Download Presentación en las Jornadas Monetarias y Bancarias BCRA 2011

Presentación en las Jornadas Monetarias y Bancarias BCRA 2011
Jane D’Arista
Co-coordinator of the SAFER Project on Financial Reform at the Political Economy Political Economy Research Institute, University of Massachusetts/Amherst, EE. UU.
Let me begin by making a few underlying points that provide a context for my presentation.
The first is that the crisis was certainly not unforeseen; that many heterodox economists,
many practitioners, saw it coming. But the major fault line, which had been widening over
more than three decades, was the shift from a bank-based to a market-based financial
system without any assessment of its implications for the existing regulatory frameworks
around the world. There were certainly clear warning signals at the time. One of them was
the unprecedented growth of financial sectors relative to the economies in which they were
located. One thinks obviously of Iceland but then, after the crisis erupted, the Bank of
England reported that in the period 2001-2007 the balance sheet of the UK banking system
rose three-fold.
In the case of the United States, the debt of the financial sector rose from 64% to 114% of
GDP over the decade that ended in 2007. I remember lecturing in 1999 on flow of funds
accounts and pointing out to students that, in one quarter in 1997, the financial sector had
borrowed more than all other sectors put altogether. My students protested vehemently that
financial institutions are intermediaries: how could this be? It was because they had ceased
to be just intermediaries; they were borrowing and taking positions for their own account.
In other words, they were moving away from transactions involving nonfinancial borrowers
and reducing their dependence on customer transactions for growth and profitability. As
they continued to do over the decade, the large financial institutions increasingly severed
their link with the real economies in which they were located.
There has been much discussion about the causes of the financial crisis and numerous
prescriptions for dealing with it. Even now, however, it is not clear that the discussion has
reached an adequate depth diagnostically and, certainly, in the case of prescriptions, we are
not there yet.
To make the point, I would like to discuss two of the reforms included in the Dodd-Frank
Act, which eventually passed last year in the U.S. The first focuses on the provisions that
deal with interconnectedness, the meaning of which we discovered after the Lehman
Brothers collapse revealed the intricate web of interactions between financial institutions
that ensured systemic repercussions as problems developed. In my view, the provisions of
Dodd-Frank that address that problem are both diagnostically and prescriptively correct –
an amazing outcome given the contentiousness of the legislative process. The second part
of my presentation will deal, however, with capital requirements and I will argue there that
it is most unfortunate that this paradigm has been reaffirmed in the U.S. legislation and by
the organization of central bankers at the Bank for International Settlements without an
adequate assessment of the extent to which capital requirements caused the crisis and
hindered recovery from it.
Interconnectedness is a problem that has developed over at least three decades - the result
of changes in funding practices that evolved as the U.S. financial sector shifted from a
bank-based to a market-based system. This shift had its origins in the external or so-called
euro markets where, since the 1970s, borrowing and lending among financial institutions
have accounted for 80% of all cross-border transactions. This funding pattern was allowed
to develop because Congress and federal regulators were sympathetic to U.S. banks’
argument that reserve requirements on deposits were a tax on profits which other
institutions did not have to pay. And, with passage of the Gramm-Leach-Bliley Act in
1999, they won their argument that they should be able to do all they were doing in the
international market at home. Among the Act’s liberalizations was authorization to adopt
euro-market practices in funding traditional and nontraditional transactions without having
to rely on deposits and thus avoid reserve requirements. At that point, the larger
institutions increasingly relied on the wholesale capital markets for re-purchase agreements
and commercial paper, intensifying their reliance on other financial institutions for funding.
The consequences of this shift in funding have been quite extraordinary: the growth in
liabilities not constrained by reserve requirements, inflated balance sheets, and the rise in
leverage, proprietary trading and off-balance sheet commitments. Rapid and unsustainable
growth is reflected in the increase in US banks’ share in total corporate profits from a
historical average of 10% to a peak level of 40% in 2002 before a decline to 30% by 2007.
Meanwhile, the growth of the market for repurchase agreements zoomed upward from $1
trillion in 2001 to $4.3 trillion by the time Bear Stearns went down in March 2008,
reflecting a level of borrowing from other financial institutions that fueled leverage and
expanded the size of positions taken through proprietary trading.
To explain how these related changes in bank behavior led to collapse, it is necessary to
bring a macro indicator into the discussion – namely, the extraordinary expansion in
liquidity that occurred during the period from the beginning of the new millennium until
the onset of the crisis in 2007. As others have mentioned in presentations, warnings about
excessive liquidity were being made well before the crisis. Some, including the BIS,
blamed central bankers in the major economies for excessive money and credit growth.
Others, the IMF included, blamed sustained low US interest rates from 2002 to 2004 for the
housing bubble and therefore the collapse of asset prices that triggered the crisis.
Thus the IMF proposed that the Federal Reserve should raise interest rates because the
speculative positions that the institutions were taking were growing larger and larger – the
reason being that they had to expand to capture the same profits that could be made if
interest rates were higher. While this is not a prescription that reflects the Fund’s broader
economic mandate, it is a realistic reflection of alarm about the dominance of speculation in
the international financial sector.
As the scale of speculative positions soared, debt monetization by financial institutions
contributed to the process that created excess liquidity. Large international banks, U.S.
investment banks and hedge funds used assets that were on their balance sheets as collateral
for borrowing and used the borrowed funds to take positions for their own account. The
mechanism was formally called carry-trade. It consisted in borrowing in short-term
markets where interest rates were low and investing in longer-term assets at higher rates.
Often the funding was acquired in one national market for investment in another and
resulted in increases in the volume of capital flows. In that case, sales of the funding
currency lowered its exchange rate while purchases of the investment currency raised its
rate and augmented the profitability of the position.
In some cases - Lehman Brothers, for example - the initial borrowing was used for lending
(reverse repos) to other institutions such as hedge funds. While Lehman was a primary
source of funding for hedge funds in this period, over time the growth in borrowing and
lending among all the major international institutions became so large that the demand for
collateral grew exponentially. Initially, government securities were the preferred collateral
and there was a rising demand for U.S. Treasuries and euro-denominated government debt,
especially among European banks,. The growing demand for government securities made
it easier for countries to borrow at significantly lower interest rates but, in time, the supply
of sovereign collateral began to thin and U.S. mortgage-backed securities became
acceptable substitutes. Then, as demand for collateral to support the expansion of
proprietary positions continued to rise, more subprime mortgages were included in the
pools backing securities. The next step was the movement into synthetic assets, such as
collateralized debt obligations and swaps. At that point, the international institutions had
created a totally hollow system in which balance sheets were pure froth and collapse was
inevitable.
On the way down, the process was quicker and more dramatic. Weakening housing prices
precipitated margin calls to top up the value of collateral backing short-term borrowing and
that, in turn, required charges against capital. Charges against capital exacerbated the
erosion of confidence in counterparties. As a result, the crisis of confidence in institutions’
creditworthiness intensified the need to preserve capital. None was willing to lend or to
buy assets that others had to sell. Assets became toxic at an early stage in the process and
the ability to fund positions became more difficult as the value of collateral continued to
sink and, in time, impossible. Lack of information on prices, volumes, etc. in wholesale
money markets aggravated the loss of confidence in markets themselves and resulted in
further losses.
Loss of confidence is always a factor in financial crises. In this crisis, loss of confidence
precipitated a run on the financial sector by the financial sector - an implosion at the
epicenter of a hollow system which had been created by the web of interconnected debt
within the financial sector.
What Dodd-Frank does to address the process that led to collapse and continues to impede
the recovery of the credit system is very simple. It amends the National Bank Act, which
has been in place in the U.S. for 150 or more years, to reaffirm the requirement for
diversification. The quantitative restrictions that have limited U.S. banks’ lending to
individual non-financial borrowers as a share of capital and surplus have been extended to
apply to financial borrowers. Three provisions – sections 609, 610 and 611 – deal with the
problem of overexposure in transactions with other financial institutions and their own
affiliates by national banks, state banks and savings institutions.
A related and equally important reform included in these Dodd-Frank provisions is the
expanded definition of what constitutes credit exposure. That definition now includes not
only lending but derivatives, repurchase agreements, reverse repurchase agreements and
securities borrowing and lending. Moreover, it introduces a broad definition of what
constitutes a derivative. And, most important, it requires banks to assess their total credit
exposure to a given financial or non-financial customer by aggregating all the above
channels for extending credit to individual customers and using the aggregate amount for
purposes of meeting the quantitative limit on credit extensions in relation to capital and
surplus.
The interesting thing about these provisions is that they appeared in the Senate version of
the bill introduced on March 14, 2010 and were adopted in the final version of the Act with
almost no discussion. They required no studies or rule making and were to become
effective a year after passage of the Act – that is, in July 2011. So far, bank lobbyists have
not focused on them but, because they are embedded in law, they must be applied and,
when they are, the clamor for repeal will surely follow. The reason is that these provisions
are amazingly appropriate in dealing with the causes that precipitated the crisis. If fully
implemented, one of their more powerful effects will be to shrink the financial sector
because there will be less funding available to support highly leveraged, off-balance sheet
positions and proprietary trading.
Turning to the second part of my presentation, the argument is that capital requirements are
an ineffective tool to prevent or deal with a systemic crisis. Capital is, of course, important
as a measure of solvency for individual institutions and as the traditional numerator used to
assess leverage and asset diversification. Used as the basis for measurements, capital plays
a critical role in soundness regulation but imposing requirements is only effective as a
microprudential tool. Achieving an aggregate level of capital adequacy across a financial
sector does not transform this tool into an instrument of macroprudential regulation. Its
failure to constrain the expansion of lending in the boom years before the crisis and its
ongoing threat to solvency in the downturn underscore its weakness in a systemic context.
Procyclicality determines both the availability of capital and fluctuations in its value as
asset prices rise and fall across the business cycle.
Reaffirming capital adequacy as the primary tool in the post-crisis regulatory framework
has necessarily raised questions about its weaknesses in the context of discussions about
systemically important institutions. How much additional capital should these entities hold
to make the tool effective? But a corollary question has not yet been discussed: how much
of an economy’s savings do we want to allocate as capital for the financial sector? Given
the growth in the financial sector’s profitability relative to non-financial corporations, is
allocating so much of the savings of the economy to financial institutions productive or
counterproductive in terms of achieving balanced growth and overall economic prosperity?
Concerns about these and other questions lead me to argue that the appropriate
macroprudential framework for the U.S. financial system requires a return to the monetary
paradigm that was replaced by the adoption of capital adequacy requirements. The
centerpiece of the Federal Reserve Act of 1913, that monetary paradigm required banks to
hold reserves with their regional reserve banks and provided the transmission mechanism
for the development of monetary policy. Indeed, transforming a soundness requirement
into a countercyclical tool in the 1920s allowed the Fed to grow from a passive into an
active institution and the authority to transmit its countercyclical influence through the
financial system to the real economy was strengthened in 1935.
By 1951, the United States had a financial system that was truly insured for soundness. At
that time, banks held 65% of all financial assets and liabilities and the coverage of reserves
was 11.5% of deposits. The almost total erosion of reserve requirements over subsequent
years left the system without a monetary cushion. Reconstituting that cushion would
provide a level of protection that capital requirements cannot achieve by creating a resource
that, uniquely, holds its face value and can be expanded in a downturn and used as a
restraint before a boom gets too far along the way.
Recent discussions reflect acceptance of the need to expand the use of quantitative limits as
macroprudential tools. Some proposals for regulatory rulings in the U.S. ask institutions to
pay attention to quantitative measures such as asset concentrations, market shares and
liquidity even though there are no explicit requirements that they do so. These are welcome
signs of a renewed emphasis on soundness but, again, a macroprudential framework
requires more than a focus on the behavior of individual institutions. It must promote the
health of the financial system in terms of its interactions with the rest of the economy. The
reaffirmation of capital as the primary regulatory tool for a fragile, post-crisis system means
that, prescriptively, we are not there yet.
Thank you.