The Causes and Consequences of the Financial Crisis

1. The Causes and Consequences of the Financial Crisis Raghuram Rajan Chicago Booth School of Business

2. Outline • The causes of the financial crisis • What needs to be done? • Regulatory changes • The consequences

3. The Financial crisis: The Proximate Causes • Bad Investments • Financed with short term debt

4. Bad Investments • Child of past crises • Emerging markets => Industrial country corporations => Industrial country household • Sophisticated Financial Sector • Effectively sold mortgages from Phoenix, Arizona to buyers around the world • $ 100 sub-prime mortgages generated $ 80 AAA • Originate to distribute spreads risks but • Quality of originations weakened • Depended on house price rising

5. Bad Investments contd. • Banks held on to poor quality assets • Signal? • Inventory? • Pieces they could not sell? • Poor governance and risk management • At the top • Through the organization • Tail risk • Writing earthquake insurance • Where were the risk managers?

6. Financed with short term debt • Short term secured debt cheaper because lenders better protected • Illiquidity (inability to roll over financing) seems remote in good times. • Market capital requirement low because losses remote. • Aided and abetted by Fed policy • Greenspan “put”

7. Credit markets freeze • Only overnight credit available • Worries about borrower credit risk? • Worries about own liquidity if lenders want money back? • Worries about lost opportunities if others dump securities? • Credit risk and liquidity premia shoot up. • “Deleveraging” • To households? • To passive financial institutions? • To banks? • To government.

8. When will credit markets find a bottom? • When the risk of large institutions collapsing is small. • Guarantee borrowing in the short term • Audit institutions • Clean up bank balance sheets by isolating/selling problem assets • Recapitalize banks through a mix of private and public funds • When the likelihood of financial assets being dumped on thin markets is small. • Allow “deleveraging” to run its course • Audit, clean up, recapitalize, private sector participation • Ring fence vs asset purchase • Nationalization

9. Regulatory questions for the future • Are countercyclical capital requirements the answer? • Is Basel II broke? • Are changes to the structure of compensation the answer? • Sprinklers, not just more firecode. • How do we deal with “too big to fail”?

10. Five consequences of the crisis 1) Discredited financial capitalism • Notion that financiers were smart & because of that deserved their wealth • Simple strategies -- at the limit, Bernie Madoff. Suspicion that a lot of Madoffs • Worries about capitalism’s ability to allocate resources and wealth 2) Tremendous shrinkage in wealth and of the middle class • Less support for property rights and low taxes • Focus on inequality

11. Five consequences of the crisis contd. 3) Political unrest • Those who are losing and have lost • Where is the unrest in the United States? Thus far channeled into the election campaign and the rise of Obama • Appeal for strong government to help. • Particularly problematic for emerging markets that have been growing fast and expectations are high. • Safety nets weak – unemployment /health insurance

12. Five consequences of the crisis contd. 4) Fiscal and policy short-termism • Fix the problem, the future be damned – the appearance of doing something • More money is the answer, regardless of the efficiency of the spending – only about $150 billion of the $ 800 billion plus package in the US will be spent by end of fiscal year 2009. 5) Protectionism – every country for itself and damn the foreigner. • Trade • Financial – guarantees, now liquidity • Employment • Fiscal – crowd out thy neighbor

13. Which countries will suffer most in the short run? • Those that have become most dependent on foreign trade or capital inflows and have the least government capacity and resources. • Emerging markets • Running large current account deficits • Dependent on foreign trade and with limited domestic demand • With limited buffers such as reserves • More risks as recession endures • Emerging from recession – accentuation of existing problems –export led strategies to build reserves by some, and sustained deficits by others.

14. Changes in global architecture • Need international dialogue in a legitimate and representative setting • G-20? Not fully representative of small countries or even large ones (Spain). But cannot have UN at table. • Eliminate the permanent IMF Board and replace it by the IMFC, which will meet quarterly at the ministerial level and biannually at the level of head of state. • Peer pressure initially to make policies more consistent • Eventually once trust is established, possible penalties – perhaps not needed then. • IMF staff can serve to prepare the agenda and background for these meetings.

15. Changes in global architecture 2) Need changes in IMF • Excessive focus on quotas and votes • Management • No new ideas from emerging markets. Need more buy-in. 3) Need more money to be deployed by IMF especially for the coming year • Borrowing by Fund from governments over and above quota. • Reserve pooling by emerging markets under a separate governance structure, but advised by the Fund. • Deals with stigma and conditionality

16. Conclusion • Many challenges • Greatest challenge is to the integrated world. • Time is ripe to push to fix international architecture in a way that is more equitable and effective. • International organizations should facilitate economic dialogue rather than be seen as the tool of foreign policy of a few advanced countries.