Derivatives
- Most derivatives are created to reduce risk
- Although face value might be $1 billion, actual risk is probably $10 million
- They are a zero sum game - for every loser there is a winner
- Large houses mismanaged risk
- Real problem was misrating
Shadow Banking
Fractional Reserve Banking?
- Name is a pejorative for the unregulated nondepositary sector
- Money had been forced into unregulated sector by overregulation
- This includes large public pension funds like CALPERS
- Ditto Fannie and Freddie
- So large amounts not backed by deposits
- Big debate in libertarian circles (Rothbard v Mises)
- Murray Rothbard claims FRB is fraudulent and an abuse of property rights
- Mises - cannot enforce 100% reserve banking
- Posner - a deposit at a bank is a loan
- Contract rights apply, not property rights
- All banks do offer 100% guaranteed deposits
FSOC and SIFIs
"Too Big to Fail"
Misconceptions
ZIRP
Mark-to-Market
- FSOC is a super-regulator
- Has power to designate SIFIs - "Systemically Important Financial Institutions"
- Entrenches "too big to fail"
- Large banks want SIFI status
- Insurance companies caught up as "cash cows" to pay for bailouts
CFPB
Risk of Contagion?
- Concept based on contagion argument
- Also applied to GM and Chrysler (why?)
- Result was Dodd-Frank Act
- All sorts of extraneous measures added
- TARP was not used for troubled assets but for bailouts
- Neal Barofsky SIGTARP
- Accounting standards issue
- How do you account for the value of an asset that changes over time?
- Mark-to-market says you value according to the current market value
- This does reveal real losses but...
- Creates accounting bubbles and crashes
- Continued lack of real recovery has led to sustained ZIRP
- Companies are not borrowing to expand but to buy back shares
- Consumers - evidence mixed
- Main beneficiary has been government borrowers
- So how can ZIRP ever end?
- Idea of Elizabeth Warren
- Financial equivalent of CPSC
- "Loans are not toasters"
- Immense power
- Immune from checks and balances
- Cracking down on any form of lending
- But fines finance firms for not lending to the right people
- AIG bailout was mainly about protecting counterparties
- Goldman Sachs was largest counterparty
- Goldman claims it had hedged the risk
- Why "save" Goldman from a non-problem?
- Why "save" Goldman and not Lehmann?
- Hank Paulson and DC connections
- Cronyism not contagion?
Monetary Policy
- Fractional Reserve Banking
- Were derivatives to blame?
- Shadow Banking?
- Contagion?
- What about deregulation?
- US Federal Reserve used monetary policy to "stimulate" economy after 2001
- Fed has "dual mandate"
- Interest rates reduced to near zero to encourage spending
- Saving became uneconomical so savers looked to other investments
- Real estate became source of speculation
The Response (US)
Moral Hazard
Deposit Insurance
Preconditions
- Deposit insurance introduced in US 1933
- Only 12 countries in 1974
- 113 in 2014
- Deposit insurance discourages savers from paying attention to actions of banks
- Encourages banks to take risks
Deregulation?
- Deposit insurance raised to $250,000
- So obvious increase in moral hazard - vicious circle with other regulations
- Has also prompted regulators to exercise their powers more
- "Operation Choke Point"
- "Too Big To Fail"
- Bailouts
- Dodd-Frank
- FSOC
- CFPB
- Deposit insurance rise
- ZIRP
- Financial deregulation is an extraordinary myth
- SarbOx had vastly increased US regulation
- Only real deregulation was government housing policy
- UK - "deregulation" of 1980s in fact introduced government regulation
- Alphabet soup of regulators
Financial Technology
- Monetary policy
- Moral hazard
- Modern financial technology
- International regulatory environment
- Accounting standards
- New technologies led to "quant" phenomenon
- Value at Risk models were a pretense of knowledge
- VaR a Gaussian model so ignored "tail risk"
- VaR encouraged use of very risky instruments
- If you don't know what you're doing and play with fire, you will get burnt
International Regulation
Basel III
- 1973 - Herstatt Bank collapse led to calls for international regulation
- 1988 - Basel I
- 2004 - Basel II
- "Risk-weighting" of assets
- OECD - Basel accords led to unconventional banking practices designed to skirt regulations
- Even more complicated version of Basel II
- Same problems apply
- Forcing consolidation of medium-sized banks
- Those banks then become large banks...
- Bank of England (Andy Haldane) - regulatory discretion is necessary
Housing Policy
Rating Agencies
The FSB
The 2008 Crisis
The Response (Int'l)
- Legacy of Jim Crow had led to discrimination in housing lending
- Community Reinvestment Act of 1977
- Banks encouraged to lend to minority communities
- Meanwhile, Fannie and Freddie drive banks out of "prime market"
- Banks developed products to make "subprime" lending profitable
Precipitants
- International super-super regulator
- Coordinates international regulatory cooperation
- Two degrees removed from accountability
- Is driving harmonization of regulation
- Rohac/Sinclair - result could be next crisis will be deeper and wider
- In US, regulators demanded CDOs have risk ratings set by one of three agencies
- Banks employed the agencies, not the purchasers of CDOs
- Systemic overrating of CDOs
- Buyers routinely failed in due diligence (others didn't)
Stress Tests
- Basel III
- Financial Stability Board
- International regulatory cooperation
- Stress Tests
- The Eurocrisis
- Government Housing Policy
- Zoning
- Rating Agencies
- SEC Actions
Causes?
- Preconditions
- Precipitants
- Triggers
Misconceptions
The Response
How should we regulate the system?
SEC Regulations
- Stress Tests are being used all over the world
- Iceland 2008 - passed
- Ireland 2010 - passed
- Cyprus 2013 - passed
- December 2014 - UK banks pass...
- Problem: lower risk-weighted asset scores do not mean lower risk
- Problem: single, weak scenario
- Kevin Dowd
Zoning
- Sarbanes-Oxley (box checking)
- Financial disclosures meaningless
- With Eliot Spitzer, destroyed investment research model
- Banks started trading their own capital instead of clients'
- So encourage higher leveraging
- Randal O'Toole: American Nightmare
- States with strict urban planning controls suffered worse in housing crisis
- California - prices doubled then collapsed
- Georgia - Prices up 25%, no decline
- Zoning creates artificial scarcity, constraining supply
The Eurocrisis
- Not the place to go into detail
- Important to note that banks purchased huge amounts of sovereign debt after 2008 using Basel II guidelines
- Sovereign debt proved to be very risky
- Banks passed stress tests
Fannie and Freddie
The SubPrime Bubble
- January 2006 - "eye-popping 43% of first-time home buyers purchased their homes with no-money-down loans" (Nat Assn Realtors)
- Bellwether Index of construction, mortgage and investment firms shows bubble popped about then
- White House - "soft landing" Ha!
A Liberal Response?
- Purpose is to expand mortgage market by securitizing morgtages
- "Government-sponsored"
- Had line of credit but never used
- Underwrote half of all mortgage market
- $15 billion losses by July 2008
- Congress passed act to create FHFA and bail FF out in July 2008
- Bailout total up to $360 billion
Triggers
Lehman Bros
- Reduce perverse incentives
- "Skin in the game" (prudential, not mandated)
- Competition - more banks
- Abolish deposit insurance
- Government out of housing policy
- "Bundesbank" monetary policy
- Repeal death taxes
- The subprime bubble
- Bear Stearns
- Fannie & Freddie
- Lehman Brothers
- AIG
- Competitor of Bear Stearns
- Posted big losses July 2008
- Share price cratered
- In September, filed for bankruptcy
- Expected bailout so did not plan for bankruptcy risk
- No bailout - why?
- Fed felt this was a solvency issue not a liquidity issue as with BS
- But...
Common Features of Financial Crises
Bear Stearns
- BS actually increased its exposure in 2006-7
- Leverage ration went from 5:1 to 36:1 after the bubble had already burst
- Two subprime funds lost all value July 2007
- March 2008 - Fed Bailout (Cox: "lack of confidence")
- Volcker: Fed actions "extend to the very edge of its lawful and implied powers"
AIG
Dowd and Hutchinson 2010
From 1720 to 2008
- Rampant speculation*
- Government involvement
- Monetary policy
- Bad regulation
- Financial innovation
- Major insurance firm
- London office had diversified (Man Utd)
- $58 billion "AAA" subprime assets
- Credit rating downgraded
- Losses magnified by mark-to-market
- Liquidity crisis
- Sept 2008 Fed bailout of $85bn with stock as collateral
Note: speculation not a bad thing
Too Big to Fail?
Regulating the Financial System
Iain Murray
July 2015