Laurenti, Adolfo Sept 29 11

Failure Before the Eruption of Financial Crises: How Could They Have Been Avoided?

A Practice in Search of a Theory

September 29, 2011

Adolfo L. Laurenti Deputy Chief Economist

Overview  A crisis – what crisis, and for whom?  From imbalances to crisis: an analytical outline  Imbalances  Triggers  Propagation  Prevention: a practice in search of a theory  Concerns

Adolfo L. Laurenti, September 2011

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A crisis – what crisis, and for whom?  "A financial crisis is a non-linear disruption to financial markets in which adverse selection (ex-ante) and moral hazard (ex-post) problems are exacerbated so that financial markets are unable to efficiently channel funds to the most productive investment opportunities.“ Mishkin (NBER 1996)

 Systemic nature of financial crises

 Systemic risk: what is emergency to some (i.e. markets) should be StandardOperating-Procedure to somebody else (i.e. governments and regulators)

Adolfo L. Laurenti, September 2011

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From imbalances to crisis: an analytical outline

Imbalances

Triggers

Propagation Mechanism(s)

Adolfo L. Laurenti, September 2011

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Imbalances Exchange Rate

Domestic Debt

crisis

Banking Taxonomy from Reinhart & Rogoff Adolfo L. Laurenti, September 2011

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External Debt

Triggers  Sachs (1995) – exogenous shocks – policy shocks – exhaustion of borrowing limits – self-fulfilling panic

 Mishkin (1996) – increase in interest rates – increase in uncertainty and risk premia – asset markets effects on balance sheets

– bank panics and bank runs

Adolfo L. Laurenti, September 2011

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Propagation  It depends on specific institutional framework  Potentially limitless  It goes from obvious linkages to the arcane: – bank lending – inter-bank funding – money markets – commercial paper – securitized products

 Flight to safety  Absolute preference for cash, safe currencies, “real” collateral

Adolfo L. Laurenti, September 2011

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Prevention: a practice in search of a theory (I)  In theory, a holistic approach makes most sense

 Authorities have instruments to intervene at each level: imbalances, triggers, and propagation mechanisms – early warning – circuit breaker – "quarantine"

 ex-ante – macro-prudential regulation

– Glass-Steagall & Volcker rule – ring-fencing (Vickers' Commission) – risk-based capital requirements (Basel I-III) – centralized clearing & settlement for financial derivatives & complex products

 ex-post – lender of last resort ["lending freely at penalty rates to solvent institutions“] – "buyers of last resort" – Bailout and/or resolution powers Adolfo L. Laurenti, September 2011

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Prevention: a practice in search of a theory (II)  In practice, idiosyncratic nature of shocks and transmission resulted in extensive ad-hoc measures undertaken by U.S. authorities during the most recent financial crisis  By the Federal Reserve – New rules for the Discount Window – Maiden Lane – New lending facilities – New swap lines with foreign central banks – Expansion of the balance sheet

 By the Federal Government – TARP – FDIC

– Ad-hoc measures re: Bear Stearns, the auto sector, Fannie and Freddie

 On net, actions range from “outstanding” (e.g. CPFF - commercial paper) to “awful” (e.g. Maiden Lane)

Adolfo L. Laurenti, September 2011

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Concerns  We are learning a lot; lack of any systematic approach to crisis management is becoming less and less justifiable  Fractured nature of U.S. regulatory landscape is becoming an impediment to a more comprehensive policy on systematic risk  Government and regulators should be part of the solution, not of the problem – Some evidence that the opposite is true (Cochrane on TARP, Zingales on “Too Big To Fail”)

 Ad hoc intervention: trade-off between flexibility and creativity on the one side, and uncertainty on the other At a time of extreme market uncertainty, the rule of law anchors expectations and provides guidance to market participants

 Non-systemic obligations should bear risk of losses  New institutional and regulatory framework should be built around the principle of “robust” regime vs. first-best regime

Adolfo L. Laurenti, September 2011

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“Robust Institutions” “Good” Outcomes  “Worst-Case Philosophy” in constitutional political economy (J. Buchanan) Regime A

Regime B

 As circumstances depart from an ideal set of assumptions at C*, the outcome of regulatory regimes A and B becomes less and less favorable  In case of elevated tail risk, regulatory regime B is more “robust” than regime A, even if under ideal conditions regime A would be first-best

 “Robust” design should be implemented at every level: players, rules of the game, financial instruments, regulatory agencies C*

Adolfo L. Laurenti, September 2011

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Regulatory Design

Investment Management

Global Markets

Insurance Services

Consulting

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