Lesson 2

Has the last crisis been the last one ever?

Hopes and reality• „Spain is not Greece“ Elena Salgado, Spanish minister of finance

2/2010• „Portugal is not Greece“ The Economist 4/2010• „Greece is not Ireland“ George Papaconstantinos, Greek minister of

finance, 11/2010• „Ireland is not Greece„ Brian Lenihan, Irish minister of finance,

11/2010• “Ireland is not Spain or Portugal” - Angel Gurria, general secretary

OECD, 11/2010• “Spain is not Ireland or Portugal” - Elena Salgado, Spanish minister

of finance, 11/2010• „Italy is not Spain” - Ed Parker, Fitch, 6/2012• “Spain is not Uganda” – Mariano Rajoy, Spanish prime minister,

6/2012• “Uganda does not intend to be like Spain” - Sam Kutesa, Ugandian

minister of foreign affairs, 6/2012

The past and the future …

• The Glass-Steagall Act from1933 consisted of 37 pages and has supported the financial stability of the US economy for over 70 years …

• The Dodd-Frank Act from 2010 consists of 848 pages, together with the related implementation regulation it represents several hundreds of documents with over 30 000 pages …

Few questions we are dealing with … these are not minor issues, indeed

• Is the eurozone capable of surviving?• If yes, at what cost – and how will these costs distributed?• What needs to be done (changed) for the euro to survive

(institutions, policies …)?• Are the decisions, taken recently, sufficient?• Short term vs long term effects of decisions …• Do we really need to be scared of the consequences if the

euro collapses?• If it does, how would that impact to global financial

system, economies …• If the eurozone remains heterogeneous (and it certainly

does), who are the losers and who are the winners (and why is that, how did it occur?)

Just a few questions we are dealing with … ctd

• Are politicians ready to embark on genuine changes?

• Most importantly, are voters ready to support genuine changes? …

• … meaning: are voters willing (yet) to subscribe to the principle of cross-boarder redistribution and solidarity ( far beyond the current state of play…)

• Are we all ready for a fiscal union?• Is an EU economic government THE solution .. If

yes, are we talking about a technocratic OR democratic governmental platform? Question: what is the difference between the two?

Just a few questions we are dealing with … ctd

• Is the welfare state (EU – redistributive - social model) able to survive? In what form and with what content? Just have a look around the globe and try to compare …

• Actually, let's not be shy to ask even broader questions: is this not the sun set of market economies and is the future not linked to state interventionism? Are we ready to go, once again, the same road leading to the abyss? And why is it that some politicians (ironically some of them the most powerful in EU) are pushing towards the same mistakes, committed already by others in the past??

• And, without willing to be provocative, what will now happen in/to France? If Hollande suggests (as he already did), that he wants a) the Eurobonds and b) to give priority to fiscal growth stimuli, what consequences may this lead to?

Just a few questions we are dealing with … ctd

• Actually, is it not that the fiscal union has started to emerge de facto (through transfers of debt (provide example), interstate lending, fiscal rescue packages to banks etc …?

• And, by the way, when we talk about fiscal union in the eurozone (EU), what precisely do we have in mind? Is it having harmonised taxes, or a centralised (federal) budget with its own revenue and expenditure (on what?) .. What is actually needed in the fiscal field for the fiscal policy to be able to support the monetary union?

• And is it not, that by adopting an extensive scheme of redistribution, a harmonised welfare state across EU, actually new divergences will emerge (or the present ones will become more visible), implying even more transfers (redistribution)?

And finally, a few questions (all implied by the crisis) about ourselves and the euro

(EU) …• Do we still see benefits of joining (which ones)?• How valid is the argument that, actually, the

eurozone is (and has always been) a kind of moving target?

• If it moves where it is supposed (and expected) to move, why should we care (or care more than before)?

• Can we ignore how open our economy is and how integrated it is with the EU, eurozone and Germany most specifically?

• Do we have the capacity to assess our own situation objectively?

And, broadly considering …

• Are politicians (governments) ready to make the move towards fiscal (and political) union (= mutualising the costs)

• And, even more importantly, are voters (taxpayers) ready to make that step??

But let's take it from the beginning

• A crisis is a more or less drastic correction of imbalances, created in previous times …

• In most cases, a crisis is generated by an overheating of the economy, apparent through „bubbles“ on various markets

• Unsustainable deviations are misinterpreted as trends• But, at the end of the day, the disciplining role (power) of the

market can hardly be avoided …• Although crises may be of a diverse nature (monetary,

banking, debt), they have all one thing in common: risks are being underestimated, old truth is being (intentionally) overlooked, prudential behaviour weakened

The roots of crisis are always found in „good times“, when the world looks pretty and sweet

The recent episode …

• A prolonged period of low inflation, implying low profit returns on investment all around the world, combined with an unprecented surge in free liquidity Explain why

↓- Investors ready to search for and accept higher risk- Creativity in new and complex investment products, offering higher

returns (and distributing – hiding – (excessive) risks- Enormous diversification of financial intermediary, an extremely robust

surge of the non-banking intermediary (partially in response to ever increasing limitation imposed by regulators

- In an environment of unshakable trust in an ever growing global economy, driven by new global players (mostly the BRICs) showing an unlimited hunger for growth

- The psychology of investors „if they can make it, we have to make it as well, if they succeeded, we will as well“

- Expectations and instructions of bank shareholders to managements – pressure on profits, shortening of investment horizons

The recent episode … ctd- Expectation of small investors, depositors, shareholders: all of them

willing to „be there, get their own part“ – lesson of human psychology: would anyone resist to become rich, if risks seem to have evaporated from the scene?

- Regulation got relaxed (example: the Glass-Steagall Act terminated)- Supervisors felt asleep, overlooked syndromes of forthcoming

trouble – assets bubbles etc)- Mistakes of central bankers, overlooking the bubbles (and the

message these bubbles were sending to policy makers), a misinterpretation of the long period of low inflation …

- Unfortunate (fiscal) decisions by governments, very populist and difficult to take back (as we see it today in the streets of Athens, Madrid, Rome, Paris and even Prague): „debt can be resolved by economic growth“ (now we know – again – that this is not true)

- However, caution is needed today: more regulation should not be (once again) assimilated to better regulation

The financial causes:• Development of a „shadow“ (or parallel) banking, various special

purpose vehicles (SPVs), investment banks (detached from primary deposits and with huge leverage ratios), investment funds, hedge funds

• A failure to properly supervise the credit process: the mortgage provider would, for instance, sell, within the six months, the risk to a third party: thus, his motives to assess the creditworthiness of clients went severely weakened

• This third party would, for instance, wrap the mortgage risk into packages, together with other risks to make them look better (risk diversification…), than they would contract an agency to get a rating of the package (in most cases very good) and they would sell the package further down the road

• At the end of the day, some investors would buy non transparent, but still well rated instruments, and would even make a hell lot of money out of it

Please note: the risk has not disappeared, it merely got hidden (became thus even more like a time bomb)

VK about the roots …

• The western civilisation has made, in the last couple of decades, a fatal mistake: it has created a model, which does not put on top the economic output (from which everything else should be derived), but, instead, puts on the top various and autonomous claims of individuals, interested or social groups, and even entire states. This a radical reversal of the key sequence …

• … which led to a situation when resources and needs were detached, as were revenues and expenditures

• It was all supported by the fact, that governments (at least some of them) seemed to have an almost unlimited capacity to borrow …

The igniter …• These were the mortgages: supported widely by governments,

which articulated policies to promote access to housing even to sub-prime clients (US is the most striking example): subsidies, benefits, weakening the supervision requirements etc …

• Leading to almost no assessment of creditworthiness of clients, lending even more than 100% value of the property, progressive interest rates (lower at the start to attract clients) with instalments often, at the beginning, even below the due interest payment etc

• The mortgage brokers were only interested to sell as many contracts as they could

• Value appraisals got systemically overshot (everyone down the chain interested in achieving the higher price possible)

• Rating agencies: got on board as well …Just before the crisis, the mortgage sector has almost entirely ignored

all prudential principles: the focus on (quick) profit prevailed on everything else, the main focus was no longer on the capacity of the

borrower to repay but on the ability of the creditor to sell the risk

„ Securitization was based on the premise that a fool was born every minute“.

Globalization meant that there was a global landscape on which they could search for those fools..

And they found them everywhere“.

J. Stiglitz

Role of institutions (governments, regulators, supervisors): far from being innocent

• Community Reinvestment Act (1977, J. Carter): support access to housing

• Fannie Mae and Freddie Mac (government sponsored enterprises, purpose: access to housing for low income people)

• Commodity Futures Modernisation Act (2000): derivates exempted from regulatory requirements and supervision and minimum reserve requirements

• 2002: FED terminates supervision of mortgage companies

• 2004: Securities and Exchange Commission grants an exemption from the required debt-to-net capital ratio to Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Sterns, Morgan Stanley (the allowed leverage ratio increased from 12 to 40)

And than, the party was over …

• When Lehman collapsed, no one new precisely, where the risk would emerge from and how it would hit the financial accounts of market players

• Confidence amongst market participants was gone …

• And so was liquidity from the market …• Consequently, the ability (and willingness) to

lend money to corporates was gone as well …• Producing second round negative effects on

financial institutions

Actions of authorities

• Since Lehman, everything authorities were trying was aimed at:

– restoring confidence on the markets,– substitute the missing liquidity,– stimulate the financing of the economy– and thus limit the economic and social damages

What do you think: did they succeed in that?

Examples of intervention after 2008 …

Governments:• Purchase of problem assets (essentially securities linked to subprime

mortgages) by government funds• Recapitalisation (entry into capital) of systemically important banks• Deposit guarantee schemes reinforced Question: what is your view of that?

What arguments support this and what risks does it create?• Writing-off parts of claims (or pushing third parties to do that: refer to the

Greek case)• And regulatory tsunami (Basel 3, CRD IV)+ further recapitalisation of banks

+ FTT + Resolution and Recovery (including the Bail-in) schemes, Vickers, Volker, Liikanen …

Central Banks:- Pumping liquidity into the system- Reducing interest rates- QE- Dealing on the secondary bond market

Chronology of events: how is the crisis

passing through the economy • Mortgage sector → financial intermediary

• Financial intermediary → real economy

• Real economy → a) financial intermediary (secondary effects) → b) public finance + debt crisis

• Debt crisis → a) financial intermediary → b) real economy → financial intermediary

Questions:• V or VV or VVVV … ?• Is there an escape to this vicious circle at all?• How to socialize the future costs of consolidation of financial

entities?

The debt crisis

• This phase of the crisis became visible in 2010 and 2011, though the fiscal trouble would emerge, sooner or later, in all circumstances

• 2012: situation getting even more dramatic• It has various reasons (compare Greece and Ireland)• It has severe implications

– From the market prospective, government bonds are no longer seen as safe, low-risk and low yield, investment instrument: this has severe repercussions on the quality of the bank's balance sheets and risk management

– Governments are loosing (a preferred) instrument of economic intervention (this has to be seen in conjunction with the failure of market supervision), or, at least …

– … intervention by an authority that has lost part of its own credibility may not restore market confidence as efficiently as it would be needed

– Efficiency horizons of such interventions are shortened– They have severe negative side effects (on taxpayers, benefit

recipients, market participants – banks etc)

The special case of Europe (eurozone)

• The current institutional framework has failed to perform as needed and the new has not become effective as yet … that is not helping credibility of both national governments and the EU institutions …

• Attempts to shift debt „upstairs“ (like issuing Eurobonds) have hit a kind of political barrier Explain why and discuss the underlying arguments …

• … and attempts to confine the costs to the private sector only proved to be risky (threatening the stability of the financial sector, its capacity to find capital on the market and, ultimately, jeopardizing the financing of the economic recovery) …

• … while elements of a fiscal union have emerged anyway as a by-product of events (cross boarder transfers of cash, guarantees, debt - new intervention entities with massive „firepower“ such as ESFS, Euroval) …

• …and while, at the national level, structural reforms of finance are taking place at a very different pace …

• …and while there are signs of a kind of „austerity fatigue“ … Greece, France …

Sing

le E

U

supe

rvis

or

Sing

le E

U

depo

sit

guar

ante

e sc

hem

e

Com

mon

re

solu

tion

auth

ority

an

d fu

nd

Sing

le

rule

boo

k

Banking Union

Examples of policy/supervisory reaction:

Single Supervisory Mechanism

Two Commission's proposals for the regulation presented on 12th September 2012: Regulation establishing ECB as the Single Supervisor; Proposal amending provisions in the EBA regulation.

Ambitious time schedule - entering into force on 1st January 2013 – speed vs. quality?

Task Force on the Future of Banking Supervision meeting

on 28th September 2012 EBF Position to be approved by ExCo meeting

on 25th October 2012

ECB as the Single Supervisor

All banks in the Euro area – Is it manageable and practical? Non-Euro Member States can opt-in

Fair balance between obligations and powers? Perception of banks supervised by ECB and banks supervised by national supervisors?

ECB to carry out the tasks in close cooperation with national supervisors – Any bright line or overlaps, double requirements?

Separation between the supervisory function and monetary policy functions of ECB through the establishment of a separate Supervisory Board with the responsibility for supervisory matters

Liikanen report (published on October the 2nd)

1. Legal separation of certain particularly risky financial activities from deposit taking banks

2. Role of Recovery and Resolution frameworks further increased (= wider separation as in 1) if required by the resolution authority)

3. Amendments to provide more clarity to the bail-in instruments

4. More robust risk weights for the determination of capital requirements on trading assets and real estate related loans

5. Further corporate governance reforms

Liikanen report (initial assessment)

1. Ring fencing of risky activities: probably not an issue for us (quantitative thresholds sufficient)

2. Additional ring fence dtto

3. Bail-in instruments: might have an impact on the cost of funding (differentiated across our region)

4. Impact likely, will need further evaluation

5. Corporate governance reforms: probably not the central issue for us given the business models applied in our region

So, what have we learned?

• The power of conflict of interest …

• The power of moral hazard …

• The power of black passengers …

• That the distribution of risks and risk assessment will never be the same as before

• That safe may no longer be safe

• There might no longer be a rescue of last resort …

And what about the Czechs?• How were we affected by the crisis in 2008-2009?• What about monetary, fiscal developments?• Our economy is very much open: what role does this play?• Spill over effects: how are they (would they) affecting/affect our

economy?• How important is our link to Germany?• What role was played by banks?• Is our conservative banking model an advantage?• What is the situation of our corporates?• Do we have a competitive institutional and regulatory environment?• What about the structural characteristics of our economy: are they

playing to our advantage?• Back to the beginning: is Euro a topic for us? If not today, then when

will it be?• Why are we not growing (unlike others in the neighbourhood)???

Share of interest expenditure on general budget revenue (%)

-14-12-10

-8-6-4-20246

Finl

and

Den

mar

k

Swed

en

Luxe

mbo

urg

Bulg

aria

Cypr

us

Net

herl

ands

Ger

man

y

Aus

tria

Belg

ium

Slov

enia CR

Slov

akia

Port

ugal

Ital

y

Esto

nia

Lith

uani

a

Fran

ce

Pola

nd

Hun

gary

Spai

n

Latv

ia

Mal

ta UK

Rom

ania

Irel

and

Gre

ece

2008 2009EU27, 2008 EU27, 2009SGP, 3%

General Government DeficitsGeneral Government Deficits(in % of GDP, EDP methodology)(in % of GDP, EDP methodology)

Czech R: -2.1% of GDP in 2008 and -6.6% of GDP in 2009

  EU17 Greece Italy Portugal Spain Ireland

2007 66,2 105,4 103,6 68,3 36,1 25,0

2008 69,9 110,7 106,3 71,6 39,8 44,4

2009 79,3 127,1 116,1 83,0 53,3 65,6

2010 85,4 142,8 119,0 93,0 60,1 96,2

2010/2007 129,0% 135,5% 114,9% 136,2% 166,5% 384,8%

Public debt to GDP ratio… increasing fast

Exposures of banking sectors to PIIG countries ( bil. USD)

• France 646 25% GDP

• Germany 533 16,1% GDP

• UK 347 15,4% GDP

• NL 151 19,2% GDP

• Spain 127 9% GDP

• USA 147 1% GDP