-advance payment terms, and the importer can avoid payment issues associated with non-ship-ment, late shipment, or damaged shipments

as in any of these situations banks will not pay the exporter.

Around 40 per cent of all trade finance contracts utilise ‘letters of credit’ (LoC). This requires the importer to ask its issuing bank for a LoC that in effect guarantees payment for the imports. Using the LoC as collateral, the exporter will often obtain a working cap-ital loan from its negotiating bank to cover the goods production costs.

Banker’s acceptanceAssuming that all of the documents are in order, the issuing bank will issue a banker’s acceptance to the negotiating bank guaran-teeing payment at a specified future point in time. Although the working capital loan is repaid by the exporter, the negotiating bank needs to raise money to cover the cost of payment to the exporter, in addition to the funds it will need to raise for the initial working capital loan. This is often achieved by selling the issuing bank’s bankers accept-ance to other investors.

Over the past several decades ‘open account’ transactions have become increas-ingly common. In these transactions, import-ers do not use banks to guarantee payments to exporters. In order to handle these high risk transactions, exporters often turn to non-bank financials like the CIT Group, which provide working capital loans, export insurance, and export factoring (buying trade credits from the exporter at a discount).

For example, a 2007 survey of sup-pliers using open account transactions (Scotiabank, 2007) found that 38 per cent of respondents used financial institutions for post-shipment financing, 30 per cent used them for pre-shipment financing, while 49


per cent used them for buyer default insur-ance, 24 per cent used institutions to obtain political risk insurance, and 22 per cent used them as export factors. The fact that all documentary credit transactions and at least half of all open account transactions require financial institutions to provide capital or insurance suggests a strong potential for a financial accelerator in trade.

Starved of creditA financial crisis can create a number of problems in this payment process. If an exporter’s negotiating bank cannot easily raise capital, the bank may not be able to make working capital loans or discount the exporter’s trade credits. This may leave the exporter starved of credit and unable to ship on time. Similarly the bankruptcy or finan-cial difficulties that major non-bank financial institutions like CIT and AIG faced meant that many exporters using open account transactions were left scrambling for insur-ance support and financing.

Similarly, if an importer’s issuing bank runs into trouble, foreign negotiating banks may not accept their LoC which undermines both the negotiating bank’s willingness to provide working capital and payment guar-antees to the exporter.

While all the parties in these transactions may be able to locate new guarantors this is likely to take time. Finding new banks to take on credit risk is likely to be particularly difficult in the midst of a financial crisis when there is enormous uncertainty about the exposure of many, if not all, financial institu-tions to toxic assets.

All of this suggests that the defaults in the interbank lending markets that occurred in

the wake of the 2008 Lehman Brothers bank-ruptcy may have made banks exceedingly risk averse about lending to each other; this break down in the interbank lending is likely to have had a significant impact on exporters.

We examine the impact on exports resulting from the Japanese financial crisis of the 1990s; the Japanese case is an ideal laboratory for understanding these forces for a two main reasons:1) As was the case of the financial crisis

that came to a head in 2008; the crisis in Japan was also caused by twin real estate and stock bubbles that metastasised into interbank loan market defaults.

2) Because Japanese data enables us to match exporters with their negotiating banks, we can assess directly how much a decline in the health of an exporter’s bank affects the exports of a firm relative to its domestic sales.

Sensitivity to exportsOur results suggest that exports are much more sensitive to the health of negotiating banks than domestic sales. The relation-ship between bank health and the change in exports is not only statistically signifi-cant but also quantitatively important. Of the 10.5 per cent decline in Japanese exports that occurred following the bank-ing crisis of 1997, we find that the direct effect of declining negotiating bank health on exports was caused approximately a third of the decline.

This is probably underestimated because declining bank health may have negatively affected Japanese exporters through other channels in addition to that of trade finance.

Our study raises a number of important


implications vis-a-vis the recent financial crisis. Although Japan’s recession and bank-ing crisis was severe at the same time it was largely localised. However, this time around the financial crisis was global in nature and featured banks in many countries.

In the US, the unwillingness of markets to lend over the short-term to banks was clear from the rising interbank loan spreads from a typical 50 basis points over treasury rates up to 450 basis points following the Lehman bankruptcy. All of these indicators point to a seizing up of short-term credit markets. It would therefore be hard to see how this could not have had a profound impact on the ability of firms to export.

There is good reason to believe that the recent crisis may have had a greater impact on exporters than the Japanese one. The global nature of the crisis may mean that both exporters’ and importers’ banks suf-fered capital losses, making it even harder for exporters to finance their trade. This all suggests that the impact of the recent glo-bal crisis on international trade may be even greater than that of the Japanese crises in the 1990s. •

The views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System.

ReferencesAmiti, Mary and David E. Weinstein (2009), “Exports and

Financial Shocks.” CEPR DP 7590.

Auboin, Marc (2009), “Restoring Trade Finance: What the

G20 Can Do.” in The Collapse of Global Trade, Murky Pro-

tectionism, and the Crisis: Recommendations for the G20,

ed. Richard Baldwin and Simon Evenett, London: Centre for

Economic Policy Research.

Baldwin, Richard (2009), (Ed). The Great Trade Collapse:

Causes, Consequences and Prospects, VoxEU.org ebook,

27 November. Available: [http://www.voxeu.org/index.

php?q=node/4297]

Bekaert, Geert and Robert Hodrick (2008), International

Financial Management Ch 18. New Jersey: Prentice Hall.

Bernanke, Benjamin S, Mark Gertler, and Simon Gilchrist

(1999), “The Financial Accelerator in a Quantitative Busi-

ness Cycle Framework”, in J.B. Taylor and M. Woodford

(ed.), Handbook of Macroeconomics, edition 1, vol. 1,

Chapter 21: 1341-93, Amsterdam; New York and Oxford:

Elsevier Science, North-Holland.

Bricongne, Jean-Charles, Lionel Fontagné, Guillaume Gaul-

ier, Daria Taglioni, and Vincent Vicard (2009) “Firms and the

global crisis: French exports in the turmoil,” Bank of France.

Campbell, Douglas L, David Jacks, Christopher M. Meissner,

and Dennis Novy (2009), “Explaining Two Trade Busts: Out-

put vs. Trade Costs in the Great Depression and Today”,

VoxEU.org, 19 September.

Chinn, Menzie (2009), “What Does the Collapse of US

Imports and Exports Signify?” econbrowser.com

Chor, Davin and Kalina Manova (2009) “On the Cliff and

Back? Credit Conditions and International Trade during the

Global Financial Crisis,” Stanford University.

Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar

(2009a). “The Collapse of International Trade during the

2008–2009 Crisis: In Search of the Smoking Gun.” Univer-

sity of Michigan, mimeo.

Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar

(2009b). “The collapse of US trade: in search of the smok-

ing gun,” VoxEU.org, 27 November.

Mora, Jesse and William Powers (2009). “Did trade credit

problems deepen the great trade collapse?” VoxEU.org,

ebook, 27 November. Available: [http://www.voxeu.org/

index.php?q=node/4297]

Organisation of Economic Co-operation and Develop-

ment (2009), OECD Economic Outlook 1 (85).

Scotiabank (2007). “2007 AFP Trade Finance Survey: Report

of Survey Results”, Association for Financial Professionals,

October.


Market risk

A case of mistaken identity: the illusion of ‘too big to fail’

Intelligence Capital’s Avinash Persaud argues global policymakers need to focus

more on market risk rather than TBTF.

PoliCYMakers and commentators have recently argued for downsizing banks that are ‘too big to fail.’ this arti-cle argues that the logic is based on an illusion. in 2006 a list of institutions con-sidered ‘too big to fail’ would not have included northern rock, Bear sterns, or even lehman Brothers. instead, regula-tors should aim to make the financial sys-tem less sensitive to error in the markets’ estimate of risk.

A new global governance was forged in the white heat of the financial crisis. The G7 gave way to the G20 (Eichengreen 2009). Leaders representing 80 per cent of the world’s pop-ulation met and were resolute in calling for a global policy response to the crisis.

Governments opened the fiscal sluice gates, interest rates were slashed, the International Monetary Fund (IMF) was given additional resources, and the Organisation for Economic Co-operation and Development (OECD) finally got tough with European tax havens. But as the ashes cooled, senior officials are quoted one day in the international press saying that a global

approach to banking regulation is necessary, and the next, saying “nobody is going to tell us how to regulate our banks”. Beneath the veil of global unity, different regional per-spectives and national actions are emerging. This is most clear in the area of international banking regulation.

Damage limitationIn Europe, the thrust has been on how to regulate financial markets in order to miti-gate future crises. It should be emphasised that credit mistakes are made during the boom, not during the crash. Better regulation during the boom years (and perhaps better monetary policy, too) could limit the extent of the bust.

Moreover, in a crash, markets are not very discerning and it is hard to strike the balance of who to save and who to leave to the wolves. Consequently, ‘Europeans’ are focused on how to limit the crashes by intro-ducing macro-prudential regulations such as counter-cyclical charges and minimum liquidity buffers.

In the US, perhaps reflecting a greater belief in markets and a stronger mistrust of


regulation, the emphasis has been on find-ing market-friendly ways to contain the spill-over of bank failure. US policy debates are occupied with concerns that banks should not be ‘too big to fail’; that private investors, not taxpayers, should hold ‘contingent capi-tal’ which carry implicit or explicit conversion into equity in a crash, and that improvements must be made to the functioning of ‘over-the-counter’ markets through greater use of centralised trading, clearing and settlement.

These proposals are less about modifying capital requirements and more about prohi-bition and taxation and are micro-prudential in nature. Banks would not be allowed to do ‘risky’ things (the ‘Volcker plan’) and large balance sheets will be taxed to repay the bail-out funds (the ‘Obama Levy’).

In the former crisis countries of Asia, where banking regulation followed new international banking rules more closely, the view is more sanguine. Officials from Indonesia, Thailand, Malaysia, Philippines and Australia argue that because the econo-mies of Asia largely escaped the crisis, it must actually be about poor supervision by their European and American peers. They argue that we should tinker less with regulation and instead deepen supervisory capacity.

It was them, not usThe principal point of convergence between these perspectives is that the crisis was caused by ‘the others’ and ‘they’ had bet-ter get their house in order. But regional perspectives and national action should be seen as inevitable as long as national tax-payers provide the bailouts. A European Union (EU) bailout of Greece will further integration, not kill it. Elsewhere, more local

regulation may not be such a poor second best. The record of policymakers with regard to the international regulation of banks is hardly a source for optimism. One global mistake is far worse than a few smaller ones, and small developing countries in particular need to be wary of international banking rules forged in developed countries with a view to expanding developed country banks into the emerging world.

Playing to the galleryOne other point of intersection between these regional perspectives concerns big banks. This has less to do with a conver-gence of regulatory thinking on bank size or function and more to do with the com-mon need to play to the political gallery and raise taxes somewhere. Robin Hood, previ-ously banished from the Kingdom by Prime Minister Thatcher and President Reagan, has returned.

This desire to raise taxes from bankers sits well with the idea that policy should offset the incentive for banks to become systemi-cally more important. I have long argued this point (Persaud 2008), but I have also come to realise that the notion that we should con-centrate our efforts on making sure banks are not ‘too big to fail’ is partly based on an illusion.

Bank balance sheets bloated by lever-age are systemically dangerous, and regu-latory or fiscal policy should address this through liquidity buffers and leverage ratios. But given how contagious crises are, it is likely that what is ‘too big to fail’ is actually small. Any list of institutions that were ‘too big to fail’ conjured up in 2006 would not have included Northern Rock, Bradford &


Bingley, IKB Deutsche Industriebank (IKB), Bear Sterns or even Lehman Brothers. Banks lend to banks. While some are more illiq-uid than others, they are intrinsically illiquid institutions. It does not take a large failure to lead to panic. High-yielding deposits can fly out of the website almost as quickly as money market funds can withdraw. In a cri-sis, almost everyone is ‘too big to fail’.

Moreover, we can have as large a boom and subsequent crash, with the same eco-nomic misery, in a world of only small banks. Some will recall the Secondary Banking Crisis of 1973-1975 in the UK; some 30 rela-tively small financial institutions had to be supported by the Bank of England follow-ing the preceding property boom. The 1973-1975 crisis rivals, and on some measures exceeds, the impact on the UK of the current financial crisis.

It was one of the reasons that developed country regulators began to take a more benign view of large banks snapping up smaller ones. The fashionable argument of the day was that small, competitive, finan-cial institutions were inefficient and had lit-tle ‘franchise value’ and so they would under invest in their own longevity – by having less conservative lending practices – than larger, more profitable banks.

Brave new worldCrashes follow booms. Booms are fuelled by some new dawn – normally the arrival of new technology – that makes bankers feel that the world is a brighter place, risks have decreased, and that they are therefore justified in lending and leveraging more. This behaviour is even more acute in the modern age of ‘risk-sensitive’ regulation than in the

old-fashioned world of credit and concen-tration limits and lending rules of thumb. The systemic effect of having one large bank engaged in rapid lending growth is no dif-ferent than having several small banks do so. It may even be easier to resolve a crisis with one large bank.

It is argued that the underestimate of risk by bankers is encouraged by the further belief that if it all goes ‘belly up’ their institu-tions are too big to fail and their jobs would be safe. But if that latter belief dominated bankers’ thinking, they may not worry about their jobs but they would still worry about their savings.

More fools than knavesThey would not wrap themselves up in the equity of their institutions and the lever-aged products they are selling. But they did. The revealed preference of bank and banker behaviour is that they did not lend more because they thought they could get away from selling risk to others, or because they knew there would have to be some sort of bail out, but because they thought it was safe. They were more fools than knaves.

The main driver of excessive lending and leverage is a mistaken view of risks, by everyone and not just big banks. The riski-est institutions were not the largest. Some very large institutions, such as J.P. Morgan and HSBC, proved safer than others and did not seek or require state funding, while those that failed were relatively small, e.g. IKB, Bear Sterns, etc. There is an all too narrow divid-ing line between this argument and the one that got us into this mess.

Big banks like the idea that regula-tion should care less about size of banks


and more about their riskiness, and so they championed the ‘risk-sensitive’ approach to bank regulation, not least because they had the bigger risk models and databases, so risk-sensitive regulation was more onerous for their smaller competitors.

Bigger booms, deeper bustsA better argument for curbing bank size is the excessive influence of big banks on pol-icy. The problem is that if booms are fuelled by an underestimation of risks, and regula-tion is made more sensitive to the estima-tion of risks, then the booms will be bigger and the busts deeper. This is the fallacy of the ‘risk-sensitive’ approach to risk manage-ment, regulation and auditing. This is a fairly fundamental point, but I have discussed it before and would like to highlight here how the solution to this issue relates to current proposals.

What we are looking for is regulation that makes the financial system less sensitive to the error in the markets’ estimate of risk, not more so.

There are two ways to do this. The first is to observe that this error is strongly cor-related to the boom-bust cycle. Booms have similar characteristics – strong growth in bank balance sheets and credit, a rise in leverage, etc. The appearance of these would imply an increased probability of the mar-ket underestimating risk and so regulators should raise minimum capital requirements when they spot these trends.

‘This time it’s different’Counter-cyclical capital requirements fit in with this idea. A range of indicators would have to be used to calibrate the rise in the

capital requirements and perhaps some dis-cretion, but not too much. Market-efficiency zealots will complain that the market can-not make predictable mistakes, but there are many reasons why the market fails to correct its systemic error, the least rigorous being that booms are always founded on the fal-lacy of why ‘this time it is different’, one that takes in regulators and bankers. Recall the essays in central bank stability reports on how credit derivatives were bringing new stability to the financial sector?

The second way to reduce the sensitiv-ity of the financial system to the errors of estimating risk, is to limit the flow of risks to institutions with a structural capacity for holding that risk, and not a statistical capac-ity. In this way when the risk modellers get it wrong we are in less trouble. Credit risk is best hedged through diversification across uncorrelated credits. Liquidity risk is best hedged through diversification across time.

Capacity for riskMarket risk is best hedged through a com-bination of diversification across assets and time (having time to decide when to sell). In the past, risks of similar statistical magnitudes were considered fungible and simply flowed to whoever was prepared to pay for it.

But while banks with short-term fund-ing and many branches originating differ-ent loans have a deep capacity for holding credit risks, they have a limited capacity for holding market risks and little capacity for holding liquidity risk. Insurance companies and pension funds on the other hand have limited capacity for credit risk, but more for market and liquidity risks. The capacity for


risk is related to the maturity of funding and not what an institution is called.

This idea resonates to some degree with the former Chairman of the Federal Reserve Paul Volcker’s idea of banks severing their exposure to proprietary trading (market risks), hedge funds, (market risks) and pri-vate equity (liquidity risks). But we must be wary of arbitrary distinctions – some hedge funds behave like banks and some banks like insurance companies.

Beware bank-bashingAlthough the response to the crisis is becom-ing more of a national issue and less global, current proposals to reform banking regula-tion have some promise. This is especially the case in the area of counter-cyclical measures being discussed by the Basel Committee and

the Volcker proposal to fragment financial institutions, though fragmentation should be along the lines of risk-capacity and not legal entities or names. We should also be careful, however tempting it may be, to expect too much from bashing big banks. •

Editor’s noteThe editor wishes to thank VoxEU – www.voxeu.org – and the UK-based Intelligence Capital Ltd for allowing the Journal of Risk & Regulation North Asia to publish a revised version of this paper.

ReferencesEichengreen, Barry (2009), “The G20 and the crisis”,

VoxEU.org, March 2.

Persaud, Avinash (2008), “Why bank risk models failed”,

VoxEU.org, April 4.


Reprint Service

ContactChristopher RogersGeneral [email protected]

Articles & PapersIssues in resolving systemically important financial institutions Dr Eric S. RosengrenResecuritisation in banking: major challenges ahead

Dr Fang DuA framework for funding liquidity in times of financial crisis

Dr Ulrich BindseilHousing, monetary and fiscal policies: from bad to worst

Stephan Schoess,Derivatives: from disaster to re-regulation

Professor Lynn A. Stout Black swans, market crises and risk: the human perspective

Joseph RizziMeasuring & managing risk for innovative financial instruments Dr Stuart M. Turnbull Red star spangled banner: root causes of the financial crisis Andreas Kern & Christian FahrholzThe ‘family’ risk: a cause for concern among Asian investors

David SmithGlobal financial change impacts compliance and risk

David DekkerThe scramble is on to tackle bribery and corruption

Penelope Tham & Gerald LiWho exactly is subject to the Foreign Corrupt Practices Act?

Tham Yuet-MingFinancial markets remuneration reform: one step forward Umesh Kumar & Kevin MarrOf ‘Black Swans’, stress tests & optimised risk management

David SamuelsChallenging the value of enterprise risk management

Tim Pagett & Ranjit JaswalRocky road ahead for global accountancy convergence

Dr Philip GoethThe Asian regulatory Rubik’s Cube





135

Compliance

Global financial change impacts

compliance and risk

EastNet’s head of products management –

compliance, David Dekker, details a potent

chemical reaction in financial markets.

About a year ago we saw the first signs

of a transformation in the financial world

and in the last months the credit crisis

has transformed the financial world at

an explosive pace. the change that is

occurring is much broader in scope than

originally expected. banks that were

considered to be too big to fail or fall

are either failing or being taken over by

financial institutions that are more finan-

cially sound, resulting in a huge para-

digm shift in how banks are regarded by

the public and other banks.

Since banking largely revolves around

trust and the ability to service customers, los-

ing a customer and determining the impact

of it, should be part of the ongoing risk

management of the organisation, as well as

monitoring the riskiness of existing and new

products and the customers using/buying

these products. But there are more changes

and challenges in the banking world that are

threatening banking as we have known it.

The banks will, in the future, not be the

default vehicles by which to move our funds,

maintain our balances and portfolios; they

will just be one of companies amongst oth-

ers that will be able to offer these services.

These days we should rather speak about

financial institutions than banks, or moni-

tored financial service providers, a name that

covers their current and future activities.

Look at how rapidly we have moved

from physical interaction on the banks

terms (location and hours of operation) to

electronic payments then Internet banking.

Again the banks were still in charge, but

as mentioned the paradigm is shifting to a

world where we (physical persons and cor-

porations) pay each other without the banks

involvement with new technologies such as

mobile payments.

Network providers

In the future the banks and organisations

such as SWIFT, NACHA and other pay-

ment networks become network providers

that allow you to send money from A to B

and will charge you for the network traf-

fic that you generate. This brings similari-

ties with industries such as telecom, energy

suppliers and cable companies. The financial

world is clearly undergoing an important


33

Opinion

Deregulation, non-regulation and ‘desupervision’ Professor William Black examines the causes of the mortgage fraud epidemic that has swept the United States.THE author of this paper is a leading

academic, lawyer and former banking regulator specialising in ‘white collar’ crime. As one of the unsung heroes of the Savings & Loans debacle of the 1980s, Professor Black nowadays spends much of his time researching why financial markets have a tendency to become dys-functional. Renowned for his theory on ‘control fraud’, Prof. Black lectures at the University of Missouri and Kansas City. He is the author of ‘The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.’ A prominent commenta-tor on the causes of the current financial crisis, Prof. Black is a vocal critic of the way the US government has handled the banking crisis and rewarded institutions that have clearly failed in their fiduciary duties to investors.

The following commentary does not nec-essarily represent the view of the Journal of Regulation and Risk – North Asia. “The new numbers on criminal refer-

rals for mortgage fraud in the US are just in

and they implicitly demonstrate three criti-cal failures of regulation and a wholesale failure of private market discipline of fraud and other forms of credit risk. The Financial Crimes Enforcement Network (FinCEN) released a study this week on Suspicious Activity Reports (SARs) that federally regu-lated financial institutions (sometimes) file with the Federal Bureau of Investigation (FBI) when they find evidence of mortgage fraud.

Epidemic warningThe FBI began warning of an “epidemic” of mortgage fraud in their congressional testi-mony in September 2004 – over five years ago. It also warned that if the epidemic were not dealt with it would cause a financial cri-sis. Nothing remotely adequate was done to respond to the epidemic by regulators, law enforcement, or private sector “market dis-cipline.” Instead, the epidemic produced and hyper-inflated a bubble in US housing prices that produced a crisis so severe that it nearly caused the collapse of the global financial system and led to unprecedented bailouts of many of the world’s largest banks.

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Journal of Regulation & Risk - North Asia, Volume II, Edition I, Spring 2010