The background to the financial crisis.docx

1、The background to the financial crisisThe background to the 2007 financial crisisC.A.E. GoodhartPublished online: 19 February 2008# Springer-Verlag 20071 IntroductionThere have been many facets to the current financial crisis. It is difficult for a single person to put together a completely coherent

2、 story of everything that has happened, unless they have been working for one of the banks at the centre of the storm. Rather like the blind men who feel aspects of the elephant, commentators, like myself, are likely to have a personal view; it may take quite a long time before a comprehensive histo

3、ry of this crisis can be written, and this is not such a complete history. Subject to that caveat, let me begin with a survey of some of the background influences that led up to this crisis. 2 The mis-pricing of riskIn many respects, this crisis was foreseen in advance. Almost every central bank whi

4、ch published a Financial Stability Review, and international financial institutions, such as the BIS and IMF, which did the same, had been pointing for some time prior to the middle of 2007 to a serious under-pricing of risk. This was characterised by very low risk spreads, with differentials betwee

5、n risky assets and safe assets, having declined to historically low levels. Volatility was unusually low. Leverage was high, as financial institutions sought to add to yield, in the face of very low interest rates. Those same institutions were apparently prepared to move into increasingly risky asse

6、ts in order to do so, often leveraging themselves several times in pursuit of that objective. Indeed, at the beginning of the crisis, that is prior to August 2007, there was some general satisfaction among the monetary authorities that the undesirable and excessive under-pricing of risk was in the p

7、rocess of being reversed.IEEP (2008) 4:331346How had this come about?(a) Very low interest rates, 20012005In part, this under-pricing of risk had resulted from the long period of extraordinarily low nominal, and very low real, interest rates that had continued from the ending of the Tech bubble in 2

8、001, until central banks generally began to raise interest rates again in 2005. Figure 1 shows the time path of interest rates in the USA, in the Eurozone and in the UK.In the aftermath of the Tech bubble, there was a considerable fear in the USA that price deflation might ensue. Moreover, there app

9、eared to be a world glut of savings, driving down real interest rates all around the world, (Bernanke 2005).The fear of deflation, and the savings glut, led to a period of expansionary monetary policies, with nominal policy interest rates at very low levels, and with accelerating monetary growth in

10、several countries. In Fig. 2, are shown the rates of monetary growth for the USA, the Eurozone and the UK over the years from 2001 to the present.(b) The great moderation/stabilityThis period of monetary expansion, and low interest rates, did not lead on directly to any increase in inflation in good

11、s and services prices, i.e. in the CPI or RPI in the major nations. Indeed, these years were a continuation of what has become known as the Great Moderation or the Great Stability. Ever since the early 1990s, the major developed countries in the world, with the possible exclusion of Japan, have enjo

12、yed a Golden Age. During this Golden Age, inflation has been kept low and stable, very close to the inflation targets, either explicit or implicit, that the monetary authorities have maintained. This has not been at the expense of greater volatility of output; rather the contrary, as output has rema

13、ined growing steadily and with few, if any, cycles. Although growth in Europe has been slightly disappointing, growth in other parts of the world, notably in the USA, but also in ex-Japan Asia, has been remarkably stable and strong. This persistent macro-economic stability led many to believe that m

14、acro-economic risks had been significantly reduced. The implication was that investment generally, and financial conditions in particular, were subject to less aggregate, macro-economic risk than in the past.(c) The Greenspan put (?)Moreover, whenever financial markets in the USA had weakened sharpl

15、y over the previous 20 years, or so, for example Black Monday of October 19, 1987; the housing crisis in 1992; the Asian Crisis in 1997/1998; or the collapse of the Tech Bubble at the end of 2001, the Federal Reserve had always moved in swiftly to prevent the financial downturn spreading more widely

16、 into the economy. A view had been developing that the Fed would support financial markets successfully from any serious collapse. If the downside was protected, by what became termed the Greenspan put, then equivalently the risks to financial investment would be considerably less. The existence of

17、such a Greenspan put remains contentious.Some, such as Alan Greenspan himself, deny that such a protective floor to the financial markets ever existed. Alternatively, there is an argument, as made by Kohn 2007, that the Fed behaved more symmetrically than its critics have claimed. They argue that th

18、ere was no such asymmetry; financial markets tend to decline much more rapidly than they rise, so any symmetric offset would be much more visible in terms of cuts in interest rates during sharp asset price declines, than in the form of offsetting increases in interest rates during periods of market

19、upturns. Be that as it may, many criticise the Fed, in particular, for behaving in an asymmetric manner. And, such behaviour, whether imagined or not, was part of the framework that led many investors to see the world as less risky in the new Millennium than it has been in the twentieth century. The

20、 conclusion of all these factors, however, was that there was a clear and apparent widespread under-pricing of risk. This can be illustrated in a variety of ways, some of which are shown in the charts in Fig. 3ad below.3 The new financial structureLiberalised financial markets are very innovative. T

21、he last 10 years have seen enormous strides in the development and extension of new forms of securitization and the growing use of derivatives of all kinds. This is not the place to document these manifold changes, but the growth of various collateralised debt instruments, in the form of collaterali

22、sed mortgages, etc., has been fast and widespread in recent years.This has been combined with a revised banking strategy, that began in the USA, but has spread recently to Europe and abroad. This goes by the general title of Originate and Distribute. Under this strategy the banks originate loan busi

23、ness, for example in the form of residential mortgages, and then pool baskets of these loans, together in various ways, and securitise and distribute them, so that such loans, changed into new securitised format, leave their balance sheet. So they originate the loans, securitise them, and then distr

24、ibute them to various non-bank financial institutions. All this leads to a disinter mediation of assets off banks balance sheets. To some degree, this transfer of such assets off balance sheets is more artificial than real. Banks establish conduits, which they owned and were non-bank subsidiaries, w

25、hich held many of these securitised assets. They also formed close connections with many structured investment vehicles (SIVs), which, though they did not own them directly, they had close links with them as sponsors. All this was done in some large part for reasons of regulatory arbitrage. These co

26、nduits and SIVs were largely financed by asset backed commercial paper (ABCP). The assets on the books of these SIVs, etc., had a long maturity, whereas the ABCP were usually of a short maturity, ranging from 1 to 3 months. There was clearly a significant funding risk involved in such financial inst

27、itutions. In order to protect themselves, in some part, from such funding risk, these institutions usually had contingent arrangements with their sponsoring bank, whereby, if it was not possible to roll over the ABCP, the commercial banks with whom they had a connection would step in and provide the

28、 funding instead.Indeed, in general, commercial banks maintain contingent liabilities as lenders of last resort to capital markets, and indeed as underwriters to capital markets, for example in the issue of various kinds of private equity obligations and other forms of buy-outs of the equity of comp

29、anies. Fig. 3 (continued)The role of banks as holding contingent liabilities and underwriting capital markets was especially vulnerable when they had close direct connections, for example the Bear Sterns hedge funds which ran into trouble in the middle of the summer, the Banque Nationale de Paris, w

30、hich had problems with its related institutions in June, the Landesbanken IKB and Sachsen Conduits, and the subsequent SIVs, etc. One continuing accusation is that the process of Originate and Distribute made the originating bank less concerned about the quality of credit assessment and monitoring o

31、f the borrowers conditions during the course of the outstanding loan, since it was no longer on the originating banks books. There are many anecdotal suggestions that such a decline in credit assessment and monitoring has occurred alongside the new procedure of Originate and Distribute; however, the

32、re is only just now beginning to be academic research to assess whether this may indeed have happened. But, credit quality was not only supposed to be assessed and checked by the originating bank; it was also supposed to be assessed by the credit rating agencies. Indeed, the ability to distribute th

33、ese various forms of collateralised debt depended very heavily indeed on the reputation and ability of the credit rating agencies to do so. Given the scale and volume of the market, and the growth of the market to encompass many lenders who were unable to check the credit quality of the original loan pool themselves, the whole sys