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					THE BANKING CRISIS 2007-?: HOW DID WE
GET HERE AND WHERE DO WE GO FROM
               HERE?


                        David T Llewellyn

                       Loughborough University
                  CASS Business School (London),
      Vienna University of Economics & Business Administration,

                   Consultant Economist, ICAP plc


                    ISDA/PRMIA, London
                      13th October, 2009



                                                                  1
•   “Financial systems were very close to total meltdown” (Strauss-Khan,
    IMF).

•   “The financial crisis is probably the biggest in history” (Charlie Bean)

•   “This is a once-in-a-century crisis” (Alan Greenspan).

•   “Major sectors of America‟s financial system are at risk of shutting
    down. Without immediate action by Congress, America could slip into
    a financial panic.” (GW Bush)

•   “Le laisser-faire c‟est fini, et la fin d‟un monde” (N Sarkosy)

•   “….this largely under-regulated system is collapsing today. ” (P.
    Steinbruck).

 “Greatest crisis in the history of financial capitalism” (Lord Turner,
    Turner Report)


                                                                               2 2
    PUNCTURED EQUILIBRIUM IN
          EVOLUTION
• Extinctions

• New evolutionary patterns

• New models for survival

• Not all survivors individually survive

                                           3
        CENTRAL THEMES
• A transformational banking crisis
• Excess financialisation and banking
• Banking expanded beyond its marginal social value
• Induced by:
       * banking as a mature industry
       * financial innovation: CRS instruments
       * environmental factors
       * ROE focus in short-term
• Impact on: risk assessment/risk pricing/lending/
  gearing/cost of capital
• Complex layers of causality
• Context of structural change
                                                      4
• Edifice of ideology
• Faulty risk models
• New bank business models: ultimate cause
• Network externalities: implications for regulation
• The crisis will pass and normality will return……….but
  what is the new “normal”?
• Transformational at four levels:
       * size of the banking system
       * bank business models
       * financial system structure
       * Regulatory Regime


                                                          5
• Equilibrating mechanisms:
      * higher capital ratios
      * higher cost of capital
      * risk assessment
      * pricing of risk
• Impact on credit: volume v. displacement
• Not status quo ante but status quo ante ante
• Financial innovation (CRS) has efficiency benefits
• Baby and the Bathwater


                                                       6
      STRUCTURAL CHANGE
• Sharp rise in the pace of financial innovation,
• Increasing “financialisation” of economies,
• New banking models
• More market-centric structure of financial systems, (rise
  in the role of financial markets relative to institutions in
  the finance system)
• Sharp rise in the use of derivatives markets,
• Emergence of so-called “shadow banks” (hedge funds
  and structured investment vehicles (SIVs)
• Growing “funding gap”: wholesale funding


                                                             7 7
•   Globalisation of finance.
•   Increase in leverage
•   Intra-system leverage
•   Reduced liquidity holdings
•   Increased maturity transformation: banks and others
•   Power of network externalities
•   Increased connectivity
•   Increased complexity of instruments and exposures
•   Diversification produces less system diversity



                                                          8
 HOW DID WE GET HERE ?
(1) Proximate causes:
        * sub-prime defaults & US house prices

(2) Environmental:
        * asset price bubbles
        * global liquidity
        * Global savings glut
        * low/less volatile interest rates
        * market-centric system
        * globalisation

(3) Incentive Structures:
         * bank managers, shareholders, rating agencies,
                  supervisors

(4) Ideology



                                                           9
(5) Supervision
        * failure to act against know concerns
        * lack of macro-prudential regulation & linkages

(6)   Enhanced network externalities

(7)   Ultimate causes:
          * financial innovation and credit risk
          * new bank business models: SIVs etc
          * rating agencies
          * LPHI risks: disaster myopia – dilemma
          * weak RAMS
          * corporate governance

(8) Risk Models




                                                           10
    THE IDEOLOGICAL CONTEXT
          THE EDIFICE OF IDEOLOGY



•   Rational expectations
•   Efficient markets
•   Markets self-correcting
•   Liberalisation
•   Shareholder Value theory
•   No bubbles

                                    11
                BUT LIMITED
•   Systemic: fallacy of composition
•   Behaviour not always “rational”
•   Herding
•   Over-shooting and bubbles
•   Periods of collective euphoria
•   Systemic problems: externalities
•   Incentive structures
•   Dysfunctional expectations
•   Respond to macro environment

                                       12
          AN ALTERNATIVE PARADIGM
1. Banks ceased to behave as banks

2. Excess “financialisation” via banks: implicit “subsidy” to banks
        * excess gearing
        * under-estimation of risk
        * under-pricing of under-estimated risk
        * artificially low cost of capital
        * perceived safety net
        * short-termist ROE strategy
        * faulty risk models
        * excessive focus on efficient markets hypothesis
        * collective euphoria
        * low-probability-high-impact risks (LPHI): disaster myopia

3. Perverse incentive structures within banks

4. Network externalities


                                                                      13
 “IT‟S ELEMENTARY DEAR WATSON”
            (Sherlock Holmes)



If any industry is “subsidised” or under-
prices its product, it will grow too fast and
become too big and to a level that
becomes unsustainable without the
subsidy.


                                                14
     NETWORK EXTERNALITIES
• Increased connectedness: fewer degrees
  of separation
• Reduced systemic diversity
• Externality of responses
• Fallacy of Composition
• Derivatives: increased length of network
  and reduced degrees of separation


                                             15
   REGULATION IMPLICATIONS

(1) Systemic focus

(2) Key institutions in the network

(3) Structure of the network




                                      16
           NEW MODELS
• Bank assets relative to deposits: funding
  gap
• Bank loans relative to sum of RWA
• Investments and trading relative to
  balance sheet
• Money market funding and securitisation
• Credit derivatives

                                              17
18
         BANK MODELS


• Traditional: Originate and hold
• Securitisation: Originate and sell
• Credit Default Swaps: Originate and
  insure



                                        19
                 RESULT
        Bank of England FSR, October 2008

• Inflated balance sheets
• Expansion into assets whose underlying
  value/quality/liquidity were unknown
• Over-reliance on wholesale funding
• Increased gearing into higher risk assets
• Inter-connections not realised


                                              20
Banks stopped behaving like banks




                                    21
                POSITIVE VIEW

 “If risk is properly dispersed, shocks to the overall economic
    system will be better absorbed and less likely to….threaten
    financial stability”, (Greenspan, 2002)

“the development of credit risk transfer [CRT] has a potentially
   important impact on the functioning of the financial system. It
   provides opportunity for more effective risk management
   promises the relaxation of some constraints on credit availability
   and allows more efficient allocation of risk to a wider range of
   entities. The pricing information provided by new CRT markets is
   also leading to enhanced transparency and liquidity in credit
   markets.” BIS (2003).

“these increasingly complex financial instruments have especially
   contributed to the development of a far more flexible, efficient,
   and resilient financial system than existed just a quarter-century
   ago” (Greenspan, 2002).

                                                                        22
               IMF GLOBAL FSR
                         April, 2006


“There is a growing recognition that the dispersion of credit
  risk by banks to a broader and more diverse group of
  investors, rather than warehousing such risk on their
  balance sheets, has helped make the banking and
  overall financial system more resilient”

“The improved resilience may be seen in fewer bank
  failures and more consistent credit provision.
  Consequently the commercial banks may be less
  vulnerable today to credit or economic shocks”


                                                                23
        NEGATIVE VIEWS

“Derivatives are financial weapons of mass
  destruction, carrying dangers that, while
  now latent, are potentially lethal to the
  financial system.” Warren Buffet, 2002

“[CDOs] are the most toxic element of the
  financial markets today”, Quoted by
  Howard Davies (FSA), 2002
                                              24
 A VIEW ON FINANCIAL INNOVATON


“Not all innovation is equally useful….if the instructions for creating a
   CDO squared have now been mislaid, we will I think get along quite
   well without it. And in the years running up to 2007, too much of the
   world‟s intellectual talent was devoted to ever more complex
   financial innovation whose maximum possible benefit in terms of
   allocative efficiency was at best marginal, and which in their
   complexity and opacity created large financial stability risks”.



Adair Turner, Financial Services Authority, January 2009


                                                                            25
         RECONCILIATION

Increased resilience to small shocks
               v.
Greater danger of LPHI shocks
• Herding behaviour
• Incentive structures
• Speculative leverage
• Linkages between markets
                                       26
      WHAT WENT WRONG

• Not always understood
• Not shift credit risk
• Rebound via system
• Opaque
• Transformed nature of risk: credit-liquidity-
  funding-solvency
• Excessive use
                                              27
Good parents do not throw the baby away
 with the bathwater

    • Financial innovation
    • Credit-risk shifting instruments
    • Efficient markets paradigm

                                          28
NORMAL DISTRIBUTION

                    normal distribution

     0.25


      0.2


     0.15
                                               normal distribution
      0.1


     0.05


       0
-5          0   5     10            15    20




                                                                     29
      FAULT LINES IN MODELS

•   Fat tails are more common than normal distribution
•   Short time period
•   Correlation rises when volatility is high
•   Traditional hedging across assets becomes weaker
    when most needed
•   VAR models based on normal distribution
•   Ignores network externalities
•   Assumes individual actions do not have systemic
    implications
•   Systemic risk may be highest when measured risk is
    lowest: encourages behaviour which creates systemic
    risk
•   Fallacy of Composition                                30
                  PROBABILITY OF OCCURRENCE
SERIOUSNESS OF
 OCCURRENCE


                         LOW          HIGH

                 LOW

                                   PRICE



                          CRISIS
                 HIGH   POTENTIAL     X
                                              31
                1.0
Probability
of a Disaster
                              Disaster Myopia
     π

         0.001


                      Subjective

 Actual =   π„


          π*
             0
                 t                  t+m   t+n   Time


                                                       32
DISASTER MYOPIA


  Availability Heuristic

            v.

  Threshold Heuristic

                           33
    RISK MANAGEMENT LESSONS
•   Silo problem
•   Portfolio risk
•   Rams skills at the top
•   Less reliance on mathematical models
•   Limitations of VAR models
•   LPHI risks
•   Systemic risk issues
•   Understand the products
•   Incentive structures: short term profit v. long
    term value

                                                      34
   MATHEMATICAL MODELS


“Not everything that counts can be counted,
  and not everything that can be counted
  counts”

(Albert Einstein, 1936)

                                              35
The crisis is transformational




                                 36
     A VIEW OF THE FUTURE

1.   Size of the banking system

2.   Bank business models

3.   Financial system structure.

4.   Regulatory Regime
       * Regulation
       * Supervision
       * Corporate governance
       * Market discipline
       * Incentive structures
       * Intervention strategies


                                   37
     1. SIZE OF THE BANKING SYSTEM



•   Enhanced risk assessment
•   Non-subsidised risk: demand
•   Higher capital ratios
•   Higher cost of capital
•   Penalties on Safety Net access
•   Incentive structures

                                     38
           DISPLACEMENT
•   Securitisation
•   Shadow banks
•   Non-finance companies: supermarkets
•   Capital market: bank credit to bonds
•   Credit derivatives?




                                           39
2. BANK BUSINESS MODELS

•   Traditional model of banking
•   Less reliance on wholesale funding
•   Less reliance on rating agencies
•   Less complex business structures
•   Less use of credit derivatives

                                         40
    3. FINANCIAL SYSTEM STRUCTURE

• Casino v. Utility: banks as utilities linked to a casino

• Investment v. Commercial banking: quid pro quo for
  rescues

• Size of banks

• Simpler/more transparent legal structures

• Banks as utilities ?

• Narrow banking?

                                                             41
OBJECTIVES OF THE REGULATORY
           REGIME
1. Reduce probability of failure

2. Lower the cost of failures

3. Systemic stability




                                   42
    4. STRATEGIC OPTIONS FOR
           REGULATION
1. Structural regulation

2. Increased regulatory intensity

3. Special Resolution Regime: PCA and
   pre-insolvency closure

4. Regulatory Regime focus
                                        43
              GLASS-STEAGALL
          INVESTMENT v. COMMERCIAL BANKING
                  THE CASE FOR


•   Risk contamination
•   Contract with tax-payer
•   Deposit insurance
•   Utility banking
•   Regulation and supervision complexity




                                             44
      GLASS-STEAGALL: AGAINST
• Not practical: fuzzy and arbitrage
• Where is the evidence?
• “Problem” business (e.g. securitisation) could end up on
  DP dimension of the balance sheet
• Retail banks also in trouble in the crisis
• Can reduce risk
• Inefficient: break-up of synergies
• Global competition
• RAMS superior approach
• Specialist investment banks can have systemic
  dimension: Lehman Brothers
• Anti-competitive

                                                         45
             4. REGULATION

• Higher capital requirements
• Emphasis on “true” capital
• Leverage ratio
• Cyclical capital adjustment
• Dynamic provisioning
• Regulation by “economic substance”: the
  ”boundary issue”
• Treatment of OBS vehicles and shadow banks
• Increased capital against trading books

                                               46
• Reward systems and incentive structures
• Capital related to “connectedness”?
• Liquidity requirements
• Core funding ratio ?
• Systemic focus: Macro-prudential regulation:
  capital and provisioning
• Penalise systemically important banks
• Size penalty?
• Increased globalisation focus

                                                 47
       AN ALTERNATIVE REGULATORY
               STRATEGY
•   Rules can be hazardous and costly
•   Simple rules: gearing ratio ?
•   Limited risk-sensitivity of capital requirements
•   Focus on outcomes rather than processes
•   Focus on system rather than banks
•   Supervision rather than regulation
•   Enhanced role for market discipline
•   Rules on intervention

                                                       48
    PROBLEMS WITH NO
    RESOLUTION MODEL
• Uncertainty and unpredictability
• Time-inconsistent decisions
• Bargain for economic rents
• Political pressures: forbearance
• Uncertainty over rights and
  obligations
• Uncertainty over customers‟ access
                                       49
           RESOLUTION STRATEGY:
              REQUIREMENTS
•   Minimal loss/risk to tax-payer
•   Predictable model: not ad hoc
•   No interruption to bank business
•   Shareholders not protected
•   Not create moral hazard for the future
•   Sustain systemic stability
•   Competitive neutrality
•   Avoid bargaining for economic rents
•   Limit claim on Deposit Protection Fund

                                             50
      INTERVENTION STRATEGIES

•   More explicit ex ante resolution regimes
•   PCA and SEIR
•   Closure before insolvent
•   Shareholders not to be protected
•   Bad Banks
•   Bridge Bank
•   Continuity of business
•   Fast pay-out
•   High impact firms develop own resolution plans

                                                     51
WHAT ABOUT COMPETITION?




                          52
     Thankyou for listening……




www.butlerasset.com   53        Local Authority Name
                                                  53
……………if you were!


                    54

				
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