LESSONS FROM PAST FINANCIAL CRISES Thorvaldur Gylfason Joint

LESSONS FROM PAST FINANCIAL CRISES Thorvaldur Gylfason Joint Vienna Institute Course on Macroeconomic Policies in Times of High Capital Mobility Vienna, Austria May 16– 20, 2011

OUTLINE 1. The Great Crash and its consequences 2. What is a systemic banking crisis? 3. Main origins of a crisis 4. From crisis recognition to crisis management 5. Theories of financial crises 6. Policy responses in financial crises 7. Banks and incentives 8. Twelve lessons from recent crisis

THE GREAT CRASH AND ITS CONSEQUENCES The Great Depression 1929 -39 produced a deep slump in output in the US and elsewhere, with dramatic consequences It also triggered reforms that reduced volatility in output, reducing the likelihood of another great crash Stabilization of output Regulation of banks and other financial institutions 1

STABILIZATION WORKED, OR WHAT? Change in Canada’s per capita GDP from year to year 1871 -2003 (%) 20 15 . next door? . S U e th t u o b a w Ho 10 0 1871 1874 1877 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 5 -5 -10 -15 -20 bank Canada had no major Depression, t a re G g n ri u d s re u il fa its Deposit sh li b a st e t o n id d d n a until 1967 n o ti ra o rp o C e c n ra su In Source: Maddison (2003).

CANADA Standard deviation of per capita GDP fell from 6. 6% 1871 -1945 to 2. 3% 1947 -2003 Yet per capita GDP growth remained virtually the same (2. 1% vs. 2. 2%) In postwar period, active stabilization was the norm plus careful federal rather than decentralized financial supervision Canada’s banks are universal, universal offering both commercial and investment banking services Even so, recent financial crisis passed Canada by Firewalls between commercial banking and investment banking were not in place in Canada

STABILIZATION WORKED, OR WHAT? Change in US per capita GDP from year to year 1871 -2003 (%) 20 15 10 on during Great Perhaps bank regulati stabilize GDP d e lp e h so al n io ss re p De 0 1871 1874 1877 1880 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 5 -5 -10 -15 -20 ls between Roosevelt-era firewal d investment commercial banking an Act 1933) l al ag te -S ss la (G g n ki ban -25 Source: Maddison (2003).

UNITED STATES Standard deviation of per capita GDP fell from 6. 4% 1871 -1945 to 2. 4% 1947 -2003 Yet per capita GDP growth remained virtually the same (2. 3% vs. 2. 1%) From the 1960 s onward, active stabilization was the norm, as was federal as well as local financial supervision from 1933 onward Automatic stabilizers helped From 1870 to 1914, federal expenditures decreased from 5% of GDP to 2%, rising back to 5% by 1929 From 1945 to date, federal expenditures doubled from 10% of GDP to 20%

STABILIZATION WORKED, OR WHAT? Change in UK per capita GDP from year to year 1871 -2003 (%) 15 10 on during Great Perhaps bank regulati stabilize GDP d e lp e h so al n io ss re p De 0 1831 1835 1839 1843 1847 1851 1855 1859 1863 1867 1871 1875 1879 1883 1887 1891 1895 1899 1903 1907 1911 1915 1919 1923 1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 5 -5 -10 -15 r capita e p f o n o ti ia v e d rd a d t stan Not quite as clear, bu 1947 -2003 %. 8 1 to 5 4 9 -1 1 3 8 1 % growth fell from 3. 1 Source: Maddison (2003).

STABILIZATION WORKED, OR WHAT? Change in French per capita GDP from year to year 1821 -2003 (%) 50 40 30 n during Great o ti la gu re k an b s ap rh Pe abilize GDP st d e lp e h so al n io ss Depre 20 0 1821 1825 1829 1833 1837 1841 1845 1849 1853 1857 1861 1865 1869 1873 1877 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 10 -20 Source: Maddison (2003).

STABILIZATION WORKED, OR WHAT? Change in German per capita GDP from year to year 1851 -2003 (%) 20 0 1851 1854 1857 1860 1863 1866 1869 1872 1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 10 Stefan Zweig (1942) Die Welt von Gestern -10 -20 -30 uring Great d n o ti la gu re k an b s Perhap d stabilize GDP Depression also helpe -40 -50 Source: Maddison (2003).

STABILIZATION WORKED, OR WHAT? Change in Swedish per capita GDP from year to year 1821 -2003 (%) 10 0 1821 1825 1829 1833 1837 1841 1845 1849 1853 1857 1861 1865 1869 1873 1877 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 5 -5 -10 uring Great d n o ti la gu re k an b s Perhap d stabilize GDP Depression also helpe -15 Source: Maddison (2003).

WHAT IS A SYSTEMIC BANKING CRISIS? The emergence of systemic banking crises has been associated with the liberalization of financial systems worldwide However, since the mid- to late 1990 s a number of crises have been of unprecedented scale and consequences: Mexico 1994 Asian Crisis 1997 -1998 Russia 1998, Ecuador 1998, Turkey 2001, Argentina and Uruguay 2002 US 2007 and its aftermath, including Iceland 2

WHAT IS A SYSTEMIC BANKING CRISIS? A banking crisis is systemic in nature if a loss of confidence in a substantial portion of the banking system is serious enough to generate significant adverse effects on the real economy The adverse effect on the real economy arises from disruptions to the payments system, to credit flows, and from the destruction of asset values Let’s look at some evidence which demonstrates the devastating nature of systemic crises

Banking Problems Worldwide 1980 -2002 Banking Crisis Significant Banking Problems No Significant Banking Problems/Insufficient Information

EXAMPLES OF SEVERE IMPACT ON REAL GDP GROWTH In billions of local currency Finland Source: IMF. Indonesia

EXAMPLES OF SEVERE IMPACT ON REAL GDP GROWTH In billions of local currency Sweden Source: IMF. Thailand

EXAMPLES OF SEVERE IMPACT ON REAL GDP GROWTH In billions of local currency Ecuador Source: IMF.

EXAMPLES OF MILDER IMPACT ON REAL GDP GROWTH In billions of local currency Korea Source: IMF. Norway

MAIN ORIGINS OF A CRISIS Need to distinguish between Causes and origin of a systemic crisis Trigger of the crisis Two views (or schools of thought) on origins of systemic crises Institutional failure leads to systemic crisis (classical view) view Common exposure of financial sector to certain risks (endogenous cycle view) view 3

MAIN ORIGINS OF A CRISIS: CLASSICAL VIEW Some weak banks in the system, they stay above water until an external shock hits E. g. , weak management, weak risk management systems, leading to balance sheet deficiencies, mismatches External shock can be anything (e. g. , exchange rate shock, political crisis) Weak banks go under and, through contagion, pull others into problem zone Crisis become systemic Helps explain some crises, but not recent ones Source: Diamond and Dybvig (JPE, 1983)

MAIN ORIGINS OF A CRISIS: ENDOGENOUS CYCLE VIEW Systemic crisis follows from fact that banks have common exposures to macroeconomic risks Origin of scenario leading to endogenous cycle may differ from crisis to crisis, but … … pattern of response is similar I. e. , how they get these common exposures Sources: Minsky (1982), Kindleberger (1996)

MAIN ORIGINS OF A CRISIS: ENDOGENOUS CYCLE VIEW Starting point: Economic conditions are considered favorably Risk evaluation is also favorable Access to credit is relaxed (subprime!) Endogenous or Profits go up self-feeding cycle Generalized state of euphoria Procyclical behavior Boom in asset prices and markets (amplification) Asset price bubble is forming Risk perceptions remain favorable But, imbalances start to emerge here and there … … and suddenly the situation goes into reverse E. g. , through a change in mood

MAIN ORIGINS OF A CRISIS: THE TRIGGERS The trigger can be anything E. g. , change in mood, bad economic or political news, problems in neighboring countries, rumors Irrespective of origin, a crisis first emerges as a liquidity problem in one, some, or all banks Symptoms Bank goes repeatedly to interbank market Bank calls repeatedly upon lender-of-last resort and requests roll-over When the rumors spread, liquidity problems trigger deposit withdrawals (Asia) or credit lines that are being cut (Turkey) Liquidity problems are typically symptoms of underlying solvency problems

FROM CRISIS RECOGNITION TO CRISIS MANAGEMENT Start of crisis often seems chaotic When a problem arises in one bank Is it an isolated case or will it spread? It takes time to assess situation and recognize that it is systemic Lack of preparedness on the authorities’ side Vested interests in delaying recognition, i. e. , in avoiding fiscal costs as well as in accepting blame 4

FISCAL COSTS OF SYSTEMIC CRISES (% OF GDP)

FISCAL COSTS OF BANK RESTRUCTURING: MAIN COSTS ITEMS Liquidity support If banks prove insolvent, and can’t repay liquidity support received earlier from central bank Deposit insurance Government pay-outs as part of deposit insurance scheme or blanket guarantee Bank recapitalization Through the government If the government agrees to assist in recapitalizing the banks through some scheme Through restructuring of impaired assets A (government) asset management company buys impaired assets from banks in exchange for government bonds

FISCAL COSTS OF BANK RESTRUCTURING: INDONESIA % of GDP Billions of USD Liquidity support provided by central bank, and taken over by budget 12 20 Recapitalization, including blanket guarantee 23 40 Purchase of NPLs and capital provided to asset management company 12 20 Interest cost (for the budget) 3 5 51 85 Total

FACTORS INFLUENCING FISCAL COSTS OF BANKING CRISES How long it takes politicians to recognize that they are face a crisis (+) … … and the time from the point of recognition to the time of action Quality of institutions (-) Level of corruption (+) Efficiency of judicial system (-) Restructuring approach (+/-) Strict vs. accommodating strategy (moral hazard) Types of incentives given during recapitalization Handling of impaired assets (+/-) Possible payback to government (+/-)

SIZE OF RESCUE PACKAGES IN CURRENT CRISIS Source: BIS (2009).

FINAL WORD ABOUT CRISIS MANAGEMENT Need for political leadership and coordination Managing a financial crisis Is a macro-undertaking with lots of microdecisions Involves tackling a number of politically contentious (vested interests), and often technically complex, issues Involves burden sharing and redistribution of wealth, with most parts of society affected

THEORIES OF FINANCIAL CRISES Economic theories of financial crisis have tended to follow events Different models correspond to specific country cases Recent theories tend to reflect failure of markets to avert socially costly outcomes, with focus On problems in the markets themselves (particularly in asset markets) due to asymmetric information/agency problems, etc. On the role of economic policymakers (esp. central banks) that, in attempting to control credit creation to stabilize economy, unwittingly amplify boom/bust cycles On why markets do not always produce optimal solutions, see Freefall (2010) by Stiglitz The Origin of Financial Crisis This Time Is Different (2009) (2008) by Cooper by Rogoff and Reinhart 5

EARLY WARNING SIGNS Large deficits Current account deficits Government budget deficits Poor bank regulation Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt Ratio of short-term liabilities to foreign reserves Mismatches Maturity mismatches (borrowing short, lending long) Currency mismatches (borrowing in foreign currency, lending in domestic currency) Increased inequality

ICELAND: CURRENT ACCOUNT 1989 -2008 (% OF GDP) Pepper, salt, or gold, anyone? Mid-2008 time: ig b , s e y , s n a e Beyond our m cts) e j o r p o r d y h , g in ous q Investment (h hn) o J n o lt E , s t e j , s jeep q Consumption ( End 2008

LEVERAGE AND FINANCIAL CRISES Many crises are characterized by over-leveraging Increases I. e. , risk aversion, interest rate/exchange rate changes Usually, crises involve debt repayment difficulties for government, households, or corporate sector Debt vulnerability of debtors to external changes servicing tends to become harder as crisis develops Foreign credit dries up, banks need to deleverage, value of collateral falls, trade credit becomes more difficult, etc. Does this help crisis prediction or crisis prevention? Extent of debt depends on interest rate/exchange rate What appears to be a manageable situation, proves unmanageable when variables change Debt levels change and so, too, does bank capital

ICELAND: EXTERNAL DEBT 1989 -2008 (% OF GDP) Net External Debt (% of GDP)* End 2008 Mid-2008 *Excluding risk capital

ICELAND: EXTERNAL DEBT 1989 -2008 (% OF GDP) International Investment Position (% of GDP)* End 2008 Mid-2008 *Including risk capital

ICELAND: RATIO OF BANK ASSETS TO GDP 2007 (END OF YEAR) in’s GDP a it r B f o % 0 0 1 : s Barclay ny’s GDP a m r e G f o % 0 8 : Deutsche Bank Source: Union Bank of Switzerland

ICELAND: RATIO OF BANK ASSETS TO GDP 1992 -2007 Mid-2008

ICELAND: CENTRAL BANK FOREIGN EXCHANGE RESERVES 1989 -2008 End 2008 Rule h t n o m e e r h T Mid-2008

ICELAND: CENTRAL BANK FOREIGN EXCHANGE RESERVES 1989 -2008 le u R n a p s n e e r G Giudotti- Mid-2008 End 2008

ASIA: RATIO OF SHORT-TERM LIABILITIES TO FOREIGN RESERVES 1997 an p s n e e r G it t o id u G rule

INEQUALITY AND CRISES Increased inequality in distribution of US income and wealth during roaring 1920 s Bubble conducive to higher incomes at top end of distribution, and vice versa Crisis of 2007 Subprime lending supported and made possible in part as compensation for increased inequality (Rajan) If so, inequality helped trigger crisis

ICELAND: GINI INDEX OF INEQUALITY 1993 -2008 (DISPOSABLE INCOME) 45 o the rest t h ic r e h t m o r f en Shift of tax burd 40 35 30 25 20 15 10 5 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 98 19 97 19 96 19 95 19 94 19 19 93 0 Source: Internal Revenue Directorate.

POLICY RESPONSES IN FINANCIAL CRISES To restore confidence in a financial crisis, a policy program needs to be announced that is seen by creditors as comprehensive and fully financed First policy dilemma How to halt pressure on currency while bolstering domestic demand Should interest rates be temporarily raised? Should fiscal policy be tightened? Should capital controls be introduced? 6

POLICY RESPONSES IN FINANCIAL CRISES Second policy dilemma Should financial and firm-sector problems be tackled up front or left until later? Should banks be recapitalized with public funds? Perhaps no choice Solvency issues Forms of restructuring Should there be regulatory forbearance? Should public or private debts be restructured? Should government be involved in corporate restructuring?

INTEREST RATE POLICY Pros and cons Increasing rates Helps external adjustment, reduces capital flight Deflationary when domestic demand is already in decline Places further stress on over-leveraged firms Middle class bonus Reducing rates Exerts greater pressure on exchange rate Obscures/postpones structural problems Credit supply constrained by banking problems

FISCAL POLICY “Mistake” in Thailand IMF program 1997 Rationale for tighter fiscal policy Fiscal space in Iceland program 2008 Fiscal policy in Korea Difficulty of running a deficit Social programs in Asia Fiscal policy in Argentina Size of haircut and extent of fiscal adjustment Preparing for post-crisis vs. getting through the crisis

MORE ON FISCAL POLICY IMF’s conditional support for fiscal stimulus Short-run constraints on fiscal policy Time lags Credibility Type of fiscal action Longer-term issues of debt sustainability Difficulty of specifying a medium-term framework in the midst of a financial crisis Different speeds of recovery Impact on potential output Exit from fiscal stimulus Economics and politics

CAPITAL CONTROLS Speculation in Asian crisis Experience of Malaysia and Hong Kong Malaysian speculation Capital flight Mahathir’s controls Hong Kong and the hedge fund conspiracy Transparency short selling and regulations against

LARGE REVERSALS OF CAPITAL FLOWS

PRUDENTIAL REGULATIONS AND CAPITAL CONTROLS Growing acceptance of use of prudential regulations to limit systemic risk in banking system and, more generally, in national and international economy Countercyclical Blanchard Liquidity ratios Differentiated by currency Reserve use of prudential ratios requirements Differentiated by maturity Limitations Regulatory arbitrage Nonfinancial sector flows

MORE ON CAPITAL CONTROLS Recent cross-country evidence on effectiveness of capital controls Controls tend to have short-term impact, over time market participants find ways of circumventing Controls tend to change composition rather than overall volume of flows But, Ostry et al. (IMF Staff Position Note 10/04) find that “in the recent crisis the output decline of the countries that had maintained capital controls in the run-up to the crisis was lower than in other countries without capital controls” There are difficulties in empirical testing – how to measure capital control, what measures introduced at same time, what was counter-factual? Source: Global Financial Stability Report, IMF, April 2010.

BANKING CRISES HAVE CALLED CAPITAL LIBERALIZATION IN DOUBT Financial globalization is often blamed for crises in emerging markets It has been suggested that emerging markets had dismantled capital controls too hastily, leaving themselves vulnerable More radically, some economists view unfettered capital flows as disruptive to global financial stability These economists call for capital controls and other curbs on capital flows (e. g. , taxes) Others argue that increased openness to capital flows has proved essential for countries seeking to rise from lower-income to middleincome status

ROLE OF CAPITAL CONTROLS Capital controls aim to reduce risks associated with excessive inflows or outflows Specific objectives may include Protecting a fragile banking system Avoiding quick reversals of short-term capital inflows following an adverse macroeconomic shock Reducing currency appreciation when faced with large inflows Stemming currency depreciation when faced with large outflows Inducing a shift from shorter- to longer-term inflows

TYPES OF CAPITAL CONTROLS Administrative controls Outright bans, quantitative limits, approval procedures Market-based controls Dual or Explicit multiple exchange rate systems taxation of external financial transactions Indirect taxation E. g. , unremunerated reserve requirement Distinction between Controls inflows on inflows and controls on outflows on different categories of capital

EVIDENCE: IMF ANNUAL REPORT ON EXCHANGE ARRANGEMENTS AND EXCHANGE RESTRICTIONS IMF (which has jurisdiction over current account, not capital account, restrictions) maintains detailed compilation of member countries’ capital account restrictions The information in the AREAER has been used to construct measures of financial openness based on a 1 (controlled) to 0 (liberalized) classification They show a trend toward greater financial openness during the 1990 s But these measures provide only rough indications because they do not measure the intensity or effectiveness of capital controls (de jure versus de facto measures)

STRUCTURAL PROBLEMS Structural characteristics can sometimes be seen as root cause of a crisis In Korea, exceptionally high debt-equity ratios, low profitability of corporate sector, and increasing use of foreign currency bank loans to shore up finances in largest chaebol were viewed as indicative of structural problems, including lack of corporate governance, nonstandard accounting rules, directed lending, barriers to entry in various industries, failure of prudential regulation, etc. But many of these problems had been integral parts of the previously successful model of development IMF program 1997/98 contained many structural reforms to tackle these problems, some relevant, some dubious The criticism of these structural conditions was that their implementation prolonged the crisis; they were not immediately necessary. The counter-argument was that if changes had not been made at that time they would not have been introduced at all Only in the midst of a crisis could political support be mobilized to effect large institutional changes

NARROWING OF STRUCTURAL CONDITIONALITY The case of Indonesia and crony capitalism Too many conditions, too political IMF programs and political stability Streamlining of structural conditionality Recent IMF programs and structural measures Linkages between structural measures and macroeconomic stability

BANK RESTRUCTURING Testing banks for solvency How big is too big to fail? Closing banks in the absence of a deposit guarantee Indonesia Public ownership of private banks What conditions are needed? Purchasing “bad assets”– finding a price

REFORM OF PRUDENTIAL REGULATIONS Proposals for regulatory reform in previous crises focused on widening coverage to prevent regulatory arbitrage and separating regulators and enhancing independence of supervision so as to reduce influence of governments and central banks The theme emerging from the global financial crisis is different in that prudential regulation was seen to pay insufficient attention not only to the risk management techniques of financial institutions but also to the build up of systemic risk Regulators need to look at a wider view of risk than from focusing on stability of financial institutions in isolation One proposal is that regulators focus rather on macro -prudential monitoring of the financial system as a whole

REGULATORY REFORMS While some calls have been made for changes that place regulators back within central banks, other recent proposals (in US House of Representatives, US Senate, UK, EU) call for the creation of councils, each comprising existing supervisory authorities and national central banks within their country (area), that would monitor the buildup of domestic financial systemic risk For the banks themselves, most authorities see the need for larger capital requirements, particularly for systemically important institutions, i. e. , those with high degree of interconnectedness within the system However, consensus on the modalities of capital surcharges has not yet emerged

CORPORATE DEBT RESTRUCTURING Corporate debt restructuring and IMF programs Korea, Indonesia, more recently Latvia, Iceland Case for government intervention Three different approaches Case-by-case market-based approach Across-the-board with direct government involvement Intermediate approach with government financial incentives See Thomas Laryea: Approaches to Corporate Debt Restructuring in the Wake of Financial Crises, IMF Staff Position Note, January 2010

SHARING THE COSTS OF FINANCIAL CRISES Government’s role in allocating the costs of a crisis Tax policies Social programs and redistribution during crisis Subsidies to financial institutions and enterprises Socializing losses and inter-generational effects Impact of government policies on future incentives

ROLE OF IMF AND MORAL HAZARD Insurance and externalities of crisis mitigation IMF and allocation of costs of crisis between countries Incentive effects of “bailouts” Future crisis prediction and prevention

SPOTTING THE NEXT CRISIS Different causes in each new wave of crises There are limits to individual country risk analysis Cross-section econometric techniques

IDENTIFYING THE ONSET OF THE NEXT CRISIS Market Pressure Indices Mecagni et al. (2007) Index = -(FXt – FXtrend) – ln(NEERt/NEERt-1) + St – Kt Combines individual indicators FX (international reserves) NEER (nominal effective exchange rate) S (secondary market spread on sovereign bonds) K (net private capital flows as a ratio to GDP) All variables are standardized with their mean = 0 and their standard deviation = 1 The aim is to show deviations from normal levels of the components The start of a crisis is identified as the first of two consecutive quarters in which the value of the index is positive

IDENTIFYING FINANCIAL STRESS Financial Stress Indicators (IMF, 2008) rely on financial variables for 17 countries Equal-variance weighted average of seven variables 1. 2. 3. 4. 5. 6. 7. Banking-sector beta TED spread Inverted term spread Corporate spread Stock decline Time-varying stock volatility Time-varying real exchange rate volatility Financial stress if index is one standard deviation above its trend

CRISIS PREDICTION: EARLY WARNING SIGNS, AGAIN Typical Signal Indicators: Overvaluation of currency in real terms Financial liberalization Low output growth Fall in asset prices Weak exports High interest rates Rise in inequality See Kaminsky and Reinhart (1999)

CRISIS PREDICTION Type I and Type II Errors Both probability models and signal extraction models give too many false alarms Particularly difficult to get timing right In general, the empirical record of crisis prediction remains poor, particularly in out-of-sample tests

CRISIS PREVENTION Desirable elements to help prevent crises Sound macroeconomic policies Sound financial sector regulation and regular surveillance Sufficient international reserves Rigorous debt sustainability analysis

RELATED REFERENCES International Monetary Fund. “What Happens During Recessions, Crunches and Busts? ”, Stijn Claessens, M. Ayhan Kose and Marco E. Terrones, Working Paper WP/08/274, December 2008 International Monetary Fund. “The Role of Indicators in Guiding the Exit from Monetary and Financial Crisis Intervention Measures — Background Paper”, IMF Policy Paper, January 2010 International Monetary Fund. “Lessons and Policy Implications from the Global Financial Crisis”, Stijn Claessens et al. , Working Paper WP/10/44, February 2010

PAUL VOLCKER ON US BANKS Paul Volcker, Chairman of the Fed 1979 -87, said 8 December 2009 at a conference organized by the Wall Street Journal: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth – one shred of evidence. ” He added that in the U. S. the share of financial services in value added had risen from 2% to 6. 5%, and then asked: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid? ” 7

BLACK’S RECIPE FOR CONTROL FRAUD ays it all When the title s f and Romer: o rl e k A y b le ic rt A y for Profit” tc p ru k n a B : g n ti o “Lo “The Best Way to Rob a Bank is to Own One” 1. 2. 3. 4. When a senior officer deliberately causes bad loans to be made he does not defraud himself He defrauds the bank’s creditors and shareholders, shareholders as a means of optimizing fictional accounting income It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required Grow really fast Four-point recipe Make really bad loans at higher yields Pile up debts Put aside pitifully low loss reserves

BLACK’S RECIPE FOR CONTROL FRAUD l Brooks’s e M m o fr is t p ri c The s ucers (1968): d o r P e h T , ie v o m than a hit r e tt e b s y a p p o A fl “The Best Way to Rob a Bank is to Own One” 1. 2. 3. 4. When a senior officer deliberately causes bad loans to be made he does not defraud himself He defrauds the bank’s creditors and shareholders, shareholders as a means of optimizing fictional accounting income It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required Grow really fast Four-point recipe Make really bad loans at higher yields Pile up debts Put aside pitifully low loss reserves

TWELVE LESSONS FROM CRISIS 1. Need legal protection against predatory lending because of asymmetric information 8 Like laws against quack doctors, same logic Patients know less about health problems than doctors, so we have legal protection against medical malpractice Same applies to some bank customers vs. bankers, especially in connection with complex financial deals 2. Do not let rating agencies be paid by the banks Fundamental conflict of interest Also, prevent accountants from cooking the books 3. Need more effective regulation of banks and other financial institutions Work in progress, Paul Volcker in charge

TWELVE LESSONS 4. Read the warning signals Four rules, or stories § The Aliber Rule Count the cranes! § The Giudotti-Greenspan Rule Do not allow gross foreign reserves held by the Central Bank to fall below the short-term foreign debts of the domestic banking system Failure to respect this rule amounts to an open invitation to speculators to attack the currency § The Overvaluation Rule Sooner or later, an overvalued currency will fall § The Distribution Rule • The distribution of income matters

ICELAND: GINI INDEX OF INEQUALITY 1993 -2008 (DISPOSABLE INCOME) 45 o the rest t h ic r e h t m o r f en Shift of tax burd 40 35 30 25 20 15 10 5 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 98 19 97 19 96 19 95 19 94 19 19 93 0 Source: Internal Revenue Directorate.

TWELVE LESSONS 5. Do not let banks outgrow Central Bank’s ability to stand behind them as lender – or borrower – of last resort 6. Do not allow banks to operate branches abroad rather than subsidiaries, thus exposing domestic deposit insurance schemes to foreign obligations Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300. 000 British depositors and 100. 000 Dutch depositors May violate law against breach of trust

TWELVE LESSONS 7. Central banks should not accept rapid credit growth subject to keeping inflation low As did the Fed under Alan Greenspan and the Central Bank of Iceland § They must restrain other manifestations of latent inflation, especially asset bubbles and large external deficits § Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth

TWELVE LESSONS 8. Erect firewalls between banking and politics Corrupt privatization does not condemn privatization, it condemns corruption 9. When things go wrong, hold those responsible accountable by law, or at least try to uncover the truth: Do not cover up In Iceland, there have been vocal demands for an International Commission of Enquiry, a Truth and Reconciliation Committee of sorts If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself Public – and outside world! – must know National Transport Safety Board investigates every civilaviation crash in United States; same in Europe

TWELVE LESSONS 10. When banks collapse and assets are wiped out, protect the real economy by a massive monetary or fiscal stimulus Think outside the box: put old religion about monetary restraint and fiscal prudence on ice Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth § Physical capital (typically 3 or 4 times GDP) and human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP) § So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less

TWELVE LESSONS National wealth The structure can withstand the removal of the top layer unless the financial ruin seriously weakens the fundamentals Human capital Physical capital Financial capital Even so, tremendous damage in Iceland, equivalent to up to 7 times GDP

TWELVE LESSONS 11. Shared conditionality needs to become more common § As when the Nordic countries providing nearly a half of the $5 billion needed to keep Iceland afloat imposed specific conditions on top of the IMF’s conditions § This may come up again elsewhere § E. g. , in Greece now that the EU and the IMF have been called on to support Greece together § For this, clear and transparent rules tailored to such situations ought to be put in place

TWELVE LESSONS d n E e h T 12. Do not jump to conclusions and do not throw out the baby with the bathwater Since the collapse of communism, a mixed market economy has been the only game in town To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized Even so, it remains true as a general rule that banking and politics are not a good mix But private banks clearly need proper regulation because of their ability to inflict severe damage on innocent bystanders Do not reject economic, and legal, help from abroad