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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.