The Financial Crisis: Who’s to blame?

1. The Financial Crisis: Who’s to blame? Howard Davies Director, LSE HSE Cultural Centre, Moscow 14 December 2009

2. Rolling Stone described Goldman Sachs as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

3. Who is most to blame for the current financial crisis? % Source: Thisismoney.co.uk, June 2009

4. Some suspects • economists - “if anything needs fixing, it’s the sociology of the profession” – Dani Rodrik (Harvard) • business schools – the Guardian • testosterone – Scientific American: “risk-taking in an investment game with potential for real monetary pay-offs correlates positively with salivary testosterone levels and facial masculinity” • video games – Professor Susan Greenfield of Oxford • human greed – Rowan Williams • Jews

5. Who blames “the Jews” for the financial crisis? Source: N Malhotra, Y Margalit: State of the Nation. Boston Review, May/ June 2009.

6. Views of Members of the EuropeanParliament % blaming 49 US banks 29 Investment banks 29 Credit Rating Agencies 28 US regulators 25 Hedge funds 23 EU banks 6 EU regulators ……and the answer?

7. …66% recommend deeper political union in Europe, as a key response to the crisis

8. Russians trust their government more than the British do.. What is your level of trust in the government to manage the financial situation? Average response, scale from 1.0 (no trust) to 10.0 (full trust). Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.

9. But the social impact is large Projected impact of the crisis on the poverty rate, percentage of people with income level below minimum subsistence, 2007-2009 Source: Russian Economic Report No. 19, World Bank.

10. The impact of the crisis on the long-term development objectives in Russia: dynamics of GDP level in Russia 2007-2020, (q1-2006=100) Source: World Bank Projections, Strategy 2020.

11. Russians are more confident in banks What is your level of trust in the stability of the banks? Average response, scale from 1.0 (no trust) to 10.0 (full trust). Source: WIN CRISIS INDEX, 3rd Wave of the Worldwide Barometer of the Financial Crisis.

12. Russia is one of the countries where level of optimism is above the average Source: Worldwide Barometer of the Financial Crisis – August 2009, BVA.

13. “ Bank failures are caused by depositors who don’t deposit enough money to cover the losses due to mismanagement”. Dan Quayle

14. The Credit Crisis: A Five-Act Shakespearian Tragedy Act One: Subprime Act Two: Liquidity Act Three: Unravelling Act Four: Meltdown Act Five: Pumping

15. Real GDP % growth forecast, October 2008 Source: Financial Times European Economic Forecast.

16. Real GDP % growth forecast, July 2009 Source: Financial Times European Economic Forecast.

17. The IMF forecast a modest recovery next year Gross domestic product forecast (% change), constant prices, 2007-2014 Source: IMF World Economic Outlook Database, October 2009.

18. But global unemployment is likely to continue to rise Unemployment (Million) and unemployment rate (%), 1999 - 2009 Source: ILO, Trends Econometric Models, December 2008.

19. What are the underlying causes? • global imbalances • loose monetary policy, leading to • mispricing of risk • credit bubble • ‘excess’ leverage, facilitated by procyclical regulation, and regulatory arbitrage • ‘excess’ unmanaged growth of the financial sector, which magnified risks, rather than diversifying them

20. Global current account imbalances grew rapidly from 2003 Estimates of account balances for selected countries ($ Billion), 1993-2007 Source: Datastream, FSA Calculations.

21. Monetary policy was loose, especially in the US Deviation of policy rates from Taylor rule (%), 2000-2009 Source: Bank of England, Speech of Charles Bean at the Annual Conference of the European Economic Association, 25th Aug 2009.

23. Household debt rose sharply Household debt as % of GDP, 1987-2007 Source: FSA, ONS, Federal Reserve, Eurodata, Datastream

24. US house prices doubled in five years Case-Shiller Home Price Index (2000 Q1 = 100), Jan 1987 - 2005 Source: Silverlake, Case-Shiller Price Index.

25. House prices rose rapidly in much of Europe also Real house price changes over the last ten years (%), 1996-2006 Source: ECB, National Statistical Offices, IMF, EMF, Italian Ministry of Infrastructure, Morgan Stanley Research.

26. Bank Balance Sheets expanded Large-cap banks’ aggregate assets rose to 43x tangible book equity Source: Silverlake, Capital IQ.

27. UK banks leverage grew sharply from 2003 onwards Major UK banks’ leverage ratio, %, 1998 - 2008 Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data. Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.

28. As did the securitised credit market ABS – volumes outstanding, $ Billion, 1996 - 2007 Source: The Turner Review, March 2009.

29. And the outstanding credit default swaps Credit default swaps, $ Trillion, H2 2004 – H1 2008 Source: The Turner Review, March 2009.

30. Resecuritisation magnified credit creation Capital Structure Containing Subprime Loans Subprime Mezzanine CDO Containing BBB Subprime Bonds 100% 100% 11% SUPER SENIOR AAA CUMULATIVE LOSSES 8.6% 40% AAA AA A BBB Equity 28% 20% 11% 11% 7% 7% 7% 0% 0% Source: Morgan Stanley.

31. Private Equity Leverage Multiples grew Debt/EBITDA, 2002 - 2007 X Source: Silverlake, Morgan Stanley, Capital IQ.

32. Growth in Hedge Fund Assets & Leverage accelerated Source: Silverlake, Through Q308 – HFR industry report; Q408 projections based on CS analysis.

33. This points to the need for monetary policy to focus more on - credit growth - financial intermediation, and - asset prices …with a stronger emphasis on the risk of financial instability

35. Weak regulation may not have been the main cause of the crisis, but it is important to reform it • trust in markets, and in regulation, has been affected, which damages investment and economic growth • the global system does not meet the needs of global markets

36. Trust Average response on a scale from 1 to 5 to the question, “How much do you trust…”, where 1 means “I do not trust at all” and 5 means “ I trust completely.” Source: The Financial Trust Index.

37. Trust in financial markets, and government, has fallen Average response to the question, “How has your trust in some of these institutions changed in the last three months?” “Would you say your trust in…has 1) increased a lot; 2) increased a little; 3) decreased a little; 4) decreased a lot; or 5) has there been no change in your trust.” Source: The Financial Trust Index.

38. The crisis revealed problems with • the existing regulatory architecture: • Hopelessly complex global structure • Lacking a central authority to drive co-operation and make changes happen • US system balkanised and ineffective • European system a fudge – neither truly European nor truly national • No two national systems the same

39. Global Committee Structure - A Regulator’s View G-20 (Gov’ts) IMF World Bank (Gov’ts) OECD (Gov’ts) WTO FATF (Money Laundering) IASB (Accounting IASC Financial Stability Board IAASB (Audit) PIOB Monitoring Group Bank for International Settlements (Central Banks) G-10 (Central Banks) Basel Committee (Banking) IOSCO (Securities) IAIS (Insurance) IFIAR (Audit) Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007. CGFS CPSS Joint Forum

40. IOSCO Structure • Regional Committees • Asia-Pacific • Europe • Interamerican • Africa-Middle-East Presidents’ Committee Co-ordination Committee (with Basel and IAIS) Executive Committee Emerging Markets Committee Chairs’ Task Force Technical Committee Principles Implementation Committee • Working Groups • Disclosure and Accounting (WG1) • Secondary Markets (WG2) • Market Intermediaries (WG3) • Enforcement & Cooperation (WG4) • Investment Management (WG5) • Standing Committees • Multinational Disclosure and • Accounting (SC1) • Secondary Markets (SC2) • Market Intermediaries (SC3) • Enforcement & Cooperation (SC4) • Investment Management (SC5) Specific issue Task Forces SRO Consultative Committee Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007. Specific issue Task Forces E.g. CPSS-IOSCO Internet Task Force

41. A new European Framework for Safeguarding Financial Stability European Systemic Risk Council (ESRC) (Chaired by President ECB) Members of ECB/ESCB General Council (with alternates where necessary) Chairs of EBA, EIA & ESA European Commission + + Information on micro-prudential developments Early risk warning European System of Financial Supervision (ESFS) European Banking Authority (EBA) European Insurance Authority (EIA) European Securities Authority (ESA) National Banking Supervisors National Insurance Supervisors National Securities Supervisors Macro-prudential supervision Micro-prudential supervision Source: De Larosière Report, February 2009.

42. National Regulatory Structures 57 3 Other bank regulators 49 Central Bank 10 35 Central banks as banking regulator No Central Bank interest 7 54 Non-Central Bank 39 28 Central bank as one pillar 2 Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications.

43. And there were a number of regulatory failures US Financial markets regulation was uncoordinated and overlapping - Promoted regulatory “competition” European Regulation also at fault: complex mix of European and national rules In the UK, weak FSA regulation of Northern Rock, and the Bank of England too distant from financial markets

44. More regulatory failures Key markets were unregulated • Non-bank private mortgage industry • Credit Default Swaps • No exchange, central clearing or capital requirements Insurance industry in the US was lightly regulated • No federal regulator • Missed “one-sided” credit insurance & CDS risks taken on by AIG and others Basel II capital requirements were flawed • Allowed too much leverage, over-reliance on credit ratings, and didn’t encompass liquidity • Pro-cyclical: as asset prices rose, banks seemed to need less capital

45. G20 Summits “Reshaping the global financial and regulatory System” • Enhance corporate governance and risk management • Strengthen prudential regulation, but with a ‘managed transition’ to avoid exacerbating the downturn • Regulate financial activities according to their economic substance and ensure regulation is consistent in all jurisdictions

46. G20 Summits “Reshaping the global financial and regulatory system” • Financial Stability Board with standing committees • Membership of FSB, Basel etc extended to BRICs and others • Expanded coverage of regulation to include systemic hedge funds • Tighter controls on offshore centres • Tighter regulation of credit rating agencies • More and better quality capital in the banking system • Macro-prudential mechanism to respond to asset price bubbles • Regulatory controls on bank remuneration

47. What about the bankers themselves?

48. Failures in the financial firms themselves may have been even more important • Poor risk management • excessive reliance on Value at Risk Models • herding behaviour • inadequate hedging • Flawed capital allocation mechanisms • trading strategies under-capitalised • Incentive structures which reward short-term risk-taking • Weak corporate governance: boards ignorant of the risks management were taking on

49. And, finally, there are majorproblems with Economics – and efficient markets Much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst” Prof. Paul Krugman, Princeton “The unfortunate uselessness of most ‘state of the art’ academic monetary economics” Prof. Willem Buiter, LSE “The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year” Alan Greenspan

50. The Global Financial Centres Index Source: City of London Corporation, Global Financial Centres Index, Report - 6, September 2009.