Asia Financial/Currency Crisis: 1997 - 1998

1. Asia Financial/Currency Crisis: 1997 - 1998 • Hot money – capital flight • Vicious circles  Debt burdens  Bankruptcies  Depression • Asset price collapse • Currency depreciation • Lender of last resort • Conditionality: Tight money/austerity • Unorthodox policy • Exchange controls (?)

2. Financial Crises: East Asia 1997-1998 Financial liberalization in the early 1990s: Lending boom/weak supervision/lack of expertise. Banks accumulated losses/net worth declined. Uncertainty increased stock market declines and failure of prominent firms Domestic currencies devaluated (1997). Rise in actual and expected inflation.

3. Subprime-Triggered Financial Crisis of 2007 - 2009 Financial innovations in mortgage markets: Subprime and Alt-A mortgages Mortgage-backed securities Collateralized debt obligations (CDOs) Housing price bubble forms World savings glut Increase in liquidity from cash flows surging to the US Subprime mortgage market  housing demand and prices up. Agency problems arise “Originate to distribute”  principal (investor) agent (mortgage broker) problem. Commercial and investment banks/rating agencies …weak incentives to assess quality of securities Information problems surface… A “Minsky Moment” Housing price bubble bursts/Crisis spreads globally http://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

4. A “Global Saving Glut” The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

5. The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

6. Vicious Spirals Unleashed Demand – Jobs – Wages – Income – Spiral House Price – Foreclosure Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks

7. Financial Crisis of 2007 - 2009 (cont’d) Banks’ balance sheets deteriorate Write downs Sale of assets and credit restriction High-profile firms fail Bear Stearns (March 2008) Fannie Mae and Freddie Mac (July 2008) Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008). Fed pumps up bank reserves: TARP/TALF,etc. Lend and lend freely Bailout package enacted House votes down the $700 billion bailout package (9/29/08)  Stock market slumps  Bailout passes on October 3. Congress approves a $787 billion economic stimulus plan on February 13, 2009. Recession deepens

8. ResponsesLender of Last Resort / Spender of Last Resort • Tax Rebate $124 bil. • Fed Fund Rate Cuts • Fannie/Freddie $200 bil. • Bear-Stearns $29 bil. • AIG $174 bil. Fed “Facilities” • Primary Dealer Credit Facility (PDCF) $58 bil. • Treasury Security Loan Facility (TSLF) $133 bil. • Term Auction Facility (TAF) $416 bil. • Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. • Money Market Investor Funding Facility (MMIFF) $540 bil. • More Fed Fund Rate Cuts … Hold At ~0% • Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. • Term Asset-Backed Securities Loan Facility (TALF) $200 bil. • Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity • Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act • TARP II • Stress Tests

9. Vicious Spirals Reversed? Tackle them all together! Vicious Spirals Unleashed Refinance Mortgages • Stimulus • Program • Infrastructure • Spending • Tax Cuts Demand – Jobs – Wages – Income – Spiral House Price – Foreclosure Spiral Deleveraging – Debt Deflation Spiral • Revive dual banking system • Cash for Trash • Recapitalize banks • Revive securitization Government Revenue – Cutback Spiral Federal Aid To States Global Repercussion Spiral • G – 20 • Coordinated Stimulus Macroeconomic Linkages and Feedbacks Macroeconomic Linkages and Feedbacks

10. December, 2008) 8% 6% 10% 37% 12% 16% 31% 10% 13% 31% 7% 3% 7% 9% http://www2.fdic.gov/sdi/main.asp

12. Off Balance Sheet Assets/Activities Structured investment vehicles (SIVs) Loan sales Fees for Foreign exchange trades for customers Servicing mortgage backed security Backup lines of credit/overdraft privileges Standby lines of credit guaranteeing securities/commercial paper Trading activities  Principal – agent problem Bond markets Foreign exchange markets Financial derivatives

13. Shadow Banking System • Financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. • Finance companies • Asset backed commercial paper (ABCP) conduits • Limited purpose finance companies • Structured investment vehicles (SIVs) • Credit hedge funds • Money market mutual funds (MMMFs) • Securities lenders • Government sponsored enterprises (GSEs) • Interconnections with each other and traditional banking system • ABCP • Asset backed securities • Collateralized debt obligations (CDOs) • Repurchase agreements • Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks. http://www.ny.frb.org/research/staff_reports/sr458.pdf

14. Possible Reforms • Increase/tighten capital requirements • Trade derivatives only on public exchanges tranparency • “Mark – to – funding” accounting • Value assets relative to date their funding must be repaid • Rapid “resolution” of TBTF institutions • Make bankruptcy credible • Put creditors at risk  eliminate moral hazard of TBTF

16. McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching • Interstate Banking and Branching Efficiency Act (1994) deregulates branching • Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals • Glass-Steagall

17. Regulating Finance: Regulation and Its Discontents • Lots of bases to cover Cover one by regulation or deregulation  Unintended Consequences • Reactions to regulatory policies  frustrate regulator intent Regulate bank balance sheets  off-balance sheet activities Emplace a safety net  bankers become skydivers • Regulation spreads to cover innovations  complexity  ineffectiveness Win by gaming the system

18. Primary Supervisory Responsibility of Bank Regulatory Agencies • Comptroller of the Currency—national banks chartered by Federal government since 1863 • Federal Reserve and state banking authorities—state banks that are members of the Federal Reserve System • Fed also regulates bank holding companies • FDIC—insured state banks that are not Fed members • State banking authorities—state banks without FDIC insurance

19. Innovations: Response to Interest Rate Volatility • Adjustable-rate mortgages • Financial Derivatives Innovations: Response to Information Technology • Bank credit and debit cards • Electronic banking • ATM/Home banking/ABM/Virtual banking • Junk bonds • Commercial paper market … backed by banks • Securitization Innovations:Avoiding Regulation/Loophole Mining • Sweep accounts … reserve requirements • Money Market Mutual Funds … Regulation Q

20. Decline of Traditional Banking • Decline in cost advantages in acquiring funds (liabilities) • Rising inflation  rise in interest rates and disintermediation • Low-cost source of funds, checkable deposits, declined in importance • Decline in income advantages on uses of funds (assets) • Information technology  less need for banks to finance short-term credit • and issue loans • IT  lower transaction costs for other financial institutions • Bank Responses: • Riskier Lending … Commercial real estate, leveraged buyouts, takeovers • Off balance sheet activities

21. Size Distribution of Insured Commercial Banks, September 30, 2008 ???? 3,046 4,039 486 86 7,640 39.9 52.9 6.1 1.1 1.3 9.7 10.0 79.0

22. Bank Consolidation Interstate Banking and Branching Efficiency Act, 1994 • Skirting branch restrictions • ATMs, Bank Holding Cos. • Skirting branch restrictions • ATMs, Bank Holding Cos.  Geographic deregulation • Pre-Crisis Findings: • Net interest margin up • ROA, ROE up for big • banks • Intrastate deregulation • more positive for all but • big banks • Interstate deregulation • helps big banks most • Non-performing loans • down for biggest banks • but up for smaller banks • State of economy has • stronger impact on bank • performance than • branching deregulation • Benefits of bank consolidation • Increased competition  close inefficient banks • Efficiencies from economies of scale and scope • Lower chance of failure -- diversified portfolios • Costs • Fewer community banks  less lending to small business • Banks in new areas  increased risks/failures

23. The U.S. regulatory regime: In need of reform? Sources: Financial Services Roundtable (2007), Milken Institute.

24. Asymmetric Information and Bank Regulation Government safety net • Deposit insurance and FDIC • Short circuits bank failures and contagion effect • Payoff method • Purchase and assumption method • Fed as lender of last resort: Too BIG to Fail • Financial consolidation Exacerbates Too Big to Fail • Safety net extended to non-bank financial institutions Safety Net  Moral Hazard Problems • Depositors don’t impose discipline of marketplace • Banks have an incentive to take on greater risk Safety Net Adverse Selection Problems • Risk-lovers find banking attractive • Depositors have little reason to monitor bank

25. Attempted solutions: Constrain banks from taking too much risk • Promote diversification • Prohibit holdings of common stock • Set capital requirements … Capital as cushion • Minimum leverage ratio • Basel Accord: risk-based capital requirements … but there’s regulatory arbitrage Prompt corrective action: Close ‘em down when capital inadequate • Monitor … CAMELS • Capital adequacy • Asset quality • Management • Earnings • Liquidity • Sensitivity to market risk • Disclosure requirements … mark-to-market issue • Restrictions on competition … make banking boring

26. http://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdfhttp://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdf

28. Failed Banks Update Year Number • 2000 2 • 2001 4 • 2002 11 • 2003 3 • 2004 4 • 2005/2006 0 • 2007 3 • 2008 QI+Q2 4 • 2008 Q3 10 • 2008 Q4 12 • 2009 Q1 21 • 2009 Q2 24 • 2009 Q3 50