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Reflections on the Financial Crisis: Back to Fundamentals

Reflections on the Financial Crisis: Back to Fundamentals. F. Montes-Negre t 1/ VUZF University, Sofia May 10, 2012 1/ The views are exclusively mine and do not represent those of the IMF or its Board of Directors. (Ambitious) Agenda.

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Reflections on the Financial Crisis: Back to Fundamentals

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  1. Reflections on the Financial Crisis: Back to Fundamentals F. Montes-Negret 1/ VUZF University, Sofia May 10, 2012 1/ The views are exclusively mine and do not represent those of the IMF or its Board of Directors.

  2. (Ambitious) Agenda • Motivation: Dramatic changes in financial markets & banking • The theoretical framework frames the questions & the questions limit the scope of the answers; • The “problem” of very low interest rates; • Financial viability in terms of cash flows; • Three critical financial ratios: • Leverage (ROE); • (Loan/Deposit) ratio; and • Loan-to-Value (LTVs) ratio • Credit underwriting standards and housing finance; • Pro-cyclicality and downward “spirals”; • Aligning incentives faced by different stakeholders; • Some conclusions – What happened, more than Why it happened? • Annexes: (1) Housing Crisis (Ireland & Spain); (2) Reading Market Signals (CDS)

  3. Dramatic Changes in Financial Markets and Banking

  4. Dramatic Pace of Change in Finance

  5. The emergence of a large “shadow banking” system

  6. US: Rapid Growth of Non-bank Asset Pools

  7. “Run” on Asset-Backed Commercial Paper

  8. Pro-Cyclical role of rising “haircuts”

  9. Downward pro-cyclical “spirals”: Margin Calls

  10. The Theoretical Framework

  11. Different Theoretical Frameworks

  12. Before & after: Effects of Financial Crises

  13. Upward pro-cyclical “spirals” (Euphoria)

  14. The “problem” of very low interest rates

  15. Some Consequences of very low interest rates for a prolonged period of time (the “Great Moderation”) Macroeconomic Consequences: • Encourages consumption over savings; • Raises credit demand and possibly leads to household over-leverage; • Reduces cost of maintaining fiscal imbalances; • Encourages bank leverage & riskier “search for yield”. Microeconomic Consequences: • Distorts investment rules (see next slide); • Leads to misallocation of resources (capital); • Encouragers rising marginal (K/L) ratios;

  16. (Public Debt/GDP)

  17. Deficit Financing & Debt Rollovers

  18. Inter-Temporal Opportunities for Investment and Financing (with decreasing marginal productivity of capital)

  19. The IRR and Financial Interest Rates • Simple two-period model; • Optimal Investment rule: Invest up to the point where the marginal productivity of capital (slope of the production function) is equal to the market (financial) interest rate (slope of M”M”’): I₀ * = (Y₀ – P₀). • Yield in period 1: (P₁ - Y₁)= (Y₀ – P₀) (1+ρ), where ρ= average productivity of invested capital. • To the left of D’ it is not rational to continue investing, since the return will be below what it can be obtained from a financial placement. • If market interest rates fall (the slope of M”M”’ flattens), two things happen: (i) present consumption becomes more attractive; and (ii) and more projects are “accepted’ by the decision rule. At the limit the rule become non-biding and possibly sub-optimal investment projects are selected (wasteful investments).

  20. Financial viability in terms of cash flows

  21. The Cash-flow problem Financial viability: • “Hedge”: cash flows sufficient to meet all payment commitments on outstanding liabilities; • “Speculative”: balance sheet cash flows larger than the expected income receipts, requiring rollover of obligations or increased debt; • “Ponzi”: increasing debt to pay debt. (2) & (3) require portfolio transactions to meet payment commitments, exposing units to changes in financial market conditions.

  22. Three Critical Financial Ratios

  23. Three Ratios that Almost Brought Down the Financial System • 1. Leverage: Return on Equity (ROE) • 2. Funding: Loan to Deposits (L/D) • 3. Credit Risks: Loan-to-Value (L/V) Three Critical Ratios:

  24. Profitability as Main Driver:“The Engine of Capitalism” • Bank’s Return on Equity: ROE= (π/K)= (π/A) . (A/K)= ROA x Leverage π= Profits, K= Capital, A= Assets • Not all the πs and As were real: misleading accounting and off-balance sheet operations; • ROE contingent on a given level of risk: principal-agent problem & new misleading risk management technology; • Provided mainincentive for bank managers to induce an explosion in debt financing: negative systemic externalities. “The private incentive to increase leverage created not only fragile institutions but also an unstable financial system” (BIS).

  25. Reducing Banks’ Leverage: K More Bank Capital: • For all banks (independent of sources of funding)? • For the largest only? Tier 1? • In all or some jurisdictions? • How about NBFIs? More disintermediation? • Effects on lending rates? Fairness/dilution? • Lending rate needs to cover the cost of own and borrowed funds, any expected credit losses, all administrative expenses, net of some potential “relationship” and other benefits of making the loan. • The sensitivity of the lending rate will vary to increases in capital, but more capital will make loans more expensive.

  26. Pricing implications of more K Effective lending rates (L): L(1-t) ≥ (K. rk) + [(D. rd)+ C + A -O)] (1-t) Where: t=marginal tax rate; K= proportion of K backing the loan, rk= required rateof return on marginal K; D= proportion of debt and deposits funding the loan (L-E); rd= effective marginal rate on D, C= credit spread; A= administrative expenses; O= other offsetting benefits to the bank of making the loan.

  27. Reducing Banks’ Leverage: A • Reducing Bank Assets: • More disruptive to reduce leverage by reducing bank assets than by increasing K: “credit crunch”; • “Fire sales” of less liquid bank assets can increase losses and transmit contagion throughout system; • Cross-border implications; • Bringing off-balance sheet operations into banks’ BS makes a net asset reduction even more difficult;

  28. Over-Leverage of all players: Banks

  29. (L/D) Ratio and Market Share of Bank Foreign Subsidiaries

  30. High Leverage of EU Major Banks

  31. Credit underwriting standards and housing finance-

  32. US Housing Bubble

  33. US Housing prices and financial crisis

  34. US: Household Debt to Disposable Personal Income(135 in 2007)

  35. Importance of Mortgage Financing in the BS of EU and USA Banks

  36. Depletion of Borrower’s Equity in FX Home Loans: LTV in local currency = [ (LCHF.FXR) / V (1- pd) ] For loan-to-value ratios of 70% and 80%, depreciation of the exchange rate (FXR) or a reduction of property prices (p) leads quickly to negative equity values for bank borrowers (i.e.; numbers in excess of 100% in tables below). 42

  37. Propagating Factors, Pro-cyclicality and downward spirals

  38. Crisis Propagating Factors: Accounting Rules (“Accounting for Bank Uncertainty”, Haldane, BoE, December 2011)

  39. De-stabilizing Pro-Cyclicality “The striking feature is that leverage is pro-cyclical in the sense that leverage is high when balance sheets are large, while leverage is low when balance sheets are small. This is exactly the opposite finding compared to households, whose leverage is high when balance sheets are small”. Adrian & Shin, 2009

  40. Perverse incentives: Banks Upswing phase: • Encourages leverage ( to max. ROE) and closely associated bankers’ remuneration (not linked to risk-adjusted factors or ROA). • “Search for yield” leads and more capital might lead to more risk-taking. • Regulatory arbitrage and “shadow banking”. Downward phase: • Over reacting through de-leveraging and excessive risk-aversion.

  41. Aligning incentives faced by different stakeholders

  42. Result of Banks’ Perverse Incentives

  43. €15 tr. in total bank assets and €5 tr. of RWAs (2007)

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