From the End of Bretton Woods to the Global Financial Crisis: 40 Years of Turbulence

From the End of Bretton Woods to the Global Financial Crisis: 40 Years of Turbulence Risk Management Conference Dr. Hugo Bänziger The European Association for Banking & Financial History13.06.2014

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • Latam Debt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Default etc. • Risk Management matures … • … and fails in the Global Financial Crisis • Conclusions

30 Years of Stability followed by 40 Years of TurmoilDid Risk Management Make a Difference?

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • LatamDebt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Default • Risk Management matures … • … and fails in the Global Financial Crisis • Conclusions

The US Financial System after 1933Segregation, Deposit Insurance, Supervision & FED Reforms • March1933, Bank Holiday & Emergency Banking Act • Bank Recapitalisation & Resolution Power • March 1933, Securities Act • Regulation of primary market (underwriting) • Mandatory registration & prospectus, transparency requirements • June 1933, Glass-Steagall Act • Separation of investment & commercial banks • Federal Deposit Insurance Corporation (FDIC) • Regulation Q & Large Exposure Limits • Regulatory Reporting & Supervision • June 1934, Securities & Exchange Act • Establishment of SEC, Regulation of secondary trading (stocks, bonds) and Exchanges • June 1935, Banking Act (FED Reform)

The Bretton Woods SystemStable Exchange Rates, Bail-out Mechanism, USD as Gold substitute • BrettonWoods Conference in 1944 with 44 allied signatory countries • 3 Pillars of Bretton Wood System • Free Trade (GATT, 1947 in Geneva) • Fixed Exchange Rates & Capital Controls (IMF) • Development & Recovery (IBRD, World Bank) • All currencies pegged to USD • USD pegged to gold at $35.-/oz • Pegs & capital controls were adjustable • Adjustments for France, Germany and UK • With international recovery, trade volume increased faster than gold supply • Gold pools after 1961 to defend USD peg • US was the world’s central banker source: Oono K, www.grips.ac.jp

Banks in Europe and AsiaEmerging from the Ashes of World War II • Germany & Japan were bankrupt after WW II. Banks were largely worthless • Inflation was rampant until the currency reform of 1948and the pegging in 1949 • Japan created the Keiretsu system to finance the reconstruction via BoJ • Germany used its Landesbanken • Bank lending was the key instrument • Cross-shareholdings and -directorshiplimited risks of loanportfolio • France nationalised banks in 1945 • The UK saw a sharp contraction of its economy after World War II • Capital controls across Europe & Asia

The Banking Business Model 1945 to 1973Simple, stable and highly regulated • Banks were national and had few other assets than loans & cross-shareholdings • Deposit rates were regulated • No interest or foreign-exchange risk • Investment banks were partnerships • Limited international capital mobility • Sub-due level of IPOs & bond offerings • Limited secondary trading – if any • Tightly regulated risks on balance sheets • Banks organised in branches & regions • Every country supervised banks • Business & risk management identical source: Du, L. (2014), Cambridge Judge Business School Source: R. W. Goldsmith (1965), National Bureau of Economic Research

New Developments in the 1960sReturn of Capitalist Dynamics • President Johnson’s ‘Big Society’ program & Vietnam War root cause of US inflation • EEC and Japan made currency convertible in 1958 and 1964 respectively • 1963: Interest Equalisation Tax – large USD amounts build up outside US • 1963: Italian Autostrade issues the first USD denominated Eurobond • To lower funding cost, US corporates re-discover Commercial Papers for ST debt • Banks counter by offering convenience accounts and Certificates of Deposits • 1959: IBM offers computer service centers • NYSE allows members to go public in 1970

The End of Bretton Woods1961 – 1971 From Stable to Floating Currencies • 1960s see a negative US balance of payment, the increase in international trade and the return of large international capital flows • 1965: banksbegin to establish large international loan-underwriting syndicates • Bretton Woods’ gold pools partially successful • 1967: Sterling devaluation after run on £ • 1968: US Congress repeals 25% gold covery ratio for US Dollar • 1968: France & other countries start to increase holding of physical gold • 1971: Nixon unilaterally closed the ‘gold window’ – gold convertability ends • 1973: Japan & EEC let their currencies float • The once stable asset classes of fixed income (bonds) & foreign exchange become volatile • Luckily, most banks still operate domestically

1973 and its ConsequencesThe World becomes volatile • Black Scholes Model for valuation of options • Chicago Board of Options Exchange • First Mobile Phone Call • ATMs rolled out all over the US • President Nixon resigns • Yom Kippur War • Oil Shock – Recessions return • IBM S/370 and HP 9800 spread in the banking industry • Glass fibre optic cables invented • It becomes possible to handle large trading volumes

The Oil ShockImpact on Financial Markets • Because US oil production peaked around 1970, OPEC oil embargo lead to sharp re-pricing of oil & energy in 1973 • The significantly increased $ proceeds flowed primarily to the interbank market and gave the City of London a boost • The $ liquidity needed to be invested – lending to Less Developed Countries • The flow provided the backbone for the significant growth in syndicate lending • Eurodollar bond market took off (CSFB) • US Investment Banks expand to Europe • New financial centers around the globe: Frankfurt, Hong Kong, Singapore

Information Technology and CommunicationChanging the Dynamics of Banking • 1981: IBM 5150 Personal Computer • WordPerfect, Lotus 1-2-3, PowerPoint, Access became widely used applications • Rapid decline of processing cost • 1977: 1st fibre optic cable in California • 1986 SOFFEX (EUREX) 1st electronic options & futures trading platform • 1988: 1st trans-atlantic cable • All banks invested heavily in technology • IT systems followed accounting process; regional set-up with monthly closing of the bank’s books • IT systems were hardcoded, embedding data in processing instructions Ln (Cost per million instructions) 1970 1980 1990 1950 1960 Apple II: Micro computer IBM PC Compaq Portable DEC PDP-1: Mini computer source: Morrison, Wilhelm 2004

Institutional InvestorsThe new owners of the bank’s liability side • Mid1950: the Mutual Funds industry develops in the US (1970: AuM 48bn) • Mid1960: Funds reached Europe • Mid1960: Establishment of US Money Market Funds (207 AuM 4.0 tr) • Demographics in US & Europe force a re-thinking of government run ‘Pay-As-You-Go’ pension systems • 1972: 3-Pillar Retirement System in CH • 1974: Employment Retirement Income Security Act (EIRSA) • 1992: UK Pension Scheme Act • 2002: Hartz IV reform in Germany • Total global deposits of $ 26tr vs. $ 80tr of professionally managed funds • Many of these institutional investors have statutory return requirements

International ExpansionBanks Become Global • Absence of currency controls spurs free flow of international capital • National banks establish branches abroad • Citibank has today 9’000 branches in 44 countries • Santander makes only 13% of its profits in its home market in Spain • Anchor productsare commercial loans and consumer credit • Merger wave begins (Citi, JPM, BofA, BNPP, RBS, BoS, HSBC, BBVA, UniCredit etc) • Rapid consolidation of US investment banks • By 2000, ≈ 70 partnerships become 5 large brokers/dealers: Goldman Sachs, Morgan Stanley, Merrill Lynch, LehmanBrothers, Bear Sterns • Consolidated: Shearson, Dean Witter, Loeb, Kidder Peabody, Paine Webber, Hutton, White Weld, Salomon Brothers, First Boston

Deregulation – Animal Spirits RestoredThe end of the straight jacket • 1958 / 1964: Abolishment of capital controls in both EEC and Japan • 1973: free floating of currencies • 1980: Removal of regulation Q – restrictions on deposit interest rates • 1980: Removal of business restrictions for Savings & Loan Associations • 1984: Removal of barriers to interstate banking • 1986: ‘Big Bang’ in City of London • 1992: Maastrich Treaty: 4 Liberties (Goods, Capital, Labour, Services) • 1999: Graham-Leach-Billey Act removes Glass-Steagall separation • 2006: European Directive on Services in Internal Markets

Early Days in Risk ManagementEscalation to the Top • Establishment of new credit committees on board level • Joint liability for credit decisions • Branch and regions managed by trusted ex-pats with little credit authority • New HQ units for credit policies for main products (loans) • Matched funding strategies • Market & settlement risk hidden in accrual books • 1974: Settlement risk became visible with Herstatt Bank – not easy to settle across countries Source: S.Krisiloff 2012

The Basel Committee for Bank Supervision (BCBS)Central Bank Governors Take Notice • The end of Bretton woods with free flow of capital and floating exchange rates made many central bank governorsnervous • 1971: a standing BIS committee was set up to assess the macro-economic impact • 1975: following the collapse of Herstatt Bank, the BCBS was established, including for the first time bank-supervisors • When 1982 the Latin American Debt Crisis revealed the insufficient capital levels of US Money Center Banks, Congress raised capital standards and tightened supervision • FED Chairman Volcker went to the BCBS in 1983 to ask for equivalent international capital requirements (Japanese banks!) • The result was the Basel Accord on Capital (Basel I) in 1988 • It introduced RWAs and min. Tier 1&2 ratios

The Derivatives Revolution“Eventually, everything will become tradable” – Alan Wheat, CEO CSFB Derivative financial instruments (notional amounts outstanding in billions of US dollars) • Technology advances (PC), revolution in communication (fiber) and deregulation made global trading possible • Arbitrage on a global level provided big revenue opportunities • Derivatives highly profitable in 1990 (20bp for CS, 8bp for IRS) • Both investment and universal banks built large trading operations with thousands of live trades • By the end of the century, all asset classes were traded under FV and VaR • Financial Markets have become truly global. Indonesian bonds were sold to US investors, RMBS to European buyers • Derivatives essential to risk management Source: G. Capelle-Blancard 2010

Short History of Value-at-Risk (VaR)Performs well for liquid markets but not in cliff events • Traders developed VaR and FV simultaneously in order to calculate probability of loss in a portfolio at a given confidence level • VaR was calibrated with historical data or Monte-Carlo simulation • 1989: VaR found quickly its way into management reporting (JPMorgan) • 1996: the Basel Committee (BCBS) developed capital requirements for market risk based on VaR • 1992: JPM began marketing Risk Metrics which was based on VaR for managing risks • 1998: EU adopted CRD I which introduced VaR based min. capital requirements for market risk • 2007: SEC required all banks to publish their VaR numbers in their annual report • In 2010, EU complemented VaR with SVaR+IDR

Short History of Fair Value AccountingThe Law of Unintended Consequences • Started with futures trading mid-1980s to calculate margin requirements • 1986: Establishment of SOFFEX, 1st fully electronic exchange • In 1990, few banks (Bankers Trust, CSFP, GS, JPM) used Fair Value to account for their OTC Derivatives • 1993: FAS 115 allowed banks to use Fair Value for equity and debt securities in trading books • FV allowed netting of positions (hedge) • 1994: when $ yield curve turned, many banks suffered significant losses • These losses accelerated the use of FV • 1994: credit default swaps – JPM, CSFP • Market liquidity was not a criteria for FV

The Unintended Consequence – Light Capital Treatment Traded Assets and respective Risk Weighted Assets Trading RWA % Assets RBS 2007 237bn N/A N/A RBS 2012 173bn43bn 25% Citibank 2007 538bn109bn 20% Citibank 2012321bn41bn 13% Deutsche Bank 2007 596bn14bn2% Deutsche Bank 2012439bn53bn12%

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • LatamDebt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Crisis • Risk Management matures … • … and fails in the Global Financial Crisis • Conclusions

Latin American Debt CrisisThe Lost Decade • Many LatAm countries borrowed huge sums from international banks in 1970s • Cumulative debt growth rate: >20% p.a. • Most spent on infrastructure & development • 2nd oil shock made balance of payment massively negative • Tightening of monetary policy in US and Europe increased interest rates sharply • 1982: Mexico and Brazil defaulted • 16 Latin countries re-scheduled • Austerity programs induced recessions • USA: banks could delay loss regognition for several years until 1987 • Bready Bonds: ≈1/3 of debt forgiven source: J.A.Ocampo 2013, data from The World Bank and ECLAC

Japanese Asset Bubble 1986When Japanese Banks Bought the Rockefeller Center • Unrestricted money & credit supply – BoJ cut ST rates from 5% (1986) to 2.5% (1989) • Export boom made corporates cash rich– subdue demand for commercial loans. Stock market boom lowered cost of capital • Deposit rich banks pushed into mortgages & margin lending • Price peaks in 1988/1990 • Two lost decades of economic growth • Sanyo Sec., Yamaichi Sec., LT Credit Bank & Nippon Credit Bank rescued by government • Wave of mergers created the big banking conglomerates of today • Tax payer’s bill: ¥ 9.3 tr (USD 91bn)

Savings & Loan Associations 1980 – 19951/3 of 3’240 Thrifts failed • S&L lent their deposits long-term fixed • Interest rate increase by FED to curb inflation caused big banking book losses • In 1976, S&L controlled 80% of $ 700bn mortgage market • 1980: deregulation allowed Thrifts to expand commercial & consumer banking but without adequate oversight • Thrifts grew 56% from 1980 – 1983 by financing speculative malls & property developments • 1989: Resolution Trust Corporation • RTC resolved 747 S&L to 1995 • Losses: USD 160bn (tax payers 120bn)

Scandinavian Financial Crisis1991-92Well-fare State Re-designed • Rapid expansion of lending due to sharp increase of short term debt in banks • Property prices peak in 1991 • Bubble bursts in 1991 - 1992 • Loan loss provisions 1990 - 1993: Sweden 4.5%, Finland 3.4%, Denmark 3.0%, Norway 2.7% • 1991: Governments had to guarantee all deposits • Nordbanken & Gotabanken nationalized • Governments created bad banks which took over distressed debt for equity • GDP dropped by 5% 1990 - 1993 • Unemployment rate on new 6% plateau

The Tequila Crisis 1994NAFTA – To Good to be True • North American Free Trade Agreement entered in effectJanuary 1, 1994 • NAFTA accounts for 21% of world GDP • Mexico entered NAFTA with overvalued Peso • In anticipation, government and consumer spending increased rapidly – all debt financed • For political reasons, government kept interest rates low (election year) • As investors started to sell Tesobonos, central bank reserves got depleted • December 1994: Peso devaluation • USA steps in with a $ 50bn stabilisation package • Three largest Mexican banks went bust and were sold (Citibank, BBVA, Santander) • Mexico recovered quickly due to low debt levels

Asian Debt Crisis 1997 - 1998The Curse of Portfolio Investments • Based on strong economic performance, pegged currencies attracted a significant USD short-term money & portfolio investments • Most was invested long-term in real estate, projects or infra-structure • Crony capitalism syphoned off a large portion of these funds. This mis-allocation of investments was one of the root causes. Investments produced no cash flows for servicing debt • Mid1997, investors wanted to get out • When governments could not defend the peg, currencies crashed. Cut off from access to finance, GDP dropped. In Thailand & Indonesia banks collapsed. • IMF intervened with package of $ 40bn • Korea’s bank had a bad debt problem • HK, Singapore & Taiwan were able to defended their peg

Russian Crisis 1998When the Ruble turned to Rubble • Overvalued exchange rate & the large fiscal deficit under Yeltsin at the core of the crisis • In March 1998, the Russian government faced difficulties in placing Ruble denominated debt with Russian banks and investors • Government debt was placed abroad where it was picked up due to high coupon rates • IMF granted a package of $ 22bn to stablize market and swap short-term GKO to long-term Eurobonds • Yeltsin decided to keep the $ peg in July • In August, investors started to flee. Stock market crashed, Ruble plummeted by 75% • 17 August, Ruble devaluation & moratorium • Inkombank, Oneximbank, Tokobank closed • Massive capital outflows, inflation at 85% Graph source: Morrison, Wilhelm 2004

Dot Com BubbleLearning the wrong lesson? • Low level of $ rates provided start ups with easy access to capital • Investors were looking for higher yielding assets to compensate low yielding treasuries • Internet became available to wider public in 1990. By 2002, almost all US schools had access to internet • Netscape browser • 1995: amazon.com, 1998: Google • AOL merger with Time Warner Jan 2000 • FED increased $ rates 6x in early 2000 • 10th of March 2000, bubble burst with NASDAQ at 5’408.60 points • 2000 – 2002: $ 5tr in market value destroyed • But 48% of dot.com companies survived • There was no bank financing

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • LatamDebt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Crisis • Risk Management matures … • … and fails in the Global Financial Crisis • Conclusions

Risk Management MaturesEconomic Capital Concept • Value-at-Risk captured the risk of a portfolio • Economic Capital attempted to capture the risk of the entire enterprise • Risk calculated with various comfort levels: 99%, 99.5% or 99.8% • Computer runs took easily an entire night • Concept developed on trading floors • Popularized by JPM’s Risk Metrics 1992 • Used to allocate capital in some firms – often against stiff resistance • Key challenge: availability & quality of data • Loss-Given-Default not retrievable • Probability of Default of banks? • Operational loss data spotty • With a high degree of accuracy, we calculated garbage

Risk Management Matures IIRisk Management Divisions • Dedicated Risk Managers are first found on the trading floors managing single books • Concept appears first time in GE Capital which is known for its six-sigma concept • With Sarbanes-Oxley it quickly spreads to the manufacturing industry in the US • Mid1990: James Lam from GE Capital the world’s first CRO? • McKinsey, Oliver Wyman and other consultants advocate for independent risk organisations as early as 1993 • Role of Risk Management? First or 2nd line of defence? • Risk systems independent or fully integrated? • Centralized or decentralized organisation? • Role of Risk in Capital Management? Amy Brinkley, CRO BofA

Regulation Becomes GlobalSupervisory Principles and Basel II • 1997: Core Principles on Supervision (3 Lines of Defence) • 1999 – 2004: Basel II Process • 2 Consultation Papers • 2 Impact Studies • Based on Economic Capital concept • Advanced Approach based on internal models and data • Let to significant capital savings in Europe • FDIC objected; not implemented in the USA • National discretions; home – host issues • Model x model x model = unknown unknowns RWA = 12.5*K*EAD K = LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ (-1) × (1 + (M - 2.5) * b (PD))

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • LatamDebt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Crisis • Risk Management matures … • … and fails in the Great Financial Crisis • Conclusions

Global Financial CrisisSystemic shocks, high volatility & unprecedented policy interventions Phase 1:Private sector debt bubble implodes as US housing market collapses Phase 2:Unprecedented intervention transfers risk to public sector Phase 3:Sovereign debt crisis 3m Euribor – 3m Eonia swap rate, in bps (lhs) Itraxx Euro XO generic, 5y spread, in bps (lhs) S&P cuts Greece rating to junk VIX implied volatility index S&P 500, % (rhs) US downgraded, growth slowdown, EMU crisis focus shifts to Italy US bank stress-test results EU/IMF announce €110 bn bailout for Greece and €750 bn EFSF Fed rate cuts Greece reveals budget deficit numbers Fed approves takeover of Bear Stearns by JPM IKB warning and bailout EU bank stress-test results Japan earthquake Hypo Real Estate rescue Fortisstate support announced Takeover of AIG & Merrill Lynch, Lehman files for Chapter 11 UK bank capital injections Sources: Bloomberg, DB Research

The Epicenter of the Global Financial CrisisUS Mortgage Market • Total size: USD 13.1tr1 • Community Reinvestment Act Lending: USD 4.5tr • % of prime mortgages in Freddie Mac & Fannie Mae: • 1990: 80% • 1999: 45% • 2007: 15% • Around USD 2.0tr of aggregated losses during the Global Financial Crisis • Taxpayers paid $ 0.5tr, investors $ 1.5tr 1 Data a/o Q32012 from The US Federal Reserve Bank Source: Schiller-Case

The Epicenter of the Global Financial CrisisSecondary Triggers

The Epicenter of the Global Financial CrisisLeverage Evolution of Liabilities of MFIs 1998 – 2012, Euro-Area, in EUR bn Evolution of Assets of MFIs 1998 – 2012, Euro-Area, in EUR bn

The Global Financial CrisisShort Narrative • Trading & Investment Portfolios key revenue generators for EU and US banks • Collapse of US housing market spilled into ABS market • Any bank with open ABS positions suffered big losses • Liquidity dried up. First LT debt, then Money Markets, then trading positions • Large central bank interventions necessary as early as July 2007; large expansion of their balance sheets • Bail-outs in 9 & 10/2008 for US & EU banks • Quantitative easing as early as 3/2009 • Sovereign debt crisis in Europe after 2/2011 • EU banks unable to fund in both $ and EUR, LTR necessary Source: ECB data

Presentation Outline • 30 Years of Stability followed by 40 Years of Turmoil • The Business Model of Banks after Bretton Woods • The Forces which undid Bretton Woods • 1973 and its consequences • Early Days of Risk Management • The Derivatives Revolution, Value-at-Risk and Fair-Value Accounting • LatamDebt, Scandinavia, Tequila, Asia, Dot com bubble, Russian Crisis • Risk Management matures … • … and fails in the Great Financial Crisis • Conclusions

The Global Financial CrisisCulmination of 40 Years of Instability • Key drivers for GFC • Asset-Liability Mismatch • Large Leverage • Banks became investors • Insufficient transparency • Lack of governance • Total failure of risk management • Regulation not up to date • Basel II focussed on credit risk • Liquidity rules were outdated • Insufficient capital for market risk • Increased leverage not addressed • Crisis Accelerators • Global Interconnectivity of Banks • Fair Value triggered fire sales • Complexity overpowered management • Lack of capital market discipline

The Global Financial CrisisOpen items to address • Main losers of GFC were investors • Insurance, pension plans and mutual funds havel each 1/3 of global USD 80tr AuM. How to protect society’s safety net for rainy days and old age? • Market Structure of the Financial System • The pipes & pipelines to be utilities: payment systems, clearing & settlement do not need to be part of the private, risk taking sector • Markets to be accessible for everyone at the same price and liquidity • Trading to move back to exchanges • Proper representation of values • Capital market discipline requires a high level of transparency – way beyond what bank do today • Fair Value only for truly liquide instrumentsapproved by supervisory authorities • Simplify Corporate Governance • Checks & Balances; CEO-CFO-CRO one ticket

AppendixLiquidity inFinancialMarkets NYSE Turnover Asian Bond Turnover

From the End of Bretton Woods to the Global Financial Crisis: 40 Years of Turbulence