Guest Blog: Financial Crisis and Reform Déjà Vu
By Simon van Norden
"Once you've seen one financial market crisis...you've seen one financial market crisis."
-- Attributed to Federal Reserve Board Governor Kevin Warsh by former US Treasury Assistant Secretary for Economic Policy Phillip Swagel in The Financial Crisis: an Inside View, March 2009, p. 4.
The financial crisis has set a lot of records so far; it's certainly the worst US banking crisis of my lifetime. Some, as suggested by the above quote, see such crises as unique events; each one is singular and there's not much to be learned about how to handle one from looking at past crises. For example, there's no precedent that I know of for a banking crisis involves the failure of the biggest counterparties for credit default swaps.
I think a much smaller number of people see the crisis differently; they think of it as another potato, a big one. No two potatoes are exactly alike in size and shape, but they all taste pretty much the same and you can use the same recipe for most of them. For that reason, it’s interesting to see to what extent the current crisis behaves like other crises, even if it has some unique features.
I think there's some interesting parallels between the current crisis, the Savings and Loan (S&L) crisis of the 80s and 90s, and the Long-Term Capital Management (LTCM) Crisis of 1998. But before I talk about that, let me talk about what a "typical" banking crisis looks like.
The Basel View of "Typical" Banking Crises
If we set the way-back machine to 2004, a time long before terms like ARM, CDS, and AIG entered common conversation, we can see what people thought a typical bank crisis looked like. That's the year the guys in Basel who worry about such things published "Bank Failures in Mature Economies." They looked at the main banking crises in developed countries from 1980 to 2000 and asked themselves what they saw. To be sure, they saw some differences, but they also saw some patterns. Here's part of their main conclusions (note that "credit risk" is Banker for "bad loans").
Most of the widespread [banking] failures required some amount of public support, sometimes in very large amounts. All of the episodes that involved large amounts of public support were caused by credit risk problems. ...The widespread banking crises that involved credit risk were remarkably similar. A period of financial deregulation resulted in rapid growth in lending, particularly in real estate related lending. Rapidly rising real estate prices encouraged more lending, abetted by lax regulatory systems in many cases. When economic recessions occurred, inflated real estate prices collapsed, leading directly to the failures. (BIS, 2004, p.66)
That sounds a lot like what the US (and some other countries) experienced immediately afterwards. There had been some financial deregulation, which was followed by a period of very rapid growth in real-estate-related lending. Rapidly rising real estate values encouraged more lending. The biggest difference seems to be the last point; the recession did not cause real estate prices to collapse; they had peaked by 2006 and fell before the recession started. We could probably also argue about whether it was financial deregulation or "financial innovation that avoided regulations" that helped fuel the increase in real-estate lending. However, in this view the boom and bust cycle in real estate, the subsequent fallout for the banking sector, and the need for a major publicly-funded bailout is not remarkable; we’ve seen this kind of story before. In fact, Reinhart and Rogoff have gone so far as to tabulate what happens to government debt in the aftermath of a banking crisis. They find that real government debt increases by an average of 86% in the three years after the start of a crisis. So regardless of how you feel about the US government's spending during the crisis, it seems less remarkable when compared to what typically happens in a banking crisis.
Figure from Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. "The Aftermath of Financial Crises." American Economic Review, 99(2): 466–72.
Three American Financial Market Crises
More support for the view that banking crises follow similar patterns can be found by comparing the last three US banking crises; the S&L crisis of the late 80s and early 90s, the collapse of LTCM and the most recent crisis. The S&L crisis closely followed the pattern described by the BIS report quoted above; financial deregulation, followed by a rapid growth in real estate lending, creation of local speculative bubbles in real estate prices, and the failure of institutions as bubbles burst (For descriptions of the S&L crisis, see BIS (2004) or the GAO 1996 report). The General Accounting Office put the cost of the S&L bailout to US taxpayers at $132.1 billion, or a bit under 2% of GDP (United States General Accounting Office (1996) "Financial Audit: Resolution Trust Corporation's 1994 and 1995 Financial Statements," Table 3 and author's calculations). That may seem small compared to the size of TARP or this year's projected federal deficit, but it was shocking at the time.
At first glance, the LTCM crisis appears quite different; no bank failed (LTCM was a hedge fund), its failure was unrelated to real estate investment or credit risk, and the crisis was resolved at no cost to the taxpayer. However, the LTCM crisis showed that, as a result of deregulation, a systemic crisis could start outside the regulated banking system. Another GAO study noted:
The LTCM case illustrated that market discipline can break down and showed that potential systemic risk can be posed not only by a cascade of major firm failures, but also by leveraged trading positions. LTCM was able to establish leveraged trading positions of a size that posed potential systemic risk primarily because the banks and securities and futures firms that were its creditors and counterparties failed to enforce their own risk management standards. (US GAO (1999) p. 29)
The same report noted:
- Gaps in [US Government agencies'] regulatory authority limits their ability to identify and mitigate systemic risk (US GAO (1999) p. 24)
- Regulators did not identify weaknesses in firms' risk management practices until after the crisis (US GAO (1999) p. 16)
- Monitoring did not reveal the potential systemic threat posed by LTCM (US GAO (1999) p. 17)
and provided a variety of proposals (some of which are mentioned below) to reform the financial system by reducing systemic risks.
The success of those reforms can be judged by role of similar factors in the most recent US banking crisis. An important factor in the latter has been the role of trading in derivative securities, primarily mortgage-based securities and credit default swaps (CDS). Again, government oversight of this market was limited due to faith in the market's ability to manage its exposure to risk, and was further weakened by divided responsibilities between multiple agencies. Regulators and private lenders alike were again unaware of major firms' exposure to losses on derivative securities; this time even the heads of major financial institutions were not aware of the extent of their own exposures. Again, this was in part due to the lack of transparency, lack of clearing and high leverage afforded by trade in Over-the-Counter (OTC) derivatives (particularly those traded at Bear Stearns.) Again, weaknesses in firms' risk management practices became apparent only in hindsight. Again, major financial firms that were not regulated as traditional deposit-taking banks took on highly-leveraged positions and posed major systemic threats to the banking system. These included several investment banks (such as Bear Stearns, Goldman Sachs, Lehman Brothers, and CitiGroup) and the insurance company AIG.
Looking at recent events from this perspective, I still see the size of the losses as breathtaking, but the causes and dynamics seem much more familiar. What bothers me is that some of the suggested solutions sound pretty familiar too; make derivative trading more transparent, improve coordination among the regulators, give regulators more power to control systemic risk in new places, and so on. Despite that, not only was there another crisis, but it was much larger than the two previous crises combined.
This post written by Simon van Norden.