Financial Crises, Regulatory Failure and the policy response Ray Barrell

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Financial Crises, Regulatory Failure and the
policy response Ray Barrell
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Regulation and the financial crisis

• Low real interest rates stimulated borrowing and
  financial innovation
• Long rates were low because of high saving
  especially by Asian economies
• Short rates were held low in the US
• New features of the market were not stress tested
  for downturns
• New asset backed securities hid risk rather than
  shared or reduced it
• Reliance on wholesale markets was unwise

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Real interest rates
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Personal Sector Borrowing
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Real house prices
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US problems

• Losses of in the US perhaps 1.4 trillion
• Sold on as asset backed securities
• Over half to European banks
• Sub prime loans may have defaults of over 1
  trillion because of US bankruptcy law
• unwise lending masked by originate and
  distribute model
• Evaluation of securities based on individual not
  group default rates
• Lehman was a US bank

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US bond spreads highest since 1931-33
Baa corporate bonds minus 10-year government
bonds, weekly averages
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Could we predict the crisis

• Traditional crisis prediction models did not pick
  up the risks that were developing
• The build up of debt was worrying
• The house price bubble was a concern
• The regulatory architecture was flawed
• The dangers of securitisation were not seen
• None of these were under the control of the
  monetary authorities
• A crisis means credit rationing
• (Barrell et al 2006 Journal of Financial
  Stability)

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The costs of the crisis

• The crisis has exposed deficiencies in risk
  management and prudential regulation
• relied too heavily on mechanical models.
• aggravated private and economic losses
• Fiscal costs at first limited, and so far no more
  than 3 of GDP, well below average
• The capital base of the US and European banking
  systems is 10 of GDP
• The average fiscal cost of crisis is 10 of GDP
• The most recent crisis was preventable (by
  nationalising Lehman) and prior to that was a
  scenario and not part of a central forecast

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What is to be done - US and UK

• Recapitalisation of the banking system needs to
  be more systematic
• Mark to market losses on corporate bonds are 40
  percent of losses
• They may be temporary and could be taken into a
  bad asset bank
• Monetary policy can do very little
• Fiscal policy can help as there are more
  liquidity constrained consumers
• Debt worries are not wise

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What has to be done in Europe

• Fiscal policy coordination will take place at a
  council of EMU finance ministers
• Open economies gain most from coordination
• Germany has the least to gain and the most to
  give in a coordinated package
• Bargaining will be within the group
• Redesigning the fiscal architecture will take
  place mainly in the same body
• The missing pillar will be rebuilt in a council
  of EMU finance ministers

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A new financial architecture

• Changes in liquidity and capital adequacy rules
  suggested by the BIS will put strong constraints
  on global banking
• EMU countries will have to consider joint macro
  prudential regulation
• The Single Market in Financial Services will
  probably have to be rolled back
• Negotiations on fiscal policy may be coordinated
  with macro prudential discussion
• The UK may stand outside the redesign and the
  institutions it creates