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Global contagion

"Starting in the United States subprime mortgage market, the financial crisis spread quickly, infecting the entire United States financial system and, almost simultaneously, the financial markets of other developed countries. No market was spared, from the stock markets and real estate markets of a large number of developed and emerging-market economies, to currency markets and primary commodity markets. The credit crunch following the collapse or near collapse of major financial institutions affected activity in the real economy, which accelerated the fall in private demand, causing the greatest recession since the Great Depression. The crisis has affected most strongly companies, incomes and employment in the financial sector itself, but also in the construction, capital goods and durable consumer goods industries where demand depends largely on credit. In the first quarter of 2009 gross fixed capital formation and manufacturing output in most of the world’s major economies fell at double digit rates. Meanwhile problems with solvency in the non-financial sector in many countries fed back into the financial system.

In the course of the crisis, financial distress spread directly across stock and bond markets and primary commodity markets, and put pressure on the exchange rates of some emerging-market currencies. The uniform behaviour of so many different markets that are not linked by economic fundamentals can be attributed to one common factor: the strong speculative forces operating in all these markets."

As participants in financial markets often seek speculative gains by moving before others do, these markets are always “ready for take-off”, and eventually interpret any “news” from this perspective. Indeed, they often tend to misread a situation as being driven by economic fundamentals when these are just mirages, such as perceived signs of economic recovery in certain economies or fears of forthcoming inflation. As long as prices are strongly influenced by speculative flows – with correlated positions moving in and out of risk – markets cannot function efficiently.

New US rules for correspondent concentration risk

"The FDIC, Board, OCC, and OTS (the Agencies) are issuing final guidance on Correspondent Concentration Risks (CCR Guidance). The CCR Guidance outlines the Agencies’ expectations for financial institutions to identify, monitor, and manage credit and funding concentrations to other institutions on a standalone and organization-wide basis, and to take into account exposures to the correspondents’ affiliates, as part of their prudent risk management practices. Institutions also should be aware of their affiliates’ exposures to correspondents as well as the correspondents’ subsidiaries and affiliates. In addition, the CCR Guidance addresses the Agencies’ expectations for financial institutions to perform appropriate due diligence on all credit exposures to and funding transactions with other financial institutions.

I. Background

The Agencies developed the CCR Guidance to outline supervisory expectations for financial institutions1 to address correspondent concentration risks and to perform appropriate due diligence on credit exposures to and funding transactions with correspondents as part of their prudent risk management policies and procedures.2 Credit (asset) risk is the potential that an obligation will not be paid in a timely manner or in full. Credit concentration risk arises whenever an institution advances or commits a significant volume of funds to a correspondent, as the advancing institution’s assets are at risk of loss if the correspondent fails to repay.

Funding (liability) concentration risk arises when an institution depends heavily on the liquidity provided by one particular correspondent or a limited number of correspondents to meet its funding needs. Funding concentration risk can create an immediate threat to an institution’s viability if the advancing correspondent suddenly reduces the institution’s access to liquid funds.

For example, a correspondent might abruptly limit the availability of liquid funding sources as part of a prudent program for limiting credit exposure to one institution or organization or as required by regulation when the financial condition of the institution declines rapidly. The Agencies realize some concentrations arise from the need to meet certain business needs or purposes, such as maintaining large due from balances with a correspondent to facilitate account clearing activities.

However, correspondent concentrations represent a lack of diversification that management should consider when formulating strategic plans and internal risk limits.

The Agencies generally consider credit exposures arising from direct and indirect obligations in an amount equal to or greater than 25 percent of total capital3 as concentrations. Depending on its size and characteristics, a concentration of credit for a financial institution may represent a funding exposure to the correspondent. While the Agencies have not established a funding concentration threshold, the Agencies have seen instances where funding exposures of 5 percent of an institution’s total liabilities have posed an elevated risk to the recipient, particularly when aggregated with other similar sized funding concentrations.

Interconnectedness and an overlarge financial sector

Examining financial sector life-cycles on both sides of the Atlantic, ECB Executive Board Member Lorenzo Bini Smaghi "point[s] to the fact that the expansion of the financial sector in the pre-crisis years was not an Anglo-American phenomenon" and asks an easy question.

"Has the financial sector grown too big? "

Yet, instead of presenting a simple summary of generational / structural / secular / cyclical drivers, Bini Smaghi provides insight into central bank strategy by virtually admitting being held hostage by Mr. Market's mood.

"The crucial idea is the recognition that systemic risk is endogenous to the financial system as it depends on the collective behaviour and the interconnectedness of financial institutions, financial markets and market infrastructures, as well as the interaction between the financial system and the macro-economy. "

Bini Smaghi's argument is that financial sectors become bloated, inefficient allocators of capital that lack 'size thresholds.' Spanning various metrics of 'too profitable to prevent, too large to optimize', his premise is that financial sectors naturally transition from symbiotic stewards of capital to parasitic pests.

" Figure 7 shows the evolution of banking sector assets in the UK during the twentieth century. While they stood at around 50% of GDP until the 1970s, they rose to 300% by 2000, and to 550% by 2007. While part of this development is a natural consequence of being an international financial centre, it is difficult to justify such a dramatic expansion merely on the grounds of the rising importance of finance as a tool to fuel growth. In addition, the explosion in the size of the financial sector has posed major problems for regulators in the wake of the financial crisis, when they were faced with addressing the systemic implications of very large, individual banks. For example, in 2007 the liabilities of Barclays exceeded the UK’s GDP, the liabilities of Deutsche Bank stood at 80% of Germany’s GDP, and the liabilities of Fortis were several times larger than the GDP of its home country, Belgium. [18] As some observers rather provocatively remarked, such financial institutions may not just be “too-big-to-fail”, but in fact “too big to exist”. "

Juxtaposing Greece with Lehman, his jab ain't too shabby either.

"While democracies need time to take decisions, financial markets act quickly, accelerating their position-taking at any sign of indecision by the policy authorities. Furthermore, the Lehman Brothers case shows that democracies are not always able to deliver the most rational and efficient solution. Under certain circumstances it is thus rational for markets to bet on the irrationality of the democratic decision-making process. It was irrational to let Lehman Brothers fail, but it happened. Those who bet on that failure earned a substantial amount of money. So why not bet on a possible irrationality of European decision-making?"

And he earns points for being straightforward.

"To be clear, with the exception of a few proposals (for instance the so-called Volcker rule), the new regulatory framework does not directly address the issue of downsizing a too large financial industry. Rather, its goal is to enhance financial stability, by reducing the riskness of the whole system via macro-prudential supervision, and by curbing the risks undertaken by single financial institutions, via micro-prudential regulaton. "

Has the Financial Sector Grown Too Big?

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB, Nomura Seminar Kyoto, 15 April 2010

--The paradigm shift after the financial crisis

....The main concern ten years ago was that the international financial system would be put under stress again by emerging markets, not by the core of the system, as if the underestimation of risks could not happen in advanced economies. We had to learn the hard way that sophisticated financial markets are also prone to exuberance and contraction phases which hamper their proper functioning. We thus have to ask ourselves some difficult questions on how these markets can function better and better serve economic development.

Before getting to the main topic of my speech today, which concerns the size of financial markets, let me say a few words about some recent events in European financial markets, which may be of interest to you, also to underline how complex and sometimes irrational these markets tend to behave.

Last week-end the euro area member states agreed on the procedure, mechanism and financial amount to support Greece in its fiscal adjustment programme, with a defined burden sharing mechanism and non-concessional pricing scheme. This will enable Greece to implement its adjustment programme without loosing market access and ensuring a sustainable burden of the debt.

This announcement makes it clear what the euro area authorities have said since many months, i.e. that a scenario of default and exit from the euro area, which some market participants and observers had toyed with, was simply absurd. The cost of such a doomed scenario, on which not many have really thought thoroughly, is immensely larger than implementing the adjustment that the Greek society has to do in any case. This has been recognized not only by the Greek Government but also by its citizens.

If it was so obvious - one might ask - why wasn’t the decision by the euro area countries and the Greek government taken earlier? It is indeed a good question. The answer has much to do with the political process and the time that it sometimes takes in our democracies to take certain decisions. It took months for the Greek Government to realise that, in light of the new data on the budget deficit, it had to backtrack from its election promises and reverse its budgetary policy by 180 degrees. It took time for the other euro area governments to realise that a support package was needed to ensure the credibility of the adjustment in the eyes of financial markets.

While democracies need time to take decisions, financial markets act quickly, accelerating their position-taking at any sign of indecision by the policy authorities. Furthermore, the Lehman Brothers case shows that democracies are not always able to deliver the most rational and efficient solution. Under certain circumstances it is thus rational for markets to bet on the irrationality of the democratic decision-making process. It was irrational to let Lehman Brothers fail, but it happened. Those who bet on that failure earned a substantial amount of money. So why not bet on a possible irrationality of European decision-making?

European policy makers may have underestimated the self reinforcing nature of market trends. If a speculative strategy based on a certain hypothesis, such as the default of Greece, delivers capital gains over time – as has been the case since the fall of 2009 – it is bound to attract an increasing number of investors. As a result, the market pressure increases, making the hypothesis more realistic. The action needed to convince market participants that the hypothesis is unrealistic and to stop the mounting speculative wave has to be firm. Vague statements that some event, such as a default, will not occur, are not sufficient to calm the markets. Concrete actions are needed. This was not fully understood over the last few months.

But there is another element which might have been underestimated and needs to be further considered in thinking about how our democracies can cope with certain financial market developments. As an increasing number of investors take positions based on the same hypothesis, their ability to influence the final outcome increases. The incentive to do all that is needed to ensure that the outcome coincides with their underlying assumption is enhanced by the substantial capital gain that these investors would obtain if their strategy is successful and, conversely, the substantial loss they would suffer if their underlying hypothesis is not realised. In other words, it is in the interest of those who bet on a sovereign default that ultimately the country defaults. They have thus the incentive to do what is in their power to induce the country to default. This applies not only to countries but also to individual companies or financial institutions.

In a competitive financial market, with many players unrelated to each other, such incentives do not necessarily create distortions. However, in markets characterised by conflict of interest, collusive behaviour and lack of transparency, actions by individual agents may lead to outcomes which do not reflect market efficiency and an optimal allocation of resources. Just to give concrete examples of what may and has happened recently, we have seen rating agencies not acting as rating agencies, when they stated that they had to wait for the reaction of the markets before assessing whether the corrective measures taken by Greece were sufficient to change their view.

Market analysts and observers’ views have been widely publicised without revealing potential conflicts of interest, such as sitting in advisory boards or acting as consultants for major investment houses or hedge funds. This above is not an excuse for the slow decision making in the euro area, which is partly constrained by national processes. But the fact that financial markets may take undue advantage of any sign of weakness, using all instruments at their disposal to transform uncertainty into profit, has been underestimated.

The agreement reached over the last week-end is very important and marks a key turning point in the crisis. But this experience should now be used to create a more efficient decision making process within the euro area aimed in particular at preventing similar situations from occurring in the future and eventually at solving them more efficiently.

Let me turn now to the main topic of my speech today, which relates to the size of financial systems. There is an emerging consensus that while financial markets are generally conducive to economic growth, in the run-up to the recent crisis they were operating on an excessive scale. While policy-makers’ efforts to prevent a systemic meltdown and mitigate the negative impact on the real economy after the bubble burst have been largely successful, the crisis caused the deepest recession since the 1930s, and imposed large fiscal and social costs on economies throughout the world.

We need to re-examine our all-too-easy assumptions that a large financial sector invariably benefits the real economy. We have to acknowledge that the financial sector, not to mention some of its components, may sometimes become “too large”. It can end up posing a threat to both economic and financial stability, so we have to enhance our understanding of where the optimal threshold lies. We also need to identify the regulatory measures that can address the problem best: namely, preventing the financial industry from becoming too large and taking excessive risks, leading to the emergence of bubbles, and to the proliferation of complex and opaque financial instruments. And we should avoid imposing restrictive measures that will prevent the financial sector from channelling resources towards productive opportunities. In doing so, we need to make sure that our measures target non-traditional financial markets as much as traditional banking, in order not to encourage regulatory arbitrage and a return to “business as usual” outside the auspices of regulators.

Today my remarks will revolve around four main points. First, I will claim that efficient financial markets enhance growth. However, if they grow “too large,” then they may lead to a misallocation of resources and cause costly crises. Second, I will present evidence showing that in the build-up to the crisis, the size of the financial sector outgrew its trend. Third, I identify some of the main reasons why this occurred and discuss how to avoid that such imbalances materialise again. To this end, regulation and supervision can play an important role. Fourth, while ensuring that the financial sector does not grow beyond its optimal size, the new regulatory framework should not reach the point of financial repression.

1. The optimal size and role of the financial sector

The debate on the relationship between financial markets and the real economy habitually occupies the intellectual space that exists between Joseph Schumpeter’s insights into the ability of well-developed financial systems to stimulate economic growth, and Joan Robinson’s observation that “ where enterprise leads, finance follows”. [1] The experience of recent decades from emerging as well as industrialised countries has mostly confirmed the first claim, namely, that deeper financial markets improve economic efficiency, lead to a better allocation of productive capital, and increase long-term economic growth. However, the frequent financial shocks associated with dynamic financial industries, and in particular the recent economic crisis, also highlight the role large financial markets play in downside risk. This combined evidence implies that there is a trade-off between a highly vibrant financial sector and the overall stability of the financial system. In fact, some scholars have gone as far as to claim that financial instability can only be eliminated by restricting the same productive forces which are responsible for long-term growth. [2]

What I will argue in this speech is that one aspect of the financial sector which can give us key insights into this trade-off is its size. When reasonably large, financial markets promote economic efficiency by identifying productive opportunities and transforming savings into the investment necessary to finance those opportunities. However, when they become “too large”, relative to what is implied by economic fundamentals, problems like financial complexity, poorly understood financial innovation, herding behaviour, and endogenous risk-taking – to name just a few – suddenly outweigh the benefits. The recent financial and economic crisis is a stark example of that. The pre-crisis period was characterised by the growing size, complexity and interconnectedness of financial markets, with subsequent detrimental effects on the global economy. In order to address the problem, regulatory measures are being taken to impose limits on the propensity of the financial sector to create downside risk. But a fine balance needs to be reached: these measures must be effective but not punitive; they need to address the crux of the problem without unduly limiting the ability of financial markets to sustain economic growth.

In general, the gradual growth of the financial sector is driven by both structural and conjunctural factors. On the one hand, higher relative productivity, resulting in higher profits and wages, and the necessity to service ever increasing global savings are fundamental reasons why the financial industry has gradually expanded. These are structural issues, and they will hardly go away in the future – it is conceivable that emerging market economies will keep exhibiting high savings rates, and thus large and efficient financial markets will be required to service them. On the other hand, there are cyclical deviations from this trend, driven by risk-taking, excessive leverage, the search for yield as well as the proliferation of opaque financial instruments, among other things. It is therefore essential to think of the optimal “threshold” beyond which the financial sector is “too large” – not in absolute terms, but in terms of deviations from the trend. At such a point, the size of the financial industry starts to become detached from what economic logic would imply.

Before I go into further detail on this front, it is perhaps useful to explain why we still need a large and dynamic financial industry. In general, deep and efficient financial markets improve economic performance both by raising the level of growth [3] and by allocating productive capital [4] more efficiently, ultimately generating benefits for the society as a whole. Consider, for example, the long-standing point in academic and policy discussions on the differences in average GDP growth between the US and continental Europe. It has been suggested that deeper financial markets across the Atlantic are to a large extent responsible for the larger increases in productivity, the faster pace of industrial innovation, and the generally more dynamic economy of the US compared with that of Europe. For example, deeper credit markets probably account for the higher rate of business start-ups in the US. The difference is especially visible when it comes to the financing of innovative ideas, where the much larger US venture capital industry has been credited over the years with the emergence of whole new industries and such innovative corporate giants as Microsoft, Cisco Systems, Google (to name just a few). Out of the world’s 500 largest companies, 26 American ones have been founded since 1975, compared with only 3 European ones, showing a larger turnover of industry leaders. [5] These two aspects of “creative destruction” – new business creation and innovation – are crucial when we come to think of why deeper financial markets can benefit economic growth.

The same pattern is seen when we compare European economies. Econometric estimations suggest that improvements in corporate governance, in the efficiency of legal systems in resolving conflicts in financial transactions and in some structural features of the less developed European banking sectors are all factors that are likely to help the financial system reallocate capital faster from declining sectors to those with good growth potentials. [6] In addition, recent ECB research has pointed to the fact that large differences persist among European countries in terms of new business creation and patenting activity. It has concluded that much of this difference can be attributed to the existence of more developed credit markets and risk capital markets. [7]

All this evidence has led most financial economists to think of the relationship between finance and growth as one in which “more is better”. However, the recent crisis has revealed that a financial sector which goes beyond a certain threshold (or breaking point) can harm the economy and society as a whole. In particular, we have seen that an oversized financial industry tends to exacerbate information asymmetries, moral hazard problems, and the hunt for yield, leading to excessive risk-taking and over-leveraging of the system. The events of 2007-2008 suggest that when financial sectors are “too large”, the allocation of resources may become inefficient. Examples of such misallocation were abundant during the dot-com expansion, when many high-tech projects of little value were generously financed. Numerous examples of misallocation were associated with the credit growth of the early 2000s as well, of which the expansion of the US sub-prime mortgage market is just the most obvious one. We can think of examples in Europe too – for instance, growth in Spain relied for years on an ever-expanding real estate sector fuelled by increasing borrowing.

Looking at specific market segments, there are plenty of examples showing the excesses of the financial sector, and also illustrating the importance that the “shadow” banking system has played in this crisis. For example, the growing use of securitisation by banks led to a distinctly lax screening of loans. [8] As a result, mortgage credit growth became disconnected from both relative and absolute income growth in the sub-prime market. [9] The crisis itself started not as a traditional bank run on deposits, but as a securitized-banking run driven by the withdrawal of repurchases (“repo”) agreements from the balance sheets of investment banks, which had been funding roughly half of their assets through repo markets. [10]

During financial bubbles, the search for yield intensifies, risk-taking is everywhere, and leverage in the system may increase at unsustainable rates. The exponentially rising volume of financial assets and transactions, especially by highly leveraged and interconnected institutions, can increase financial instability. Shocks to the system can lead to fire sales and asset price decreases, resulting in liquidity spirals and widespread bankruptcies. [11]

On the “real” side, the aftermath of the busts which follow unsustainable booms are frequently associated with falling housing prices, collapsing equity prices, and lasting declines in output and employment. Under certain circumstances, the negative impact on potential output could be long-lasting rather than transitory (see Figure 1). In addition, financial crises like the recent one tend to worsen the fiscal position of many countries. Government debt explodes in the wake of banking crises, fuelled not so much by the cost of recapitalising the banking systems but by collapsing tax revenue. [12]

Balance sheet network analysis of too-connected-to-fail risk

The 2008/9 financial crisis highlighted the importance of evaluating vulnerabilities owing to interconnectedness, or Too-Connected-to-Fail risk, among financial institutions for country monitoring, financial surveillance, investment analysis and risk management purposes.

This paper illustrates the use of balance sheet-based network analysis to evaluate interconnectedness risk, under extreme adverse scenarios, in banking systems in mature and emerging market countries, and between individual banks in Chile, an advanced emerging market economy.

EU banks struggle in lending markets

"Many European banks have become shut out of the international lending markets because of continuing concerns over Greece, sparking fears that some could collapse as they run out of cash.

Greek and Portuguese banks cannot borrow in the international money markets, while weaker European banks are also struggling to raise money as fears of counterparty risk have grown sharply.

Even French and German banks have faced problems raising money because of their exposure to Greek sovereign debt. Barclays Capital estimates French and German banks hold almost €40bn in Greek bonds.

Brian Kim, a currency strategist at UBS, said banks' reticence to lend matched their caution on lending to rivals that had held collateralised debt obligations at the height of the financial crisis in 2008.

"Recall how in March and September 2008 interbank lending began to show signs of stress as counterparty risk jumped, with banks unwilling to lend to their peers for fear that counterparties were excessively burdened with illiquid assets such as CDOs," he said. "Replace CDO with Greek or Portuguese bonds, and this is the risk that now looms."

Another banker said: "There is rising hope of an international rescue package, but this may not be enough for some banks that could go bust because of the squeeze on lending. Liquidity, or cash, is the most important thing for any business."

Inter-dealer trading


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