Financial Crises: A Hardy Perennial

1. Financial Crises: A Hardy Perennial Jerry Caprio Williams College

2. Outline • What does finance do? • Why crises matter • Financial breakdowns: why and how? …. why so often? 4. What governments (should) do in response • Let it burn? Rescue all? 5. Crisis prevention

3. 1. Functions of Finance • Mobilize savings • Allocate scarce capital to best uses • Monitor recipients of society’s capital • Facilitate payments • Mitigate risk • Evidence: finance matters

4. 2. Why crises matter • Impact on economy • Loss of output, jobs • Impact on people • hurt the poor... and most everyone else • Frequency • Contagion • Fallout: reform efforts slowed or aborted • Lessons: on disease and wellness • Oh yes: we are in one now!

5. 2. What is a Crisis? • A run on the currency, or on the banking system. • The payments function is impaired IMF • When the system is insolvent • All functions impaired • Allocation, monitoring, risk mitigation, mobilization and payments World Bank • When ‘the return of your money is more important than the return on your money.’ Will Rogers

6. 1996 1999 1999 1996 1996 1998 2. East Asia poverty before and after the financial crisis Poverty rate (percent) 40 30 20 10 0 Indonesia Rep. of Korea Thailand

7. 3. Why finance is fragile • Individuals not fully rational in assessing risk • Framing affects decision -- e.g. bonds vs. stocks; growth vs. value stocks • Excessively weight recent experience (myopia) • Trade on noise rather than on fundamentals • Exhibit positive feedback • Finance depends on information and trust

9. La Plus ca Change… • “When the rest of the world are mad, we must imitate them in some measure.” John Martin, Martin’s Bank, 1720 • “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, ex-CEO, Citibank, July 2007

10. 3. Banking is more fragile • Demandable debt • If banks only had equity claims on each side of their balance sheet, there would be no runs except if fraud. • Term transformation • Leverage -- which increases substantially in most crises • Opacity and incentives • Sensitive dependence on initial conditions • portfolio, skills, regulations, markets, information capital.

11. Information?

12. Disinformation Pays Well

13. 3. Emerging market bankingmore fragile still • Greater information problems (usually!) • Generally smaller size of market • Regime shifts more common • Domination of banking and debt finance, usually short term • Greater real, nominal, financial volatility • Weak/insolvent at the point of liberalization • Poor sequencing of financial reforms

14. 3. From Good Bankers to Bad Bankers • Technical mismanagement • Cosmetic mismanagement • Upside down income statement, evergreening • Desperate mismanagement • Speculation • Pay high rates of return • Fraud, flight or other exit

15. 4. Government to the Rescue? • Macro dilemma: bailouts or let it burn? • Rescue the innocent? • How real is moral hazard? • ‘Micro’: sorting out financial and corporate sectors • Preparation for the next one

16. 4. Government as owner? • The good news: the state has the capacity to takeover failed banks in a crisis • The bad news: the state is a lousy owner and manager of banks • Conclusions: • 1. Avoid state takeover if possible • 2. Sell off quickly. The price of the bank will produce criticism, but the revenue is rounding error.

17. 4. Insolvency for private, nonfinancial firms • Difficult/impossible to raise funds • Management might engage in fraud/moral hazard behavior, or reduce effort • Market forces firms tore-trench QUICKLY to profitable core • Mark down liabilities and equity • Debt holders take loss • New funding only after restructuring • Management replaced, assets sold, workers laid off • Message: failure to use resources well is bad.

18. 4. Governments as bank restructurers • Inject new capital early • Delay hard choices • Do not collect much on assets • Protect shareholders and creditors • Do not shrink the bank • Do not layoff employees • Reduce accountability of regulators • Message: Failure is OK

19. 4. In times of crises • Selection of winners and losers is what markets do best • Rather than have governments pick survivors, pick a rule, e.g. $$$ for all banks that • secure matching private funds • restrict dividends/payouts for private parties • adhere to stiff transparency requirements • U.S. model in the 1930s (RFC).

20. 5. Crisis Prevention • Diversify, diversify, diversify • Make them pay: • Generous liability limits for those gambling with other people’s money • Better regulation: • Information • Incentives to use it • Compensation -- Back to the Future • Remember to mind the store …. for the next one! • Current Basel model puts excessive weight on official supervision, neglects macroprudential risks. Both are errors.

21. 5. Regulatory Fixes • Disclosure -- a never-ending story • Incentives to monitor -- sub. debt -- vs. incentives for equity investors • End off-balance sheet entries. • Unrate the rating agencies -- end NRSRO distinction. Consider public subsidy of ratings, expose fund managers to legal oversight.