Lessons from Past Financial Crises

1. Lessons from Past Financial Crises Thorvaldur GylfasonJoint Vienna InstituteCourse on Macroeconomic Policies in Times of High Capital MobilityVienna, AustriaMay 16–20, 2011

2. Outline • The Great Crash and its consequences • What is a systemic banking crisis? • Main origins of a crisis • From crisis recognition to crisis management • Theories of financial crises • Policy responses in financial crises • Banks and incentives • Twelve lessons from recent crisis

3. The great crash and its consequences 1 • 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

4. Stabilization worked, or what? Change in Canada’s per capita GDP from year to year 1871-2003 (%) How about the U.S. next door? Canada had no major bank failures during Great Depression, and did not establish its Deposit Insurance Corporation until 1967 Source: Maddison (2003).

5. 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, 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

6. Stabilization worked, or what? Change in US per capita GDP from year to year 1871-2003 (%) Perhaps bank regulation during Great Depression also helped stabilize GDP Roosevelt-era firewalls between commercial banking and investment banking (Glass-Steagall Act 1933) Source: Maddison (2003).

7. 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 1960s 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%

8. Stabilization worked, or what? Change in UK per capita GDP from year to year 1871-2003 (%) Perhaps bank regulation during Great Depression also helped stabilize GDP Not quite as clear, but standard deviation of per capita growth fell from 3.1% 1831-1945 to 1.8% 1947-2003 Source: Maddison (2003).

9. Stabilization worked, or what? Change in French per capita GDP from year to year 1821-2003 (%) Perhaps bank regulation during Great Depression also helped stabilize GDP Source: Maddison (2003).

10. Stabilization worked, or what? Change in German per capita GDP from year to year 1851-2003 (%) Stefan Zweig (1942) Die Welt von Gestern Perhaps bank regulation during Great Depression also helped stabilize GDP Source: Maddison (2003).

11. Stabilization worked, or what? Change in Swedish per capita GDP from year to year 1821-2003 (%) Perhaps bank regulation during Great Depression also helped stabilize GDP Source: Maddison (2003).

12. What is a systemic banking crisis? 2 • The emergence of systemic banking crises has been associated with the liberalization of financial systems worldwide • However, since the mid- to late 1990s 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

13. 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 What is a systemic banking crisis?

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

15. Examples of Severe Impact on Real gdp Growth In billions of local currency Finland Indonesia Source: IMF.

16. Examples of Severe Impact on Real gdp Growth In billions of local currency Sweden Thailand Source: IMF.

17. Examples of Severe Impact on Real gdp Growth In billions of local currency Ecuador Source: IMF.

18. Examples of milder Impact on Real gdp Growth In billions of local currency Korea Norway Source: IMF.

19. 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) Common exposure of financial sector to certain risks (endogenous cycle view) Main origins of a crisis 3

20. 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)

21. 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)

22. 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!) • Profits go up • Generalized state of euphoria • Boom in asset prices and markets • 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 Endogenous or self-feeding cycle Procyclical behavior (amplification)

23. 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 Main origins of a crisis: the triggers

24. From crisis recognition to crisis management 4 • 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

25. Fiscal Costs of Systemic Crises(% of GDP)

26. 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

27. Fiscal Costs of bank restructuring: indonesia

28. 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 (+/-)

29. Size of rescue packages in current crisis Source: BIS (2009).

30. Final word about crisis management • Need for political leadership and coordination • Managing a financial crisis • Is a macro-undertaking with lots of micro-decisions • 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

31. Theories of financial crises 5 • 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 (2008) by Cooper • This Time Is Different (2009) by Rogoff and Reinhart

32. 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

33. Iceland: Current account 1989-2008 (% of GDP) Pepper, salt, or gold, anyone? Mid-2008 • Beyond our means, yes, big time: • Investment (housing, hydro-projects) • Consumption (jeeps, jets, Elton John) End 2008

34. Leverage and financial crises • Many crises are characterized by over-leveraging • Increases vulnerability of debtors to external changes • I.e., risk aversion, interest rate/exchange rate changes • Usually, crises involve debt repayment difficulties for government, households, or corporate sector • Debt 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

35. Iceland: External debt 1989-2008 (% of GDP) Net External Debt (% of GDP)* End 2008 Mid-2008 *Excluding risk capital

36. Iceland: External debt 1989-2008 (% of GDP) International Investment Position (% of GDP)* End 2008 Mid-2008 *Including risk capital

37. Iceland: Ratio of Bank assets to GDP 2007 (end of year) Barclays: 100% of Britain’s GDP Deutsche Bank: 80% of Germany’s GDP • Source: Union Bank of Switzerland

38. Iceland: Ratio of Bank assets to GDP 1992-2007 Mid-2008

39. Iceland: Central bank foreign exchange reserves 1989-2008 End 2008 Three-month Rule Mid-2008

40. Iceland: Central bank foreign exchange reserves 1989-2008 Giudotti-Greenspan Rule Mid-2008 End 2008

41. Asia: Ratio of short-term liabilities to foreign reserves 1997 Guidotti-Greenspanrule

42. Inequality and crises • Increased inequality in distribution of US income and wealth during roaring 1920s • 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

43. Iceland: Gini index of inequality 1993-2008 (disposable income) Shift of tax burden from the rich to the rest Source: Internal Revenue Directorate.

44. Policy responses in financial crises 6 • 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?

45. 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?

46. 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

47. 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

48. 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

49. 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 and regulations against short selling

50. Large reversals of capital flows