The background to the financial crisis.docx
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Thebackgroundtothefinancialcrisis
Thebackgroundtothe2007financialcrisis
C.A.E.Goodhart
Publishedonline:
19February2008
#Springer-Verlag2007
1Introduction
Therehavebeenmanyfacetstothecurrentfinancialcrisis.Itisdifficultforasinglepersontoputtogetheracompletelycoherentstoryofeverythingthathashappened,unlesstheyhavebeenworkingforoneofthebanksatthecentreofthestorm.Ratherliketheblindmenwhofeelaspectsoftheelephant,commentators,likemyself,arelikelytohaveapersonalview;itmaytakequitealongtimebeforeacomprehensivehistoryofthiscrisiscanbewritten,andthisisnotsuchacompletehistory.Subjecttothatcaveat,letmebeginwithasurveyofsomeofthebackgroundinfluencesthatleduptothiscrisis.
2Themis-pricingofrisk
Inmanyrespects,thiscrisiswasforeseeninadvance.AlmosteverycentralbankwhichpublishedaFinancialStabilityReview,andinternationalfinancialinstitutions,suchastheBISandIMF,whichdidthesame,hadbeenpointingforsometimepriortothemiddleof2007toaseriousunder-pricingofrisk.Thiswascharacterisedbyverylowriskspreads,withdifferentialsbetweenriskyassetsandsafeassets,havingdeclinedtohistoricallylowlevels.Volatilitywasunusuallylow.Leveragewashigh,asfinancialinstitutionssoughttoaddtoyield,inthefaceofverylowinterestrates.Thosesameinstitutionswereapparentlypreparedtomoveintoincreasinglyriskyassetsinordertodoso,oftenleveragingthemselvesseveraltimesinpursuitofthatobjective.Indeed,atthebeginningofthecrisis,thatispriortoAugust2007,therewassomegeneralsatisfactionamongthemonetaryauthoritiesthattheundesirableandexcessiveunder-pricingofriskwasintheprocessofbeingreversed.
IEEP(2008)4:
331–346
Howhadthiscomeabout?
(a)Verylowinterestrates,2001–2005
Inpart,thisunder-pricingofriskhadresultedfromthelongperiodofextraordinarilylownominal,andverylowreal,interestratesthathadcontinuedfromtheendingoftheTechbubblein2001,untilcentralbanksgenerallybegantoraiseinterestratesagainin2005.Figure1showsthetimepathofinterestratesintheUSA,intheEurozoneandintheUK.
IntheaftermathoftheTechbubble,therewasaconsiderablefearintheUSAthatpricedeflationmightensue.Moreover,thereappearedtobeaworldglutofsavings,drivingdownrealinterestratesallaroundtheworld,(Bernanke2005).
Thefearofdeflation,andthesavingsglut,ledtoaperiodofexpansionarymonetarypolicies,withnominalpolicyinterestratesatverylowlevels,andwithacceleratingmonetarygrowthinseveralcountries.InFig.2,areshowntheratesofmonetarygrowthfortheUSA,theEurozoneandtheUKovertheyearsfrom2001tothepresent.
(b)Thegreatmoderation/stability
Thisperiodofmonetaryexpansion,andlowinterestrates,didnotleadondirectlytoanyincreaseininflationingoodsandservicesprices,i.e.intheCPIorRPIinthemajornations.Indeed,theseyearswereacontinuationofwhathasbecomeknownastheGreatModerationortheGreatStability.Eversincetheearly1990s,themajordevelopedcountriesintheworld,withthepossibleexclusionofJapan,haveenjoyedaGoldenAge.DuringthisGoldenAge,inflationhasbeenkeptlowandstable,veryclosetotheinflationtargets,eitherexplicitorimplicit,thatthemonetaryauthoritieshavemaintained.Thishasnotbeenattheexpenseofgreatervolatilityofoutput;ratherthecontrary,asoutputhasremainedgrowingsteadilyandwithfew,ifany,cycles.AlthoughgrowthinEuropehasbeenslightlydisappointing,growthinotherpartsoftheworld,notablyintheUSA,butalsoinex-JapanAsia,hasbeenremarkablystableandstrong.Thispersistentmacro-economicstabilityledmanytobelievethatmacro-economicriskshadbeensignificantlyreduced.Theimplicationwasthatinvestmentgenerally,andfinancialconditionsinparticular,weresubjecttolessaggregate,macro-economicriskthaninthepast.
(c)TheGreenspanput(?
)
Moreover,wheneverfinancialmarketsintheUSAhadweakenedsharplyovertheprevious20years,orso,forexampleBlackMondayofOctober19,1987;thehousingcrisisin1992;theAsianCrisisin1997/1998;orthecollapseoftheTechBubbleattheendof2001,theFederalReservehadalwaysmovedinswiftlytopreventthefinancialdownturnspreadingmorewidelyintotheeconomy.AviewhadbeendevelopingthattheFedwouldsupportfinancialmarketssuccessfullyfromanyseriouscollapse.Ifthedownsidewasprotected,bywhatbecametermed‘theGreenspanput’,thenequivalentlytheriskstofinancialinvestmentwouldbeconsiderablyless.Theexistenceofsucha‘Greenspanput’remainscontentious.
Some,suchasAlanGreenspanhimself,denythatsuchaprotectivefloortothefinancialmarketseverexisted.Alternatively,thereisanargument,asmadebyKohn2007,thattheFedbehavedmoresymmetricallythanitscriticshaveclaimed.Theyarguethattherewasnosuchasymmetry;financialmarketstendtodeclinemuchmorerapidlythantheyrise,soanysymmetricoffsetwouldbemuchmorevisibleintermsofcutsininterestratesduringsharpassetpricedeclines,thanintheformofoffsettingincreasesininterestratesduringperiodsofmarketupturns.Bethatasitmay,manycriticisetheFed,inparticular,forbehavinginanasymmetricmanner.And,suchbehaviour,whetherimaginedornot,waspartoftheframeworkthatledmanyinvestorstoseetheworldaslessriskyinthenewMillenniumthanithasbeeninthetwentiethcentury.Theconclusionofallthesefactors,however,wasthattherewasaclearandapparentwidespreadunder-pricingofrisk.Thiscanbeillustratedinavarietyofways,someofwhichareshowninthechartsinFig.3a–dbelow.
3Thenewfinancialstructure
Liberalisedfinancialmarketsareveryinnovative.Thelast10yearshaveseenenormousstridesinthedevelopmentandextensionofnewformsofsecuritizationandthegrowinguseofderivativesofallkinds.Thisisnottheplacetodocumentthesemanifoldchanges,butthegrowthofvariouscollateraliseddebtinstruments,intheformofcollateralisedmortgages,etc.,hasbeenfastandwidespreadinrecentyears.
Thishasbeencombinedwitharevisedbankingstrategy,thatbeganintheUSA,buthasspreadrecentlytoEuropeandabroad.Thisgoesbythegeneraltitleof‘OriginateandDistribute’.Underthisstrategythebanksoriginateloanbusiness,forexampleintheformofresidentialmortgages,andthenpoolbasketsoftheseloans,togetherinvariousways,andsecuritiseanddistributethem,sothatsuchloans,changedintonewsecuritisedformat,leavetheirbalancesheet.Sotheyoriginatetheloans,securitisethem,andthendistributethemtovariousnon-bankfinancialinstitutions.Allthisleadstoadisintermediationofassetsoffbanks’balancesheets.Tosomedegree,thistransferofsuchassetsoffbalancesheetsismoreartificialthanreal.Banksestablishconduits,whichtheyownedandwerenon-banksubsidiaries,whichheldmanyofthesesecuritisedassets.Theyalsoformedcloseconnectionswithmanystructuredinvestmentvehicles(SIVs),which,thoughtheydidnotownthemdirectly,theyhadcloselinkswiththemassponsors.Allthiswasdoneinsomelargepartforreasonsofregulatoryarbitrage.
TheseconduitsandSIVswerelargelyfinancedbyassetbackedcommercialpaper(ABCP).TheassetsonthebooksoftheseSIVs,etc.,hadalongmaturity,whereastheABCPwereusuallyofashortmaturity,rangingfrom1to3months.Therewasclearlyasignificantfundingriskinvolvedinsuchfinancialinstitutions.Inordertoprotectthemselves,insomepart,fromsuchfundingrisk,theseinstitutionsusuallyhadcontingentarrangementswiththeirsponsoringbank,whereby,ifitwasnotpossibletorollovertheABCP,thecommercialbankswithwhomtheyhadaconnectionwouldstepinandprovidethefundinginstead.
Indeed,ingeneral,commercialbanksmaintaincontingentliabilitiesaslendersoflastresorttocapitalmarkets,andindeedasunderwriterstocapitalmarkets,forexampleintheissueofvariouskindsofprivateequityobligationsandotherformsofbuy-outsoftheequityofcompanies.
Fig.3(continued)
Theroleofbanksasholdingcontingentliabilitiesandunderwritingcapitalmarketswasespeciallyvulnerablewhentheyhadclosedirectconnections,forexampletheBearSternshedgefundswhichranintotroubleinthemiddleofthesummer,theBanqueNationaledeParis,whichhadproblemswithitsrelatedinstitutionsinJune,theLandesbankenIKBandSachsenConduits,andthesubsequentSIVs,etc.
Onecontinuingaccusationisthattheprocessof‘OriginateandDistribute’madetheoriginatingbanklessconcernedaboutthequalityofcreditassessmentandmonitoringoftheborrowers’conditionsduringthecourseoftheoutstandingloan,sinceitwasnolongerontheoriginatingbank’sbooks.TherearemanyanecdotalsuggestionsthatsuchadeclineincreditassessmentandmonitoringhasoccurredalongsidethenewprocedureofOriginateandDistribute;however,thereisonlyjustnowbeginningtobeacademicresearchtoassesswhetherthismayindeedhavehappened.But,creditqualitywasnotonlysupposedtobeassessedandcheckedbytheoriginatingbank;itwasalsosupposedtobeassessedbythecreditratingagencies.Indeed,theabilitytodistributethesevariousformsofcollateraliseddebtdependedveryheavilyindeedonthereputationandabilityofthecreditratingagenciestodoso.Giventhescaleandvolumeofthemarket,andthegrowthofthemarkettoencompassmanylenderswhowereunabletocheckthecreditqualityoftheoriginalloanpoolthemselves,thewholesys