LECTURE 2RECENT GLOBAL AND EUROZONE CRISES: DID WE LEARN A GOOD

LESSON?

Sabur Mollah, PhDAssociate Professor of Finance

Stockholm Business School

PART I: HOW SIMILAR? HOW DIFFERENT? HOW COSTLY?

How Similar?Global financial crisis has four features

similar to earlier episodes: ◦Asset prices rapidly increased in a number

of countries before the crisis. ◦A number of key economies experienced

episodes of credit booms ahead of the crisis. ◦There was a dramatic expansion in a variety

of marginal loans, particularly in the mortgage markets of several advanced economies, which together led to a sharp increase in systemic risk.

◦The regulation and supervision of financial institutions failed to keep up with developments.

How Similar? Asset Price Boom The overall size of the U.S. housing boom

and its dynamics – including rising house prices in excess of 30 percent in the 5 years preceding the crisis and peaking six quarters prior to the beginning of the crisis – is remarkably similar to house price developments in the so-called Big Five banking crises episodes (Finland, 1991; Japan, 1992; Norway, 1987; Sweden, 1991; and Spain, 1977).

How Similar? Credit BoomsThe prolonged credit expansion in the run-up

to the crisis was also similar to other episodes.

Credit booms generally coincide with large cyclical fluctuations in economic activity—with real output, consumption, and investment rising above trend during the buildup phase of credit booms and falling below trend in the unwinding phase (see Fig. 1).

In the upswing, the current account tends to deteriorate, often accompanied by a surge in private capital inflows.

How Similar? Credit Booms

How Similar? Credit BoomsAs in past episodes, international financial

integration helped facilitate some of these trends.

Specifically, large capital inflows were associated with acceleration of GDP growths and for many countries, with credit expansion.

In addition, output growths were accompanied by large swings in aggregate demand and in the current account balance, with a strong deterioration of the current account during the inflow period (see Fig. 2).

How Similar? Credit Booms

How Similar? Marginal Loan and Systemic risk

In the United States (and to some extent the United Kingdom), a large portion of the mortgage expansion consisted of loans extended to subprime borrowers—households with limited credit and short employment histories.

Debt servicing and repayment were, hence, vulnerable to economic downturns and changes in credit and monetary conditions.

This maximized default correlations across loans, generating portfolios highly exposed to declines in house prices, confirmed ex-post through the large non-performing loans when house prices declined.

How Similar? Regulation and Supervision

Episodes of large credit expansion have also been associated with rapid financial liberalization, and poorly supervised and unregulated financial innovation.

Evidence indeed shows that past crises often followed credit expansions triggered by financial liberalization not accompanied by necessary regulatory and prudential reforms (see Demirguc-Kunt & Detragiache, 1998).

Moreover, imbalances often resulted from poorly sequenced regulatory reforms.

Underdeveloped domestic financial systems were often unable to intermediate large capital inflows in the wake of capital account liberalizations. Poorly designed financial reforms and deficient supervision often led to currency and maturity mismatches and to large and concentrated credit risks.

How different? Key Aspects

The crisis was different than the previous ones in at least four new aspects. ◦ First, there was a widespread use of complex and

opaque financial instruments. ◦ Second, the interconnectedness among financial

markets, nationally and internationally, with the United States at the core, had increased in a short time period.

◦ Third, the degree of leverage of financial institutions accelerated sharply.

◦ Fourth, the household sector played a central role. These new elements combined to create unprecedented sell-offs in the fall of 2008 and resulted in the global financial crisis.

How different? Increased opaqueness

The progressive expansion of more opaque and complex securities and the increasing delinking between borrowers and lenders worsened agency problems.

How different? Financial integration and interconnectedness

Financial integration has increased dramatically over the past two decades.

Capital account openness and financial market reforms have led to massive increases in cross-border gross positions, especially among OECD countries.

There has also been an increasing presence of foreign intermediaries in several banking systems, including in many emerging markets (see Goldberg, 2009).

As a result, international risk sharing, and competition and efficiency have increased, but so has the risk of rapid spread of financial shocks across borders. Indeed, several emerging markets have experienced sudden stops in this period.

How different? Role of Leverage

The buildup of an unusually high degree of leverage of financial institutions and borrowers contributed to the propagation of shocks (see Brunnermeier,2009).

Leverage increased sharply in the financial sector, directly at commercial banks in Europe, and through the shadow banking system and the rising share of investment banks and non-deposit-taking institutions in the U.S.

The leverage buildup among households especially differed from previous crises.

In the run-up to Japan’s real estate crisis, for example, while the household debt-to-income ratio increased sharply, measures of households’ leverage (the household debt to-assets ratio) declined, suggesting that Japanese homeowners built equity in their properties as real estate prices soared.

How different? Role of Household

The current crisis, however, largely originates from overextended households, in particular with respect to subprime mortgage loans.

While aggregate credit growth in the United States was less pronounced than in previous episodes, reflecting slower corporate credit expansion and the securitization of mortgages, the growth of household debt was excessive.

Credit to households rose rapidly after 2000, driven largely by mortgages outstanding, with interest rates below historical averages and financial innovation contributing to an increase in outstanding household debt.

How costly? Dynamics of Recessions Associated with Financial Crises.

How costly? Dynamics of recessions associated with financial crises.

How costly? Dynamics of recessions associated with financial crises

PART II: WHAT IS THE WAY FORWARD?

Regulations and the development of markets

The history of regulatory restrictions also shows that policy makers are often too slow to repeal some of these restrictions, even if market signals are clearly indicating that they may no longer be relevant.

Regulations and the development of markets

National authorities are often not quick enough to repeal some of the national regulatory restrictions that over time demonstrate their irrelevance in an increasingly interdependent global economy.

In an increasingly interdependent global economy, try to fix a national financial system in the absence of an effective global framework with full support of all nations, both national and international markets tend to become distorted and also lead to further global financial instability over time.

Regulations and the development of markets

The recent US financial reforms package intends to address some of the loopholes that have contributed to the financial crisis in the US which in turn contributed to the emergence of the GFC.

Financial integration will lead to less overall regulation

Recent crises are the ongoing waves of globalization, less money is flowing from rich countries to poor countries.

The recent global financial crisis has exacerbated capital outflow from developing to developed countries and there is uncertainty regarding the pace of financial globalization in post global financial crisis.

Such a slow process of financial globalization is the consequence of the absence of an integrated, cohesive and inclusive global financial system that would allow private investors to invest around the world in locations where a better marginal rate of return will occur, regardless of national border considerations.

Financial integration will lead to less overall regulation

While open market policies and the process of financial integration have been applied, national regulations and restrictions declined and financial efficiency increased.

Reforms of the international financial architecture

The recent global financial crisis provided a unique opportunity for both national and international institutions to re-examine a number of issues that led to the recent global recession and possibly ways in which we can improve both national and international financial systems.

These four areas are Surveillance of systematic risk, international coordination of macro-prudential response to systematic risk; cross border arrangements for financial regulation and funding for liquidity support or external adjustment.

The evolution of central banks following the global financial crisisThe IMF (2009a) has identified macroeconomic

policy failure as one of the causes of the recent global financial crisis.

The IMF states that macroeconomic policies ‘‘did not take into account the build up of systemic risks in the financial system and in the housing markets.”

In response, the IMF has proposed an improvement in macroeconomic policy.

It states that ‘‘central banks should adopt a broader macro-prudential view, taking into account in their decisions asset price movements, credit booms, leverage, and the build up of systemic risk.”

Financial information gaps and global financial stability

The process of learning that has allowed national authorities to collect economic data over the last 75 years may well provide an opportunity to see how one can relate this learning to the requirements of the 21st century.

Again, in the context of how crises could lead to improvement or major reforms, the recent global financial crisis is providing an opportunity to lay a new foundation to go beyond national economic data and work towards a global financial system that would allow cross border sharing of financial data and more cross border measurement and management of financial risk.

Conclusion Unless international agreements are ratified by all

nations and become part of national rules and laws, the presence of regulatory arbitrage and the lack of adequate cross border information and data may prevent the global economy from addressing the underlying causes of the recent global financial crisis.

The recent global financial crisis has provided a unique opportunity to go beyond economic data and attempt to capture cross border financial data and other information that could assist international and national institutions to measure and manage financial risk more effectively.

Finally, that only an internationally integrated financial system will make large banks global, both when operational and in the event of insolvency.

References:Classens S, Kose MA, Terrones ME

(2010) The global financial crisis: How similar? How different? How costly? Journal Asian Economics 21: 247-264.

Moshirian F (2011) The global financial crisis and evolution of markets, institutions and regulation. Journal of Banking & Finance 35: 502-511.