Failure Before the Eruption of Financial Crises: How Could They Have Been Avoided? A Practice in Search of a Theory
September 29, 2011
Adolfo L. Laurenti Deputy Chief Economist
Overview A crisis – what crisis, and for whom? From imbalances to crisis: an analytical outline Imbalances Triggers Propagation Prevention: a practice in search of a theory Concerns
Adolfo L. Laurenti, September 2011
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A crisis – what crisis, and for whom? "A financial crisis is a non-linear disruption to financial markets in which adverse selection (ex-ante) and moral hazard (ex-post) problems are exacerbated so that financial markets are unable to efficiently channel funds to the most productive investment opportunities.“ Mishkin (NBER 1996)
Systemic nature of financial crises
Systemic risk: what is emergency to some (i.e. markets) should be StandardOperating-Procedure to somebody else (i.e. governments and regulators)
Adolfo L. Laurenti, September 2011
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From imbalances to crisis: an analytical outline
Imbalances
Triggers
Propagation Mechanism(s)
Adolfo L. Laurenti, September 2011
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Imbalances Exchange Rate
Domestic Debt
crisis
Banking Taxonomy from Reinhart & Rogoff Adolfo L. Laurenti, September 2011
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External Debt
Triggers Sachs (1995) – exogenous shocks – policy shocks – exhaustion of borrowing limits – self-fulfilling panic
Mishkin (1996) – increase in interest rates – increase in uncertainty and risk premia – asset markets effects on balance sheets
– bank panics and bank runs
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Propagation It depends on specific institutional framework Potentially limitless It goes from obvious linkages to the arcane: – bank lending – inter-bank funding – money markets – commercial paper – securitized products
Flight to safety Absolute preference for cash, safe currencies, “real” collateral
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Prevention: a practice in search of a theory (I) In theory, a holistic approach makes most sense
Authorities have instruments to intervene at each level: imbalances, triggers, and propagation mechanisms – early warning – circuit breaker – "quarantine"
ex-ante – macro-prudential regulation
– Glass-Steagall & Volcker rule – ring-fencing (Vickers' Commission) – risk-based capital requirements (Basel I-III) – centralized clearing & settlement for financial derivatives & complex products
ex-post – lender of last resort ["lending freely at penalty rates to solvent institutions“] – "buyers of last resort" – Bailout and/or resolution powers Adolfo L. Laurenti, September 2011
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Prevention: a practice in search of a theory (II) In practice, idiosyncratic nature of shocks and transmission resulted in extensive ad-hoc measures undertaken by U.S. authorities during the most recent financial crisis By the Federal Reserve – New rules for the Discount Window – Maiden Lane – New lending facilities – New swap lines with foreign central banks – Expansion of the balance sheet
By the Federal Government – TARP – FDIC
– Ad-hoc measures re: Bear Stearns, the auto sector, Fannie and Freddie
On net, actions range from “outstanding” (e.g. CPFF - commercial paper) to “awful” (e.g. Maiden Lane)
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Concerns We are learning a lot; lack of any systematic approach to crisis management is becoming less and less justifiable Fractured nature of U.S. regulatory landscape is becoming an impediment to a more comprehensive policy on systematic risk Government and regulators should be part of the solution, not of the problem – Some evidence that the opposite is true (Cochrane on TARP, Zingales on “Too Big To Fail”)
Ad hoc intervention: trade-off between flexibility and creativity on the one side, and uncertainty on the other At a time of extreme market uncertainty, the rule of law anchors expectations and provides guidance to market participants
Non-systemic obligations should bear risk of losses New institutional and regulatory framework should be built around the principle of “robust” regime vs. first-best regime
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“Robust Institutions” “Good” Outcomes “Worst-Case Philosophy” in constitutional political economy (J. Buchanan) Regime A
Regime B
As circumstances depart from an ideal set of assumptions at C*, the outcome of regulatory regimes A and B becomes less and less favorable In case of elevated tail risk, regulatory regime B is more “robust” than regime A, even if under ideal conditions regime A would be first-best
“Robust” design should be implemented at every level: players, rules of the game, financial instruments, regulatory agencies C*
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