The Transatlantic Banking Crisis: Lessons, EU Re- forms ... · PDF fileAppendix P.J.J. Welfens...

Paul J.J. WelfensEuropean Institute for International Economic Relations

University of Wuppertal (www.eiiw.eu)Jean Monnet Chair for European Economic Integration & Chair for

Macroeconomics; Alfred Grosser Professorship 07/08 Sciences Po, Paris; Non-Resident Senior Fellow AICGS/Johns Hopkins University

The Transatlantic Banking Crisis: Lessons, EU Re-forms and G20 IssuesPaper to be presented at the European

Commission (DG II), June 16, 2009

(c) 2009, Welfens; [email protected]

EIIW as Research Institute: more than 10 years of award-winning research…

UU

P.J.J. Welfens www.eiiw.eu (2009)

One of our projects: EIIW International Research Project on Russia (Brussels)

Wuppertal: Economics (Master; CHE)=top 5% universities in EU2

EIIW

Contents

1. Introduction2. The Dynamics of the Banking Crisis3. Theory of Sustainable Financial Globalization4. Setting Priorities for Global and EU Policy Reforms5. Key Medium Term Policy Issues

Fall of investment underestimatedUnfinished EU and global reform agenda

Appendix

P.J.J. Welfens www.eiiw.eu (2009) 3

Issues


Solving the banking crisis has priority overexpansionary fiscal policy (?): Measures takenadequate?World recession intensifies problems of banks

1. Introduction


OFHEO House Price Index divided by US GDP deflator (1991:Q1 = 100 for indices)


OFHEO Real House Price Index in the U.S. (M, Q, Y)

0,90

1,00

1,10

1,20

1,30

1,40

1,50

1,60

1991

Q1

1992

Q1

1993

Q1

1994

Q1

1995

Q1

1996

Q1

1997

Q1

1998

Q1

1999

Q1

2000

Q1

2001

Q1

2002

Q1

2003

Q1

2004

Q1

2005

Q1

2006

Q1

2007

Q1

2008

Q1

2009

Q1

Data Source: Federal Housing Finance Agency

Starting Points, Amplifiers of the Banking Crisis

Global imbalances: US CA<0; financed by China‘s excesssavings (?)Loose US monetary policy under GreenspanOpaque financial innovations such as securitization & over-the counter trading of risk (CDS)

Increase of required rate of return on equity NYNegative international spillovers in markets for risk=misallocation of capital/capital flowsTransatlantic banking crisis, world recession


Financial Markets, Shadow Banking, Economic Globalization

Financial markets/banks have globalized in 90s Traditional problems have remained: asymmetricinformation and moral hazard (cf. Reinsurance)Basel I/II: incentive for off-balance sheet activity = shadow-banking increased; supervisors ignored the process

Financial innovations have acceleratedSecuritization wave (already 80s: NICs debts…)Trading risk through CDS – over the counter! Banks often with poor risk management (BIS, 2000)


State of the System; ConsistentInternational Cooperation in the Crisis?!

US under president Bush Jr. hesitant; refused FSAP for the USA – IMF policy monitoring poorIn the midst of US banking crisis US govern-ment refused for ideological reasons to bail out Lehman Brothers; Paulson: no idea of cost…

Financial globalization without globalization of politicalminds: US Congress would not have given guarantees forpotential foreign investor, Barclays Bank from the UK. European Commission hardly active, despite fin. integrationExperience in crisis in EU similar: national rescue operation


OECD Banks Facing Depreciations and Losses; + Recapitalization


TARP (US) and Estimates (seeBloomberg, June 2009)

$ 700 bill. TARP/US, June 09: 100 bill. left; US banks allowed to repay $68 bill.(stress test ok?)

Losses of banks ($ 180 bill. Freddie & Fannie; Bank of America: 113, Wachovia 102, Citigroup 102, UBS 53, Washington Mutual 45, HSBC 42, JP Morgan 41, RBS 31, HBOS 26…; DB 19, Bayern LB 16, IKB 14, Commerzb.10, HRE20?), funds & insurance companies (AIG: $ 90 bill.)

2007-May 2009 = $ 1471 bill. (IMF: add $ 2000

$ 1236 recapitalization = $ 235 bill. missing (problemor not?)


Some Critical Issues (see paper)

$ 235 bill. missing recapitalization as problem?Lack of bank equity capital = lack of loans = creditcrunch; BUT rise of equity capital ratio=highercredit multiplier (1) & (2) = prob (wet feet):

1) Micro view on banks: Equity capital=umbrella, 2) Aggregate: +credit implies higher probability of rain

Further depreciations and losses to be expectedfrom toxic assets as such, rating agencies will downgrade assets/banks in world recession€ zone more bank based than US,UK; €problem?


Transatlantic Banking Crisis…

US banking sector (profits) inflated in 1990s(Some) Lessons from Great Depression not learned

reading Galbraith on GD illuminating: very expansionarymonetary policy + hyperspeculation in real estate in Florida in the 20s. Also UK overvalued ₤ 1925. At least in 2007/08 „ONLY“ US problem; No. 2 economy EU has modest problem

Robert LUCAS in his AER presidential addressexplained 2003 that depression risk irrelevant..Few economists critical towards hot speculation/ higher required rates of investment on equity: …SHILLER; ARTUS/VIRARD (2005)


Problems

Banks: Too big to fail (nothing has changed); mitigated by EU single market programm & creationof €zonePrudential supervisors in UK, Germany, Ireland, Belgium etc. (and US) have failed;

Responsibilities split across national institutions (ofteninvolving central banks)National prudential supervisors often incompetent: egGermany – legalistic approach; no economic approach!


US $ surprisingly stable

Fear of lack of $ liquidity$-save heaven effects; Risk premium for othercurrencies: +demand for $-denominated assets

Assumption that US will get out of recession prior to EU/Eurozone where policy coordination is weakRising global demand for $: official foreign reserves (in $) increase while trade shrinks – if short term foreigndebt(D‘) rises(LDCs!), +Mglobal$


Why is the EU interested in quicklycoping with the problems?

Continuing strange interventions =underminingMarket Economy(confidence in banks is declining in D)Potential revival of protectionism/nationalismDestabilization of banks + stock markets = un-dermining confidence in social security reformsInability to fix the OECD system = end of G8 = beginning of G20 and rising impact of China = impacton political liberalization in Asia, shift in favor of ChinaThe longer the crisis, the more tensions within EU: €zone vs. Non-€; problems with enlargements; pol. mix? P.J.J. Welfens www.eiiw.eu (2009) 16

Macroeconomic key problems 2008/09


08: Problem withorder inflow ascancellations notrecorded;

Investmentfalls sharply;survey showsthat there isno currentcredit crunchNEW SURVEY

Progress withQuest Modelof Commission…

Banking Crisis and World Recession: Dynamics…

Interdependencies between banking crisis and world recession notwell understood

October 08 IMF World Economic Outlook suggests that €zone will have slower growth, NO recessionAnalytically doubtful IMF event analysis: looking at financialcrisis in Fin., Sweden etc. for understanding the impact of Transatlantic Banking Crisis (???No)Required is 2 Country Perspective including financialmarkets +role of expectation shocksMissing link between output model & adequateportfolio modelling (see eg WELFENS, 2008c)


Confusion about the Key Sources of theUS and Transatlantic Banking Crisis

G20 meeting in DC in Nov. 08; London: April 09Debate about the causes of the crisis

Arguments that hedge funds do not play a role in thecurrent crisis – this view is doubtful (to be explained)

Blame is on greedy bankers in Wall Street, Lombard Street and elsewhere; and poorly working rating agencies; and on expansion of business with asset-backed securities(ABS, securitization) & structured financial products such as collaterlized debt obligations (CDO: containing layers of ABS1, ABS2 etc.)


2. The Dynamics of the Banking Crisis: TrueStory of the US/Transatlantic Crisis

1) Unregulated Hedge Funds with super rates of returns put pressure on US banks to come up withhigher rates of return on equity2) Banks increasingly engaged in off-balance sheetactivities – sold ABS/MBS (mortgage backedsecurities) to Special Investment Vehic-les (SIVs), including own SIV which obtained large credit linesand refinanced through short-term commercial paper; growth of off-balance sheet activities – prudentialsupervisors weak! BUT Spain ok


Some Observations on the Banking Crisis

Decision-horizon of bank managers often short-termBalance sheet mismatch:short-term financing of long term project

Incentive systems for managers:Superbonus in golden years (also traders)Superb salary even in miserable years (also traders)RESULT is of big private high volatility of rate of returnon equity banks (see e.g. Germany)

Big banks exploiting economies of scale??


Four-year Variance of the Rate of Return on Equity1 for Major Banking Groups in Germany2

Return on equity (1) by important groups of banks in Germany (2)

Commercial Banks (3)

of which

Total Major Banks

Regional Banks and

other Credit Banks State Banks Savings Bank

Cooperative Central Banks

Credit Cooperatives

Period Pillar 1 Pillar 2 Pillar 3 1997 0.24 3.85 0.33 1.27 1.99 1.69 2.62 1998 55.02 168.18 6.91 1.68 3.34 44.96 6.48 1999 56.40 185.00 8.64 1.24 5.13 69.66 6.74 2000 62.30 202.66 6.46 1.76 5.34 70.74 5.61 2001 76.88 212.81 26.20 7.06 9.93 92.14 4.24 2002 11.31 15.43 20.00 9.05 8.45 12.38 1.46 2003 28.69 58.57 9.72 20.53 3.95 20.22 1.41 2004 15.57 39.77 3.65 11.26 0.98 2.47 1.54 2005 112.78 290.58 3.63 14.84 1.08 3.13 2.52 2006 116.83 293.59 2.34 34.23 0.54 3.08 1.92

1994- 1999* 13,12 14,6 12,61 9,76 19,25 14,88 15,51 2000- 2006* 5,76 5,3 7,22 4,34 10,1 5,04 10,2

*Variance 76,66 192,97 15,60 21,85 26,90 56,91 14,15 * Average rate of return on equity (based on annual values), variance is for 1994-2006; the variance for 1997 is based on rates of return for 1994-1997, the variance for 1998 is based on 1995-1998. 1) Net income before taxes in percentage of average equity (including Fonds for general banking risks, excluding jouissance rights).– 2) All reporting credit institutions, that fall under the under the MFI-definition of the ECB and have the status of universal banks.– 3) Major banks, regional bank and other credit banks as well as branches of foreign banks.

Highvariance

TAX!!

US: FDIC-Insured Institutions by Asset Size; Numbers,

and Return on Assets in Percentage 1998-2008)

Institutions/Asset Size

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*

Greater than $ 10 Billion

76 1.28

82 1.16

80 1.13

106 1.31

110 1.42

117 1.28

118 1.30

119 1.32

119 0.82

114 0.13

104 1.12 (1.22)

$ 1 billion to $ 10 Billion

318 1.49

313 1.29

320 1.31

450 1.45

471 1.42

480 1.44

512 1.28

530 1.22

549 0.99

562 -0.15

451 1.17 (1.32)

$ 100 million to $ 1 Billion

3029 1.36

3078 1.28

3194 1.20

4118 1.17

4211 1.18

4285 1.19

4339 1.24

4399 1.17

4425 0.99

4498 0.33

3958 1.11 (1.06)

Less than $ 100 mil.

5157 1.01

4842 1.01

4486 0.91

4680 1.00

4390 0.95

4093 1.01

3863 1.00

3633 0.93

3440 0.75

3131 0.31

4171 0.88 (0.95)

Total/ weighted Average

8580 1.27

8315 1.19

8080 1.16

9354 1.31

9182 1.38

8975 1.29

8832 1.28

8681 1.28

8533 0.86

8305 0.12

Apparently: Economies of scale US banking not really big=Pro dismemberment

!

Key Insights: Collapse of Interbank Market in 07/08 = banks going foroff-balance self-created market failure

Growth of banks‘ off-balance sheet activitiesplus subprime crisis = market for lemonsproblem: uncertainty about info qualityof balance sheets of banks rising (white spots…)

Info uncertainty leading to the near-collapse of the interbank market in 2007 (AKERLOF problem)

US policy failure allowing Lehman Brothers to go bankrupt fully killed confidence among banks



Banks: High rate of return on equity 25%; riskfree rate 4%: risk premium 21% - excessive!

4b

4a6

8 9

7

3

Hedge Funds:

High Rate of Return

US Banks: Required Rate of

Return on Equity is Raised

EU Banks: Rate of Return is

Raised

Creation of Special Investment Vehicles (SIV): Increasing Off-balance activities through asset-backed-

securities (ABS) and mortgage-backed-securities (MBS)

Write-downs on portfolios reduces

confidence into banks

Banks must take back ABS/MBS into their

books; massive down-writing on assets

1 2

Refinancing through

commercial papers

Top ratings

S T O P

US Real Estate Market; fall of house

prices undermines

confidence for ABS/MBS

US-stock mar-kets

5Interbank

market collapsesCentral

bank intervenes

10

11

Dynamics of the Banking Crisis

Subprime only part of story

Banks started trading risks

Bank buys credit insurance (Credit Defaults Swap: CDS), then it can sell the CDS to another bank orhedge fund which eg combines CDS with ABS in CDO and sells it to another fund – all these CDS transactions take place over the counter and thusare known neither by the supervisors nor by themarket at large (although serious counterparty risk); no clearing house, no global record: Irrisponsible!


Rating Firms worked poorly…

USSEC Report shows that leading US rating firmsdelivered poor work in many cases

Nice fantasy ratings created illusion about top qualityof assets traded in international financial market

Strangly, the risk premia in 2003-06 fell in the US, although credit volumes recorded high growth


Distorted Risk Premia in 2003-06; markets gave distorted signals!!


US: Yields on Corporate and Treasury Bonds

Source: IMF, Global Stability Report Statistical App., Sept-2007 Figure 3

Source: Goodhart, 2007

Market anomaly

Surprising 2008, close to global meltdown in October

Global chaos in financial markets in 2008Desperate Ministers of Finance in OECD countriesChina‘s government shocked about US (Freddie/Fanny)

World real economy massively negatively affected


Basic Issue & Policy Response:

Is this global cyclical downturn (09) OR unavoi-dable correction of earlier excessive growth?Aggressive cuts of interest rates

Zero in US & UK in 2009: welcome to liquidity trap?Dramatic fall of interest rate of government bonds

Massive fiscal policy packages: US $ 780 over 2 years;EU countries with smaller/similar package(+automatic stab)China with expansionary fiscal policy packageGovernment capital injected in private banks!

PART of downturn is structural correction (seeabove)… P.J.J. Welfens www.eiiw.eu (2009) 30

Neutrality vs. Implicit penaltyfunction for excess growth


∫∫ −− ⎟⎠⎞

⎜⎝⎛ −=⎟

⎠⎞

⎜⎝⎛ −

'

00

0 'ln'ln T

T

rtrtT

dtedt

Ydrdterdt

Yd α

Fig. 1: Growth under Doping and Bubble-related Recession

IH

T’ T

F

E

B

A

0

G

r, gY

r0=gY#

t

r1=gY1#

Neutrality means α=1: that cumulatedoutput loss = previous output gain;can one obtain artificial growth bonusby „growth speeding“ ? Steady stategiven by growth rate of output =rOr penalty; later: level of growth pathis reduced OR growth trend itself

No penalty on „growth speeding“?

Strange developments in crisis

Real interest rate r(yield: government bonds) isunnormally low: distorting allocationStandard portfolio model: [μR (σR) is expected yield(standard deviation) of stocks, σ‘ is standard deviationof portfolio yield, μ‘ expectation value of yield of portfolio, r risk free rate; utility lnU= αlnμ‘ – α‘ lnσ‘; α‘>0, α>0]:

Equilibrium of investors: α‘μ‘/(α σ‘) = [(μR – r)/σR]r = μR - [(α’μ’σR]/(ασ’)]; falling expected yields in industry(μR), rise of risk premium, including preference shock[α’/α…]


Empirical issue: how deep is the shock? Raising degree of risk aversion?

5 ChallengesRestore confidence = limiting probability of financial accidents (hedge funds)Reestablish transparency = eliminate Akerlofproblem AND make allocation of risk visible…Restore responsibilityCreate incentives for consistent ratings = public good (not private good): everybodypaying into pool from which rating financedStimulate more long term decision-making in banks


The Priority Reforms should be 5 steps


Arguments in favor of new tax regime: institutional innovation!

A variance tax encourages bankers to take a morelong term view and pursue sustainable bankingstrategy (low variance means no additional tax, high variance – eg top rate of return on equity this yearand low rate of return next year – means high tax); incentive systems in banks will then be reformed(traders!)Problem in recessions? But: total tax could be zero in official recession period


Why a New Tax Regime on Banks‘ & Funds‘ Profits is Important


3. Theory of Sustainable Financial Globalization

1. Long term benefits on the basis of consistentinstitutional framework and clear responsibilities2. Consistent mix of regional organizations(responsibilities) and global organizations3. Effective crisis management (do we understandthe global system? IMF/OECD etc)4. Acceptable international burden sharing5. Leadership or joint policy clubs


Financial Globalization is notsustainable under old rules

Unclear financial innovation system:Many useful innovations; setting standards…(?)Some innovations complex =„confidence good“ = potential market failure(market for lemon problem)

Negative external international effectsfrom inadequate national regulations (US)Competition in world capital markets notworking: Too big to fail problems in I & II; creates perverse incentives: high risk bias. competitionfavors big countries=big banks


If there are negative asymmetric externaleffects in credit markets /banking sector

International NET capital flows will be distortedUnder flexible exchange rates trade flows distor-ted(trade balance = capital account balance

Interdependency of financial marketsIf risk premia – interest rates - are distorted…then exchange rates are distorted..exchange rate overshooting (Dornbusch model(?))…international misallocations of resources


Country I (a) is net exporter of risk (CDS); but if negative external effects in I considered II is net importer!!


Figure 1: Asymmetric Negative External Effects and International Capital Flows

pW1

M*

G*

H*

GF

J

K

DD*0

C* D*

B*A*

C

D

BA

DD0

SS0

p SS01

q0 σ0

p0

0

a) b)

pW0

q2 q1

p*

SS*0

p*0

q*1 q*0 q*2 σ*

M

Market for risk in country I (a) and country II (b); if price for risk is distorted all asset prices will be distorted!

Reinsurance: Price of risk in reinsurance…; market indicators of risk

Problems in reinsurance:Asymmetry of information & moral hazardSolution in reinsurance: reinsurance requires about 50% equity stake for original insurance companies

Price of risk difficult to determine in markets: Eg: distance to default is a market indicator for risk; based on stock market price – if stock market price isdistorted then price of risk is tooIf there is overshooting in forex markets there will bedistortions in stock market pricing and thus…


Strategic Policy Question forStructural Reforms


Economic analysis suggests that establishing „good regulation“ is difficult (egproblem of regulatory capture); undermining financial innovation dynamics…

4. Global and EU Policy Options; EU‘s three-pronged new regulatory approach


Additional institutional changes

New originate-to-distribute approchInitial originator of ABS must guarantee that ABS sold in thecapital market will be repurchased at any moment at a minimum of 50% of the initial price; avoids problem of missing pricing(08)Originator should take 20% equity tranche ABSConsumer protection must be reinforced in EU: Bankers which sell just 1 or a few assets (providing no riskdiversification) to client must be liable!


Key Issues I in 2009/2010General perception

Banking crisis: most reforms accomplishedGlobal recession: 2010 economic upswing (€zone, D, US)

Alternative view which is realistic:Banking crisis partly resolved; key structural reformsmissing: balance sheet quality (Akerlof-type market forlemons problems) has even worsened – 09: banks allowedswitching fair value/initial priceInvestment depressed in OECD+NICs due to fear of credit crunch (surveys: no crunch…so what?)


Key Issues II in 2009/2010


1) Is analysis of deviation fromexogenous e-quilibrium ok?Shift of growth path vs. fall intrend growth 2)Modellingbanking sector…3) If excess growthrelevant: modestfiscal policy impulses ok

If one asksfirm i whet-her or notcredit crunchis relevant for the firm i, answers willbe biased…;ask aboutJjfirms/sector

Key Issues III in 2009/2010

If – on side of firms – fear of expected creditcrunch continues to depress investment…

Investment lower than standard models would implySerious problems for Germany whose investment sector‘sand knowledge-intensive services‘ exports strongly =dependson global investmentInvestment multiplier & (-consumption)accelerator negative; unemployment rising, deficit+Restructuring of banks & improvement of balance qualityshould be adopted quickly!€zone/EU+US+CH


Key Issue IV: Eastern Europe

Countries of Eastern Europe will face problems; inability to cope with regional challengesBaltic Countries‘ exchange rate systems are notdesigned for banking crisis+global depression

Strong devaluation needed (ok for small open economy) + support by IMF/EBRD/EUPolicy dialogue about minimum corporate tax rate…

Analytical task force EU+ECB+X needed to take a quick look at the issues


European Commission and European Parliament should take bold initiative

European Commission should start sorting out the structural adjustment problems within EU: egBaltics; no unconditional IMF funds for EU countriesEstablish transatlantic and global parliamentarydebate on financial globalization; establish BIS Parliamentary Control (EP+US+x). BIS lacks control!!!!!!!

Re-establish the EP Research Unit (former DG IV); as regards financial market reforms: quite importantto have good research and thus analytical support formembers of EPMore EU-wide prudential supervision; see Telcoregulation… P.J.J. Welfens www.eiiw.eu (2009) 49

Incentive-compatible Institutions and Rules

Gov. bond emissions via big banks which effectivelyimpose high deficits on EU countries? NONational back-up plans for rescuing banks havedestroyed level playing field in EU single market: banks from big countries have advantages(tax/power)FSAP USA missing: IMF and US are to blame; equalrules to be applied in the futureNegative external international effects from as-ymmetric ineffective financial market regulation whichcalls for reforms; otherwise PIGOU tax


Further to dos in the EU

EU prudential supervision to be establishedEU crisis management should focus on triade; incl. focus on ASEAN, MERCOSUR etc.EU adjustments at macro level

Germany/€-zone: tough 09/10; UK reregulation (?)Baltic EU countries: massive depreciation required, support by EU/EBRD…; discussing minimum corporate tax rate (establish 2-way solidarity)

EU expenditure ratio at the supranational level couldbe raised=automatic coordination (infrastr.; R&D) whilenational expenditures be reduced


Role of Member Countries


Taxing profits; AND variance of rate of return on equity

includes bench-marking efforts

What the G20 should achieve?

Imposing new rules; IMF?/WTO/BIS – unclearCorrecting global current account imbalances;

Impact of real exchange rate adjustment small(McKinnon argument). See also Modified Marshall Lerner condition (appendix); in countries withforeign direct investment: absolutesum of import elasticities >2!US: rise of relative price of tradable price required for

dCA>0 (OBSTFELD/ROGOFF, 2005); China‘s surplusmaintained, so CA deficits of the EU rising?


Challenges for the Euro

Banking crisis+ world recession couldundermine rating of US and thus stability of thedollarMore appreciation pressure on the Euro to beexpected; more exchange rate volatilityPotential benefit of €zone membership could increaseprovided that prudential supervision in Eurozone isimproved and sustained competition reestablished…(competition has weekened due M&As and due to de-globalization in 08/09 etc.)


Critical Point is Revitalization of Interbank Markets

Reestablish confidence, give adequate incentives, protect confidence

Create fully consolidated balance sheets of banks and eliminateuncertainties about basic valuation of assets: CDS clearing houseplus guaranteed offer by intitial orginator of ABS that it will buy back theABS package at 50% of the price at any time

ECB should give preferential interest rate for access to centralbank liquidity to those bank which are active in interbankmarket – and more medium term than short termCreate regional clubs of homogenous „trusted banks“, latermerge institutionally club1, club2, club 3


Key Challenges

No EU or OECD sustainability policy if there is no long termand stable banking systemSerious problems ahead: Ukraine, Russia (?)etc.How fast is recovery? (sustained recovery in Great Depression in US: after five bear rallys; until spring 09 we had 3)Future crisis handling should be different: Logic of EU singlefinancial market must be observed


Policy Recommendations1) Put pressure on Baltic countries= devaluation: to avoid chaos & destabilization2) Emphasis on transatlantic cooperation in cre-ating a newcompetitive banking system3) New tax system for banks and other financial marketactors = more stability4) New EU Surveys: on Investment; data on „true orders“ (netof cancellations!)5) Focus on EU innovation system, incl. financial innovation6) Limits on non-traditional monetary policy7 ) Benchmarking Report on prudential supervision EU memb.8) Back to Normal?


What to do about bubbles?Given the experience of the early 1930s and 2007-09, namely

that the collapse of a major bubble goes along with deflationarypressure the central bank should have the mandate to fight excessive asset prices. Avoiding future deflation thus would be part of the goal to maintain price stability.

At the same time governments should create the option to introduce a temporary sales tax in asset markets so that tax-based government interventions to tame a bubble in asset markets are an alternative or complementary policy option.


EU Lisbon Post-Banking Crisis


Sustainable social security reform = long term view! DURING EU CRISIS:crisis management with automatic increase of power for Commission

Reestablishing competitive bankingsystem, fiscal pol., structural reforms


Analytical Issues (Q is Tobin‘s P‘/P; P‘ stock price index, θ turnover rate of portfolio, V isvelocity); ß‘:=(ß-1)/ß

Shortening of capitalization horizons? ≈ endogenousbankruptcy probabilityHow expansionary was/is monetary policy (V is velocity)? (FIELD,

1984; WELFENS, 2007b): [M/P]V(i) = Y + [QKθ] ψ

[M/P]V(i) = Y1 +(AL)ψß ‘ [Qθ]ψ; Y=Kß(AL)1-ß

dlnM/dt+EV,idlni/dt -dlnY/dt –d(AL)ψß‘[Qθ]ψ/dt ≈ π

Financial innovation system? We know little about financialinnovation as compared to industrial innovation; how to build fin. innov. sys

Cost of crisis, benefits and of sustainable fin. glob.


3 Minimum TasksMake degree of financial globalization and politicalglobalization more consistent (if political nationalismdominates, no financial globalization)Get more realistic about serious problems ahead

EU Commission has broad view, but lacks survey data on investment /fear of credit crunch (do not ask firm i: are youafraid of…; ask about j firm!): Start EU survey now!

Integration (EU92) & globalization inter-dependent; establish consistent EU/€zo-neregulation & export this approach =more stability in world economy


Appendix 1: Can we explain key dynamics of the crisis (interest rate i, exchange rate e)?

Modified Branson useful; in the short term givenstock of domestic bonds B (one of three equations), foreign bonds F – denominated in foreign currency – (i* isforeign interest rate, i*‘ is sum of i* and expecteddepreciation rate)stock of money M; P is the price levelEndogenous: desired shares of portfolio: n(…), f(…), b(…);n+f+b=1; only e and i to be determined

Crisis means disintegration of market, rise of riskpremium


Branson Model and Monetary Condition Index (Monetary Neutrality Index: MNI; no infl.)

(1) B/P = b(i,i*‘)A‘; slope -eEb,i/(fi)(2) eF/P = f(i,i*‘)A‘; slope eEf,i/[i(1-b)](3) M/P = n(i,i*‘)A‘; slope –eEn,i/(fi)(4) A‘= B/P + eF/P + M/P; Only 2 of the 3 equilibrium conditions are independent; definemonetary neutrality indexMNI=ß‘e+ß“i; (>MNI= dY>0; dY/dK will rise, so di>0 in t+1); note: slope de/di=-ß“/ß‘



The Branson Model and the MonetaryNeutrality Index (MNI)Fig. 5: Basic Model and Expansionary Open Market Policy (note thatpoints above Monetary Neutrlity Index line indicate expansion of Y and hence of marginal product of capital which in turns will raise i!

FF0 FF0

MNI0

BB1 BB0

E0E0

E1

e

αBB0

MM0

i0 i0

e0 e0

e1

0 i0i1 i

MNI

e a) b)

MNI0


Reduction of Foreign InterestRate in the Branson Model

E1

FF1 E1

BB1 BB0

FF1

BB1 BB0

E0E0

e

FF0

i0 i0

e0 = e1

0 i0i1 i

FF0

e a) b)

e0

e1

Fig. 6: Depreciation (a) versus Fall of Interest Rate


The Banking Crisis: Rise of the Interest Rate (Less Integration); & Higher Risk Premium

Fig. 7: Rising Financial Market Integration (a); Rise of Risk Premium (b)

e3

BB1 FF2BB2

E2

E3

0

E2

I H

G

E0

e

e0

BB0

FF1

FF0

MM0

MM1

0 i0 i

a)

e0e1

i0 i1 i

MM1

FF1

b)

MM2

Appendix 2: World Economic Outlook 2008 Oct. (IMF)


Source: IMF (2008), World Economic Outlook Financial Stress, Downturns, and Recoveries, October 2008, International Monetary Fund, Publication Service, Washington D.C., pp. 149

Appendix 3: World Price Index Formula; Relative tradable price in country I and II will fall (excess supply large in world recession); absolute nontradable price will fall in I & II (excess supply of housing stock will reduce rents): $ appreciation= world deflation =+rec


=P W

( )

⎜⎝⎛ ⎟

⎠⎞

−

PeP*

1 α

α where α ∈ ] 0 , 1 [

We have P * = ( )P T * '*α

)(( )P N * '*1 α−

P = ( )P T 'α

)(( )P N '1 α−

P T = e P T *

(1) P α = ( ) )(( ) )( PP NT '1' αα α−

= ( ) ( )( )PPP NNT '' αα α−

= ⎟⎟

⎠

⎞

⎜⎜

⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

PPP N

TN

'α α

(2) ( )( )Pe * 1 α−

= ( )( ) ( )( )( )PPe NT * '*1* '* 1αα α− −

=

( )

⎟⎟

⎠

⎞

⎜⎜

⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛−

PPPe N

TN

*

* '**

1α α

Therefore the world price index is given by P W

(3) P W = ⎟⎟

⎠

⎞

⎜⎜

⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

PPP N

TN

'α α ( )

⎟⎟

⎠

⎞

⎜⎜

⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛−

PPPe N

TN

*

* '**

1α α

Explaining the World Price level

1) φ = φ (lny)2) φ* = φ* (lny*)3) PN = Mλ[Nd/N]λ‘4) PN* = M*λ*[Nd*/N*]λ‘*5) eF*/P = f[M/P + QK]; Q= P‘/P6) (eF*/P)/(QK) = f[M/(P’K) +1]6‘) lne + lnF* - lnP’ – ln K = f[M/(P’K) +1]

Appendix 4:Return on Equity for Major Banking Groups in Germany

Return on Equity (1) for Major Banking Groups in Germany (2) Commercial Banks (3)

of which Total Major Banks Regional Banks and

other Credit Banks

State Banks Savings BanksCooperative

Central Banks

Credit Cooperatives Period

Pillar 1 Pillar 2 Pillar 3 1994 10,93 12,48 10,08 7,84 19,21 15,16 17,38 1995 10,31 10,18 10,68 8,87 22,58 12,98 19,48 1996 10,77 11,79 10,15 8,66 21,38 14,8 17,72 1997 9,68 7,38 11,52 10,9 19,37 12 14,94 1998 27,36 39,51 16,75 11,69 17,82 28,57 12,84 1999 9,69 6,23 16,51 10,61 15,18 5,74 10,7 2000 8,19 6,34 11,58 8,14 13,39 12,95 8,59 2001 4,74 4,96 4,13 4,78 9,16 4,43 7,46 2002 0,97 -3,14 8,99 2,8 8,15 4,56 9,68 2003 -6,24 -12,85 4,53 -4,25 10,89 0,66 10,64 2004 -0,42 -3,97 5,66 1,07 9,72 2,91 10,32 2005 21,82 31,72 8,63 6,44 10,45 5,25 13,79 2006 11,24 14,01 7,01 11,4 8,95 4,49 10,93

1994- 1999 13,12 14,6 12,61 9,76 19,25 14,88 15,51 2000- 2006 5,76 5,3 7,22 4,34 10,1 5,04 10,2

Variance 76,66 192,97 15,60 21,85 26,90 56,91 14,15

1) Net income before taxes in percentage of average equity (including Fonds for general banking risks, excluding jouissance rights). – 2) All reporting credit institutions, that fall under the MFI-definition of the ECB and have the status of universal banks. – 3) Major banks, regional bank and other credit banks as well as branches of foreign banks.

Additional perspective: If country I causes negative externality in I and II (b); allocation ok, but price of risk too low worldwide

P.J.J. Welfens www.eiiw.eu (2009) 72If full price of risk becomes apparent in t1+n: Governments pick up the tab!

K’

L’

M’

J’

Z

DD0*

D’C’

k’0

k’1

DD0

GI

CF

D

EB

A

H

p

0

p1

p0

q1q0 q

p*

q*

B’A’

0

a) b)

k’0*

k’1*

Y

Y’

Paul J.J. Welfens, EIIW (www.eiiw.eu) 73

Appendix 5: Marshall-Lerner Condition (see Welfens 2009a)

…FDI and GDP aspects imply that the modified Marshall-Lerner condition stated here – for the case of an economy with FDI and multinational companies – is stricter than the traditional Marshall-Lerner condition. It will be useful to define X” as the ratio of real exports to real imports and to denote the elasticity of X” with respect to the real exchange rate q* as EX”,q* . For a two-country setup – with both countries producing in accordance with a Cobb-Douglas production function (output elasticity of capital is ß; in foreign country ß*) and with two-way foreign direct investment –, one may express the modified condition for an improvement of the current account (with φ, φ* denoting import elasticities in the home country and the foreign country) indirectly as.


Economic Modelling Framework: α is the share of foreign capital stock owned by investors from country 1

1) Z*= Y*(1-αß*) + α*ßY /q*2) Z= Y(1- α*ß)+ q*αß*Y*3) X = X(q*, (1-αß*)Y* + α*ßY/q*);4) J = J(q*, Y(1-α*ß) + q*αß*Y*);5) X= q*φ* x [Y*(1-αß*) + α*ßY/q*] 6) J = q*-φj [Y(1-α*ß)+ q*αß*Y*]Consider X” := X/(q*J) instead of current acc.

GNP (Z) is GDP plus net factor income from abroad; relevant in the case offoreign direct investment; imports and exp. depend on Z, Z*, respectively (!)


Formal Analysis

7)

Using the parameter Ω from the implicit definition Y*= ΩY gives:

8)

*

1-

*+ -2

q* x [Y *(1- ß*) + *ßY /q*]X "q* j [Y (1- *ß)+ q* ß*Y *]

x [q*Y *(1- ß*) + *ßY ]q* 0j [Y (1- *ß)+ q* ß*Y *]

ϕ

ϕ

ϕ ϕ

α α=

α αα α

= <α α

( ) ( ) ( ) ( )( ) ( ) ( ) ( ) ( )

( )( ) ( ) ( ) ( ) ( )

( )( ) ( )

*+ -2ln X" ln q* ln x [q*Y*(1- ß*) + *ßY] ln j [Y(1- *ß)+ q* ß*Y*]

*+ -2 ln q* ln x ln j ln q*Y*(1- ß*) + *ßY

ln Y(1- *ß)+ q* ß*Y*

*+ -2 ln q* ln x ln j ln q* Y(1- ß*) + *ßY

ln Y(1- *ß)+ q* ß* Y

*+ -2 ln q*

ϕ ϕ= + α α − α α

= ϕ ϕ + − + α α

− α α

= ϕ ϕ + − + Ω α α

− α α Ω

= ϕ ϕ + ( ) ( ) ( )( )

ln x ln j ln q* ß*q* + *ß

ln 1- *ß+ q* ß*

− + Ω−α Ω α

− α α Ω


The elasticity is calculated using the equivalence:

9)

10)

X",q*E

( )( )

( ) ( ) ( )1

X",q*

d ln X" d ln X" d ln q * d ln X"E q *

d ln q * dq * dq * dq *

−⎛ ⎞

= = =⎜ ⎟⎝ ⎠

X",q*

1 ß* ß* 1 *ß 1- *ßE *+ -1+ *+ -11 ß* + + ß*q* q*

−α α⎡ ⎤− −⎢ ⎥α α= ϕ ϕ < ϕ ϕ−α α⎢ ⎥Ω Ω⎣ ⎦

Role of Shortterm Foreign Debt D‘($); country II is reservecurrency country, but we have flexible exchange rates;endogenous Y,Y*,r,r*,q*; Q Tobin‘s P‘/P

(1) Y = C(Y-T, QK, q*Y*) + I(D‘q*,q*,r) + G + X(q*,Y*,Y) –q*J(D‘,q*,Y*,Y); equilibrium IS(2) M/P = hY – h‘r (exp. inflation 0); LM curve(3) X(q*,Y*,Y) – q*J(D‘,q*,Y*,Y)= bq*D‘; CA(4) Y*= C*(Y*-T*, Q*K*, Y/q*, D‘)+ I*(q*,r*) + G* + J(D‘,q*,Y*,Y) - X(q*,Y*,Y)/q* (5) M*/P* =h*Y* -h‘*r* +hq*jY –v‘r* +v“q*D‘dY/dG, dY/d(M/P), dY/dQ*, dY/dD‘, dY*/dD‘,…


Some of the issues („home country“ ROW is rest of theworld or EU; * is foreign; D‘ short-term foreign debt)

Modelling the demand for $ is inadequate in many models forthe US and global economy, assume that real demand for $ reserves is proportionate to volume of imports J

Consistent modeling≠standard approach; eg $ money market

equilibrium: overestimation of H*i* if the demand for money forUS $ puts focus only on US demand (H*); add demand for $ in the restof the world (depending on i*, trade, D‘)$ market equilibrium M*/P*=H*(Y*,i*)+H(J,i*,D‘); where imports J in ROW written J=j(q*)Z; Z is GNP; J=j(q*)[Y(1-α*ß)+ αß*q*Y*]; ß* isoutput elasticity in the US, ß in Rest of the World; α is the share of capital stock owned by US investors; q* real exchange rate. Cobb-Douglas in US and in ROW.


What to avoid in the global reform process


Banking Crisis Raises Issues aboutSocial Market Economy

Property/liability rights and competition workBut competition in banking not established.Why?

Clear liability rules lacking:In the US not applicable to owner of housesTop managers of banks and banks themselves rarelyliable; government bail-out of big banksPrudential supervisors failed!! Responsibility?!

Internationalization of external effectsNegative international effects of inadequate national (US) banking regulation ignored so far


References (selected)

ARTUS, P.; VIRARD, M.P. (2005), Le capitalisme est en train de s’autodétruire: Paris: Editions la DécouverteFROOT, K.A.; STEIN, J.C. (1991), Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach, Quarterly Journal of Economics, November, 1191-1217.GOODHART, C.A.E. (2007), The background to the 2007 financial crisis, International Economics and Economic Policy, Vol. 4, 331-339.OBSTFELD, M.; ROGOFF K.S. (2005), Global current account imbalances and exchange rate adjustments, Brookings Papers on Economic Activity, Vol. 1, 2005, 67-146.WELFENS, P.J.J. (2007), Banking crisis and prudential supervision: a European perspective, International Economics and Economic Policy, Vol. 4, 358-367.WELFENS, P.J.J. (2008a), Innovations in Macroeconomics, 2. rev. and enlarged edition, Heidelberg und New York: Springer. WELFENS, P.J.J. (2008b), Transatlantische Bankenkrise, Stuttgart: Lucius)WELFENS, P.J.J. (2008c), Portfolio Modelling and Growth, EIIW Working Paper No. 160, EIIW at the University of Wuppertal, forthcoming in International Economics and Economic Policy, Vol. 5, November.WELFENS, P.J.J. (2008d), Financial Market Integration, Stability and Economic Growth in Europe, Paper presented at the Jean Monnet Workshop, Financial Market Integration, Structural Change, Foreign Direct Investment and Economic Growth in the EU25, Brussels, DG II/Europäische Kommission, 28. April, 2008, in: WELFENS, P.J.J. ET AL., ed. (2008), Financial Market Integration, Adjustment and Growth, Heidelberg und New York: Springer (forthcoming).WELFENS, P.J.J. (2009b), Financial Markets, Growth and Instability: Theory and Policy Issues, Heidelberg und New York: Springer (forthcoming).WELFENS, P.J.J. (2009a), Marshall-Lerner Condition and Economic Globalization, EIIW Working Paper No. 168, EIIW at the University of Wuppertal.WOLF, H. (2007), Rethinking banking supervision in the EU, International Economics and Economic Policy, Vol. 4, 368-373.



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