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The Financial Crisis: Lessons for Developing and Emerging Market Countries


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Title: The Financial Crisis: Lessons for Developing and Emerging Market Countries

The Financial Crisis Lessons for Developing and
Emerging Market Countries
Ugo Panizza
  • Was it a surprise?
  • The role of financial innovation
  • 7 lessons for financial regulation

The roots of the crisis
  • "I think this economy is down because we built
    too many houses"
  • What really went wrong
  • Weak regulatory regime
  • J. Stiglitz said this is the not surprising
    consequence of appointing as regulators people
    who don't believe in regulation.

A Crisis Foretold
  • If each crisis is different from the previous one
    we risk of fighting the last crisis
  • But are they different?

Was it a surprise?
  • Certainly some new elements
  • Originate and distribute model
  • Financial derivatives
  • Shadow banking system
  • But the basic mechanism is always the same
    (described by Kindleberger and Minsky)

Was it a surprise?
  • A positive shock leads to high growth, low
    volatility, and low risk aversion
  • This leads to an increase in leverage which
    further boosts asset prices and leads to even
    more risk taking
  • People start thinking that asset prices can only
    go up
  • People who say that the situation cannot continue
    forever are made fun of and marginalized
  • The standard answer is "This time is different"
  • If they are in the financial sector they lose
    their jobs
  • The trend is your friend

Was it a surprise?
  • Of course things are never different
  • Each time the instrument is different (Tulips,
    Inexistent countries, Railways, Internet stocks,
  • Nobody knows what will come next (for sure not
    subprime mortgages)
  • But the mechanism will be the same

Was it a surprise?
  • Research by Claudio Borio of the BIS shows that
    two or three variables (credit growth, stock
    prices growth and housing prices growth) can
    predict financial crises 2-4 years in advance
    with considerable precision
  • (not the exact time of course)
  • A few people (Robert Shiller, Nouriel Roubini)
    and institutions (UN, BIS) were screaming, but
    nobody listened to them

Was it a surprise?
  • Policymakers did not do anything because the
    operated under the assumption that markets know
  • I made a mistake in presuming that the
    self-interest of organizations, specifically
    banks and others, were such is that they were
    best capable of protecting their own shareholders
    and their equity in the firms. It shocked me. I
    still do not fuIly understand why it happened
  • They also thought that cleaning up the mess was
    easy and cheap

Was it a surprise?
  • Academic economists where seduced by policymakers
  • we were in sync with policymakers lured by
    ideological notions derived from Ayn Rand novels
    rather than economic theory. And we let their...
    rhetoric set the agenda for our thinking and
    for our policy advice. Acemoglu (2008)
  • Incentives also matter, both in business schools
    and econ departments (Eichengreen, 2008)

Was it a surprise?
  • So, it should not have been a surprise
  • Ideology
  • Incentives

  • Was it a surprise?
  • The role of financial innovation
  • 7 lessons for financial regulation

The role of financial innovation in the subprime
  • How did NINJAs get all these loans?
  • In the old system, bankers carefully evaluated
    loan applicants and used a lot of soft
  • With securitization, bankers can sell the loans
    and care less and less about creditworthiness,
    soft information became irrelevant
  • (This is both good and bad less racial bias but
    also less information)
  • But why would anybody buy bad loans?
  • Some people thought that financial innovation
    could do the trick (especially the 'pooling' and
    'tranching' of CDOs)
  • However, even these sophisticated instruments
    were only sustained by excessive optimism

Crazy assumptions
  • FPA What are the key drivers of your rating
  • Fitch "FICO scores and home price appreciation
    of low single digit or mid single digit"
  • FPA What if home price appreciation was flat
    for an extended period of time?
  • Fitch "Our model would start to break down."
  • FPA What if home price appreciation were to
    decline 1 to 2 for an extended period of time?
  • Fitch "The models would break down completely."
  • FPA With 2 depreciation, how far up the
    ratings scale would it harm?
  • Fitch "It might go as high as the AA or AAA
  • Conference call between First Pacific Advisor
    (FPA) and Fitch Rating (Coval, Jurek and
    Stafford, 2008)

Crazy assumptions
But at least the banks were safe
  • Not really because they went back in the game
    with lightly regulates SIV
  • (more on regulatory arbitrage later)

Who was right?
  • There is growing recognition that the dispersion
    of credit risk by banks to a broader and more
    diverse group of investors has helped make the
    banking and overall financial system more
    resilient commercial banks may be less
    vulnerable today to credit or economic shocks
  • IMF Global Financial Stability Report, Spring
  • Assuming that the big banks have managed to
    distribute more widely the risks inherent in the
    loans they have made, who now holds these risks,
    and can they manage them adequately? The honest
    answer is that we do not know.
  • BIS 77th Annual Report, June 2007

The lighter side of the story
  • PG13
  • It contains strong language

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  • Was it a surprise?
  • The role of financial innovation
  • 7 lessons for financial regulation

1 Focus on the Right Definition of Financial
  • Information arbitrage efficiency
  • In a market that is efficient according to this
    definition, prices reflect all available
    information and, without insider information, it
    is impossible to earn return that constantly beat
    the market.
  • In technical parlance, in an informational
    efficient market the best asset pricing model is
    a random walk.
  • Fundamental valuation efficiency
  • The price of a financial asset is completely
    determined by the present value of the future
    stream of payments generated by that asset.
  • Full insurance efficiency
  • According to this definition, a market is
    efficient if agents can buy and sell insurance
    contracts covering all possible states of nature
  • Often referred to as Arrow-Debreu contracts

1 Focus on the Right Definition of Financial
  • Transactional efficiency
  • It refers to the market's ability to process a
    large number of transactions at a low cost.
  • Functional efficiency
  • It relates to the value added of the financial
    industry from society's point of view (it could
    thus also be called social efficiency).

1 Focus on the Right Definition of Financial
  • Functional efficiency essentially boils down to
    two things consumption smoothing and economic
  • From the point of view of a regulator, social
    efficiency should be the only relevant definition
    of efficiency
  • Several financial products can yield large
    private returns but have no social return

Large Private Returns, But Where Are the Social
  • In 1983, the US financial sector generated 5 per
    cent of the nation's GDP and accounted for 7.5
    per cent of total corporate profits.
  • In 2006, the US financial sector generated 8
    percent of GDP and accounted for 40 per cent of
    total corporate profits.
  • In the meantime, the US financial sector had to
    be bailed out 3 times in three decades
  • Tobin (1984) There must be something wrong with
    an incentive structure which leads the brightest
    and most talented graduates to engage in
    financial activities remote from the production
    of goods and services
  • Rodrik (2008) What are some of the ways in which
    financial innovation has made our lives
    measurably and unambiguously better

1 Focus on the Right Definition of Financial
  • Key objective of regulatory reform
  • Do not stunt financial innovation but weed out
    financial instruments which increase risk but
    have no social return
  • Litan (2009)
  • Avoid regulatory cycles
  • Learn from near misses

2 Market-Based Regulation Does Not Always Work
  • There are flaws with the assumption that markets
    know best and regulators should not try to second
    guess them
  • Regulation is necessary because markets sometimes
    do not work.
  • How can one avoid market failures by using the
    same evaluation instruments used by market
  • Market-based risk indicators (such as high-yield
    spreads or implicit volatility) tend to be low at
    the peak of the credit cycle, exactly when risk
    is high

3 Avoid Regulatory Arbitrage
  • Deposit-taking banks are special because the main
    source of their success --the provision of
    liquidity-- is also their main weakness.
  • The stereotypical bank collects demand deposit
    and grants illiquid loans
  • This maturity transformation process allows to
    direct vast resources towards potentially
    productive investment projects
  • However, this is also a source of fragility
  • Banks are subject to crises of confidence and
    self-fulfilling runs (DD)

3 Avoid Regulatory Arbitrage
  • Given the importance of the banking system, few
    policymakers are willing to tolerate the
    possibility of a self-fulfilling run
  • Especially because there is a simple method to
    prevent such runs.
  • A lender of last resort with a deposit insurance
  • Like all insurance schemes, deposit insurance and
    the presence of a lender of last resort may lead
    the insured bank to take too much risk

3 Avoid Regulatory Arbitrage
  • This is the classic moral hazard problem, which
    is also the main justification for regulating
  • Normally, banks take more risk by reducing
    capital ratios and thus increasing leverage.
  • As a consequence, modern prudential regulation
    revolves around the risk-adjusted capital
    requirements established in the Basel I and Basel
    II Accords

3 Avoid Regulatory Arbitrage
But regulation needs to be comprehensive!
4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • Bank regulation tends to be micro-prudential and
    concentrates on the behaviour of individual
  • This assumes that policies aimed at guaranteeing
    the soundness of individual banks can also
    guarantee the soundness of the whole banking
  • This is a fallacy of composition because actions
    that are good and prudent for individual
    institutions may have negative systemic
  • Problems with mark-to-market accounting
  • Problems with ratings

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • Consider the case of a bank that suffers large
    losses on some of its loans
  • The prudent choice for this bank is to reduce its
    lending activities and cut its assets to a level
    which is in line with its smaller capital base.
  • If the bank in question is large, the banks
    attempt to rebuild its capital base will
    translate into a massive drainage of liquidity
    from the system.
  • Such drainage of liquidity will be amplified by
    the fact that banks lend to each other in the
    interbank market.
  • Less lending by some banks will translate into
    less funding to other banks

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • As a consequence, a bank's attempt to do what is
    prudent from its own point of view (i.e., to
    maintain an adequate capital ratio) may end up
    causing problems to other banks and have negative
    systemic implications
  • (this is the "interconnection" or "credit crunch"
  • In fact, banks with problems may even have an
    incentive to make the crisis systemic, because a
    large crisis will increase the probability of a
  • (this is the "bailout externality").

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • Another channel through which the current
    regulatory system may have negative systemic
    implication relates to "mark-to-market"
  • Consider again the example of a large bank that
    realizes losses and needs to reduce its risk
  • This bank will sell some of its assets and may
    thus depress the price of these assets.
  • This will lead to "mark-to-market" losses for
    banks that hold the same type of assets.
  • If these losses are large enough to make capital
    requirements binding, banks will need to reduce
    their exposure and amplify the deleveraging
  • (this is the "fire sale" externality).
  • The opposite process happens in boom periods and
    it is one of the main sources of leverage cycles.

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • By thinking in this way, one realizes that some
    of the assumptions at the basis of the Basel
    Accords do not make much sense.
  • The risk weighted capital ratios of the Basel
    Accords impose high capital charges on high-risk
    assets and low capital charges on low-risk
  • From a systemic point of view this is problematic
    for at least two reasons.

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • First, it is likely that during good times some
    assets will be deemed to be less risky than what
    they actually are and during bad times the same
    assets might be considered more risky than what
    they actually are.
  • This amplifies the leverage cycle because it
    leads to a required capital ratio which is too
    low in good times and too high in bad times.

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • Second, relatively safe assets may be those with
    the highest systemic risk.
  • If there is continuous of debt securities, going
    from super-safe assets (e.g., AAA German bunds)
    to high-risk junk bonds, and there is a sudden
    downgrade in ratings linked to a systemic crisis,
    which assets are more likely to be downgraded?
  • Not the super safe (because of flight to quality)
    and not the very high risk (because they cannot
    be downgraded by much).
  • The assets that are most likely to be downgraded
    are those on the safe side of the spectrum, but
    not super-safe (AAA-rated tranches of CDOs come
    to mind).
  • But these are exactly the assets that had low
    regulatory capital during the boom period and,
    because of the downgrade, will need a much higher
    regulatory capital in the crisis period.

4 Guaranteeing the Safety of Individual Banks Is
Not Enough
  • Macroprudential regulation needs to complement
    microprudential regulation
  • It can work like a system of automatic
    stabilizers which is also good for political
    economy reasons

5 International Cooperation
  • Data sharing
  • We don not have sufficient data on cross-border
    exposure among banks and derivative products
  • We need to develop a system for evaluating
    cross-border systemic risk
  • It is necessary to agree on regulatory
    responsibility for banks and other financial
    institutions with an international presence
  • Avoid races to the bottom
  • But no common regulatory system
  • Increase the participation of developing
    countries in standard-setting bodies and agencies
    in charge of guaranteeing international financial

6 Adjust Incentives in The Financial Industry
  • Pay structure
  • Seeking alpha
  • How do you measure alpha?
  • You can't year over year, people have incentives
    to hide risk taking and claim it's alpha
  • Credit rating agencies
  • How do you create incentives for truthful rating
    in a world where the rated pay the raters?

7 Lessons for Developing Countries
  • Protect yourself
  • Avoid appreciations
  • Accumulate reserves
  • But they are never enough
  • Avoid currency and maturity mismatches
  • Remember that it may be true that a fully open
    capital account can deliver the goods with a
    well-regulated financial system
  • But who has a well-regulated financial system?

1 The role of state-owned banks
  • Two views
  • The scarcity of capital was such that no banking
    system could conceivably succeed in attracting
    funds. . .Supply of capital for the needs of
    industrialization required the compulsory
    machinery of the government
  • Gerschenkron (1962)
  • Whatever its original objectives, state ownership
    tends to stunt financial sector development,
    thereby contributing to slower growth
  • The World Bank (2001)

1 The role of state-owned banks
  • What do the data say?
  • The World Bank is right
  • La Porta, Lopez de Silanes, and Shleifer (2002)
  • It is impossible to say about growth and
    financial development
  • Levy Yeyati, Micco, and Panizza (2006) Rodrik
  • But public banks can help stabilizing the economy
    during periods of crisis
  • Micco and Panizza (2006)
  • ..and increase the efficiency of the banking
    system in low income countries
  • Detragiache, Tressel, and Gupta (2008)
  • Gerschenkron might be right, after all

1 The role of state-owned banks
  • Governance is key
  • Some countries have excellent state-owned banks
  • Some countries have bad state-owned banks
  • Some have both types
  • A clear objective function is also necessary to
    avoid Sisyphus's syndrome
  • But remember, in bad times all banks are

The Financial Crisis Lessons for Developing and
Emerging Market Countries
Ugo Panizza