The international

financial crisis and the

way forwardCarmine Di Noia

66th EP/US Congress Interparliamentary Meeting

Transatlantic Legislators’ Dialogue

Prague

April 18, 2009

Index

Macro or Micro Financial Crisis?

Financial Regulation and Regulatory architecture

Supervision by Objective

Fixing management incentives

Macroeconomic causes

Global imbalances

Stock market bubble

House bubble

0

200

400

600

800

1000

1200

1400

1600

1800

1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008

0

50

100

150

200

250Real S&P 500 Composite Stock Price Index (left scale) Real Home Price Index (right scale, 1900 = 100)

Annual data. For stock price index value for 2008 as of December. Data sources: own calculations based on Shiller 2009.

Stock Price and Home Price Indexes in the United States, 1900-2008

0

5

10

15

20

25

30

35

40

45

1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Real S&P 500 price earnings ratio (10-yrs moving average, left scale) House price/rent ratio (1970-2008, right scale)

Data sources: own calculations based on Shiller 2009 for price earnings and on Gros 2009 for price rent ratio.

Price Earnings and Price Rent ratios in the United States, 1900-2008

US $ REER

80

100

120

82.7

118.6

91.4

-

-

-

US balance of payments, official reserves and real effective exchange rate (REER), 1996-2008

Notes: Net capital inflow calculated as residual. For real effective exchange rate, 100 = average of sample period.Data sources: Bureau of Economic Analysis 2009 for current account and GDP; IMF 2009 for official foreign exchange reserves and real effective exchange rate.

A microeconomic cause: excessive leverage

Large financial institutions over-leveraged

Excessive leverage especially for European banks and US investment banks (leverage ratio for US bank holding companies)

G-20, FSF: introduction of a simple, non-risk based leverage ratio to supplement risk-based capital requirements

Institution Total assets/equity Deposits and short-termfunding/total assets (%)

ABN Amro 33 78

Bank of America 12 73

Barclays 38 71

Bear Stearns 34 13

BNP Paribas 29 79

Citigroup 19 66

Credit Suisse 24 55

Deutsche Bank 53 80

Goldman Sachs 22 16

HSBC 17 74

JPMorgan Chase 13 68

Lehman Brothers 31 19

Merrill Lynch 32 29

Morgan Stanley 33 30

RBS 21 75

Société Générale 34 70

UBS 52 91

Avg. EU banks 33 75

Avg. US banks(excl. investment banks)

14 69

Avg. US investment banks 30 22

Data source: Bankscope, 2008.

Leverage and short-term liabilities of selected financial institutions, 2007

Regulatory structure

Regulatory structures: sectoral, by objective, functional, integrated, unified

Wave of reforms: trend towards single regulator

Still high degree of cross-country eterogeneity

Different role and involvement of central bank in prudential supervision

Banks Securities Insurance Establishment of integrated or

unified supervisors

(year)

Organisational model

Central bank with primary

responsibility for micro-prudential

supervisionAustralia P/C 1998 By objectives noAustria U U U 2002 Unified yesa

Belgium U U U 2004 Unified noDemark U U U 1988 Unified noFinland BS BS I 1993 Integrated nob

France B B/S I Sectoral/by objective

no

Germany U U U 2002 Unified yesa

Greece CB S I Sectoral yesIreland U(CB) U(CB) U(CB) 2003 Unified yesItaly CB/S CB/S I Sectoral/

by objectiveyes

Japan U U U 2000 Unified noLuxembourg BS BS I 1999 Integrated noNetherlands P(CB)/C 2004 By objective yesPortugal CB CB/S I Sectoral/

by objectiveyes

Spain CB S I Sectoral yesSweden U U U 1991 Unified noUK U U U 1997 Unified noUS CB/B S I Sectoral/by

objective/functional

no

B = One or more authorities specialised in banking oversight. BS = Authority specialised in oversight of the banking sector and securities markets. C = Authority in charge of conduct of business supervision for all sectors. CB = Central bank. I = One or more authorities specialised in oversight of the insurance sector. P = Authority in charge of prudential supervision for all sectors. P (CB) = Central bank in charge of macro- and micro-prudential supervision for all sectors. S = One or more authorities specialised in oversight of securities markets. U = Single authority for all sectors. U (CB) = Unified regulator is an agency of the central bank.a Central bank is entrusted by law to conduct only specific supervisory tasks.b The integrated regulator is an independent agency of the central bank.

Source: Herring & Carmassi (2008).

Regulatory structure of selected industrial countries

New global regulatory structure

Focus on systemic risk and systemically important financial institutions (G-20, FSF, US Treasury)

G-20: IMF and Financial Stability Board in charge of monitoring global systemic risk and safeguarding financial stability (also through Early Warning Exercises)

Proposal: two-levels regulatory system in the US and EU, by objective; IMF and FSB on top of the global regulatory structure

A Global System of Financial Regulation

Federal Reserve

System

US System ofPrudential

Supervision

US System for Investor Protection

Market Stability Regulator (Federal Reserve)

Local branches

Business Conduct

RegulatorLocal

branches

Prudential Financial Regulator

Local branches

Coordination Committee

European System of

Central Banks

European System of Prudential

Supervision

European System for

Investor Protection

European System for

Competition

ECB

European Investor

Protection Authority

European Prudential Regulation Authority

European Antitrust Authority

Coordination Committee

National Central Banks

Prudential SupervisionAuthorities

Investor Protection Authorities

Antitrust Authorities

International Monetary FundFinancial Stability Board

International Monetary FundFinancial Stability Board

US System for

Competition

AntitrustLocal

branches

US Market Stability

Regulator (Federal Reserve Board)

US Business Conduct

Regulator

US Prudential Financial Regulator

US Antitrust Authority

Coordination Committee

Coordination Committee

Fixing management incentives

Distortions in the design of compensation packages

Need to balance competing interests in governance arrangements of financial institutions

Salary structure heavily skewed in favour of the variable component and of short-term returns that were readily cashed in

Fixing management incentives

Absolute limits on pay attractive, but probably not a good solution in the long run: risk of keeping away good management and attracting lower-quality staff

Key issue: how to align compensations with the creation of long-term value for shareholders?

Need of organisational changes: risk management and control to be made fully independent of profit centres and directly accountable to an independent audit committee and, eventually, to the board

Fixing management incentives

G-20, FSF: boards of directors should play an active role in the design, operation, and monitoring of compensation schemes; need to strengthen links between compensation and risk and time horizon; public disclosure of clear, comprehensive, and timely information about compensation