Crisis prevention and resolution: Lessons from this & previous crises

Patrick Honohan

Trinity College Dublin LACEA-LAMES Meetings, Rio de Janeiro

23rd November 2008

Big losses in this crisis are due to long-standing issues (especially incentive effects, moral hazard)

but activated by (banker and regulator) overconfidence in the new formal risk management techniques

Now there’s revulsion:

no confidence in anyone’s risk models; little interbank lending and trading in complex securitiesand belief that counterparties may unknowingly be insolvent

Background

The overconfidence was widely shared

UBSWinner of Euromoney magazine’s “Global Best Risk Management

House” award for excellence in 2005

Northern RockWinner of International Financing Review’s prestigious “Financial

Institution Group Borrower of the Year” award for 2006

Regulators shared the same rose-tinted spectacles – indeed Basel 2 implies that they buy into bank and/or rating agency models

And then…

Interbank and riskfree rates (3-month) (LIBOR-OIS)

Dec 2005-Nov 2008

“Expected policy rate” (OIS) (0.48)

Interbank rate (2.15)

Source: Bloomberg

4.4

Interbank and riskfree rates (3-month) (LIBOR-OIS)

Dec 2005-Nov 2008

“Expected policy rate” (OIS) (0.48)

Interbank rate (2.15)

Source: Bloomberg

4.4

This should have been the trigger for intervention

The standard prescription for containment & resolution

1. Have legal powers enabling & requiring regulators to:

2. Intervene in undercapitalized banks, • requiring them to increase capital and to desist from unsafe

practices, and if necessary • take control of a failing bank and arrange for a sale, liquidation

or financial restructuring with the use of public funds.

3. Limited deposit insurance to insulate small depositors from anxiety and loss.

4. Liquidity provision to stabilize monetary conditions, including LOLR, but only for solvent but illiquid banks.

Legal powers: even UK & US were not ready

Northern RockEU state aid law; bank insolvency procedures

Lehman BrosBriefings suggest that it was legal limitations that

ultimately forced the bankruptcy

Deposit insurance – did not play a constructive role

Supposedly, deposit insurance is there to:

“Prevent contagious runs, ensuring market stability, and protecting the assets and peace of mind of retail depositors.”

In reality it may do no more than buy political acceptability for a strict liquidation. Can only have a limited role when it’s the wholesale funders that run.

Deposit insurance – did not play a constructive role

Northern RockCo-insurance rule (first £2K covered in full, 90% of next £33K)

encouraged run by all but the smallest; made rescue politically inevitable

Indymac bankEven covered depositors ran despite prompt payment record of

FDIC

Cross-border issues unresolved:Irish annoy neighbours by extending blanket guarantee……But only for Irish-controlled banks, disturbing level playing field

(and leaving banks on life-support)Iceland fiasco: Branch in UK not subsid, and home authorities

could not afford to meet the insured liabilities.

Liquidity policy: central banks retain independence but fail to control rates

Big expansion: Innovated in instruments, maturity, counterparties but maintained “high” collateral standard (esp. ECB tightened in September)

Mostly stayed out of explicit rescue actions (exceptions: NR; Bear Stearns; AIG)

Thus, unlike past crises, CBs are not obviously in the front line for losses, though quality of their collateral may deteriorate.

And their operational independence and inflation-targeting not yet compromised.

However, they have been unable to control market interest rates with

precision

Intervention and recapitalization

• Despite the persistent alarming indications, government intervention in insolvent banks and loss allocation was slow to start, reactive on a case-by-case basis and piece-meal.

• Previous banking crises around the world generated huge fiscal (taxpayer) costs

• In the early stages of this crisis (i.e. until about mid-September, 2008), despite big reported bank losses, the taxpayer had not been implicated in a big way.

Systemic Crises 1970-2008: Fiscal costs and GDP per head

0

10

20

30

40

50

60

0 5 10 15 20 25 30

GDP per head $000 PPP (1997)

Fis

cal c

osts

% G

DP

Honohan (2008)

Banks hit by losses fall into four failure categories

1. Ruined gamblers

2. Too opaque to survive

3. Over-leveraged mortgage lenders

4. Diversified survivors (?)

Banks hit by losses fall into four failure categories

1. Ruined gamblers Sachsen, IKB, IndyMac

2. Too opaque to survive in the market Bear Stearns, Lehman, AIG, Northern Rock (?), Fortis

3. Over-leveraged mortgage lenders Fannie and Freddie, RBS, HBOS, Northern Rock (?),

Bradford&Bingley

4. Diversified survivors (?) UBS, Citigroup, Barclays….

Losses: 3 waves

• Over-complex seniority-tranched asset-backed securities and related derivatives

– From mid-2007

• Conventional property bubble-related losses– From mid-2008

• Recession-related losses (credit cards, auto loans, etc.)

– From September 2008;

– Avoidable as of Dec 2007?

Why it’s hard to predict ultimate mortgage losses

Moral hazard: could have been worse

Heavy losses incurred by:

(i) bank shareholders (for example in AIG, Fannie Mae and Freddie Mac, IndyMac, Fortis, and several banks that have not failed, but saw their share price tumble by 80-95 per cent…RBS, Citi, Bank of Ireland),

(ii) debtholders (in Wachovia Bank and Lehman Brothers, among others), and even

(iii) depositors (in the Icelandic banks)

So although the current “standing recapitalization facilities” clearly entail moral hazard; the policy response on average to date may not have been so bad

For the future (1)

Market info and intelligence good for micro-supervision

Supervisors need better ways of collecting and processing information and opinions about systemic risk

FinStab reports are not doing the job

FSAP stress tests fight the last war

There are contrarians and some of them have a point – typically dismissed because they do not know inside details

Organizational economics may help (cf. Caricano/Posner JEP 05)

For the future (2)

More regulation?

Much more capitalOver-complex and opaque instruments may be outlawed:

(over-reaction likely)Find a viable and effective way of reducing reward asymmetry

But easy to game and downside hard to enforce

But above all, apply the textbook rules

Summary (1)

The recognition lag was too long despite alarming indications (from August 2007) in interbank rates that things were badly wrong.

Interventions were reactive to cash crunches and dealt with on a case-by-case basis as liquidity issues.

Why? Because regulators had bought into the overconfidence in risk management tools that drove the excessive expansion of capital and liquidity leverage – and they were slow to realize that revulsion had set in.

Summary (2)

What would have been better: textbook approach. Mandatory early intervention in undercapitalized banks, writing shareholders equity down to zero, selling the viable parts of the bank, allocating losses to other claimants and the taxpayer.

This approach would have allowed the large pools of capital unaffected by the US and other housing markets to enter with confidence and to make profits. (SWF and others). It would have avoided the 3rd wave of mark-to-market value declines and the recession.