The Current Banking Crisis:

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The Current Banking Crisis Whats New and Whats
Next?
Harry Garretsen

                                               
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Outline

• The current mess quick recap (see also Sterkens
  lecture!)
• Will this banking crisis turn into a financial
  crisis?
• Basic economic insights (micro, macro)
• Whats new with this crisis?
• Costs for the taxpayer and the real economy
• Prediction (2 scenarios)
• (Questions/discussion)
• -I will talk for 30-35 minutes........
• Crisis is still fast moving spot the new
  bank in the 1st slide!

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The Trigger Housing prices US
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How did we get here?

• Trigger Slowdown and fall in US housing prices
  (2006) and subsequent sub-prime mortgage crisis
• Loss of Confidence within banking sector, Aug.
  2007
• Inter-bank market shuts down just a liquidity
  crisis?
• Bank run (I) on shadow banking system (Spring 08)
• Balance sheets banks toxic assets, shares
  fall, more funding problems? solvency crisis?
• Bank run (II) financial system collapse,
  governments step in (after 18/9)
• Increased fears of (deep) recession

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Banking CrisisFinancial Crisis?

• Not all crises or financial disruptions are a
  financial crisis
• Take the stock market crash of 1987 or the
  deflation of the dotcom bubble in 2000/01
• Financial crisis financial system cannot
  perform its main functions anymore and this has
  real costs
• -Functions S?I risk spreading liquidity
  provision
• -Real costs considerable output loss
  (fiscal costs)
• -Do banking crises qualify (85)? Does this
  banking crisis qualify? (.? Yes)

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Economics is useful to get a grip on these
crises

• Micro
• 1)
• 2) efficiency of markets rationality of agents
• (take super agent Alan Greenspan in
  2005, the quote is a bit long but very
  revealing.)
• Macro (Bernanke, smarter than Greenspan??)
• 1) with imperfect financial markets credit
  crunch
• 2) financial crisis as negative aggregate supply
  shock

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With these advances in technology, lenders have
taken advantage of credit-scoring models and
other techniques for efficiently extending credit
to a broader spectrum of consumers. The
widespread adoption of these models has reduced
the costs of evaluating the creditworthiness of
borrowers, and in competitive markets, cost
reductions tend to be passed through to
borrowers. Where once more-marginal applicants
would simply have been denied credit, lenders are
now able to quite efficiently judge the risk
posed by individual applicants and to price that
risk appropriately. These improvements have led
to rapid growth in subprime mortgage lending
indeed, today subprime mortgages account for
roughly 10 percent of the number of all mortgages
outstanding, up from just 1 or 2 percent in the
early 1990s.
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It has happened before.

• A non exhaustive list Great Depression 1930s
  SL crisis in USA in 1980s Japan after 1991
  Sweden 1992 South Asian crisis of 1997/8
  etc..
• Laeven Valencia (2008) 124 banking crisis
  1970-2007!!
• Two Questions
• 1) How to explain the frequent occurrence of
  banking and financial crises?
• 2) Is the 2008 crisis different? (And if so,
  how?)

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1st Question are we all just plain stupid?

• Research on banking and financial crises
• 1) All crises are crises of success
• 2) Crises are integral part of working financial
  markets
• 3) Crises are caused by collective overconfidence
  driven by economic boom, new developments (old
  laws no longer apply) and lack of
  regulation/supervision
• Crises happen but is financial sector stable
  enough to cope?......................

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Minskys financial instability theory
Too much risky investment at the peak Growing
gap between asset prices and fundamentals
GDP
Time 1930s US 1990s Japan etc..
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Minsky financial sector is never stable
boom and bust cycles unless
Too much risky investment at the peak Growing
gap between asset prices and fundamentals
GDP
? Time 2001-2005-2008-?
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2nd question whats new about this crisis?

• So far, mainly 2 things (apart from the fact that
  we (OECD block) are now hit)
• -contagion within banking sector or financial
  sector at large (Paul Krugman)
• -transformation of banking sector from 1990s
  onwards (securitization trend)
• goodbye to the days of boring
  banking..

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Recall from 1st lecture banks balance sheets
Liabilities
Assets
Uncertain
Loans
Deposits
Opaque
Money/Capital market sensitive
Securities
Non-deposits
Risky
Stock market sensitive
Equity
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What are the costs of banking crises?

• Fiscal costs (associated with bailing out banks,
  rescuing deposit holders etc.)
• Output loss (how much gdp loss compared to
  trend?)
• LaevenValencia (2008), Brown,Bos etc. take
  note!!
• -avg. fiscal costs amount to 13 gdp
• -output loss on avg. 20 (in 4 years after the
  crisis)
• -trade off between fiscal costs and output loss

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Whats Next?

• Were heading for sharp growth slowdown
  (recession)
• Some countries are already in recession (-1
  or -2) and others will be lucky to get away with
  0 growth
• Banking crisis will make this slowdown worse
• (confidence, wealth effects credit crunch)
• But a mild recession is not the same thing as a
  full blown financial crisis or a depression (are
  we heading for a lost decade (Japan) or the US in
  the 1930s?)

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Can policy make a difference? (1)

• Short run
• -government should step in with liquidity
  support, capital and restore confidence (so yes,
  hurrah for Gordon Brown)
• -macro fiscal policy is back (monetary
  policy does not really bite now)
• But these are just policies to bring the fire
  under control

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Can policy make a difference? (2)

• Long run (sometimes economists do agree!)
• Future supervision should be improved
  (1) start of a European/maybe worldwide bank
  supervisor, (2) end of universal banking, (3)
  cope with moral hazard issues, (4) end of
  market-based (fair value!) accounting, (5) limit
  the use of derivatives
• But crises will happen again (but good policies
  reduce the probability of a future crisis in the
  financial sector)

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Can policy make a difference? (3)

• Medium run (3-5 years)
• -Backlash against private banking/international
  capital flows/globalisation in general
• -But benefits (international) private capital
  flows still outweigh the costs
• -Wheres plan B? When to de-nationalize banks
  again?
• -The Big Challenge for policy balance between
  private and public risk (concern too little
  private risk moral hazard)

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My own prediction

• Two scenarios
• -Sweden (sharp but not very long recession,
  clean up of the banking sector)
• -Japan (muddling through, zero growth for a
  decade or so, no real restructuring banking
  sector)
• Ask again after November 4th! (I think and hope
  the Sweden option is possible)

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More (daily) information..

• See for instance these 3 economists and their
  daily views on the unfolding crisis
• -Nouriel Roubini (Dr. Doom http//www.rgemonitor
  .com)
• -Paul Krugman (his blog at www.nytimes.com)
• -Willem Buiter at FT (http//blogs.ft.com/maverec
  on)
• Latest growth predictions and link to data set
  on crises
• -IMF, World Economic Outlook, October 2008 (ch.
  1 4)
• -Luc Laeven and Fabian Valencia, Systemic
  Banking Crises A New Database IMF WP, 08/224,
  Oct. 2008.

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This lecture series continues..

• Next lectures Jaap van Manen, Robert Lensink