The 2008 Global Financial Crisis in Retrospect: Causes of the Crisis and National Regulatory Responses [1st ed.] 978-3-030-12394-9;978-3-030-12395-6

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The 2008 Global Financial Crisis in Retrospect: Causes of the Crisis and National Regulatory Responses [1st ed.]

Table of contents :
Front Matter ....Pages i-xviii
A Retrospective on the 2008 Global Financial Crisis (Robert Z. Aliber, Gylfi Zoega)....Pages 1-15
Front Matter ....Pages 17-17
The Financial Alchemy That Failed (Marcus Miller)....Pages 19-41
Prudential Regulation and Capital Controls (Michael Dooley)....Pages 43-48
Three Grand State Projects Meet the Financial System (Peter Garber)....Pages 49-55
The 2008 GFC: Savings or Banking Glut? (Robert N. McCauley)....Pages 57-85
Capital Flows into the United States Ahead of the Great North Atlantic Financial Crisis (Brad Setser)....Pages 87-109
The Foreign Capital Flow and Domestic Drivers of the US Financial Crisis and Its Spread Globally (Jeffrey R. Shafer)....Pages 111-138
Financial Crises and Bank Capital (Robert Z. Aliber)....Pages 139-155
Three Reflections on Banking Regulations and Cross-Border Financial Flows (Edwin M. Truman)....Pages 157-173
Front Matter ....Pages 175-175
From a Capital Account Surplus to a Current Account Deficit (Hamid Raza, Gylfi Zoega)....Pages 177-189
Lessons from the Icelandic Financial Crisis (Sigridur Benediktsdottir, Gauti Eggertsson, Eggert T. Thorarinsson)....Pages 191-207
Iceland’s Capital Controls (Fridrik M. Baldursson)....Pages 209-226
Wage of Failure: Executive Compensation at the Failed Icelandic Banks (Gudrun Johnsen)....Pages 227-256
Financial Policy After the Crisis (Jon Danielsson)....Pages 257-279
Business Cycles and Health: Lessons from the Icelandic Economic Collapse (Tinna Laufey Asgeirsdóttir)....Pages 281-295
Ten Years After: Iceland’s Unfinished Business (Thorvaldur Gylfason)....Pages 297-325
After 100 Years of Experimenting: One Solution? (Asgeir Jonsson)....Pages 327-348
Iceland Should Replace Its Central Bank with a Currency Board (Fredrik N. G. Andersson, Lars Jonung)....Pages 349-369
Post-crisis Monetary Policy Reform: Learning the Hard Way (Thórarinn Pétursson)....Pages 371-393
Inflation Targeting, Capital Controls, and Currency Intervention in Iceland, 2012–2017 (Sebastian Edwards)....Pages 395-410
Front Matter ....Pages 411-411
Summary of Panel Discussion (Robert Z. Aliber, William White, Lawrence Goodman)....Pages 413-434
Back Matter ....Pages 435-443

Citation preview

The 2008 Global Financial Crisis in Retrospect Causes of the Crisis and National Regulatory Responses Edited by Robert Z. Aliber · Gylfi Zoega

The 2008 Global Financial Crisis in Retrospect

Robert Z. Aliber · Gylfi Zoega Editors

The 2008 Global Financial Crisis in Retrospect Causes of the Crisis and National Regulatory Responses

Editors Robert Z. Aliber Booth School of Business University of Chicago Chicago, IL, USA

Gylfi Zoega Department of Economics University of Iceland Reykjavik, Iceland

ISBN 978-3-030-12394-9 ISBN 978-3-030-12395-6  (eBook) Library of Congress Control Number: 2019932970 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2019 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover credit: Rawpixel/GettyImages/eStudio Calamar This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland



A Retrospective on the 2008 Global Financial Crisis 1 Robert Z. Aliber and Gylfi Zoega

Part I  The Source of the 2008 Global Financial Crisis 2

The Financial Alchemy That Failed 19 Marcus Miller


Prudential Regulation and Capital Controls 43 Michael Dooley


Three Grand State Projects Meet the Financial System 49 Peter Garber


The 2008 GFC: Savings or Banking Glut? 57 Robert N. McCauley


vi     Contents


Capital Flows into the United States Ahead of the Great North Atlantic Financial Crisis 87 Brad Setser


The Foreign Capital Flow and Domestic Drivers of the US Financial Crisis and Its Spread Globally 111 Jeffrey R. Shafer


Financial Crises and Bank Capital 139 Robert Z. Aliber


Three Reflections on Banking Regulations and Cross-Border Financial Flows 157 Edwin M. Truman

Part II  Iceland and the 2008 Global Crisis 10 From a Capital Account Surplus to a Current Account Deficit 177 Hamid Raza and Gylfi Zoega 11 Lessons from the Icelandic Financial Crisis 191 Sigridur Benediktsdottir, Gauti Eggertsson and Eggert T. Thorarinsson 12 Iceland’s Capital Controls 209 Fridrik M. Baldursson 13 Wage of Failure: Executive Compensation at the Failed Icelandic Banks 227 Gudrun Johnsen 14 Financial Policy After the Crisis 257 Jon Danielsson

Contents     vii

15 Business Cycles and Health: Lessons from the Icelandic Economic Collapse 281 Tinna Laufey Asgeirsdóttir 16 Ten Years After: Iceland’s Unfinished Business 297 Thorvaldur Gylfason 17 After 100 Years of Experimenting: One Solution? 327 Asgeir Jonsson 18 Iceland Should Replace Its Central Bank with a Currency Board 349 Fredrik N. G. Andersson and Lars Jonung 19 Post-crisis Monetary Policy Reform: Learning the Hard Way 371 Thórarinn Pétursson 20 Inflation Targeting, Capital Controls, and Currency Intervention in Iceland, 2012–2017 395 Sebastian Edwards Part III  Panel Discussion on the 2008 Crisis 21 Summary of Panel Discussion 413 Robert Z. Aliber, William White and Lawrence Goodman Index 435


Robert Z. Aliber Booth School of Business, University of Chicago, Chicago, IL, USA Fredrik N. G. Andersson  Lund University, Lund, Sweden Tinna Laufey Asgeirsdóttir  University of Iceland, Reykjavik, Iceland Fridrik M. Baldursson  Reykjavik University, Reykjavik, Iceland Sigridur Benediktsdottir  Yale University, New Haven, CT, USA Jon Danielsson  London School of Economics, London, UK Michael Dooley  Figure Technologies Inc., San Francisco, CA, USA Sebastian Edwards  University of California, Los Angeles, CA, USA Gauti Eggertsson  Brown University, Providence, RI, USA Peter Garber  Deutsche Bank, New York, NY, USA Lawrence Goodman Center for Financial Stability, New York, NY, USA Thorvaldur Gylfason  University of Iceland, Reykjavík, Iceland ix

x     Contributors

Gudrun Johnsen  University of Iceland, Reykjavik, Iceland Asgeir Jonsson Department of Economics, University of Iceland, Reykjavík, Iceland Lars Jonung  Lund University, Lund, Sweden Robert N. McCauley  Monetary and Economic Department, Bank for International Settlements, Basel, Switzerland Marcus Miller  University of Warwick, Coventry, UK Thórarinn Pétursson  Central Bank of Iceland, Reykjavík, Iceland Hamid Raza  Aalborg University, Aalborg, Denmark Brad Setser  Council on Foreign Relations, New York, NY, USA Jeffrey R. Shafer  JRShafer Insight, New York, NY, USA Eggert T. Thorarinsson  Central Bank of Iceland, Reykjavik, Iceland Edwin M. Truman Peterson Institute for International Economics, Washington, DC, USA William White  C.D. Howe Institute, Toronto, Canada Gylfi Zoega Department of Economics, University of Iceland, Reykjavik, Iceland

List of Figures

Fig. A.1 US dollar-denominated cross-border claims (billions of US dollars) (Note Arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B. Source Avdjiev et al. [2016]) 36 Fig. 5.1 US dollar-denominated cross-border claims: the transatlantic round-trip (In billions of US dollars) (Note The thickness of the arrows indicates the size of the outstanding stock of claims. The direction of the arrows indicates the direction of the claims: arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B. Source Avdjiev et al. (2016), based on BIS locational banking statistics) 63 Fig. 5.2 Competing hypotheses: capital flows and the US housing boom (Note The boundaries shown on this map do not imply official endorsement or acceptance by the author or the BIS. Source Author’s elaboration) (colour figure online) 64


xii     List of Figures

Fig. 5.3 Mortgage spreads and issuance, 2000–2006 (Sources Bertaut et al. 2012, p. 227, citing CoreLogic; Bloomberg) 65 Fig. 5.4 Housing price and household credit (Sources OECD; BIS) 77 Fig. 5.5 Massive bank flows to the euro periphery (In per cent of GDP) (Source Central Bank of Ireland; IMF; BIS locational banking statistics) 78 Fig. 9.1 Incidence of banking crises (Source Reinhart and Rogoff (2009) database from This Time is Different ) 159 Fig. 10.1 Capital inflows to GDP and share prices (Note Gross inflows to annual GDP are calculated as four quarter moving averages) 179 Fig. 10.2 Capital inflows, stock prices, and real exchange rate 182 Fig. 10.3 Cumulated impulse responses for period 1995Q1–2017Q3 (Note The structural shocks are plotted with 90% confidence bands) 185 Fig. 10.4 Cumulative impulse responses for different regimes (Note The solid indicates that the shock is significant whereas dotted line indicates that the shock is insignficant using 90% confidence bands) 186 Fig. 10.5 Impulse responses from different ordering 188 Fig. 11.1 Large banks liabilities 192 Fig. 11.2 Banking system size 193 Fig. 11.3 Glitnir large exposure 194 Fig. 11.4 Loans to large related parties that had large ownership in the banks 194 Fig. 11.5 Banks reported CAD ratio, percent 195 Fig. 11.6 Funding of own shares and cross funding of shares 196 Fig. 11.7 Current account balance for Iceland and selected countries, 2004–2017 198 Fig. 11.8 Iceland’s net international investment position, 1995–2016 199 Fig. 11.9 Estimated domestic/foreign breakdown of assets and claims of the old banks 199 Fig. 11.10 The potential balance of payments problem 200 Fig. 11.11 The split of the balance sheets into new and old banks 202 Fig. 11.12 Corporate debt 203 Fig. 11.13 Household debt 203 Fig. 11.14 GDP index at constant prices in domestic currency 204

List of Figures     xiii

Fig. 11.15 GDP index (Benediktsdóttir et al. 2017) 205 Fig. 12.1 Inflation, exchange rate and policy rate in Iceland 2006–2008 (Source IMF International Financial Statistics, Central Bank of Iceland) 211 Fig. 12.2 Short-term interest rates in the Asian and Icelandic crises (Note Money market overnight rate differential with USA. For Korea, Thailand and Malaysia the “policy” month is determined as in Kaplan and Rodrik [2002] [For Korea and Thailand, the policy month are defined as the month each country sought the assistance of the IMF: December 1997 for Korea; August 1997 for Thailand. For Malaysia the policy month is September 1998, the month the capital controls were imposed]; for Iceland the policy month is October 2008. Source International Financial Statistics, Central Bank of Iceland, author’s calculations) 213 Fig. 12.3 Central Bank of Iceland exchange rate, offshore rate and auction asking rate (Source Central Bank of Iceland [2015]) 215 Fig. 12.4 Real short-term interest rates in Asian and Icelandic crises (Nominal rates and periods as in Fig. 12.2) (Note Real rates calculated by using 12-month centred inflation. Source International Financial Statistics, Central Bank of Iceland, author’s calculations) 218 Fig. 12.5 Economic growth during Asian and Icelandic crises (Note Quarterly data, %-change from same quarter the previous year. Source International Financial Statistics, author’s calculations) 220 Fig. 13.1 Share of employee in total salary cost Glitnir 234 Fig. 13.2 Employee’s share in total salary cost Landsbanki 235 Fig. 13.3 Employee’s share in total salary cost Kaupthing 236 Fig. 13.4 CEO compensation base salary as share of total compensation 237 Fig. 13.5 Stock ownership and level of leverage Glitnir Bjarni Armannsson 248 Fig. 13.6 Stock ownership and level of leverage Landsbanki Halldór J. Kristjánsson 248 Fig. 13.7 Stock ownership and level of leverage Kaupthing Hreiðar Már Sigurðsson 249

xiv     List of Figures

Fig. 13.8 Stock ownership and level of leverage Kaupthing Sigurður Einarsson 249 Fig. 14.1 HSCB capital composition end 2016 259 Fig. 14.2 Capital ratios for European banks before the 2008 crisis 262 Fig. 14.3 Capital ratios for selected European banks in 2008 263 Fig. 14.4 Moving average economic growth for high-income countries (Data source The World Bank world development indicators) 267 Fig. 14.5 Growth scenarios (colour figure online) 267 Fig. 14.6 Cost of complying with Basel III 268 Fig. 14.7 ECB composite indicator of systemic stress (CISS) annual average 271 Fig. 14.8 ECB composite indicator of systemic stress (CISS) up to the 2007/8 crisis 271 Fig. 14.9 Risk, time lags, riskometers and macropru tools 277 Fig. 16.1 GNI per capita 1995–2015 (constant 2011 US $, PPP) (Source World Bank, world development indicators ) 307 Fig. 18.1 US dollar/Icelandic króna, 1875–2015. Logarithmic scale (Note A lower index value implies a weaker Icelandic króna versus the United States dollar) 351 Fig. 18.2 The interest rate of the Central Bank of Iceland and the Federal Reserve, 1995–2017 356 Fig. 18.3 The inflation rate of Iceland, from 2001Q1 to 2017Q4. The grey area covers the period with capital controls 358 Fig. 19.1 Inflation in Iceland 1970–2018 (Note Inflation is measured as the year-on-year change in the headline consumer price index. The shaded area shows the 5-year ± 1 standard deviation of inflation. Data for 1970Q1–2018Q2. Sources Central Bank of Iceland, Statistics Iceland, author’s calculations) 373 Fig. 19.2 Central bank transparency (Note The Dincer and Eichengreen transparency index for the Central Bank of Iceland and ten other inflation-targeting central banks [Australia, Canada, Chile, Eurozone, New Zealand, Norway, Sweden, Switzerland, the UK, and the US]. Source Dincer and Eichengreen [2014]) 376 Fig. 19.3 Accessibility of central banks’ publications (Note The first panel shows the yearly averages [from 2007 to 2018] of Monetary Bulletin length [main

List of Figures     xv

chapters, boxes and appendices] and the Flesch readability index [for main chapters]. The second two panels show the Flesch-Kincaid reading grade level [measuring the number of years of education required to comprehend the text] of various inflation reports and monetary policy committee minutes. Data on inflation reports from 2007 to 2016 [except Iceland from 2007 to 2018] from Haldane [2017] [linearly interpolating between data observations for 2007, 2012, and 2016] and minutes from 2007 to 2017 from Qvigstad and Schei [2018]. The central banks shown are the Central Bank of Iceland [CBoI], the Reserve Bank of Australia [RBA], the Bank of Canada [BoC], the Reserve Bank of New Zealand [RBNZ], the Bank of England [BoE], the European Central Bank [ECB], the Norwegian Norges Bank [NoB], and the Swedish Riksbank [SwR]. Sources Haldane [2017], Qvigstad and Schei [2018], author’s calculations) 377 Fig. 19.4 Central Bank foreign exchange interventions (Note Net purchases of foreign currency by the Central Bank of Iceland in Icelandic króna and the trade-weighted exchange rate of the króna January 2000–June 2018. Source Central Bank of Iceland) 380 Fig. 19.5 Target misses in advanced inflation-targeting countries (Note Average absolute deviation of inflation from inflation target [based on the inflation measure targeted in each country] in Iceland [ICE], Australia [AUS], the United Kingdom [UK], Canada [CAN], Norway [NOR], New Zealand [NZ], and Sweden [SWE] in the period 2001Q1–2018Q2. Sources Central bank websites, OECD, Central Bank of Iceland, author’s calculations) 382 Fig. 19.6 Inflation expectations and nominal volatility (Note The left panel gives inflation expectations 1, 2, 5, and 10 years ahead from surveys among financial market’s participants in Q2 of each year. The broken horizontal line gives the 2.5% inflation target. The right panel gives the standard deviation of inflation and 2- and 5-year inflation expectations [using the breakeven

xvi     List of Figures

inflation rate extracted from nominal and inflationindexed bond yields], and the dispersion of survey-based 1-year inflation expectations of households and firms over three 5-year periods. Source Central Bank of Iceland, Gallup, Statistics Iceland, author’s calculations) 383 Fig. 19.7 Credibility of the 2.5% inflation target (Note Smoothed probability of being in a low-inflation regime based on an open-economy, forward-looking Phillips curve, estimated with a two-regime Markov switching model. The shaded area shows the 1–4% inflation-target deviation band. Source Pétursson [2018]) 385 Fig. 19.8 Real economic volatility (Note The figure gives the standard deviation of annual changes in selected macroeconomic variables over five different periods. Sources Statistics Iceland, author’s calculations) 386 Fig. 19.9 Monetary policy frontiers (Note The efficient frontier shows pairs of standard deviations of inflation [deviations of annualised quarterly inflation from trend, πt] and output [annualised quarterly GDP growth, yt] which minimises the loss function    2 2 L= ∞ t=0 πt + (1 − )yt for different values of . The dots show pairs of actual standard deviations of inflation and output. The data are seasonally adjusted, de-trended, and Kalman filtered using the Central Bank of Iceland’s DSGE model. Source Central Bank of Iceland [2017b]) 388 Fig. 20.1 Policy rates in Iceland and selected OECD countries (November 2017) (Source Trading economics) 400 Fig. 20.2 Daily percentage changes in USD/ISK exchange rate, 2010–2017 402 Fig. 20.3 Daily change in the exchange rate for the bilateral US dollar to Chilean peso and US dollar New Zealand dollar exchange rates, 2010–2017 403

List of Tables

Table 2.1 Table B.1 Table B.2 Table B.3

Kaletsky’s four ages of capitalism 21 Subprime exposure by type of institution 37 Fed liquidity facilities and their users (in $ billions) 37 Fed as global LOLR: Central Bank liquidity swap lines, December 2007–August 2010 (in $b) 38 Table B.4 Big Five investment banks and survivors of the Big Eight: losses, capital injections, fines 39 Table 5.1 Asian savings glut vs European banking glut 61 Table 5.2 Non-US banks’ US securities affiliates’ underwriting of sub-prime MBS deals 67 Table 5.3 Holdings of US non-agency MBS by European banks with US broker-dealers (In billions of dollars at end-2007) 69 Table 5.4 Holdings of bonds issued in the United States by European and US investors at end-2002 and June 2007 71 Table 11.1 Net position of fiscal cost based on price to book 1.25–0.25 on the government share in the new banks (Benediktsdóttir et al. 2017) 206 Table 12.1 Statistical characteristics of exchange rates. Daily log-changes in USD against each currency 216 xvii

xviii     List of Tables

Table 12.2 Statistical characteristics of exchange rates in the post-controls period Table 13.1 Number of employees in data set Table 13.2 Total number of full-time employees of the banks on consolidated basis Table 13.3 Reported return on equity (%) for Icelandic and other Nordic Banks Table 13.4 CEO pre-tax total compensation per annum current prices. Base salary, bonuses, profits from exercised options, and pension copay Table 13.5 Stock ownership of CEOs at year end. Personal assets as well as assets through holding companies in 100% ownership of the CEOs Table 13.6 Dividend payments earned in ISK. Due to stock ownership of the CEO Table 14.1 SIFI Bank capital in national currencies in billions. End of year 2016. Some numbers are currently not known Table 15.1 Estimates of the probability of an ischemic heart disease (IHD) event among men Table 15.2 Participation elasticity calculations of various commodities in Iceland between 2007 and 2009 Table 18.1 Alternative exchange-rate arrangements. A stylized view

223 232 232 237 239 247 251 261 287 288 353

1 A Retrospective on the 2008 Global Financial Crisis Robert Z. Aliber and Gylfi Zoega

The global financial crisis of 2008 led to the most severe decline in production and employment and in world trade since the Great Depression of the early 1930s. Hundreds of banks and other financial firms failed in the United States, Great Britain, Ireland, Spain, the Netherlands, Germany, and Belgium. Greece and Portugal had sovereign debt crisis about fifteen months later; their governments would have defaulted on their debts if they had not been able to borrow from the International Monetary Fund and the European Central Bank to obtain the funds to repay maturing debt. The tenth anniversary of this global debacle provides an opportunity to review the cause or source of this crisis and the most appropriate policies and regulations to reduce the likelihood and severity of similar events.

R. Z. Aliber (*)  Booth School of Business, University of Chicago, Chicago, IL, USA G. Zoega  Department of Economics, University of Iceland, Reykjavik, Iceland e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


2     R. Z. Aliber and G. Zoega

A similar global meltdown began in mid-1997 when the currencies of Thailand, Indonesia, the Philippines, and Malaysia crashed; the banks in these countries failed. South Korea experienced a currency crisis and a banking crisis in December 1997 and then Russia defaulted on its financial commitments in the summer of 1998. Japan had a banking crisis in the early 1990s, Sweden, and Finland had currency and banking crises at about the same time. Mexico had had a currency and a banking crisis at the end of 1994. Norway had a crisis in 1988. The first of these global crises—centred on debacles in government loans— occurred in 1982 when the prices of the currencies of Mexico, Brazil, Argentina, and ten other developing countries declined sharply; the governments in many of these countries defaulted on their U.S. dollar indebtedness. The financial crisis in Iceland in 2008 can be likened to one of its earthquakes, which are caused by the sharp episodic movement of the Eurasian tectonic plate away from the North American plate. Both earthquakes and financial crises represent sudden adjustments to imbalances that had expanded over an extended period. The pressures that eventually lead to earthquakes in Iceland may have developed over many years while the friction between the two plates prevented any significant movement. A quake occurred once the increase in the pressure became sufficiently powerful to dominate the friction. The financial crisis in Iceland in 2008 developed after the country’s gross external indebtedness increased by more than thirty percent a year for six years, and its domestic indebtedness had increased by more than sixty percent a year. Nearly all of the increase in external indebtedness had been incurred by the Icelandic banks, which relied on money from new foreign loans for the interest payments on their external indebtedness. Similarly, the Icelandic households and business firms relied on money from new loans from the Icelandic banks to meet the interest payments on their outstanding loans. The system was stable as long as the supply of money from new loans enabled the borrowers to make their scheduled interest payments in a timely way. The banking crisis in Iceland developed in 2008 because the foreign banks and other lenders suddenly became much more cautious about buying the IOUs of the Icelandic banks, which meant both they no longer had the funds to

1  A Retrospective on the 2008 Global Financial Crisis     3

pay the interest to their foreign lenders on their indebtedness, and that they lacked the funds to increase their loans to domestic households and business firms. Some of the papers in this volume focus on financial developments in Iceland, some on developments in the United States. The U.S. economy is a thousand times larger than Iceland’s. The United States has a massive continental economy, international trade and investment is more important to the Icelandic economy. Both countries experienced sharp increases in cross border investment inflows; however, the ratio of the increase in investment inflows to GDP was five to six times larger for Iceland than for the United States. The increase in investment inflows to Iceland occurred because its banks sold more of their IOUs in foreign centres while the increase in these inflows to the United States reflected that China, the countries in Southeast Asia, and the oil exporting countries bought more U.S. dollar securities. Despite these differences, the process that led to the U.S. crisis was identical with the process in Iceland; the increase in investment inflows to both countries led to higher prices for securities and real estate. More than sixty countries have experienced a banking crisis since the early 1980s; each of these countries previously had a boom that often continued for four or five or more years. The prevailing view— the establishment view of former central bankers and ministers of finance—is that the crisis in each country was a national event with its origins in excessive risk-taking by domestic banks and other lenders. It’s as if in 2002 or 2003 the U.S. banks went on lending spree to sub-prime borrowers and similarly that similar lending sprees developed in Britain and Iceland and nearly twenty other counties. The competing view is that the increase in the supply of domestic credit in each of these countries was in part a response to the increase in cross border investment inflows. The increases in these investment inflows led to more rapid growth in the supply of credit in each country and in the demand for securities. The Icelandic banks could increase their loans to households and business firms at a rapid rate only because they were able to sell their IOUs to foreign banks at a rapid rate. The increase in the foreign demand for the IOUs of the Government of Greece and the Government of Portugal enabled them to finance larger fiscal deficits;

4     R. Z. Aliber and G. Zoega

these deficits expanded because foreign loans were readily available. The governments of Mexico and Brazil sold their IOUs in foreign banks because the demand was much larger than the demand of domestic residents for similar securities. The increase in the external indebtedness of these countries often was larger than the interest payments on their indebtedness. Similarly, the increase in the domestic indebtedness of households and business firms was larger than the interest payments on their indebtedness. The increase in the cross border investment inflows to most countries usually was associated with an increase in the prices of assets including stocks and real estate. As long as the increase in the indebtedness of the Government of Greece was larger than the interest payments on its indebtedness, the country’s population did not experience a burden in making its debt service obligations. The indebtedness of the Government of Greece was increasing more rapidly than the country’s GDP, which could not continue indefinitely, as this ratio increased, the lenders began to worry about the solvency of the Government of Greece; once the lenders purchases of the IOUs of the Government of Greece slowed, would the Government reduce its expenditures relative to its tax receipts so it would have more money for the interest payments. Similarly, as long as the increase in the external indebtedness of the Icelandic banks was larger than the interest payments on this indebtedness, the Icelandic banks adhered to their debt service commitments. As long as the increase in the indebtedness of a government, a business firm, a country, or a household was larger than the interest payments on its indebtedness, the borrowers had a “free lunch”, because all of the money that they needed for their interest payments was available from new loans. The free lunch may last for a few years but eventually the lenders became concerned that the increase in the borrower’s indebtedness was too large relative to their incomes. As the lenders became more cautious and reduced their demand for the borrower’s IOUs, the borrowers had to find some other source of funds to pay the interest. The trigger for each crisis was that the lenders’ demand for the borrowers’ IOUs slowed. The three Icelandic banks, much like the Government of Greece, had relied on money from new foreign loans to pay the interest on their indebtedness denominated in foreign

1  A Retrospective on the 2008 Global Financial Crisis     5

currencies; as the foreign demand for these Icelandic IOUs declined, the price of the Icelandic krona fell. The Icelandic banks were squeezed in part because the decline in the price of the currency meant that the krona counterpart of the IOUs denominated in a foreign currency increased, which immediately led to revaluation losses for the Icelandic banks on these IOUs. The capital of the Icelandic banks declined in proportion to the fall in the price of the krona. Moreover, the Icelandic households and firms that had borrowed from the banks in Reykjavik could no longer rely on money from new loans for the interest payments on their outstanding loans; some of these borrowers then sold krona securities to get the funds to pay the interest on their loans denominated in a foreign currency. The price of these securities declined, which contributed to the decline in the capital of the Icelandic banks. This pattern had been described by Irving Fisher in his classic book, Booms and Depressions; the decline in bank capital forced them to shrink their loans which then led to further declines in bank capital. The booms in the several years before each of these crises reflected the mirror of Fisher’s debt deflation process; the increase in cross border investment inflows led to higher prices of securities. The banks achieved revaluation gains on their holdings of securities, and the increase in their capital enabled them to grow their loans at a rapid rate. The necessary condition for the banking crisis in Iceland was that the country’ current account deficit was nearly twenty percent of its GDP, which meant that the price of the Icelandic krona would decline dramatically when the demand of foreign lenders for the IOUs of Icelandic borrowers would fall. The sufficient condition was that gross external indebted of the Icelandic banks was more than one hundred percent of their GDP, which meant that they would incur massive revaluation losses on their indebtedness denominated in a foreign currency once the price of the krona declined sharply. The 2008 banking crisis differed from the earlier waves because it engulfed the United States and Great Britain and other industrial countries; most of the countries involved in the previous waves were develop­ ing. Nearly twenty industrial countries experienced rapid increases in real estate prices between 2002 and 2007, less than half of these countries had crises. Every crisis was preceded by a boom, but not every

6     R. Z. Aliber and G. Zoega

boom was followed by a crisis. The countries that experienced crises may have had above average increases in investment inflows. These countries could have experienced sharp increases in investment inflows only because some other countries had the counterpart investment outflows. China and the oil exporting countries had developed large trade and current account surpluses because they intervened in the market for foreign exchange to limit the increases in the prices of their currencies. China had a dramatic increase in its exports after it became a member of the World Trade Organization in 2001. Saudi Arabia, Norway, Russia, the United Arab Emirates, and the oil exporting countries had dramatic increases in their export earnings as the world price of a barrel of petroleum increased from $30 in 2001 to $90 at the end of 2006. (This increase in the price of oil resulted from the increase in Chinese demand as its economy grew by about ten percent a year.) The counterpart of the increase in the current account surpluses of China and the oil exporting countries was that their demand for international reserve assets soared. The United States and Great Britain experienced rapid increases in investment inflows because the credit risk attached to their short term securities was low and because their securities were traded in very liquid markets. The trigger for the 2008 crisis was the failure of Lehman Brothers on September 15; the market in interbank credit froze because the banks that had excess reserves and were lenders or placers in this market suddenly became much more risk-averse. The banks that had been borrowers or takers in this market then had to find an alternative source of finance or else they would have to shrink their loans and other assets. The source or cause of the crisis was an earlier set of events; did the crisis begin with the failure of Northern Rock, the largest mortgage lender in Great Britain, in August 2008? Or did the crisis begin with the run on Bear Stearns in March 2008, which in some ways was a precursor to the run on Lehman, did the crisis begin when U.S. real estate prices began to decline during the last several months of 2006? Or was the source of the crisis the surge in U.S. real estate prices that began in 2002, the pace of the increase in these prices was much too rapid to continue and the price of real estate climbed far above the implicit equilibrium long run rental rate of return? Was the cause of the crisis

1  A Retrospective on the 2008 Global Financial Crisis     7

the surge in the demand for international reserve assets from China and the oil exporting countries; if their demand had remained unchanged, the United States and Great Britain would not have experienced large increases in investment inflows. The debt crisis in every country except Japan occurred when the foreign demand for its IOUs slowed, which usually led to a decline in the price of its currency. The crisis in Japan developed after a sharp slowdown in the growth of bank loans for real estate, which followed statements from the Governor of the Bank of Japan that the Japanese banks limit the growth of their real estate loans. Some countries experienced a panic when investors rushed to sell deposits or shares in anticipation that the lender might fail. What was the date after which a banking crisis in Iceland was 99.44% probable? Iceland may have has passed the “date of no return” after which the slowdown in the growth of investment inflows would have led to the crisis as early as the Spring of 2005; if the slowdown in the inflows to Iceland had occurred in April 2005, Iceland almost certainly would have had a severe crisis. Similarly, the United States passed its date of return at least a year before property prices peaked at the end of 2006. Each of these crises involved the correction of unsustainable imbalances. The imbalances in the external indebtedness of each of these countries continued for many months after the countries had passed the date of no return. That these countries encounter crises reflects that the lenders failed to ask the question, “Where will the borrowers get the money to pay us the interest on their indebtedness if we stop lending them the money in the form of new loans?” If more of the lenders had asked this question, they would have reduced their purchases of the lender’s IOUs long before the dates at which this reduction would inevitably lead to a crisis. That the lenders failed to ask this question in the 1970s may be understandable; they had not previously experienced a national banking crisis. The surprise is that once the lenders had searched for the cause of the early 1980s crisis, they should have asked this question every six or twelve months. The stewards of the international financial relationships— the International Monetary Fund, the Organization for Economic Cooperation and Development—should have asked this question.

8     R. Z. Aliber and G. Zoega

Every crisis leads those involved in financial regulation to ask what measures can we adopt to reduce the likelihood of that there will be another crisis. The generic answers include higher capital requirements and more restrictive limits on the types of loans that the banks can make. The rationale for these measures is rarely spelled out, but the implicit assumption is that 600 or 700 different banks caught the financial counterpart of the Spanish flu about the time. The response is to increase the perimeter of financial regulation and to increase the scope of regulation. Those who promote these regulations appear not to understand that the cause of the crises was the surge in the external indebtedness of nearly twenty countries. One of the major questions is whether the crisis in each country was a national event with its origins in excessive risk-taking by domestic lenders, or whether instead the expansion of domestic banks is a response to the increase in cross border investment inflows. The banks in Iceland and Ireland took the initiative to sell their IOUs in foreign markets so they could increase their domestic loans. The Government of Greece knew that most of the buyers of its newly government securities would be the banks in various countries in Northern Europe that were searching for yield. The U.S. banks that bought the loans of sub-prime borrowers funded their purchases by selling their IOUs in the domestic money market, which was flush with cash because of the surge in the foreign demand for U.S. dollar securities.

The Chapters in This Volume This book has three parts. The first part has eight chapters that study the causes and nature of the 2008 global financial crisis with an emphasis on developments in the United States. The focus of the chapters is on capital flows, macroeconomic imbalances, and prudential policies. Although the crisis originated in the United States, the effects were found in many countries. Iceland was the first country to seek the assistance of the International Monetary Fund in the autumn of 2008 and became, at least initially, a symbol of the excesses of the economic boom and bust. The remaining eleven chapters, which form the second part of the book,

1  A Retrospective on the 2008 Global Financial Crisis     9

study the effects of the global crisis on Iceland. The last part of the book contains a discussion by three panellists. Below we briefly summarise the content of each of the 19 chapters and start with the eight papers on the crisis in the world economy, in particular the United States. Marcus Miller argues that the growth of cross-border banking posed threats to financial stability that were ignored by central banks focusing on targeting domestic inflation. He discusses the role of pecuniary externalities, information failures, and the risk of insolvency in the subsequent “bank run”. It is argued that the financial system before 2008 was flawed by two Fallacies of Composition: first the belief that systemic stability could be guaranteed by regulations that made safer the portfolios of individual banks; second was a business model that reckoned holding securitized assets ensured liquidity whenever necessary. The author concludes that, while Iceland took exemplary action in bringing reckless bankers to justice, the failure to do this in the United States and the UK has had serious political consequences, such as the election victory of Donald J. Trump in the U.S. elections in November 2016 and, possibly, the majority vote a few months earlier in favour of the UK leaving the European Union. Michael Dooley makes a case for capital controls. He describes how the growth of international capital flows has increased the incentives by banks to choose high-risk strategies by opening the door to an almost infinite supply of leverage. He argues that the main problem with international investors when it comes to financial stability is that there are so many of them. It follows that limiting domestic financial institutions access to foreign investors can be an effective component of prudential regulation. In particular, he makes the case for required reserves on foreign deposits at domestic financial institutions. Peter Garber traces the crisis to three failed public sector projects launched in the late 1990s. These were a scheme to redistribute wealth by lending to uncreditworthy borrowers for real estate purchases in the United States; China’s export-driven growth strategy; and the launch of the euro in 1999. The rapid increase in China’s exports to the United States created a capital flow into the United States and within the Eurozone, Germany exported goods to the southern periphery and German banks lent money to banks, businesses, and governments in the south. The effect of these flows was to drive global real interest rates

10     R. Z. Aliber and G. Zoega

to very low levels and this led to the expansion of the SPVs and SIVs, effectively ways of raising short rates for those who demanded it. Robert McCauley maps the capital flows that preceded the 2008 crisis and argues that it was European banks that fuelled the U.S. housing boom. Large official inflows into U.S. Treasury and agency notes should have reinforced a U.S. mortgage market dominated by fixed-rate mortgages. Instead, one observed a big shift to mortgages priced with floating (“adjustable”) interest rates and to riskier, leveraged mortgages that agencies could not guarantee. This banking glut accounts for the parallel real estate booms and busts in Spain and Ireland. McCauley shows that the Irish and Spanish banking systems experienced capital inflows that were huge in relation to the inflows into the United States in the same years. Brad Setser finds that, first, sectoral imbalance in the United States shifted from the government sector to the household sector from 2004 to 2007; second, the available supply of Treasuries failed to grow in line with the enormous increase in central bank reserves, which incentivised more complex forms of financial engineering; third, after 2006, central bank flows fail to cleanly register in the U.S. data; fourth, the growth in private flows into the United States that coincided with record official reserve growth reflected the increasingly complex chains of financial intermediation needed to fund the U.S. deficit; and fifth and finally, some of the “missing” central bank flows—the gap between the growth in dollar reserves implied by the IMF’s data and the visible inflow into Treasuries and Agencies—likely was lent to European banks, both directly and indirectly, through the cross-currency swap market. Jeffrey Shafer discusses the prelude to the 2008 financial crisis during the Great Moderation in the United States. Lax monetary policy, fiscal stimulus, a current account deficit and innovations in financial markets set the stage for the crisis. The capital flowing into the United States fuelled a house price boom that came to a halt in 2007. Several factors contributed to the boom and bust. Long-standing government policy provided support for housing and homeownership; government-sponsored Fannie and Freddie aggressively expanded; refinancing to withdraw equity became common; innovations in the retail mortgage-backed securities market enabled mortgages to be packaged with tranches that were rated as equivalent to U.S. Treasuries for which there

1  A Retrospective on the 2008 Global Financial Crisis     11

was strong foreign demand; the risks introduced by packaging and distribution of RMBS was not well understood; underwriting standards deteriorated markedly; and, finally, the losses from bad credit decisions were multiplied by the collapse of vulnerable sources of liquidity in non-banks and off-balance sheet entities. Robert Aliber discusses the reasons for bank failures and financial crises. He makes three main points. First, U.S. macroeconomic stability would be increased if the U.S. Congress established a government agency to provide capital to individual banks after a systemic crisis causes large loan losses. Second, the crisis of 2008 is explained by a surge in the export earnings and the trade surpluses of China and the oil exporting countries, and of the increase in their demand for foreign securities on the prices of real estate and stocks in the United States and other countries that had capital inflows. The higher asset prices then caused increased consumption and current account deficits. Third, there is a criticism of Dodd-Frank. The premise of Dodd-Frank is that the crisis resulted from the decisions by banks to increase their purchases of risky securities rather than from a surge in the supply of credit from an increase in the capital account surpluses. Dodd-Frank does nothing to dampen cyclical increases in investor demand for U.S. dollar securities. Edwin Truman discusses the incidence of banking crises and concludes that there is no reason to expect an end to financial crises in the future. Moreover, he argues that financial reforms in recent years may have had the effect of increasing the severity of those crises that will occur by preventing the occurrence of smaller crises. Second, he finds that capital controls can be of use but not as a rule for all countries in all circumstances. Although a sudden stops of capital flows often precede crises they are not the underlying cause. Instead, there is greed on the part of borrowers and lenders that turns into fear when a disturbance occurs. Thus capital flow management controls, although often desirable, are not a panacea. Moreover, the authorities may find it difficult to distinguish between good and bad types of banking flows and over time capital controls will be evaded and become distortionary. Finally, Truman explores the possibility of major countries taking into account the effect of their policies on others but is not hopeful that central banks can deviate much from the local mandates.

12     R. Z. Aliber and G. Zoega

Hamid Raza and Gylfi Zoega address the issue whether the causes of financial crises in Iceland can be found locally, within Iceland, or in world capital markets. They explore the role of capital inflows in generating a stock market boom in Iceland as well as a real exchange rate appreciation. Using a VAR methodology, the authors find that the inflow of capital caused a booming stock market as well as an appreciation of the currency. Moreover, a positive shock to the stock market caused a subsequent capital inflow and appreciation. The results confirm the hypothesis that capital flows and credit generation created the stock market bubble and the overvalued exchange rate that contributed to the pre-crisis economic boom. A sudden stop of these flows made the stock market collapse and the exchange rate loose half its value. Gauti Eggertsson, Sigridur Benediktsdottir, and Eggert Thorarinsson describe the economic development that preceded the financial crisis in Iceland and draws some lessons for other countries. Of particular interest is the extent of lending to related parties in the years preceding the crash. Lessons include the importance of transparent firm ownership to facilitate supervision of insider lending and large exposures; strict rules against lending against own banks shares, and also against lending with collateral in other financial institutions shares; realising that implicit government guarantees are much weaker for cross border deposits and liabilities and that once banks are allowed to operate in different currencies or across borders, they can become victims of self-fulfilling runs simply because they do not have access to a lender of last resort; and more attention needs to be paid to capital flows, and policy tools need to be developed to respond to them. Fridrik M. Baldursson explores the effects of the economic policies prescribed by the IMF in response to the Iceland crisis. He finds that the capital controls were effective in that a gap emerged between the onshore and the offshore exchange rates; domestic interest rates did not follow foreign interest rate; and the statistical properties of exchange rate movements changed when controls were imposed and no longer indicated the presence of a carry trade. However, Baldursson argues that interest rates were kept too high, higher than in Malaysia following the 1997 crisis. Hence the capital controls did not constitute a departure from more orthodox policies prescribed by the Fund during previous crises.

1  A Retrospective on the 2008 Global Financial Crisis     13

Gudrun Johnsen studies the relationship between the compensation systems used by the Icelandic banks and the decisions made by the management that, among other factors, led to the disaster. Evidence was found of misreporting of key performance indicators. Banks’ leadership teams in all three banks engaged in a large scale market manipulation as staff option awards were used as a vehicle to falsify equity through inappropriate hedging of options via off-balance sheet SPVs, in addition to excessive lending to staff and favoured customers to purchase banks’ stocks with insufficient collateral backing. This behaviour helped meet bonus targets, derail financial supervisors and the investing public, whilst bringing and keeping incentive pay, in the form of stock and options, in the money. Loan portfolios in the failed banks were marked by excessive risk taking and funds were tunnelled to related parties. Jon Danielsson discusses the use of capital ratios and macroprudential regulation and describes the limitations of each policy: How banks can inflate capital ratios, how capital requirements fail to reduce the risk of aggregate shocks and how Basel III regulations burden smaller banks relative to larger banks. Moreover, Danielsson discusses the pros and cons of putting macroprudential regulations in the hands of a central bank, the possibility that this policy may turn out to be procyclical and the dangers faced to the credibility of a central bank that attempts to assess the economic risk of political decisions. Tinna Laufey Asgeirsdóttir reviews the literature on the relationship between the business cycles and health outcomes and then describes the results of studies on the effect of the 2008 crisis on heart health and consumption habits in Iceland. Asgeirsdóttir shows how the economic collapse in October 2008 lead to an increase in the number of heart attacks, which she attributes to the severity of the collapse and the shock that it may have caused in the population. In contrast, the collapse of the currency made the imports of alcohol, tobacco, and sweets more expensive, hence reducing their consumption with positive effects on the health of the nation. Thorvaldur Gylfason discusses the economic, political, and judicial aftermath of Iceland’s financial collapse in 2008. It considers lessons learned, or not learned, with emphasis on unsettled issues concerning the distribution of incomes and wealth, banking, and politics.

14     R. Z. Aliber and G. Zoega

The study makes three main points. First, the measurement of income flows and living standards needs to be adjusted. Second, since the crisis, Ireland has made a significantly stronger recovery than Iceland in terms of per capita income. Third, Iceland’s economic recovery from the crisis is marred by a visible deterioration of various components of the country’s social capital. Ásgeir Jónsson draws lessons from Iceland’s monetary history since sovereignty in 1918, during which time experiments have been made with various arrangements. His main conclusions are that it is not the choice of an exchange rate regime itself that is most important, but to follow the ground rules required by each framework. There is nothing to indicate that inflation targeting cannot work successfully in Iceland, as it has in other Nordic countries, if a reasonable societal consensus can be reached on the ground rules. The balance of payments has played a key role for economic stability in Iceland, and independent monetary policy is not truly an option unless it is possible to manage the capital account, directly or indirectly, irrespective of the exchange rate regime in place. This has traditionally been accomplished with capital controls, but at a great social cost. The appropriate application of macro prudential tools should offer a new ray of hope for the second century of monetary policy in Iceland. Fredrik Andersson and Lars Jonung describe Iceland’s economy and list the possible currency regimes. They ask which is the best monetary policy regime for Iceland and conclude that a flexible exchange rate with an inflation target can be ruled out because such a system has served as a shock amplifier. They find that Iceland can only maintain a domestic inflation target over the long run through capital controls. The authors consider such controls to be very costly and likely to increase corruption. Instead of a floating regime, they find that a fixed exchange rate regime is the preferred choice. But as a microstate, Iceland is not able to create sufficient credibility for such a regime, which leaves a monetary union as a solution. But since full euroization is not an option for Iceland because it is not a full member of the European Union or will be a member in the foreseeable future, the preferred monetary union alternative is, in their view, a currency board, accompanied

1  A Retrospective on the 2008 Global Financial Crisis     15

by a wide-ranging reform package to foster fiscal stability, wage and price flexibility, and financial stability. The current inflation-targeting regime did not manage to stabilise inflation at the official target in the first decade since its establishment in 2001, nor was it able to contain the large macroeconomic and financial imbalances that were building up from the middle of the decade, culminating in the catastrophic financial crisis in the autumn of 2008. The crisis triggered a major revision of the monetary policy framework and its governance and decision-making structure. These changes are described by Thórarinn Pétursson, the chief economist of the Central Bank of Iceland. His findings suggest that these reforms have increased the transparency and credibility of monetary policy in Iceland with improved inflation performance and greater overall nominal and real stability compared to before. Sebastian Edwards finds that monetary policy in Iceland has been run in an effective way since approximately 2012 and contributed in a significant way to the recovery of the Icelandic economy. He then addresses two new instruments of monetary policy; currency intervention and capital controls. He reviews the evidence for the efficacy of these instruments in other countries and suggests that the central bank make the policy framework clearer, possibly following the lead of the Reserve Bank of New Zealand, and that capital controls should be gradually lifted.

Part I The Source of the 2008 Global Financial Crisis

2 The Financial Alchemy That Failed Marcus Miller

The financial crisis and the economic, political and geopolitical responses are essential to understanding the changing face of the world today. (Tooze 2018)

Introduction With his conception of successive ‘Ages of Capitalism’, Anatole Kaletsky provides a canvas broad enough to encompass the banking crisis of 2008 and much more. After briefly outlining the Four Ages he identifies, we focus on the period of the Great Moderation when Inflation Targeting seemed to have solved the problem macroeconomic management—until it ended in spectacular failure. The rapid growth of cross-border banking—with securitized assets funded by wholesale money—evidently posed threats to financial stability that had been ignored by a regime targeting consumer prices. M. Miller (*)  University of Warwick, Coventry, UK e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


20     M. Miller

We look at three: the pecuniary externalities exerted by asset price changes on investment banking; information failures leading to an exaggerated banking boom; and the risk of insolvency in the subsequent ‘bank run ’. The financial system pre-crash was, it seems, flawed by two Fallacies of Composition: first on the part of regulators who reckoned making individual banks safe guaranteed stability of the system as a whole; and second by a business model that reckoned holding securitized assets ensured liquidity whenever necessary. Finally, we discuss how, in different countries, the law has variously been invoked to handle reckless banking.

The Four Ages of Capitalism Like Mammon, the fallen angel in Milton’s Paradise Lost whose ‘looks and thoughts were always downward bent, admiring more the riches of heaven’s pavement, trodden gold, than aught else’, economists are often blamed for focusing more on the minutiae of their models than on the wider lessons of history. With his broad-brush view of the evolution of capitalism in the West, Kaletsky (2010) offers an antidote. Since the origins of capitalism in the Industrial Revolution, he counts on three major crises to define Four Ages, as indicated in the Table 2.1. The first of these—the Victorian Age of Industrial Revolution in Britain—was characterised by laissez-faire governance, balanced government budgets and adherence to the Gold Standard. This period of unparalleled economic growth came to an end with the Wall Street crash, leading to banking collapse and the Great Depression. In the era that followed, the United States emerged as the world’s leading economy. This, the Keynesian Age, was a period of big government, managing aggregate demand to reduce mass unemployment— with action led by Franklin Delano Roosevelt, theory supplied by J.M. Keynes and impetus added by rearmament and wartime spending. It was, perhaps, a victim of its own success since, when the global economy got close to capacity and supply-side constraints began to emerge, there came the Great Inflation. In the view of John Hicks this inflation

1830–1914 (crises after WWI)

1934–1960 (crises in 1960s and 1970s)









Big Government (FDR: New Deal) Post-war US leadership of world economic order Collapse of USSR in 1990 leading to ‘Capitalist Triumphalism’ under Thatcher and Reagan Populism and protection

Victorian age Laissez- Night watchman state Faire Balanced budgets


Dollar Standard, with Keynesian age of demand rule-based intermanagement national economic order, with IMF, World Bank, WTO ‘Great Moderation’: Free-market fundaMonetarism folmentalism; with lowed by Inflation Floating rates and Targeting Deregulation. Globalisation with Regionalism Great Stagnation in Unconventional the West but not monetary policy. US the East shifts to non-cooperative behaviour

Era of Imperialism and the Gold standard


Table 2.1  Kaletsky’s four ages of capitalism

Euro crises. Slow recovery, low growth

Global financial crisis of 2008: followed by Great Recession

Shock of WWI; war debts & hyperinflation; Wall Street crash and Great Depression Global Inflation: Oil price shocks of 1973/1981; union power


2  The Financial Alchemy That Failed     21

22     M. Miller

had its origins in a real shock—the sharp fall in the real earning power of labour due to the rise in the price of primary products—oil being the obvious case in point.1 Faced with the challenge of inflation, the Bretton Woods system of pegged exchange rates ended in 1973. Thereafter many OECD countries opted for floating exchange rates together with anti-inflationary monetary policy,2 guided by the view of Milton Friedman that there was no long-run trade-off between output and inflation. Economists worked on developing a ‘monetary theory of exchange rates’ to describe this brave new world.3 In broad-brush terms, this asset-based approach implied that, with each country free to choose the growth rate for its money supply, the global outcome would be an inflation rate reflecting the average of these monetary choices, and exchange rate changes that duly reflected the differences. With prudent monetary policy at the national level, stability of the global system seemed assured. Before long, however, the monetary targets Friedman recommended were replaced by Inflation Targeting, using the Taylor rule for setting interest rates—with expectations taken to be rational rather than adaptive—leading to the Great Moderation of 1985–2007. Broadly speaking, the experience of OECD countries in the period of the Great Moderation seemed to support the perspective that Friedman had advanced, that floating exchange rates and anti-inflationary monetary policy would deliver financial stability. There were, it is true, successive and severe crises in ‘emerging markets’ leading to sharp falls in their exchange rates—the fall of the Mexican peso in 1996, and of East

1This shock ‘we have to face in terms of traditional economics, waking up from the sweet Keynesian dreams that have been with us so long… It is the attempt to bring about such a fall by a lag in money wages behind money prices that is the principal cause of the acceleration of inflation’ (Hicks 1975, p. 19). 2With European countries later clubbing together to create the euro, delegating to the ECB the task of conducting monetary policy for the Eurozone as a whole. 3See for example Bilson (1978) and Frenkel (1976).

2  The Financial Alchemy That Failed     23

Asia currencies in 1998, for example: but these could be attributed to investor panic, inadequate financial regulation or ‘crony capitalism’ in countries that had not reached ‘advanced’ status. There were, in addition, financial crises in the United States itself— the stock market break of 1987, the collapse of LTCM in 1998, and a dot-com bubble that burst in 2001; but with Alan Greenspan as Chair of the Federal Reserve System, the US financial system seemed to be in capable hands. Widely reckoned to be one of the world’s finest central bankers, he held the post for five successive terms (1986–2006) and, in 2005, received an honorary knighthood from Queen Elizabeth for his ‘outstanding contribution to global economic stability’. Nonetheless, the period ended with the most severe financial crisis since the 1930s. On this occasion, policy-makers—taking to heart the lessons of history—took extraordinary measures of monetary and fiscal stabilisation to head off a repeat of the Great Depression. The Fourth Age is where we are now. There may be problems of deleveraging, inequality and low growth in the West, but Kaletsky remains optimistic that, once again, capitalism will find a way forward. Others, President Xi Jinping of China in particular, take a very different view, offering the Chinese top-down, one-party approach as an alternative model for growth and development.

The Financial Alchemy That Failed: Three Narratives The focus in this paper is on Third Age and how to account for the Global Financial Crisis that erupted so soon after Mr. Greenspan resigned in 2006. For John Taylor, the answer is self-evident—the crisis arose because the United States had deviated from his policy rule: after the end of the dot-com bubble, policy rates in the United States were kept ‘too low for too long’. Moreover, exchange rate objectives—such as ‘competitive devaluations’—may have accentuated deviations from rules-based policy, Taylor (2018).

24     M. Miller

Others see deeper flaws in the way capitalism has been evolving.4 From an empirical perspective, Helene Rey (2013), in her Jackson Hole presentation Dilemma not Trilemma, challenged the basic MundellFleming open economy model that offers the prospect of monetary independence for economies that float. She presents empirical evidence of a Global Financial Cycle, where monetary conditions in the United States affect other countries whether or not they float. From a more institutional viewpoint, Tobias Adrian, Robert McCauley, Hyun Shin, and others have argued that the interlinking of economies through cross-border banking renders the framework of monetary independence associated with Friedman and Mundell/Fleming out of date. (Evidence of increasing financial interconnectedness is provided in Annex “Cross-Border Finance—A Snapshot”.) The historian Adam Tooze (2018) gives a comprehensive account of what he calls ‘the re-globalisation of banking’ with particular attention to investment banking—its transatlantic nature and its reliance on wholesale funding. On the presumption of efficient financial markets, however, details of money and banking were absent from the DSGE models used by Central Banks to implement their Taylor Rules. To neglect the impact that investment banking was to have on Congressional plans for the provision of finance for housing was a fatal error. As Tooze (2018, pp. 47, 48) argues: American housing policy and mortgage practice since the war had systematically favoured home ownership for the white majority. In the 1990s promoting home ownership for lower-income and ‘underserved’ minority communities became a congressional priority. …Many of the new homeowners in the 1990s and the 2000s were ethnic minority families who had been denied mortgages for decades under the regime of ‘redlining’ institutionalized by New Deal housing policy. … Fannie Mae and Freddie Mac set high minimum standards for the quality of the loans they would

4As did Greenspan himself when “in late 2008, he admitted to Congress that the crisis had exposed a ‘flaw’ in his world view. He had always assumed that bankers would act in ways that would protect shareholders—in accordance with free-market capitalist theory—but this presumption turned out to be wrong” (Tett 2013). See also Greenspan (2013).

2  The Financial Alchemy That Failed     25

buy. The Government Sponsored Enterprises didn’t support the kind of low quality, subprime loans that were beginning to fail in droves in 20052006. Those toxic loans were the products of a new system of mortgage finance by private lenders that came into full force in the early 2000s.

Instead of taxes and subsidies to redistribute income, the idea was that those on lower incomes would borrow to get on the housing ladder so—with time and house price appreciation—they could extract equity to increase consumption. But with the development of private label securitisation (PLS), the subprime experiment in ‘dynamic credit enhancement’ for low-income borrowers accelerated sharply: the injection of private sector finance was sufficient to upset the applecart. As Rajan (2010, pp. 38, 39) puts it: Unfortunately, the private sector, aided and abetted by agency money, converted the good intentions behind the affordable housing mandate and the push towards an ownership society into a financial disaster.

The beauty of the investment banking model was that mortgage lending all across the US would be funded by money at low rates: this was the financial alchemy promised and practised on Wall Street. Why did it fail? We look at three plausible narratives.5

Narrative One: Pecuniary Externalities in Investment Banking The basic idea is that asset price changes—which may be due to bank behaviour—can have powerful, potentially destabilising, feedback effects on the lending capacity of the banks themselves. How this works is outlined in Shin (2010, Chapter 3) as follows. Take two groups of investors holding a given stock of risky assets: own-money investors, with risk-averse preferences on the one hand;


further detail, see Miller et al. (2018).

26     M. Miller

and highly leveraged, risk-neutral investment banks who borrow heavily to invest in risky assets on the other. That the latter are operating with ‘other people’s money’ poses problems of moral hazard: they may take on too much risk, keeping the upside and leaving the downside to their creditors. To limit this ‘agency’ problem, creditors and/or regulators can impose balance sheet rules to check excess risk—like Value-at-Risk (VaR) rules that ensure such Highly Leveraged Institutions (HLIs) have some of their own ‘skin in the game’ to cover downside risk. So far so good. But such micro-prudential rules, which work to check idiosyncratic shocks, can generate significant amplification when shocks are correlated, i.e. they are macro shocks. If, for example, there is public information to the effect that the risky assets held by both types of investors are of higher quality than previously supposed,6 then this will increase demand, and, for given supply, raise the market price and increase the equity of investment banks with monetary liabilities. Assuming that the latter are keen to grow their business, this extra equity can, under VaR rules, permit an expansion of investment bank balance sheets—and a rise in their market share vis a vis risk-averse investors without leverage. This amplification is referred to as a pecuniary externality because it works through the effect of that market-clearing prices have on the balance sheet restrictions which govern the investment behaviour of individual banks, Davila and Korinek (2018).7 To check such externalities is the task of macro-prudential regulation (‘Macro Pru’). This may involve leverage caps and cyclical capital buffers, liquidity requirements and, perhaps, Pigovian taxes on capital gains and structural changes to limit the build-up of leverage in the financial sector. From this perspective, with cross-border banking and VaR rules—but no Macro Pru—the Western banking system was exposed to significant threats of instability before the financial crisis. 6i.e.

are less risky and/or have higher expected payoff. base their discussion on the ‘Credit Cycles’ model of Kiyotaki and Moore (1997) where the borrowers are farmers subject to the balance sheet rule that borrowing be collateralised by the land they hold: this works well for idiosyncratic shocks to farmer productivity, but correlated productivity shocks generate amplification through the price of land. 7They

2  The Financial Alchemy That Failed     27

Narrative Two: Information Failures Myopia and the Leverage Cycle Shin’s Investment Banking model assumes common knowledge of the true quality of risk assets on the market. In analysing what they call the ‘Basel leverage cycle’, Aymanns et al. (2016) assume banks are myopic in assessing risk, however, judging assets to be safe when few shocks have recently been observed even though their stochastic properties have remained unchanged. In their model of investment banking—rather like the Shin model discussed above, but with a dynamic framework where non-banks are ‘noise traders’ and banks get recapitalised if they lose equity—they obtain a Minsky-style cycle, where asset prices rise steadily for a while as investment banks expand, before crashing as risk assets are dumped in ‘fire-sales’. This analysis claims to describe forces operating at the time of the Great Moderation—a dramatic challenge to the glib assumption that price and output stability are sufficient for Financial Stability.

Asymmetric Information and Cheating In Phishing for Phools, Akerlof and Shiller (2015, p. 36) stress the role of information asymmetries and the temptation to cheat that they provide. They argue that the degree of risk involved in subprime assets was initially grossly understated, as credit rating agencies (CRAs)— skilled in assessing repayment prospects for the debt of corporations and sovereigns—were paid by the banks to give favourable ratings to complex financial products whose properties defied the type of analysis they were used to. (Such an allegation has been substantiated by subsequent findings in the law courts against Standard and Poors and Moodys, see Annex “Legal Penalties Imposed on US Investment Banks and CRAs”.) It is not only through inflated ratings that investment banks were able to mislead regulators and their creditors. According to Haldane et al. (2010, p. 89) ‘Those banks with the highest leverage are the also the ones who have reported the largest write-downs. That

28     M. Miller

suggests banks may have invested in riskier assets, which regulatory weights failed to capture’. It seems that banks could—and apparently did—assign deliberately low-risk weights in calculating the capital requirements of Basel II. This meant more profits, but much greater vulnerability. With the world’s most trusted rating agencies misleading investors and the biggest banks misleading regulators, how long could Finance remain Stable?

Narrative Three: A Bank Run That a fractional reserve bank is exposed to collapse following a ‘run’ by depositors is a familiar tale. In the classic paper of Diamond and Dybvig (1983), for example, banks provide ‘liquidity insurance’ for depositors: but panic that leads to unpredicted depositor withdrawals can induce collapse as the bank is forced to sell illiquid assets at a loss—unless the Central Bank steps in as lender of last resort (LOLR) as Bagehot had recommended. Was the securitisation of loans not, in principle, sufficient to counter this risk? With securitised assets, a bank that loses deposits need not turn to the Central Bank for liquidity: it can simply sell the marketable securities it has on its balance sheet. While this logic may be true for shocks affecting an individual bank (as such idiosyncratic shocks will tend to wash out in aggregate), it fails when shocks are correlated across many banks. Aggregate shocks will lead to collective selling, i.e. they will generate adverse pecuniary externalities. In the Diamond-Dybvig story, the involuntary deleveraging forced upon an individual bank which loses its funding may lead to its insolvency; with aggregate shocks, the adverse price effects associated with fire-sales can cause insolvency on a systemic scale. How relevant such pecuniary externalities proved is a key element in Adam Tooze’s account of the financial crisis and its aftermath. So great was the threat of fire-sales by banks facing funding freezes, he argues, that the Fed had to act as ‘Global Lender of Last Resort’ to avoid systemic collapse.

2  The Financial Alchemy That Failed     29

If the Fed did not act, what threatened was a transatlantic balance sheet avalanche, with the Europeans running down their lending in the United States and selling off their dollar portfolios in a dangerous fire-sale. It was to hold those portfolios of dollar-denominated assets in place that from the end of 2007 the Fed began to provide dollar liquidity in unprecedented abundance not only to the American but to the entire global financial system, and above all to Europe. (Tooze 2018, p. 206)

Two Fallacies of Composition The twentieth-century financial alchemy—where subprime lending would be financed by liquid funds from Wall Street—was too good to be true: it involved fallacies of composition both by the regulators and by the banks. Here’s why.

Regulators Who Were Captured The Basel Committee on Banking Supervision (BCBS), established in 1975, came to see its mission as devising bank regulations—to be applied country by country—so as to ensure financial stability in the economies of the West. Concerns that there might be an international ‘race to the bottom’ in terms of bank regulation led to the Basel Accord of 1998 with an 8% Capital Adequacy Requirement to be applied to Risk Weighted Assets. This marked a significant step in coordinating financial regulation among independent sovereign states. But, as Charles Goodhart (2011, p. 581) puts it in concluding his comprehensive study of the BCSB over the years 1974–1997, ‘the key question is: why the apparatus of financial regulation failed to prevent a systemic failure’. The view of national bank regulators and the BCBS was, Goodhart notes, that their duty lay in ‘improving the risk management practices of individual banks’, leaving out of account the potential externalities, that can threaten financial stability at a global level. To suppose, as did the Basel Committee, that balance sheet restrictions (such as VaR rules)

30     M. Miller

designed to check risk-taking at the level of the individual banks would ensure the safety of the global financial system, is, he argues, an example of the Fallacy of Composition. Why did the Committee fall into the error of ignoring such externalities? Goodhart suggests it was ‘intellectually captured’ by the industry it was regulating. Adam Tooze (2018, pp. 86, 87) puts it more strongly: The regulators were utterly subservient to the logic of the businesses they were supposed to be regulating. The draft text of what would become the Basel II regulations was prepared for the Basel Committee by the Institute for International Finance, the chief lobby group for the global banking industry …. The FDIC estimated that the introduction of Basel II would permit big banks to reduce their capital by 22%.

The Business Model that Failed The essence of the investment banking model was to finance mortgage lending across the United States by raising funds at low rates on Wall Street. Adam Tooze sketches the mechanics as follows. On the asset side, the secret was securitization: The end of the refinancing boom of 2003 in conventional mortgages triggered the push into unconventional lending…. What the private securitizers discovered was that if securitizing conventional mortgages was profitable, subprime was even more so. (Tooze 2018, p. 60)

On the liability side of the balance sheet, money markets were tapped for wholesale funding: Building a big balance sheet of Mortgage Backed Securities didn’t just involve risk on the asset side. It also involved expanding the liabilities of the bank on the funding side. This was the truly lethal mechanism at the heart of the crisis. Funds from money market cash pools were channelled into financing the holding of large balance sheets of MBS. (Tooze 2018, p. 60)

2  The Financial Alchemy That Failed     31

One mechanism used by investment and commercial banks to fund this lending was to transfer substantial amounts of risk assets ‘off balance sheet’ to their associated Special Purpose Vehicles who would in turn issue commercial paper (repayable between three months and as little as a few days) backed by the name of the parent bank. As the capital requirements on these SPVs were far less than would be required ‘on balance sheet’, this enhanced the return on capital: but by keeping risky assets effectively inside the banking system, this exposed the latter to solvency shocks and liquidity runs. A second mechanism was borrowing directly from the market via repos (i.e. transactions where the ‘borrower’ sell securities to the ‘lender’ with a commitment to repurchase at a future date at a specified price): As with commercial paper, repo was exposed to serious funding risk. You might not be rolled over. Specifically, the risk was that if an investment bank like Lehman or Bear was thought to have suffered major losses on some big part of its portfolio it would suffer a general loss of confidence. It would then … find itself shut out from critical funding. At Lehman at the end of fiscal year 2007, of its balance of $691b, 50% was funded through repo. At Goldman Sachs, Merrill Lynch and Morgan Stanley, the share was 40%. If any of these investment banks was to lose access to the repo market, at a stroke its business model would collapse. (Tooze 2018, p. 62)

The downside of this business model was that the ending of mortgage boom would pose an existential threat. And the writing was on the wall: From 2004, fully half the mortgage loans being fed into the system had incomplete or zero documentation, and 30% were interest only loans to people who had no prospect of making basic repayment [and] many of the subprime mortgages were on balloon rates that would rapidly increase after a period of two or three years. (Tooze 2018, pp. 64, 70)

Finally: What About the Law? How law courts have handled banking failures differs markedly from country to country. From this diversity, as Benediktsdottir et al. (2017) politely hint, there may be lessons to be learned.

32     M. Miller

In the US: ‘Deferred Prosecution Agreements’ US courts imposed heavy ‘fines’ on banks and rating agencies for misselling and mis-rating, as reported in Annex “Legal Penalties Imposed on US Investment Banks and CRAs”. But the courts have been criticised because, in contrast to what happened in previous crises—that of Savingsand-Loan associations in the 1980s and the accounting frauds of the 1990s, for example—‘not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis’, Rakoff (2014). In the article cited, retired Judge Rakoff notes that there has, in fact, been a shift from prosecuting high-level individuals to prosecuting companies. In order to change ‘corporate culture’, the policy pursued is to secure Deferred Prosecution Agreements (DPAs) in which the company, under threat of criminal prosecution, agrees to pay a fine and to take remedial measures to prevent future wrong-doing. As John Kay (2017) observes, however, ‘the very prevalence of such [DPA] settlements is an indication that their deterrent effect is small. Senior executives appear not to mind paying out large amounts of shareholders’ money to escape any personal liability for their actions, or the actions of those whom they ostensibly supervise’.

In Iceland: Transparency and Prosecution In Iceland, by contrast, decisive steps were taken to determine what happened and who was responsible. As reported in Benediktsdottir et al. (2017, pp. 193, 197): After the 2008 global financial crisis, the Icelandic parliament (Alþingi) established the Special Investigation Commission (SIC), which was composed of a supreme court judge, a parliamentary ombudsman, and an economist to address the basic questions of ‘What just happened?’ and ‘Were any public officials responsible for mistakes or negligence?’ The investigation was unique, in that Alþingi lifted all laws on bank secrecy in the public interest. Therefore, the SIC had unparalleled access to information about all the banks’ operations, including their loan books, tax information, reports and loan committees’ documents and minutes. Moreover,

2  The Financial Alchemy That Failed     33

it had subpoena power over bankers and any other relevant parties, such as politicians, business partners and regulators. …

Furthermore, Alþingi appointed a special prosecutor to investigate the failed banks, which resulted in several charges, including against chief executives of all three of the major banks, all of whom were either sentenced to serve jail time or still have cases pending.8 Though no evidence of bribery emerged and no corruption charges were issued by the special prosecutor (with one exception, for insider trading), the extent of malpractice uncovered by the SIC was daunting, including the purchase of own shares, illegal lending, breach of trust, and borrowing substantial sums money from the ECB and the Central Bank of Icelandic without meaningful collateral.9 As a result, ‘crash-related’ sentences handed down by the Supreme Court between 2012 and 2015 amounted to 87 prison years for 38 individuals, including a Deputy Minister of Finance, four Board Chairs, and ten CEOs (with some of these senior bank officials getting sentences of 5–6 years each), Office of the Special Prosecutor (2017). There are further sentences handed down by the District Court, involving 26 prison years for 16 people, still subject to appeal at the time of writing.

In the UK: A Parliamentary Commission on Banking Standards Legal penalties in the UK could hardly provide a starker contrast: no senior executives have so far been prosecuted. In his Reith Lectures, the historian Niall Ferguson (2013, p. 75) asserted, with only a little exaggeration: ‘the harshest punishment meted out to a banker was the “cancellation and annulment” of the former Royal Bank of Scotland CEO Fred Goodwin’ s knighthood’! For the future, however, he stressed the importance of ensuring that those who fall foul of regulatory authority pay dearly for their transgressions. 8For

more detail see Jonsson and Sigurgeirsson (2017). was common practice in Iceland for two banks to swap their debt securities with each other and for each to use the other’s debt as collateral in their borrowing from the central bank. Such collateral was referred to as a ‘love letter’” (Sibert 2010).


34     M. Miller

All the detailed regulation in the world will do less to avert a future financial crisis than the clear and present danger in the minds of today’s bankers that, if they transgress in the eyes of the authority on whom their business ultimately depends, then they could go to prison (Ferguson 2013, p. 78). A year after these words were published, however, the Parliamentary Commission on Banking Standards issued a report—Changing banking for good—outlining radical reforms to improve standards across the banking industry.10 Key recommendations include: A new Senior Persons Regime to ensure that the most important responsibilities within banks are assigned to specific, senior individuals so they can be held fully accountable for their decisions and the standards of their banks in these areas; A new licencing regime underpinned by Banking Standards Rules to ensure those who can do serious harm are subject to the full range of enforcement powers; A new criminal offence for Senior Persons of reckless misconduct in the management of a bank, carrying a custodial sentence; A new remuneration code better to align risks taken and rewards received in remuneration, with much more remuneration to be deferred and for much longer; A new power for the regulator to cancel all outstanding deferred remuneration, along with unvested pension rights and loss of office or change of control payments, for senior bank employees in the event of their banks needing taxpayer support, creating a major new incentive on bankers to avoid such risks. Parliament has recommended that ‘reckless misconduct’ should lead to imprisonment of senior managers; but the standards of proof required to establish criminal liability for executives—with funding doubtless available to marshal the very best lawyers in their defence— could well stymie this innovation. In which case, it will be left to ‘clawback’ and other financial penalties that reduce the private benefits of risk-taking to change managers’ behaviour. Time will tell. 10Subsequently,

the Prudential Regulatory Authority and Financial Conduct Authority have been developing Senior Manager and Certification Regimes (SM&CR) to support a change in culture at all levels in the banking and insurance industries.

2  The Financial Alchemy That Failed     35

Conclusion Failure to bring reckless bankers to justice is likely to have serious political consequences. Indeed, according to Michael Lewis, in the United States it already has. When interviewed by Gary Silverman for the Financial Times Michael Lewis expressed the view that the Trump phenomenon was ‘an unfortunate aftershock’ of the financial blunders of the last decade. He went on to elaborate: The collapse of the US mortgage market and the subsequent bailout of the banks left Americans of varying political views feeling that the system was rigged. I think of this as echoing the 2008 financial crisis. The marketplace for politicians just did something as weird as the marketplace for securities did, and it did it in part because of what the market did. (Gary Silverman 2016)

Postscript As suffering post-crisis austerity and voting to leave the EU were geographically correlated, the economic historian Nicholas Crafts proposes that the ultimate costs of the financial crisis in the UK should include estimates of GDP losses on leaving. Crafts, N (2019) “The Fall in UK Potential Output due to the Financial Crisis: a Much Bigger Estimate”. CAGE Working Paper No. 399, University of Warwick, January.

Annex A: Cross-Border Finance—A Snapshot The increasing interconnections of the global financial system are neatly illustrated by a graph from Avdjiev et al. (2016). This is shown as Fig. A.1, where the thickness of the arrows indicates the size of the outstanding stock of claims. As between 2002 and 2007, Europe evidently borrowed an extra $1.1 trillion in the United States, and invested this back again. So, as the authors put it, ‘the dollars raised by borrowing from US money market funds flowed back to the United States through purchases of securities built on subprime mortgages’.

36     M. Miller

Fig. A.1  US dollar-denominated cross-border claims (billions of US dollars) (Note Arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B. Source Avdjiev et al. [2016])

The fact that the gross exposure of foreign banks was hedged on a currency basis (by short-term $ borrowing) did not mean that non-US banks were protected from the US financial crisis. Given the maturity mismatch, they were seriously exposed to a funding crisis—a demand for dollars that could have led to fire-sales and insolvency had the Fed not acted as Global Lender of Last Resort, see Annex “Emergency Liquidity and Capital Support Provided to US Banks”.

Annex B: Emergency Liquidity and Capital Support Provided to Banking Liquidity Provision The US financial system was, unlike Lehman, saved from collapse. Given the existential threat that meltdown would have represented to the United States and other Western economies, the Fed as LOLR

2  The Financial Alchemy That Failed     37 Table B.1  Subprime exposure by type of institution Total of subprime assets Non leveraged institutions Total leveraged institutions Of which: US Non US

Percent of exposure (%)

Approx value ($b)

100 35 65 50 15

1400 490 910 700 210

Source Shin (2010, p. 153, Table 9.1) Table B.2  Fed liquidity facilities and their users (in $ billions) Facility

Commercial paper funding facility (ABCP/ CP) 3 month

Term Auction Facility (TAF)

Single tranche OMOs

Term Securities Lending Facility (TSLF)

Primary Dealer Credit Facility (PDCF) (overnight)

Total lending by facility Total large banks Large non-American % nonAmerican






253 201

3259 1799

910 656

2006 1017







Source Tooze (2018, p. 216)

provided liquidity to private banks in the United States and outside US boundaries too; and made swaps available to other Central Banks.11 To put the size of intervention in perspective, a brief summary of the exposure of leveraged institutions to subprime mortgages is provided (Table B.1) before giving details of support made available to private banks and Central Banks (Tables B.2, B.3). Treasury support to US Banks Alongside losses and write-downs totalling $344b incurred in 2007/2008, Table B.4 provides details of the principal capital injections made by the US Treasury using TARP funds, running to a total of almost $100b for the banks in the table.

11With QE, the Fed also stepped in as ‘market maker ’ to buy some of the risk assets the private sector was selling.

38     M. Miller Table B.3  Fed as global LOLR: Central Bank liquidity swap lines, December 2007–August 2010 (in $b) Counter party central bank Raw swap amount Standardised to 28-days swap ECB Bank of England Swiss National Bank Bank of Japan Other Central Bank Total

8011 919 466 387 … 10,057

2527 311 244 727 … 4450

Source Tooze (2018, p. 214)

Annex C: Legal Penalties Imposed on US Investment Banks and Credit Rating Agencies Fines for Mis-selling of MBS The final column of Table B.4 indicates the ‘fines’ on the Investment Banks themselves—settlements agreed to with Federal and/or State prosecutors for having misled other investors as to the quality of the MBS they sold. The sums paid by investment banks and the big commercial banks such as Bank of America, J.P. Morgan and Citigroup amount to $45b (of which $8b was levied on the two surviving investment banks, and $20b on the big banks that had taken over Bear Sterns and Merill Lynch). The largest fines come from the case against Bank of America which, in addition to acquiring Merill Lynch, had earlier taken over Countrywide Financial, the largest lender of subprime mortgages in the United States.

Fines on CRAs The allegation of collusion between CRAs and investment banks has also been the subject of court proceedings. In February 2015 S&P settled for a fine of $1.5b—and it was reported that ‘S&P executives admitted that they made decisions about testing and rating CDOs based at least partly on the effect they might have on relationships with

$691b (31; $22b)

$396b (33; $12b)

$4,272b IBs only

Lehman Bros

Bear Sterns


Credit losses and write downs 2007–2008

$41b (2.8)

$114b (4.0) $344b


$30b (5.0)

ML: $73b (7.5) BoA: $57b (1.8)

J.P. Morgan

Bank of America

Morgan Stanley $19b (2.1)

Goldman Sachs $10b (0.7)b

‘Big Eight’ banks (current survivors)

25 95





Capital injections October 2008 ($b)


in brackets are leverage, Assets/Equity, followed by Equity in brackets shows ratio of losses and write-downs to 2006 pre-tax earnings Sources Losses: Milne (2009, p. 249); Injections: Sorkin (2009, p. 524); Fines: (DoJ web reports)


$1020 (32; $32b)

Merrill Lynch

Morgan Stanley $1,045b(33; $32b)

$1,120b (26; $43b)a

Goldman Sachs Became a Bank H CO in September 2008 Became a Bank H CO in September 2008 T/O by Bank of America, September 2008 Liquidation, September 2008 T/O by J.P. Morgan, March 2008

Fate after crisis Assets, leverage, and equity end 2007

The ‘Big Five’ US investment banks (as of early 2008)

Table B.4  Big Five investment banks and survivors of the Big Eight: losses, capital injections, fines

$7b $45b


$17b (+$37b set aside)



Subsequent fines for Misselling of MBS

2  The Financial Alchemy That Failed     39

40     M. Miller

the banks issuing them’. In January of 2017, Moody’s settled for a sum of $0.9b.

References Akerlof, G. A., & Shiller, R. J. (2015). Phishing for Phools: The Economics of Manipulation and Deception. Princeton, NJ: Princeton University Press. Avdjiev S., McCauley, R., & Shin, H. S. (2016, September 28). Conceptual Challenges in International Finance. voxEU. Aymanns, C., Caccioli, F., Farmer, J. D., & Tan, V. W. L. (2016). Taming the Basel Leverage Cycle. Journal of Financial Stability. http://dx.doi. org/10.1016/j.jfs.2016.02.004. Benediktsdottir, S., Eggertsson, G., & Thorarinsson, E. (2017). The Rise, Fall, and Resurrection of Iceland: A Post Mortem Analysis of the 2008 Financial Crisis. Brookings Papers on Economic Activity, 48(2, Fall), 191–308. Bilson, J. F. O. (1978). The Monetary Approach to the Exchange Rate: Some Empirical Evidence. IMF Staff Papers, 25(1), 48–75. Davila, E., & Korinek, A. (2018). Pecuniary Externalities in Economies with Financial Frictions. Review of Economic Studies, 85(1), 352–395. Diamond, D. W., & Dybvig, P. H. (1983). Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy, 91(3), 401–419. Ferguson, N. (2013). The Great Degeneration: How Institutions Decay and Economies Die. London: Penguin Books. Frenkel, Jacob A. (1976). A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence. Scandinavian Journal of Economics, 78(2), 200–224. Goodhart, C. (2011). The Basel Committee on Banking Supervision: A History of the Early Years 1974–1997. Cambridge: Cambridge University Press. Greenspan, A. (2013). The Map and the Territory: Risk, Human Nature and the Future of Forecasting. London: Penguin Books. Haldane, A., Brennan, S., & Madouros, V. (2010). What Is the Contribution of the Financial Sector: Miracle or Mirage? In A. Turner et al. (Ed.), The Future of Finance. London: LSE. Hicks, J. (1975). The Permissive Economy. In Crisis ’75 (Special Paper no. 43). London: Institute of Economic Affairs. Jonsson, A., & Sigurgeirsson, H. (2017). The Icelandic Financial Crisis: A Study into the World’s Smallest Currency Area. New York, NY: Palgrave Macmillan.

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Kaletsky, A. (2010). Capitalism 4.0. New York, NY: Public Affairs. Kay, J. (2017, January 21). Justice Has Settled for Second Best in the RollsRoyce Scandal. Financial Times. Kiyotaki, N., & Moore, J. (1997). Credit Cycles. Journal of Political Economy, 105(2), 211–248. Miller, M., Rastapana, S., & Zhang, L. (2018, September). The Blind Monks and the Elephant: Contrasting Narratives of Financial Crisis. The Manchester School, 86(S1), 83–109. Milne, A. (2009). The Fall of the House of Credit: What Went Wrong in Banking and What Can Be Done to Repair the Damage? Cambridge: Cambridge University Press. Office of Special Prosecutor in Iceland. (2017). Prison Year Tally. Excel file. Accessed September 2018. Rajan, R. G. (2010). Fault Lines. Princeton, NJ: Princeton University Press. Rakoff, J. S. (2014, January 9). The Financial Crisis: Why Have No HighLevel Executives Been Prosecuted? The New York Review of Books. Rey, H. (2013). Dilemma, Not Trilemma: The Global Financial Cycle and Monetary Policy Independence. In Economic Policy Symposium Proceedings: Global Dimensions of Unconventional Monetary Policy (pp. 285–333). Kansas City, MO: Federal Reserve Bank of Kansas City. Shin, H. S. (2010). Risk and Liquidity. Oxford: Oxford University Press. Sibert, A. (2010, May 18). Love Letters from Iceland. Silverman, G. (2016, December 9). American Psyche: Michael Lewis on the Triumph of Irrational Thinking. Financial Times. Sorkin, A. R. (2009). Too Big to Fail. New York, NY: Viking Penguin. Taylor, J. (2018, March). Towards a Rules-Based International Monetary System. Presentation at University of Warwick. Tett, G. (2013, October 25). An Interview with Alan Greenspan. Financial Times. Tooze, A. (2018). Crashed: How a Decade of Financial Crisis Changed the World. London: Allen Lane.

3 Prudential Regulation and Capital Controls Michael Dooley

Introduction The useful framework for thinking about the stability of banking ­systems assumes that bank owners compare the present value of the franchise that follows a safe strategy that does not call on deposit insurance relative to the present value of the franchise that follows a high-risk strategy so that insurance is used and the franchise terminated. Reaching for risk and increased leverage increases earnings in the near term but shortens the expected life of the franchise and forfeits the bank’s capital. Bankers care about safety and soundness but only as long as the safe strategy results in a higher present value. A large set of incentives and institutional arrangements determine the value of these two strate­ gies and, in turn, the stability of the financial system. In this chapter we focus on how the explosion of growth in international capital flows in recent years might have tipped the incentives for banks towards a M. Dooley (*)  Figure Technologies Inc., San Francisco, CA, USA e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


44     M. Dooley

high-risk strategy. In cases where the incentives are tipped towards high-risk strategies, we argue that capital controls can make an important contribution to effective prudential regulation and financial stability. In particular, required reserves on foreign deposits at domestic financial institutions are equivalent to deposit rate ceilings for foreign investors. The equivalence of reserves and deposit rate ceilings is important because it has been demonstrated that deposit rate ceilings and, by extension, required reserves on foreign deposits can be more effective than capital requirements in ensuring financial stability.1 In some cases increasing capital requirements for insured intermediaries to international standards will not be effective in preventing high-risk strategies if domestic institutions have free access to foreign investors. While deposit rate ceilings are no longer considered a feasible instrument within domestic financial systems reserves for foreign deposits have been used in many countries, including Iceland, with some success.2

The Primrose Path or Sound Banking? Keeley (1990) argued that the US banking system had been surprisingly stable after 1936 in spite of deposit insurance because anticompetitive regulation made bank charters quite valuable as long as the bank did not utilize the insurance. In this environment, the safe strategy was optimal both for the banker and the rest of us. He showed that in the United States as financial regulation was relaxed and non-bank intermediation grew the value of safe strategies was reduced and failures increased. In that paper, and in other contributions of which I am aware, the factor that tipped the balance towards risky behaviour was a decline in the present value of the safe strategy.3 Financial innovation and deregulation


et al. (2000). Iceland’s experience see Petursson (2018). Several experts have suggested that Iceland should reduce or eliminate this policy, Edwards (2018), Forbes (2018), IMF (2017). In this Chapter we offer an analysis that supports the use of capital controls. 3The World Bank, for example, has frequently pointed out the dangers of reducing the profitability of sound banking. See Caprio and Summers (1996). 2For

3  Prudential Regulation and Capital Controls     45

reduced banks’ market power in deposit and credit markets and made a safe long-lasting strategy less valuable. We argue below that more recently the important shift in incentives in countries like Iceland has been an increase in the present value of high-risk strategies. Hellmann et al. (2000) set out a formal model of the dynamic nature of a bank’s decision to risk intervention by the authorities to terminate the bank. They focus on the deposit rate ceilings as a prudential policy and argue that rate ceilings are superior to capital requirements in insuring that banks manage risk in order to enjoy long-run profits. The intuition is straightforward. Deposit rate ceilings permanently increase bank profits and therefore the franchise value of a safe strategy. Capital requirements decrease the value of the high-risk strategy insolvency to the bank owners but also decrease the future profitability of the safe strategy. Put another way, it is obvious that capital requirements increase the owner/manager’s skin in the game and that some level of required capital will encourage safe strategies. But it is also clear if near-term profits from a high-risk strategy are high enough the rational manager can pull enough earnings out of the bank to more than cover the onetime loss of the capital when the bank is eventually terminated. Moreover, this bank will have no trouble attracting additional capital since this is a profitable strategy. Recent international discussions of prudential regulation have focused on international standards for capital requirements. In our view, the comparison of capital requirements and deposit rate ceilings has not gained traction because deposit rate ceilings proved to be a very difficult policy to implement. In the United States, for example, deposit rate ceilings were an effective deterrent to banks competing with other banks for deposits but generated significant problems for the system as competition for deposits by non-bank financial intermediaries became quantitatively important. It seems likely that the gradual elimination of deposit rate ceilings contributed to the instability of the US system in two ways. First, as emphasized by Keeley (1990) and others the loss of market power in the deposit market reduced the franchise value of safe strategies. But in our view, the more important lesson for today is that the elimination of deposit rate ceilings in increasing the profitability of high-risk strategies. One of the parameters in the HMS model is the elasticity of demand for an individual bank’s liabilities with respect to the deposit rate offered

46     M. Dooley

by that bank. Imagine a virtuous bank considering going for broke. In a closed economy with an effective deposit rate ceiling, the demand for the individual bank’s deposits is very inelastic. Moreover, other policies such as limits on interstate banking and branch networks limit the market for a bank’s deposits. In countries such as Iceland with highly concentrated banking systems attempts to capture deposits from a few other banks will invite retaliation and generate limited increases in deposit market share. The bank can always substitute higher for lower risk assets but cannot quickly leverage the high-risk strategy. Our conjecture is that the growth of gross international capital flows tipped the balance towards risky behaviour leading to the 2008 crisis. In many countries, domestic prudential regulation was successful before 2008 because an individual bank’s ability to increase its market share of domestic deposits and, in turn, quickly leverage a high-risk strategy was quite limited. But, as gross capital flows across national borders grew rapidly after 2000, the constraint on the high-risk strategy eroded and it is possible that this tipped the balance towards risky behaviour in many countries, including Iceland. The explosion of gross international capital flows meant that banks gained access to a much larger set of depositors. In the context of the HMS model, this increased the elasticity of demand for the individual bank’s deposits. In turn, the risky asset choice could be levered and the value of going for broke increased, perhaps substantially. It is not necessary or useful to assume anything different about the behaviour of non-residents as compared to residents. That is, individual residents and non-residents have the same supply elasticity but a much larger pool of non-residents makes the market elasticity for a bank’s liabilities, including capital, much larger. The problem with international investors is that there are so many of them. Note also that this development makes capital requirements less effective. If the high-risk strategy becomes much more valuable the bank will have no problem in attracting new capital to the now more profitable franchise. It also seems likely that domestic institutions will have no trouble in attracting international managers familiar with high-risk strategies. An obvious regulatory response is to limit non-resident access to the domestic financial system. The attraction of capital controls is that

3  Prudential Regulation and Capital Controls     47

the authorities do not have to identify or deal with all the other distortions that are encouraging their financial institutions to go for broke or even which institutions have gone to the dark side. There are, of course, many problems with capital controls but the problems are shared by other prudential regulations. The best menu of second-best prudential regulations for a country is an empirical question.

Conclusions The analysis fits with recent contributions by BIS economists (2015) based on what they call the “triple coincidence.” Their idea is that economic statistics and analysis and the policymaking institutions designed to influence economic outcomes were developed in an era where economic activity, currency use and policy regimes largely interacted within the borders of one or a few sovereign nations. They argue that the explosion of gross international capital flows in recent years has made the correspondence between finance and geography much less reliable. In the good old days, national boundaries provided inelastic demand curves for individual bank’s liabilities. The growth of gross international capital flows in recent years has opened the door to leverage and high-risk strategies. The main problem with international investors for financial stability is that there are a lot of them. The predominant policy response has been increasing and unifying capital requirements for financial institutions. But this policy reduces the attractiveness of both safe and high-risk strategies. For many countries limiting domestic financial institutions access to foreign investors can be an effective component of prudential regulation.

References Avdiiey, S., Mccauley, R., & Shin, H. S. (2015). Breaking Free of the Triple Coincidence in International Finance (BIS Working Papers No. 524). Caprio, G., & Summers, L. H. (1996). Finance and Its Reform: Beyond Laissez Faire. In D. Papadimitriou (Ed.), Stability of the Financial System (pp. 400–421). New York: Macmillan.

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Edwards, S. (2018, June). Monetary Policy in Iceland: An Evaluation. Report Prepared for the Government of Iceland for a Review of Iceland’s Monetary and Exchange Rate Policy. Forbes, K. J. (2018, June). Macroprudential Policy After the Crisis: Forging a Thor’s Hammer for Financial Stability in Iceland. Report Prepared for the Government of Iceland for a Review of Iceland’s Monetary and Exchange Rate Policy. Hellmann, T. F., Murdock, K. C., & Stiglitz, J. E. (2000). Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough? The American Economic Review, 90(1), 147–165. IMF. (2017). Iceland: (2017) Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Iceland (International Monetary Fund Country Report No. 17/163). Keeley, M. C. (1990). Deposit Insurance, Risk, and Market Power in Banking. The American Economic Review, 80(5), 1183–1200. Petursson, T. G. (2018). Post-Crisis Monetary Policy Reform: Learning the Hard Way. This Volume.

4 Three Grand State Projects Meet the Financial System Peter Garber

Introduction Which exogenous forces in the global system led to the crisis? Did it emerge from a financial bubble that popped, underpinned by implicit bailouts? Certainly, the subsequent reforms in the US stemmed from this belief. Or was it a constellation of government schemes that the financial system endogenously accommodated by whatever financial magic it could conjure to profit from implementing these policy imperatives. Aimed more at glitches in its grand project’s own institutions and government finances than at weaknesses in the private financial system, the reforms in the euro system imply this view.

P. Garber (*)  Deutsche Bank, New York, NY, USA e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


50     P. Garber

Three Grand Projects Three great public sector projects have driven global macroeconomic dynamics to this day. Launched or becoming systemically important at about the same time in the late 1990s, these were: • The US’s scheme to redistribute wealth by lending on a huge scale to uncreditworthy borrowers for real estate purchases. Judging from history, such a scheme had unpromising prospects for success. • China’s export-driven development program. This kind of program had been successful previously on a smaller scale in East Asia. • The launch of the euro. This grand project was a great leap of faith. All were about the same order of magnitude of amounts bet. Each involved risking many trillions of dollars’ worth of capital, as is evident from the foreign exchange accumulation or money printing required to keep them afloat or subsequently to bail them out. Two of these grand projects were geopolitical in intent or evolved into a geopolitical rationale. This explains the doggedness of the continuing official support for them. The US dollar system already was geopolitically dominant, but it had to absorb the capital flow implications of the other two programs. China, observing the accelerating weaponization of the dollar during the last ten years in the form of cutting off banks from the dollar payments system, suddenly and quickly moved to internationalize its currency in order to form the basis for a serious alternative. The euro zone itself has also demonstrated the devastation it can inflict through the payment system by cutting off countries like Cyprus and Greece, though this occurred on economic and technical grounds. The US scheme collapsed first in 2007–2008, basically because the markets developed financial engineering methods in the form of credit derivatives to short the system. The US government was ultimately unwilling to keep its redistribution project propped up: it did not buy against the resulting short sellers of structured mortgage products. While the US came to its senses about its project, even the resulting global liquidity crisis did not force China and the EU to pull the plug on theirs. China intervened in its currency and equity markets,

4  Three Grand State Projects Meet the Financial System     51

pressured lending to industries with excess capacity, and imposed controls so that its strategy is only now ending under US protectionist pressure. The euro experiment is in its tenth year of crisis against a European leadership determined to keep buying to keep it alive via rapid money printing in support of peripheral government finance. It is now facing secession and political rebellion in the weak countries against the programs implemented to shore up and advance the system. Most macroeconomists had no strong views about the US housing finance until about a year before the collapse. Although it is the grand project that has been thought most likely to collapse by mainstream economists for more than a decade, the Chinese scheme is the only one that has not yet entered into crisis as it approaches its end-game. It may yet emerge with its original goals reached. Doubts about the long-term viability of the euro split the views of professional economists during the 1990s—usually taking the form of US versus European economists—but such doubts temporarily went into eclipse after the euro’s success in its early years. Taken together, all these schemes generated huge cross-border and internal capital flows that drove long-term real and nominal interest rates to record low levels and without the usually simultaneous o­ utbreak of unexpected inflation. It was the role of the financial markets to square the circle of packaging and channeling these flows. Given their own internal incentives, they did so with tremendous enthusiasm and obliviousness to risk and have been burdened with the social opprobrium of the collapse ever since. The progenitors of the great government projects at the root of the disaster have escaped such revulsion, however.

The Grand Projects, Real Interest Rates, and the Financial Sector Response China-Asia’s/Germany’s and, later, commodity exporters’ net capital exports dominated the sum of these schemes. Even in the presence of a record global economic boom, this drove global long-term real rates to unusually low levels at every phase of the business cycle for more than a decade and to the present day. Long rates were matched by historically

52     P. Garber

low short rates for the first five years of the millennium followed by the longest lasting inverted dollar yield curve in history (except the Volcker disinflation) until the crisis—the famous Greenspan conundrum. The historical shift in interest rates meshed with various financial sector incentives to pave the road to the crisis via a scramble for yield. This was true for all financial sector players: buy side, sell side, p ­ oliticians, regulators, rating agencies, and even the science and technology of finance in universities. Some institutions were constitutionally accustomed to the now defunct higher yield environment that promised clients unrealizable floors on their returns: insurance companies, private pension funds, and underfunded state pension schemes. Others promised themselves high returns: specialized German financial institutions looking for above market AAA, institutions with little reason to exist except the now-unavailable yield curve carry trade such as some Landesbanks, money market funds needing minimum returns to meet costs, platinum-standard university endowments, and large banks ­reaching for high ROE to keep up with peers. The low short rates until 2005 led to the expansion of the SPVs and SIVs, effectively ways of raising short rates for those who demanded it. But the real explosion in such asset-backed commercial paper structures occurred during the two-year period of inverted yield curves. The carry trade could be continued for those institutions desperate to do so by financing even higher yielding, long-term credit risk suddenly converted to AAA. Where there is demand, financial engineering will create supply designed to satisfy the letter of regulatory constraints. Private institutions with public guarantees, Fanny and Freddie were creatures of the US Congress. Driven to push housing credit to the maximum extent, they supported the major expansion of the subprime market. But the real estate boom was not confined to the US: UK, Irish, and Spanish banks and savings institutions drove mortgage markets to ultimate collapse without the use of US-style subprime. Others, such as those in Iceland, detached from serious regulation, offered clients above market deals in the old fashioned way, for example, by using offshore banks and branches that promised foreign depositors higher than market yields over the internet. They then channeled much of this to Iceland in the form of housing and infrastructure construction

4  Three Grand State Projects Meet the Financial System     53

via huge and persistent current account deficits. Although many of the claims of foreign bond holders were defaulted, depositors were repaid in the resolution of the failed banks. However, Iceland kept its new infrastructure. In the presence of the grand government projects, sell-side institutions were handed the problem of squaring the circle of the demands of the other players by sculpting and channeling capital in their usual creative way. Because of the sell side’s own distorting internal incentives, the financial engineering techniques provided by the science of finance allowed this to happen as long as liquidity was abundant. Politicians in the countries receiving the huge capital exports had to find a way to keep their economies from recession. In the US, Ireland, and Spain, they resorted to housing investment, devoting an increased share of the economy to construction; and therefore they encouraged massive lending from the domestic institutions in the mortgage ­market. In Greece, they directed the inflow to favored local populations to encourage consumption and to government employment, which created the façade of production. To keep export surpluses flowing, German financial institutions, especially those controlled by Landes politicians, acquired problematic types of paper on offer from abroad ranging from sovereign bonds of the euro periphery countries to US sub-prime paper. In the UK, industrial policy to enhance the scope of the City, then the most important UK industry, had political primacy. Regulation was separate from the Bank of England and captured by financial industrial policy priorities of the government and therefore the FSA. Regulators in the EU were under national political authority, so they were not averse to encourage actions that were detrimental to the larger interests of the EU or euro zone. For example, Spanish regulators hesitated to control the lending of their savings banks to the overheated housing market. Greek, Italian, and Spanish regulators encouraged their banks to buy local sovereign debt to finance themselves ultimately via the liquidity guaranties of the euro central banking system. They did not hesitate to conflate a local sovereign crisis into a system-wide monetary crisis. Cyprus was well known as a Russian money ­laundering operation, but nothing was done to prevent this. Finally, regulators encouraged financial engineering methods of risk management:

54     P. Garber

value at risk, mark to market and accepted the banks own models. Such methods exacerbated the liquidity crisis when volatility exploded. It was not better in the US. Politicians pushed Fanny/Freddy to lend to the uncreditworthy, thereby using them as non-appropriated fiscal operations, which ultimately had to be admitted in the federal government fiscal accounts in the bailout. This satisfied both the redistributionist impulse of a controlling or at least blocking political party, the Democrats, and the desire of the Republicans to recover from the 2001 recession. The Federal Reserve, the principal regulator of the banks, also pushed the banks to lend to the uncreditworthy, with threats to charters or branches and public shaming and lawsuits for the recalcitrant. Mortgage origination itself was a regulatory responsibility of the states, and like almost all state financial regulation, it ranged from lax to non-existent. Product development via financial engineering was pushed by business schools and economics departments. The theory and practice was almost always developed and sold under the assumption of perfect liquidity, because there was really no theory of derivative pricing in illiquid markets. Only after the collapse did they emphasize that liquidity is crucial for these schemes to work. Business school finance departments boomed producing this product, and their students were sold to the financial industry at high levels of compensation. Finance professors gained high incomes via revolving doors with hedge funds and banks as advisers and fund managers on the basis of this work.

Conclusion There are several possible causes of the collapse and Great Recession. In the US, perhaps it was the housing collapse per se that drove the real recession. Perhaps, it was the liquidity panic that collapsed the financial system. Maybe several dimensions of bubble mentality in the financial system caused the sparked the demise. But before locating the source of the problem in the proximate causes or in characterizing the event entirely as a financial bubble, it is first necessary to understand just which fundamentals set the events in motion. Were these fundamentals

4  Three Grand State Projects Meet the Financial System     55

in themselves benign? Or did they drive the financial system into the liquidity and derivative contortions that broke with the collapse of Lehman? Did the authorities acquiesce or encourage these financial fixes to advance their own economic policies? Was the housing policy in the US itself a spontaneous outburst or redistributionist spirit, or was it fostered by both parties as the boost in internal investment that would offset the deflationary macro impact of the current account deficit? Perhaps, the housing gambit was the only way of staving off the recession in the face of deflationary pressures from abroad— without it the recession may simply have arrived a few years earlier. With a fall in the real rate of interest caused by the capital flow implications of the grand projects, we would expect an internal investment boost as the formerly marginal projects along the marginal efficiency of investment curve now became viable. But which investments would these have been? Certainly, not those in manufacturing—the current account deficit reflected the flood of cheap manufactures pouring into the US and the movement of manufacturing capital and management out of the US. Nor was the displaced Labor being absorbed as much as one would normally have expected in the service industries— immigrant Labor poured in at low wages, and clerical jobs were offshored. So housing seemed to be the only outlet. But to make the housing boom work, there was a need to find new buyers and move down the chain of creditworthiness. So was born the financial magic. In Europe, the current account of the euro zone was in balance overall, but this hid the deficits in the south and the surpluses in the north. The south faced goods inflows both from Germany and East Asia with the inability to use currency depreciation to block them. So where did they invest to fight the deflationary impact? Housing in some places, government transfers and early retirement in others. All this proceeded through the creative finance and implicit backstops of the euro system.

5 The 2008 GFC: Savings or Banking Glut? Robert N. McCauley

This study analyses two hypotheses that ascribe the US financial crisis of 2008 to capital inflows. The Asian savings glut posits that net inflows into high-grade US public bonds from countries running current account surpluses led to the housing boom and bust. In sum, an excess of savings over investment abroad led to an excess of US investment over savings. The (European) banking glut holds that gross inflows into private bonds led to the boom. Leveraging up by European banks enabled the leveraging up of US households. This paper puts the spotlight on European banks as producers of, not just investors in, US mortgage-backed securities. Gross flows from Revised paper presented to the conference, “The 2008 Global Financial Crisis in Retrospect”, University of Iceland, 30–31 August 2018. The author would like to thank Robert Aliber, Michael Bordo, Claudio Borio, Brendan Brown, Richard Cantor, Jaime Caruana, Guy Cecala, Stijn Claessens, Ben Cohen, Patrick Honohan, Philip Lane, Patrick McGuire, Fernando Restoy, Catherine Schenk, Hyun Song Shin, Marcel Zimmerman, Gyfli Zoega and Daniel Zuberbuehler for helpful discussion and Yifan Ma and Jeff Slee for able research assistance. The views expressed are those of the author and do not necessarily reflect those of the BIS.

R. N. McCauley (*)  Monetary and Economic Department, Bank for International Settlements, Basel, Switzerland e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


58     R. N. McCauley

Europe better matched US mortgage market developments: private credit risk, floating interest rates and narrow spreads. European banks leveraging up also provided credit that enabled housing booms in Ireland and Spain. These findings favour the European banking glut hypothesis. Large international capital inflows seem to cause or at least enable credit booms and asset price inflation. Aliber and Kindleberger (2015) emphasise how cross-currency positions play in this nexus. Such positions can take the form of borrowing or investing. If domestic residents borrow in foreign currency and convert the proceeds into domestic currency under a flexible exchange rate regime, they put upward pressure on the currency. A stronger domestic currency in turn flatters the balance sheet of the foreign-currency borrower: liabilities in foreign currency fall relative to equity in domestic currency. This can in turn make lenders willing to lend more to the borrowers (Bruno and Shin 2015). By the same token, foreign investors who exchange foreign currency for domestic currency and buy domestic bonds push up the exchange rate. Exchange rate appreciation, in turn, produces valuation gains for foreign investors that induce further inflows into bonds. In the mid2000s, so-called carry traders borrowed dollars or euros and invested in Icelandic kroner, setting in train this self-reinforcing dynamic. Clearly, such dynamics were at work not just in Iceland, but in many other cases in which large international capital flows accompanied domestic credit booms and asset price inflation. The interpretation of Dooley (2019) is that the significance of foreign funding lies not in any behavioural difference between resident and nonresident investors or lenders, such as that arising from this currency effect. Rather, a larger pool of potential international sources of funding simply increases the elasticity of the supply of bank funding. This more elastic supply makes it feasible to leverage up a risky strategy. With sufficient leverage, near-term profits from the risky strategy may promise enough to lead a rational bank manager to go for it. “The problem with international investors is that there are so many of them”, summarises Dooley. In the Great Financial Crisis (GFC), the key role of the exchange rate in Iceland was the exception, and the global elasticity of dollar (and euro) funding was more relevant elsewhere. Dollars flowed into the

5  The 2008 GFC: Savings or Banking Glut?     59

United States to buy dollar-denominated US Treasury bonds or bonds backed by highly leveraged mortgages. Non-US banks borrowed dollars to invest in mortgage-backed securities (MBS) with borrowed dollars. For their part, capital flows to Ireland and Spain were almost entirely euro-denominated.1 In none of these cases did the foreign exchange valuations feed back to encourage inflows, as described above. In fact, the US dollar actually trended downward from 2002 to 2007, so that unhedged dollar investments gave rise not to valuation gains, as kroner investments initially did in Iceland, but rather to losses. But this dollar depreciation exerted no first-order effect on the returns to European banks who borrowed US dollars to invest in risky US securities. It did allow them to borrow more dollars for given leverage, however.2 In the 2000s the United States received two big capital flows from abroad. Debate continues over which one deserves more credit for the boom in US credit and house prices. Was it the savings glut flows or the banking glut flows? Before the crisis, Bernanke (2005) and others had implicated a set of countries running current account surpluses in the US boom.3 They argued that a savings glut in Asia (better a dearth of investment in countries hit by the Asian financial crisis in 1997–1998) and among some commodity exporters had led to a strong bid for safe US bonds. This one-way investment put downward pressure on US bond yields and stimulated US investment, especially in homes. As a result, US spending rose relative to US output, widening the US current account deficit. An Asian excess of saving over investment thus led to an excess of US investment over saving. On this view, these “trans-Pacific” imbalances ultimately caused the GFC (Ferguson 2008; Wolf 2014). 1While

Irish banks sourced funding in dollars and sterling, they swapped for euros. See Lane (2015). 2However, a second-order effect of the dollar depreciation on leverage actually encouraged European banks’ to expand their dollar books. In particular, dollar depreciation allowed such banks to borrow and lend more dollars for a given degree of leverage of their stock of capital, which was mostly held in European currencies. See Fukao (1991). 3Bernanke et al. (2011) recognised the domestic vulnerabilities that contributed to the crisis; Bernanke (2018) has emphasised the role of financial panic, recalling the “run on repo” of Gorton and Metrick (2012). Several prominent economists in the 2000s worried about current account imbalances and their accumulation into net external debt that would prove

60     R. N. McCauley

Others have pointed instead to two-way transAtlantic flows. In the 2000s, European banks leveraged up their equity with dollars borrowed from United States and other investors and ploughed them into US private debt. More than anything else, they bought private label MBS, or complex bonds based on them. Their eager buying of such private securities enabled their issuance to surpass that of government agency MBS in 2005. Leveraging up by European banks begat unsustainable leveraging by US households: the transAtlantic crisis (Bayoumi 2017). In support of this view, Borio and Disyatat (2011) found that gross capital flows from Europe to the United States dominated the net capital flows from surplus countries; they denied the link between global imbalances and the GFC. Acharya and Schnabl (2010) showed that banks from both surplus and deficit countries, mostly in Europe, set up conduits to hold risky US MBS. Shin (2012) dubbed the alternative hypothesis the banking glut. This chapter argues that, as an account of key features of the GFC, the savings glut story comes up short and the banking glut story gives more satisfaction. While the flows into US bonds from surplus countries may well have exceeded those from European banks, the latter better match developments in the US mortgage market. There European banks manned the production line of the private label MBS, as well as investing in them. Moreover, the more violent property booms in Ireland and Spain drew on relatively larger capital inflows from European banks. The rest of this chapter analyses the two capital inflows, their imprint on the US mortgage market, the role of European banks’ US securities affiliates, the skew of the European portfolio to risky US bonds and the motivations of European banks. A box sketches the larger but more traditional capital flows into Ireland and Spain. A final section concludes that European bank leverage enabled US, Irish and Spanish booms.

unsustainable. Summers (2004), Edwards (2005), Obstfeld and Rogoff (2005), and Setser and Roubini (2005), warned of an impending sudden stop of financing that would lead the dollar to plunge and the US economy to enter a recession. Krugman (2007) memorably pictured the dollar reaching a Wile E. Coyote moment and then falling.

5  The 2008 GFC: Savings or Banking Glut?     61

Comparing and Contrasting the Two Gluts Let us first compare and contrast the capital flows associated with the savings and banking gluts and then pose three questions. Which flow better matches the big changes seen in the US mortgage market? How did the role of European banks’ US securities affiliate as producers of private label MBS enlarge the European footprint in this market? And why did the European banks do it? The differences between the two stories bear emphasis (Table 5.1). Twice as much money flowed into US public bonds from Asian official investors as flowed into US private asset-backed securities (ABS) from European investors. In the first, official reserve managers purchased safe, longer-term US government obligations, generally funding themselves with domestic currency liabilities. In the second, banks purchased riskier, shorter term bonds backed by US mortgages, commercial real estate and other assets, mostly funded by short-term dollar debt. Asian reserve managers took duration risk. European banks took credit and maturity risk, buying risky so-called “spread product” to earn a margin over the cost of short-term funding. Table 5.1  Asian savings glut vs European banking glut Asian savings glut Size of inflow Direction Protagonists Demand for safe assets Duration of target bond Leverage

Capital gains/losses

European banking glut

$0.7 trillion or 5% of US GDP Two-way; European banks borrow dollars Official reserve managers Commercial banks Negative: supply to US Positive money market funds Short to medium term Medium to long term Short-term dollars borMost foreign exchange rowed from US money reserves funded with market funds and short-term domestic others currency instruments Huge losses on private Gains on US Treasury label MBS bonds; little private MBS

$1.7 trillion or 10% of US GDP One-way

Sources US Treasury et al. (2002, 2008, 2009); Table 5.4; author’s elaboration

62     R. N. McCauley

The first story presents itself as a current account story, although some countries built foreign exchange reserves despite running current account deficits and some surplus countries did not build up foreign exchange reserves (Borio and Disyatat 2011). The flow was one-way. The second story is a capital account story, with gross capital flow running in two directions. Current accounts drive long-term changes in countries’ net international investment positions, albeit with important valuation effects (Gourinchas and Rey 2014). The evolution of these positions lends itself to an analysis of sustainability that led to dire predictions of dollar crisis, as cited above. By contrast, the current account of the euro area, and of Europe as a whole, approximated balance, and few fretted about a sudden stop of European bank intermediation between US investors and highly leveraged US households. European banks funded portfolios of US assets by “round-tripping” dollar funds from the United States and back again (McGuire and von Peter 2009; Shin 2012; Avdjiev et al. 2016). In particular, dollars raised from US money market funds (Baba et al. 2009) flowed back Stateside through purchases of private MBS and other assets (Fig. 5.1). Outflows to Europe matched the inflows from Europe, leaving net flows negligible. As a result, someone who looked only at the current account balance overlooked these accumulating flows and their risks. The flows differed in their demand for safe assets. Focusing on the official inflow, Caballero et al. (2008) saw it as chasing safe assets that Wall Street had a comparative advantage in producing. In fact, official reserve managers steered clear of risky private MBS, however rated (Ma and McCauley 2014). Instead they hugged the shore of US Treasury bonds and US government supported agency bonds. Those developing this thesis overlooked European banks’ provision of safe assets to US money market funds. These banks invested the proceeds in pseudo-safe MBS, many rated AAA, in so-called “credit arbitrage” which proved far riskier than expected. Official reserve managers demanded dollar safe assets; European banks supplied them, ultimately, in many cases, thanks to their home government support.

5  The 2008 GFC: Savings or Banking Glut?     63

Fig. 5.1  US dollar-denominated cross-border claims: the transatlantic round-trip (In billions of US dollars) (Note The thickness of the arrows indicates the size of the outstanding stock of claims. The direction of the arrows indicates the direction of the claims: arrows directed from region A to region B indicate lending from banks located in region A to borrowers located in region B. Source Avdjiev et al. (2016), based on BIS locational banking statistics)

Official reserve managers had long since extended maturities from Treasury bills to Treasury and agency notes. Their sweet spot on the yield curve was at medium-term maturities (McCauley 2018; Fig. 5.2), which provided extra yield to cover the cost of domestic liabilities and dollar depreciation. By contrast, European banks preferred to match their mostly short-term dollar funding with floating rate MBS. Below we discuss how the US mortgage market reshaped itself around their demand, shifting from Treasury bills to Libor as the benchmark reference rate for adjustable-rate mortgages (ARMs). The portfolios performed very differently in the crisis. Official reserve managers enjoyed capital gains as US Treasury bond yields fell and the dollar rose (Gourinchas et al. 2012; Bénétrix et al. 2015). European banks, along with US securities firms and some large US banks, suffered massive losses. The European banks responded by reducing exposures in Europe (Cecchetti et al. 2012) and elsewhere (McCauley et al. 2019).

64     R. N. McCauley

Fig. 5.2  Competing hypotheses: capital flows and the US housing boom (Note The boundaries shown on this map do not imply official endorsement or acceptance by the author or the BIS. Source Author’s elaboration) (colour figure online)

Which Capital Flow Matches US Mortgage Market Trends? Considerable evidence links inflows of bank or more broadly debt capital to credit growth within an economy (Avdjiev et al. 2012; Hahm et al. 2013; Lane and McQuade 2014; BIS 2015, pp. 92–93). In the lead-up to the GFC, however, two very different capital inflows accompanied the boom in private credit, especially in the mortgage market, in the 2000s. One way of assessing their relative contributions is to compare the expected impact of each flow to the stylised facts of the evolution of the US bond market in those years. The Asian savings glut story predicted flows into Treasuries and agencies, lower Treasury yields, higher mortgage spreads, and more fixed-rate mortgages (Fig. 5.2, red arrow). Risk-averse reserve foreign exchange managers typically prefer safe assets, including US Treasury and agency securities (McCauley and Rigaudy 2011). Given their preference for intermediate-term notes, this inflow should have depressed Treasury yields at such maturity. US Treasury rates should have fallen by more than MBS yields (even with the diversification of reserve managers into agency securities). And the decline in fixed-rate mortgage yields should have biased mortgage lending towards those carrying fixed rates. The banking glut story focuses on the effect of banks as buyers of risky private mortgage debts. Banks favoured the wider spread over US Treasury obligations that unguaranteed mortgages promised.

5  The 2008 GFC: Savings or Banking Glut?     65

This preference favoured shifting mortgage finance from publicly guaranteed to private label MBS. Since banks’ readiest funding source is short term, a banking glut also favoured floating-rate debt. It would tend to narrow the gap between private yields (especially short to medium term) and US Treasury yields, and mortgage spreads in particular (Fig. 5.2, blue arrow). The first two predicted effects of the Asian savings glut—inflows into US Treasuries and lower Treasury yields—did indeed hold. As noted, officials invested $1.7 trillion in US Treasury and agency bonds in 2000–2007. This amounted to about 10% of GDP. Warnock and Warnock (2009) found 10-year yields were 80 basis points lower in 2005 as a result. However, predictions regarding mortgage flows and yields did not pan out. The left-hand panel of Fig. 5.3 shows that the spreads on fixedrate agency and private jumbo MBS actually narrowed in the 2000s. Furthermore, rather than this being the heyday of fixed-rate mortgages as long promoted by the US agencies, ARMs bulked large among the new mortgages securitised without agency guarantees. As a result, fixed-rate mortgages declined from an estimated 78% of MBS issues in 2001 to just 60% in mid-2007 (Goodman et al. 2008, Exhibits 1.2 and 1.5). Thus, the fixed-rate bonds that reserve managers favoured lost share in the boom. &ŝdžĞĚͲƌĂƚĞLJŝĞůĚƐ



Fig. 5.3  Mortgage spreads and issuance, 2000–2006 (Sources Bertaut et al. 2012, p. 227, citing CoreLogic; Bloomberg)

66     R. N. McCauley

In sum, key mortgage-market developments in the 2000s did not match what might have been expected from a big official flow into safe government bonds. Risky private label MBS with adjustable rates gained share and spreads narrowed. The predictions of the banking glut story perform better. First, European banks’ demand drove US mortgage finance away from government guarantees to private credit risk. Non-agency mortgages reached 55% of all gross issuance in 2005 and 2006 (Goodman et al. 2008, p. 6; see also Frankel 2006). In stock terms, non-agency securitisations reached one-third the total (Goodman et al. 2008, pp. 3–4). Second, ARMs predominated in private label MBS at 62% of private issues (Goodman et al. 2008, pp. 6, 10), conveniently allowing banks to match their short-term funding. In 2006 ARMs amounted to 40% of all (private and agency) MBS issued. In terms of rates, long-term spreads actually narrowed (Fig. 5.3, left-hand panel). Spreads also narrowed for non-agency ARMs relative to agency issues. The centre panel of Fig. 5.3 shows that the spread between sub-prime ARMs and “conforming”, agency ARMs declined by 100 basis points between 2002 and 2006, even as issuance exploded (right-hand panel). One can infer very strong demand.

European Banks as Producers of MBS The usual image of European banks as hapless investors in US MBS in the mid-2000s needs thorough revision. In Zuckerman (2009), Lewis (2010), and Dunbar (2011) and US court cases, banks from Dusseldorf or Kiel play the role of sophisticated investors in name only, serving as, in market parlance, “stuffees”. However, certain European banks played quite a different role (Bank of England 2007, p. 37). Six European banks produced private label MBS out of their US securities affiliates. They ranked among the top 15 underwriters of sub-prime MBS (Table 5.2). RBS’s Greenwich ranked first, with a 12% share, above that of Lehman Brothers, Bear Stearns and Morgan Stanley. Collectively, Greenwich, Credit Suisse (ranked fifth). Deutsche Bank (ranked seventh), UBS, Barclays and HSBC claimed a 35–40%

5  The 2008 GFC: Savings or Banking Glut?     67 Table 5.2  Non-US banks’ US securities affiliates’ underwriting of sub-prime MBS dealsa

Sources Nadauld and Sherlund (2013, p. 457), based on ABSnet; author’s calculations aShaded rows indicate European bank ownership bListed separately in the source, Greenwich Capital and RBS Greenwich are combined

share. Crucially, they retained that share as the US securities firms grabbed market share from the big US banks and others in 2004–2005 (Table 5.2, memorandum items). By 2007, banks’ business model of underwriting private MBS had evolved to include holding a substantial fraction of the product on their balance sheets. What Dunbar (2011) and Goldstein and Fligstein (2017) liken to a Henry Ford-type production line started with a “warehouse” of mortgages that underwriters would assemble into MBS. They then sliced and diced these into collateralised debt obligations (CDOs) and booked them as trading assets. By 2007, underwriters could sell

68     R. N. McCauley

lower-rated, wider-spread securities, but mostly ended up holding the “super senior” tranches in their trading books.4,5 Contemporary observation and subsequent research confirmed the nexus between underwriting and MBS holdings. The Swiss Federal Banking Commission commented (2008, p. 7): “At least towards the end of the mortgage boom, the CDO securitization business functioned only to the extent that market players such as UBS, Merrill Lynch and Citigroup were willing and able to retain ‘unattractive’ low-yield Super Senior CDO tranches of individual securitizations on the own (trading) books” (see also Zuckerman 2009, p. 176). In a study of the holdings of highly rated securitisation tranches across US-owned bank holding companies, MBS underwriting strongly predicted holdings (Erel et al. 2014). For UBS, the Commission (p. 5) reported that “the CDO Desk had not only securitized CDOs and sold such CDOs to investors, but had retained the Super Senior CDOs… on its own (trading) books”. The six European banks had $251 billion of private MBS at end-2007 (Table 5.3). A seventh, ING, held a further $46 billion in its US internet banking thrift. No doubt, the data from 2008 annual reports and official or officially mandated reports are not consistent across banks, with Credit Suisse in particular reporting on a net trading positions basis.6


contrast, Cayman Island entities owned MBS held in asset-backed commercial paper (ABCP) conduits, designed to keep the assets off the sponsor’s balance sheet. US Treasury et al. (2008, 2009) should have captured these holdings in mid-2007 as foreign. In 2007, European banks sponsored ABCP conduits holding at least $100 billion in US MBS (Moody’s 2007; Acharya and Schnabl 2010, p. 56; Acharya et al. 2013, p. 522). The last column of Table 5.3 thus understates European exposures. 5Greg Lippmann at Deutsche Bank emailed about the buyers of MBS tranches in February 2007 (US Senate 2011, p. 349): “[T]he other side is all cdos so it is the cdo investors who r on the other side who buys cdos: aaa-reinsurance, ws [Wall Street] conduits, European and Asian banks, aa-high grade cdos, European and Asian banks and insurers….some US insurers, bbb other mezz [mezzanine] abs [asset-backed security] cdos (i.e. ponzi scheme), European banks and insurers, equity some US hedge funds, Asian insurance companies, Australian and Japanese retail investors through mutual funds”. 6A position could be short over a certain range of prices, but long thereafter. Lewis (2010, Chapter 9) describes how Morgan Stanley took a short position in BBB tranches “netted” against multiple long positions in AAA tranches (sold in part to UBS), with disastrous results.

5  The 2008 GFC: Savings or Banking Glut?     69 Table 5.3  Holdings of US non-agency MBS by European banks with US broker-dealers (In billions of dollars at end-2007) Non-agency mortgage-backed Total assets Share of total bonds assets (%) Residential Commercial Total Barclays Credit Suisseb Deutsche Bank HSBC RBS UBS Total Memo: ING

31 … 20

1a … …

32 9 20

2458 1208 2840

1.3 0.7 0.7

26 … … … 46

10a … … … …

36 84 68 251 46

2354 3645c 2055 … 1930

1.5 2.3 3.3 … 2.4


from annual reports book concept; net of hedges cAssets of RBS before merger with ABN AMRO Sources Barclays (2009, pp. 106, 113), Credit Suisse (2009, p. 71), Deutsche Bank (2009, pp. 19–21), FSA (2011, p. 52), HSBC (2009, pp. 152–7), ING (2009, p. 140), Netherlands House of Representatives (2013), RBS (2009, p. 35), UBS (2008, pp. 6–7) bTrading

Moreover, some of the exposures of the other five banks were hedged, though it is not possible to say how much.7 There are good reasons to suppose that these six European banks held this quarter of a trillion dollars’ worth of US MBS in mid-2007 on the balance sheets of their US securities affiliates. As described above, their business models involved holding such securities on the US book, and contemporary observation placed them there. In addition, the ex post aggregate profitability of foreign-owned securities firms in 2008 suggest they did. In particular, European-owned broker-dealers racked up large losses in 2008 from write-downs of assets, consistent with their having retained ultimately toxic bonds on their US books. The US Bureau of Economic Analysis (BEA) reports that European-owned non-­banking finance and insurance firms took capital losses from “widespread write-downs of financial assets” (Ibarra and Koncz 2009, p. 29) of 7Deutsche Bank’s CDO desk famously put on a multi-billion dollar short (Zuckerman 2009; Lewis 2010; Dunbar 2011), but US Senate (2011) found that overall the bank remained long and took losses.

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no less than $110.8 billion in that crisis year (Lowe 2011, p. 98).8 The large holdings by European banks of private MBS on their US books deserve recognition and change the profile of European banks as holders of MBS.

Did European Banks Hog Private US MBS? A key element of the banking glut view is the drive by European banks to load up on risky US mortgages. However, Bertaut et al. (2012) report that European investors, including banks, put a weight on private label ABS of 23%, much the same as US investors, at 20% (Table 5.4, fourth column). ABS includes residential and commercial MBS, and bonds backed by car loans and other assets. These data represent holdings by residence but the more telling observation requires data compiled on a nationality basis. As noted, European banks’ balance sheets sprawled well outside European national borders. If the exposures discussed above were held in their US books, then European banks did indeed take on more than their share of the risk arising from leveraged US mortgages. From a nationality perspective, such holdings add to European investors’ holdings and subtract from US investors’ holdings. This is shown in the last two columns of Table 5.4, which add to the figures reported by Bertaut et al. (2012) on a residency basis the exposures booked in US affiliates from Table 5.3.

8The presumption is that UBS’s US affiliate took losses on the $25 billion in US ABS transferred at appraised prices by UBS to the SNB-funded Stabilisation Fund in September 2008 (Swiss National Bank 2010, pp. 83–85). In the BEA data, foreign-owned non-banking finance and insurance firms reported overall losses of $60 billion in 2008. This sum exceeded the net losses of $40 billion recorded by the rest of foreign-owned firms in the financial sector, including depository institutions. Foreign-owned depository institutions reported capital losses of $41 billion (Lowe 2011, p. 98). Much of this loss was presumably accounted for by ING Direct USA, which had boosted returns at its US internet banking thrift, ING Direct, by switching its assets from agency paper to risky Alt-A MBS (Kalse 2009). Asian- and Canadian-owned non-banking affiliates, absent from Tables 5.2 and 5.3, reported capital losses of only $1.7 billion and $5.7 billion, respectively.

5  The 2008 GFC: Savings or Banking Glut?     71 Table 5.4  Holdings of bonds issued in the United States by European and US investors at end-2002 and June 2007 End-2002

European investors Treasuries and agencies Corporate excluding ABS ABS Total US investors Treasuries and agencies Corporate excluding ABS ABS Total Memo: ABS outstanding

USD bn

Share (%)a

June 2007 Residence-based USD bn Share (%)a













93 1008

9 100

558 2381

23 100

855 2678

32 100













1807 13,480 1978

13 100 12

3621 18,138 4523

20 100 19

3324 17,842 4423

19 100 19

Nationality-based USD bn Share (%)a


of the investors’ portfolio of US bonds that is devoted to the instrument in the row heading Sources Adapted from Bertaut et al. (2012, Table 3); author’s calculations

On this showing, European investors, including banks, loaded up on risky US MBS. At end-2002, their US bond portfolio resembled that of US investors. Their portfolio consisted of mostly safe Treasury and agency securities, with about a third of it in plain vanilla US corporate bonds. By mid-2007, the profile of European investors’ US bonds had veered away from that of US investors towards riskier bonds. Even on a residence basis (Table 5.4, centre columns), European investors had shifted out of safe Treasury and agency securities into corporate bonds, while US resident portfolios kept Treasury and agency securities in first place. On a nationality basis (right two columns in Table 5.4),

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including holdings at US affiliates, European investors had promoted ABS to second place, above safe assets in third place.9 The US mortgage market reshaped its pricing around the needs of foreign banks in the 2000s, highlighting their importance as investors. Historically, ARMs were priced off of national reference rates, mostly one-year Treasury bills. As securitisation picked up with non-US banks as big investors, US mortgage bankers shifted to using offshore Libor as the reference rate. Thus, researchers at the Federal Reserve Bank of Cleveland analysing the stock of outstanding Ohio mortgages in July 2008 found that later vintages of ARMs more and more used Libor as the reference rate (Schweitzer and Venkatu 2009). The Libor-linked share of sub-prime rose from less than 60% in 2003 to reach practically 100% in 2008. The Libor-share of prime ARMs also rose from less than 20% in the turn of the century vintages to 60% by 2008.10 The benchmark was not “Changed by Wall Street, for Wall Street” as Morgenson (2012) headlined, but rather for Lombard Street (London) and for Taunusanlage (Frankfurt). In sum, European banks claimed a market share of a third or more in the production of highly leveraged MBS. Like the US securities firms analysed by Nadauld and Sherlund (2013), as these underwriters ramped up production, they sent a signal to mortgage bankers to extend more credit. Moreover, European investors, especially European banks, bulked large as ultimate holders of such paper as well. The influence of European banks in the market helped to propel Libor to displace US Treasury bills as the preferred reference rate in floating-rate US mortgages. 9Within ABS, foreign investors had more than their share of ultimately risky mortgage bonds. Beltran et al. (2008, Table 6) estimate that non-US investors held 29% of $2.2 trillion in securitised non-agency home mortgages. Including amounts in Table 5.5 on the assumption that they were held on balance sheets in the United States takes this share above 40%. This share is well above private foreign investors’ 14% of US Treasury bonds outstanding or 9% of agency bonds outstanding. 10“‘It was all about securitization, especially subprime loans,’ said Guy D. Cecala, publisher of Inside Mortgage Finance, an industry authority. ‘You had Wall Street saying, ‘If we want to sell this overseas, we have to pick a more international-flavoured index.’ Subprime lenders just started using it overnight, and then it started to spill out into any loan you wanted to securitize’” (Morgenson 2012).

5  The 2008 GFC: Savings or Banking Glut?     73

Why Did European Banks Bet the Bank on US Mortgages? Why did European banks bet the bank on US mortgages? Nadauld and Sherlund (2013) and Bayoumi (2017) highlight the role of regulation and easy access to repo finance. In the former view, the application of the international rules known as Basel II allowed big banks to use their own models to evaluate the riskiness of their assets and permitted US securities firms and European banks to pile 50 or more dollars or euros on every dollar or euro of equity. Dunbar (2011, pp. 138–139), reports that a bank did not include super senior CDO tranches in stress tests, on the grounds that their prices flat-lined at par. Bayoumi (2017) emphasises an SEC rule change that allowed private label MBS to be used to raise cash in the repo market. However, while regulation and repo finance allowed risky strategies, they do not provide an account of why bank managers chose them. This sudden increase in the availability of funding through the repo market resonates with Dooley’s story that such elasticity alone can lead bank managers to take on too much risk. But this story misses the competitive push for market share and size as important goals. One encounters the aspiration for market share and size as leitmotifs in various accounts of European banks that bet their future on US mortgages. At the top of some big European banks, decisions reportedly presumed that the endgame would be a narrow “bulge bracket” of universal banks. Big clients would reward scale with scale. On such reasoning, Barclays board is reported to have set as a strategic objective being one of the top 5 global universal banks (Augar 2018, p. 153). The CEO of RBS, which had acquired Natwest and would acquire much of ABNAMRO, is said to have spoken of growing larger than not only JP Morgan but also Barclays (Martin 2013, p. 194). Martin (2013) relates that the acquisition of ABN-AMRO attracted RBS management precisely because it would increase the bank’s capital market footprint. Zaki (2008, p. 11), describes the UBS chairman as dreaming of rivalling Goldman Sachs and Merrill Lynch.

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Institutional investors on both sides of the Atlantic failed to constrain such boards and top management at a key moment. No less than 94.5% of voting RBS shareholders approved the acquisition of ABN-Amro on 10 August 2007. This was the day after BNP Paribas suspended redemptions from three funds (Martin 2013, Chapter 12). Arguably, this was the Minskian moment of distress that well preceded the panic of September 2008. Senior management and the board signed off on growth proposals at the securities firms. Thus, UBS’ Shareholder report on write-downs of mid-April 200811 describes how, after his appointment effective July 2005, the new CEO of Investment Banking hired consultants that identified a widening gap between UBS and the top 3 competitors in fixed income, credit and commodities. The consultants recommended that UBS grow its structured credit business, with no reference to the associated risks (UBS 2008, pp. 10–11; Zaki 2008, p. 19). Board approval did not include any specification of sub-prime as part of the strategy, and the US affiliate operated without a budget for the growth of assets or risk-weighted assets (UBS 2008, pp. 26, 34).12 RBS management is said to have taken on a 12-man team of mortgage securitisation bankers from Citigroup after the team had approached its securities affiliate, Greenwich Capital, in mid-2006.13 FSA (2011, p. 140), begins its analysis of RBS’s losses in credit trading activities with precisely this

11Lewis (2010, p. 216), describes the report as “semi-frank” but it is a remarkable document. Management had to assess what went wrong in April 2008, before Lehman’s collapse in September 2008 and the subsequent Swiss government rescue. 12One symptom of the impulse to growth is that UBS not only kept portions of its own securitisations, as did other underwriters Erel et al. (2014). In addition, it bought the super-senior tranches that other banks underwrote (UBS 2008, pp. 14–15). Lewis (2010, p. 216), reports that UBS bought $2 billion of Morgan Stanley’s long postion super-senior tranches packaged with a “couple of hundred millions dollars’ worth” short position in mezzanine tranches. 13Martin (2013, p. 197) also reports that RBS doubled its market share in 2006. Perhaps the Citigroup team sought to move because it had already loaded up Citi’s balance sheet. Erel et al. (2014, pp. 405–406) note that “Citigroup recorded the largest amount of write-downs among [US] bank holding companies and its holdings of highly rated tranches, including off-balance sheet holdings, amounted to 10.7% of assets, or roughly $201 billion at the end of 2006”. See Crotty (2013) on risk-taking and bonus-making “rainmakers”.

5  The 2008 GFC: Savings or Banking Glut?     75

“strategic decision [by RBS] to expand aggressively its structured credit and leveraged finance business”. While ING differs from the others in having been more a buyer than producer of MBS, the impulse to grow its US internet banking operation ultimately caused the losses that, in turn, led to a government rescue. When it entered the US market with its proven internet banking product, it chose to establish its subsidiary as a thrift. This required that mortgage assets form the bulk of its assets. The bank is reported to have originally met the requirement by holding agency MBS. Then it backed into US private label MBS—to be sure, Alt-A, rather than sub-prime— as a means to offer higher returns to its internet depositors (Kalse 2009). Growth had other, more defensive, strategic attractions to managers of big banks. It could ward off takeover and help the credit rating. It is easy to forget how real the threat of takeover by rivals was at the time. In 2005, Deutsche Bank and Citicorp seriously considered a merger. Barclays’ bid for ABN-AMRO was topped by the consortium of RBS, Santander and Fortis. Among medium-sized banks, a refusal to engage in seemingly profitable “credit arbitrage” risked making the bank a target for acquisition. Size was also a consideration in the rating agencies reckoning of the likelihood of government support in extremis (Hau et al. 2013; King et al. 2016). So getting bigger could help raise or at least maintain the rating. In sum, it is easy to understate the role of market share and growth as motivation for European banks. Consultants helped managements to benchmark their businesses and encouraged the view that a handful of firms would end up with the lion’s share of activity. To paraphrase Kindleberger, “There is nothing so disturbing to one’s well-being and judgment as to see a competitor get bigger overnight”. Certainly, European banks did not confine their expansion to US assets or securitised assets. They played a leading role in funding the Spanish and Irish real estate and credit booms as well. There, they did not take on the ultimate risk by buying securitised mortgages. But they still provided even larger inflows of capital that enabled even larger expansions of domestic credit and even larger run-ups in property prices (Box).

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The Spanish and Irish Cases: Larger Inflows from European Banks, Bigger Booms The Irish and Spanish cases resembled the US case in several salient respects. Both featured a large increase in private credit, big run-ups in house prices and, one way or another, a huge inflow of bank capital. The securitisation of mortgages in the United States should not obscure the role of banks as buyers of the bonds (Connor et al. 2012). And rather than just a heavy reliance on floating-rate mortgage at the margin, these European economies relied entirely on floating-rate mortgages. The Spanish and Irish booms differed from the US case in important respects, however: the monetary policy background, the role of Asian savings and the importance of securitisation. In the United States monetary economists continue to debate whether the Federal Reserve set interest rates too low or responded appropriately to the observation that bond yields hardly responded to higher policy rates (the “conundrum”). Since both Spain and Ireland were part of the euro area, short-term interest rate setting looked to a broader economic domain than these two booming countries in the periphery. As a consequence, Regling and Watson (2010, p. 24) find that real short-term rates were lower in Ireland and Spain than they were in Germany (see also Bank of Spain 2017, p. 30). The investment of official reserves likely exerted less downward pressure on long-term yields in the euro area than such investment put on US Treasury yields. Dollars attracted about two-thirds of reserves in the 2000s and euros only 20–25%. Add the thoroughgoing reliance on floating-rate mortgages in these European countries and it is hard to pin much of their booms on the Asian savings glut. The role of securitisation, the focus of many analyses of the US case, was much reduced in Spain and basically absent in Ireland. In Spain, the regional cajas depended heavily on so-called covered bonds to fund their mortgages; and 75% of these were held by foreign investors (Berges et al. 2012), notably German banks. These do not remove the risk of the mortgages from the originator, so they are better viewed as long-term secured funding rather than as securitisation proper. Other forms of securitisation did not qualify for removal of the assets from the balance sheet owing to limited risk transfer (Almazan et al. 2015). With little risk transfer of real estate credit, the Irish and Spanish banks only shared their boom exposures to the extent that foreign banks participated in the credit booms directly. In Ireland’s case, the RBS subsidiary, Ulster Bank, did manage to run up significant losses, for which the UK rather than the Irish taxpayers ended up paying. In Spain, the foreign bank role was limited. The international diversification of the two largest Spanish banks did stand them in good stead as earnings abroad stabilised their profitability.

5  The 2008 GFC: Savings or Banking Glut?     77 One aspect that differs in the Irish and Spanish cases from the US case is the exposure of banks to property companies. They brought exposure not only to commercial real estate, but also to the construction of houses. On close inspection, the profitability of the latter in a boom frequently turns on speculation in raw land. This reinforced the banks’ exposures to the feedback loop among capital inflows, credit growth and real estate prices. House prices, household indebtedness and associated capital inflows all traced more extreme trajectories in Ireland and Spain than in the United States. By the lights of the OECD, at least, house prices boomed more in Spain and Ireland than in the United States (Fig. 5.4, left-hand panel). However, the US index conceals significant regional variation: the CaseSchiller 20-city index for the United States more than doubled between 2000 and the peak in mid-2006. Ireland takes the prize for the largest run up in household debt as a share of GDP (Fig. 5.4, right-hand panel). It rose by 50% of GDP through 2008, even before the ratio surged as the denominator fell. But Spain was not far behind. On this measure, the US experience was again relatively mild.1 However, the Irish and Spanish cases distinguish themselves from the US case in the scale of the capital inflow. Figure 5.5, left-hand panel shows the net foreign liabilities of the banks in Ireland with local lending business.2 It shows a net inflow of over 50% of GDP (Everett 2017). Recall that the inflow of official reserves into US Treasuries from end-2000 to mid2007 amounted to 10% of 2007 GDP, and the change in European investors’ holdings of US ABS in the same period amounted to about half that. In other words, even stripping out offshore activity in Ireland, and counting both the trans-pacific and transatlantic flows to the United States, the inflow of external funding into the Irish banking system was triple that of the United States.

Fig. 5.4  Housing price and household credit (Sources OECD; BIS)

78     R. N. McCauley

Fig. 5.5  Massive bank flows to the euro periphery (In per cent of GDP) (Source Central Bank of Ireland; IMF; BIS locational banking statistics) The inflow of bank credit to Spain also reached staggering proportions (Fig. 5.5, right-hand panel). Since Spain does not have a large presence of “offshore” banking, we simply sum the stock of BIS cross-border bank claims on nonbanks in Spain with the net claims of banks outside of Spain on banks in Spain (see Avdjiev et al. [2012] for further discussion). This aggregate rose from 15% of Spanish GDP to almost 60%. Despite the differences, a similarity stands out. European banks enabled credit booms in the United States, Ireland and Spain. US losses crippled many European banks and sapped their defences against strains in Europe. 1The US figures include credit to non-profits. 2This focus on net liabilities of certain banks incorporated in Ireland seeks to exclude the large “offshore” banking presence in Ireland. See Honohan (2006), Central Bank of Ireland (2010), and Lane (2015).

Conclusions The GFC was, in Delong’s (2009) phrase, the “wrong crisis” that struck the wrong part of the US bond market (Tooze 2018). Official reserve managers could have staged a sudden stop or even reversal of their purchase of US Treasury bonds. This could have imposed a dollar depreciation and a costly adjustment on the US economy. Instead, in

5  The 2008 GFC: Savings or Banking Glut?     79

2007–2008, highly leveraged European banks scrambled to secure dollar funding as they experienced credit losses—and the dollar appreciated sharply (McCauley and McGuire 2009). European banks’ vulnerability arose from their role as producers of the ultimately toxic assets as well as from their role as investors. As a result, their affiliates’ US balance sheets required massive write-downs in 2008. The banking glut better than the savings glut accounts for US mortgage market developments of the 2000s. Large official inflows into US Treasury and agency notes should have reinforced a US mortgage market dominated by fixed-rate mortgages that enjoyed government agency guarantees. Instead, we observe a big shift to mortgages priced with floating (“adjustable”) interest rates and to more risky, leveraged mortgages that agencies could not guarantee. The dominance of the savings glut with its demand for safe assets should have manifested itself in wider spreads but the spread of the riskiest mortgages over normal mortgages actually narrowed. The banking glut also better accounts for the parallel real estate booms and busts in Spain and Ireland. True, official reserve managers did invest in euro-denominated government bonds. But the Irish and Spanish mortgage markets work on floating rates closely tied to the policy rates set by the ECB. Again, expansion-minded European banks provide a more compelling account of these banking systems’ remarkable ease of external financing. In fact, the Irish and Spanish banking systems experienced capital inflows that were huge in relation to the inflows into the United States in the same years. The Irish and Spanish credit and real estate booms did not require features much emphasised in the US case (e.g. FCIC 2011): securitisation with (or without) risk transfer (Connor et al. 2012; CarboValverde 2012; Almazan et al. 2015; Acharya et al. 2013), or reliance on faulty, conflicted ratings (UBS 2008), or a big government role in the housing market (Rajan 2010; Morgenson and Rosner 2011). But banks in Ireland and Spain did depend on credit from European banks that were working their equity harder. Occam’s razor opts for one account for such similar and simultaneous phenomena. European banks grew at breakneck rates in the pursuit of market share, spurred by consultants who foresaw a narrow circle of global

80     R. N. McCauley

universal banks. Greater size also reduced the risk of takeover, a far from imaginary risk. Greater size also improved credit ratings if it increased the prospect of government support. Bank managers chose growth and several factors, including regulation, low volatility and access to shortterm repo finance all conspired to permit it. In addition to being the much-reported and hapless investors in bespoke mortgage securities produced by US securities firms, European banks also manned the production line and, like their US competitors, kept unsalable “safe assets” on their balance sheets.

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6 Capital Flows into the United States Ahead of the Great North Atlantic Financial Crisis Brad Setser

Introduction The crisis the United States experienced in 2008 wasn’t the balance of payments crisis that many expected. It was rather a classic crisis of financial intermediation, the result of a run that took place in the shadow banking system rather than an old-fashioned run on bank deposits. Investors in the banks’ short-term paper lost confidence in the value of asset-backed securities that the banks’ held on their balance sheet. The crisis was not precipitated by a change in China’s exchange rate management and a dollar collapse. On the contrary: China built up reserves at a record pace through the early stages of the crisis, and the loss of confidence in the shadow banking system, rather ironically, led the dollar to rally at the peak of the crisis. Yet the U.S. balance of payments should not be written out of the story of the global financial crisis: the years immediately preceding the B. Setser (*)  Council on Foreign Relations, New York, NY, USA e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


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global crisis were marked by unprecedented financial inflows into the United States. Sustaining the large housing-driven U.S. external deficits took both central bank reserve accumulation and traditional financial intermediation. Central banks were willing—even too willing—to hold dollars and fund a large (over 5% of GDP) U.S. current account deficit. But they weren’t willing to take credit risk. As the domestic counterpart to the U.S. external deficit shifted away from the fiscal deficits of George W. Bush’s first term to excessive household borrowing, the world’s largest financial intermediaries came to play a central role in the financing of both U.S. households and the U.S. trade deficit. The big banks and broker-dealers: effectively borrowed dollars from the world’s central banks and invested the proceeds in risky mortgages that had been repackaged into securities that the rating agencies judged to be safe, thanks to the joys of financial engineering and some generous grading. When this private intermediation came to a stop, the private financial system lacked sufficient capital to absorb the expected credit losses on its U.S. housing exposure—triggering a violent financial crisis and a modest adjustment in the United States’ current account deficit. Back in 2009, Brender and Pisani laid out how complex chains of financial intermediation helped to finance the deficit in the U.S. household sector. Both the growth in those chains of financial intermediation and their collapse show up in the U.S. financial account. In fact, the expansion of gross financial flows from 2005 to 2007 provided a clear indicator of growing financial complexity and building risk in the system, even if the signal wasn’t well understood at the time. The collapse of foreign demand for U.S. housing credit in the summer of 2007 should have been interpreted as a leading indicator that the “system” was under stress and many private intermediaries needed substantially more capital. This paper will make five linked analytical arguments: 1. The sectoral imbalance in the United States shifted from the ­government sector to the household sector from 2004 to 2007, and increasingly the household sector’s deficit wasn’t intermediated by ­government-sponsored (and it turned out government backed) agencies. 2. The available supply of Treasuries failed to grow in line with the enormous increase in central bank reserves—creating a shortage

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in the market that incentivized more complex forms of financial engineering. 3. After 2006, central bank flows fail to cleanly register in the U.S. data, even after taking into account the weaknesses in the U.S. data and their tendency to undercount actual central bank inflows. 4. The growth in private flows into the United States (and out of the United States) that coincided with record official reserve growth reflected the increasingly complex chains of financial intermediation needed to fund the U.S. deficit, as central banks needed to be matched to safe assets and the risk associated with privately backed U.S. mortgage pools needed to find a home. Such intermediation could have been done domestically, but many risks were warehoused offshore. 5. Some of the “missing” central bank flow—the gap between the growth in dollar reserves implied by the IMF’s data and the visible inflow into Treasuries and Agencies—likely was lent to European banks, both directly and indirectly, through the cross-currency swap market. The reversal of these flows in turn explains the surge in inflows into U.S. Treasury bills that marked the crisis.

The Shifting Sectoral Imbalance in the U.S. Economy An external deficit indicates a gap between savings and investment somewhere in the economy, whether in the corporate sector, the housing sector, or the government (Thiruvadanthai). The sectoral source of the overall U.S. external deficit hasn’t been constant. In the late 1990s, a booming corporate sector and high levels of corporate investment drove a rise in the U.S. external deficit even as the government swung into surplus. After the dot-com bubble burst, the government swung back into deficit—both for cyclical reasons and as a consequence of the 2001 and 2003 tax cuts. A fiscal deficit is a drain on national savings. Over the course of 2004 and certainly by 2005, a strengthening housing market started to propel both U.S. demand growth and raise tax revenues. The economy’s borrowing need

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thus shifted toward the household sector, as the overall external deficit remained large—in part because households didn’t cut their overall spending as oil prices rose.

The household sector is typically a net supplier of savings to the rest of the economy, so it is extraordinary when it on aggregate moves into deficit. As important, the aggregate numbers for the household sector reflected a far bigger gross borrowing need inside the household sector: some households were borrowing large sums, while others continued to save and build up financial assets. Borrowing as a share of household’s disposable income soared well above its long-term average from 2003 on as Thiruvadanthai shows in his paper on Current Account Imbalances and Debt Buildup (Thiruvadanthai 2018). Households both borrowed against rising home equity to finance current consumption (home equity lines of credit) and borrowed to buy new homes, supporting a high level of residential investment. By 2007, the federal fiscal deficit was just over a percent of U.S. GDP, while the current account deficit remained around 5% of GDP—a shift that implied a substantial deficit in the private sector. The “twin deficit”

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story was no longer substantively true; the bulk of the economy’s external borrowing need came from the private sector. Such a private sector deficit could be financed either by selling safe assets to the world while U.S. financial intermediaries took on housing risk, or by directly placing the housing risk with investors from the rest of the world.

The Rise in Reserves and Thus Demand for Safe Reserve Assets In broad terms, the shift in the sectoral composition of the U.S. savings imbalance toward households came even as external demand for U.S. financial assets shifted toward safe, government-backed bonds. In 2003, private inflows to the United States fell—putting pressure on the dollar. However, a number of key central banks, particularly in Asia, didn’t want to see the value of their currencies rise against the dollar. This resulted in an enormous increase in the pace of global reserve growth. China of course was the most important country resisting appreciation of its currency during the period. The boom in China’s exports that followed its accession into the WTO created natural pressure for appreciation. But China remained reluctant to untether its currency from the dollar—in trade-weighted terms its currency actually fell in 2003 and 2004, as its tight peg to the dollar led it to follow the dollar down. It did allow the yuan to appreciate modestly against the dollar in 2005 and 2006, but the small move against the dollar at best only offset the dollar’s depreciation against other currencies. Other emerging economies in Asia didn’t want to lose competitiveness to an ascendant China and joined the People’s Bank of China in intervention. The central banks of most of the world’s commodity exporters also resisted letting their currencies appreciate along with the rising price of oil. Emerging market reserve accumulation easily topped $1 trillion by late 2007 and early 2008. Central banks traditionally have maintained conservative financial portfolios; reserve managers generally do not have a mandate to take significant credit risk. Their natural habitat is the government bond market. In 2003 and 2004, official investors could comfortably invest their growing reserve portfolios in U.S. Treasury bonds. Net issuance of

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Treasuries reached a local peak at just under $400 billion in the middle of 2003, and declined only gradually in 2004.

Yet even over this period net issuance of Treasuries lagged the increase in global reserve growth. By 2003 the stock of global reserve assets—as reported by the IMF—topped the supply of U.S. Treasuries not held by the Federal Reserve. By the end of 2006, the stock of reserves was about $3 trillion larger than the stock of Treasuries in the market. Even after accounting for central banks holdings of euros and other reserve currencies, central banks’ dollar holdings almost certainly exceeded the available Treasury supply. By the middle of the decade foreign holders, mostly central banks, held 65% of the available stock of marketable Treasuries. Of course, the total stock of Treasuries, net of the holdings of the Federal Reserve, is the theoretical maximum that central banks could hold. In practice, the private sector needs to hold some Treasuries too— they are the collateral used to back a number of basic financial transactions. There is an upper limit to the number of Treasuries the world’s central banks can remove from the private market.

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Additional demand for safe assets could be accommodated through central bank purchases of the growing stock of bonds issued by the U.S. “Agencies.” Government-sponsored entities, notably Freddie Mac and Fannie Mae (collectively known as the “Agencies”), have traditionally helped to transform U.S. housing debt into safe assets that central banks could comfortably hold on their balance sheets, as these institutions were believed to benefit from the implicit backing of the federal government. Central banks willing to give up a bit of liquidity could obtain a small increase in yield by holding the Agency bonds, without necessarily taking any direct credit risk themselves. However, by 2004 the Agencies were under political pressure to limit the growth in their balance sheet, thanks to concerns about the contingent liability they created for the U.S. government. The growth in the Agencies mortgage pools—a measure of their overall growth that captures both the mortgage-backed securities the Agencies guarantee as well as the Agencies retained portfolio—fell from an annual average of between 2 and 3% of GDP from 2001 to 2003 to under 1% of GDP in 2005.

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The result was a fairly dramatic fall off in the net issuance of safe U.S. securities even as global reserve growth accelerated to record levels. To put everything starkly, in the four quarters from the middle of 2006 to the middle of 2007, the U.S. Treasury issued about $75 billion— on net—in long-term bonds. The constraints on the Agencies had been relaxed by then; they added just under $400 billion to their total mortgage pools. Yet over this period central banks added $1.1 trillion to their reserves (after adjusting for valuation changes) and liked added around $700 billion to their dollar holdings—a sum well in excess of the $450 billion in “safe” assets issued by the Treasury and the Agencies. In fact, from the start of 2005 to the end of 2007 the increase in the net supply of Treasuries and Agencies (proxied by the growth in Agency mortgage pools) lagged the increase in the world’s dollar reserves. The combination of a surge in central bank demand for safe, reserve assets amid relatively modest growth in supply had three main effects on global markets: Central banks could buy a portion of the existing stock of government bonds from the private market—reducing the supply of Treasuries in private hands. This both freed up private funds to flow into other assets— investment funds that sold their Treasuries to a reserve manager could buy other bonds—and worked to lower the term premium on government bonds. Central bank demand for safe assets is—to a degree—price insensitive, and thus the rise in demand worked through the market in a way that was similar to the impact of the Fed’s large-scale asset purchases. By making duration scarce, the term premium falls, lowering the cost of long-term funding (all else equal) throughout the economy. Central banks could directly take more risk in an effort to get more yields or set up subsidiaries that were empowered to take more risk to try to get more return. China, for example, appears to have handed about $100 billion of its reserves over to its state banks to manage in 2006 (by swapping reserves for the banking system’s yuan), and then it famously set up the China Investment Corporation in 2007 just as the market started to fall (Setser 2009a). The increase in the global reserves reported by the IMF in this period likely understates true official asset growth by over $100 billion a year from 2006 on, thinks to the large increase in China’s hidden reserves between the end of 2005 and the

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middle of 2008 and the substantial increase in the foreign assets of the sovereign wealth funds of many large oil-exporters. Central banks could put dollar on deposit in the world’s banks, providing the banks with dollars to lend out—or more likely, to invest in U.S. asset-backed securities. Or central banks could also engage in cross-currency swaps with the world’s large banks. This would allow the reserve manager to swap dollars for say yen, which could be invested in the safe Japanese government bond market. In the swap market, holders of dollars, generally are paid a premium to swap out of ­dollars—the bank on the other side of the swap would pay the difference between short-term U.S. interest rates and yen interest rates plus an extra premium (“the cross-currency basis”) to encourage investors to give up dollars (Concentrated Ambiguity 2018). Such swaps effectively allowed reserve managers to switch from funding the U.S. government to funding the world’s banks in dollars. With a flat yield curve, the world’s banks could only make money by borrowing short and lending long if they took on credit risk. Depressed term premiums (Bernanke et al. 2011) meant they could not make money by simply playing the yield curve (Setser 2009b). Finally, central banks could truly shift away from the dollar into other reserve assets. But there were natural limits to such portfolio shifts in a world where the key central banks were managing their currencies primarily against the dollar and primarily intervening in the dollar market. Selling too many dollars for euros would put pressure on their own formal and informal currency pegs—as they would either need to follow the weakening dollar down (raising their current account surplus) or allow their currencies to appreciate (pulling in financial flows).

A Word on Data Limitations It isn’t possible, even now, to determine exactly what central banks did with their growing reserves during this period. There are too many gaps in the data. The IMF maintains a data set on the currency composition of the world’s reserve holdings. But a number of central banks considered the

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currency composition of their reserves a state secret, and only reported their total reserves—not the distribution of their reserves to the IMF. Back in 2017, the IMF only had data on the currency composition of about 60% of the world’s reserves, as China was reporting data on the currency composition of its reserves to the IMF. Saudi Arabia and Taiwan are also outside the scope of the IMF’s detailed reporting. The “known unknown” is thus the currency composition of the reserves of those countries that didn’t report full data to the IMF at this time. It is likely that the currency composition of those countries reserves was fairly close to the currency composition of those that do report, but ultimately that is just a working assumption.1 While data on the currency composition of global reserves is incomplete, there is still more data on the currency composition of global reserves than on the portfolio composition of countries’ reserve portfolios: there isn’t aggregated global data that would show a shift, for example, out of government bonds into equities and riskier corporate debt. Those countries report data using the SDDS format to report the overall split between deposits and bonds and other investments in their reserve portfolio, but the IMF doesn’t aggregate that data. And there isn’t a common global standard for reporting data about the composition of countries bond and equities portfolios. If say central banks were in aggregate shifting from holding government bonds to the bonds issued by large systemically important banks, it wouldn’t show up clearly in any of the major reserves data sets. The other main source of information on the currency composition of global reserves comes from the detailed data the ­ U.S. reports on foreign portfolio investment in the United States. The U.S. data for the security holdings of individual countries aggregates private and official holdings. But for many surplus countries with large reserves, it provides a reasonable first approximation of the country’s reserve portfolio. Official reserves tend to appear

1Countries that report their reserves using the IMF’s SDDS template usually also report the currency composition of their reserves to the IMF, so use of the reserve template is a reasonable proxy for inclusion in the COFER data set.

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in the data more cleanly than private assets, which often are held through global custodial centers. However, the U.S. survey data almost certainly undercounts central bank holdings of U.S. bonds. A central bank that uses a non-U.S. custodian for its bond holdings won’t appear as a central bank in the U.S. data. Bonds held at say Belgium’s Euroclear will appear as private Belgian holdings. Reserves that a central bank hands over to a private fund manager to manage also, reasonably, appear as private in the U.S. data. Finally, if a central bank swaps dollars with a private counterparty in order to pick up the cross-currency basis (basically a fee for lending out its dollars) and the private counterparty then buys a U.S. bond, that too appears as a private holding in the U.S. data. In practice, estimates of global dollar reserve growth tend to match total inflows in Treasuries and Agencies more closely than they match the reported “official” central bank inflows in the U.S. data.

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The numbers on official inflows are derived from the change in the stock of central bank holdings reported in the survey data, but this still only captures the funds central banks hold directly with U.S. custodians. The close overall correlation between estimated dollar reserves and overall foreign holdings of Treasuries and Agencies suggests that relatively few central banks made risky investments themselves, even back in the pre-crisis days when Treasury supply was constrained. Ultimately though this is a judgment based on a close read of the data, not a fact that falls directly out of disclosed holdings. The gaps in the data are too large to know for sure.

The Surge in Private Inflows and Outflows That Preceded the Global Crisis There is a deep puzzle in the U.S. financial account data for the period preceding the global crisis. Between 2005 and 2008, central bank reserve accumulation soared to record levels. A look at the balance of payments of the main surplus countries indicates that the bulk of the financial outflow from these countries—the counterpart to their trade surplus—came from the buildup of central bank and sovereign wealth fund assets. On net, private funds were actually flowing into the main surplus countries at this time, as reserve growth exceeded these countries’ current account surplus. There is also good reason to believe that unprecedented growth in total reserves led to unprecedented growth in dollar reserves (Setser 2009a). The main known unknown during this period is what China was doing with its huge portfolio, and there haven’t been any major changes in the aggregate currency composition of global reserves as China’s reserves were integrated into the global data from 2015 on. Yet this is also a period when private financial inflows to the United States—judging from the U.S. data soared. In 2007, total gross inflows—including official inflows into Treasuries and Agencies, as well as private inflows into corporate bonds and cross-border bank

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lending—reached 14% of U.S. GDP, a record. Those inflows far exceeded current account deficit, which never topped 6% of U.S. GDP. They also are far larger than can be explained by reserve growth alone.

At the time, large gross inflows were seen as a sign that globalization had strengthened the stability of the United States and the global financial system: financial globalization had reduced the risk associated with the United States’ persistent, large external deficits, as the risk associated with the U.S. housing boom was being dispersed globally, rather than retained in the “core” of the U.S. financial system. The IMF, reflecting the conventional wisdom of the Federal Reserve and U.S. authorities at the time, wrote in its 2007 assessment of the U.S. economy (emphasis added): Innovation based on an “originate to distribute” model is reshaping the financial sector…the income of institutions at the core of the financial ­system, the commercial and investment banks, increasingly derives from bundling and servicing securitized assets for investors—asset-backed securities and collateralized debt/loan obligations (CDOs/CLOs)—rather

100     B. Setser

than from holding loans. The system has thus evolved to yield: (i) a profitable and well-capitalized core relatively protected from credit risks; (ii) an innovative and lightly regulated periphery, including specialized institutions that originate loans and a multitude of hedge funds that support market liquidity and price discovery; and (iii) the transfer and diversification of credit risk via a wider range of securitized assets and credit derivatives. Against this rapidly changing financing landscape, U.S. markets have remained globally pre-eminent and robust to a range of shocks.

Later in the report, the Fund wrote: Core commercial and investment banks are in a sound financial position, and systemic risks appear low. (IMF 2017)

Large private inflows during this period were interpreted as evidence that the distortions associated with the buildup in official assets were limited—reserve growth was large, to be sure, but official flows only accounted for a portion of the total inflow into the U.S. financial markets (Greenspan 2007). Most financial intermediation was occurring privately. The reality, though, was less benign. The large gross financial inflows into the U.S. at this time reflected the development of complex chains of financial intermediation, and thus were a sign of growing risk inside the financial system. With hindsight it appears likely that the rise in gross flows was directly tied to the fact that central bank dollar reserves couldn’t simply flow into the U.S. Treasury market and finance both the U.S. fiscal and external deficit. Private financial intermediaries had to match central banks desire for safety with the actual financial assets the U.S. economy was generating at the time. Consider three examples of more complex chains of financial intermediation identified. One: Central banks put dollars on deposit offshore in a European bank, which then buys “private label” U.S. asset-backed securities. This of course would show up as a private foreign purchase of U.S. corporate debt. Two: A central bank buys a two-year U.S. Treasury bond from a corporate treasurer, which then invests in a money market fund.

6  Capital Flows into the United States …     101

The money market fund in turn buys the commercial paper issued by a European bank, or a special investment vehicle domiciled offshore. And the offshore vehicle buys private label asset-backed securities. This would show up as an official inflow into the U.S. Treasury market, a private outflow into foreign short-term securities (the U.S. money market fund buying commercial paper), and private foreign inflow into long-term U.S. corporate bonds. Three: A central bank engages in a cross-currency swap with a European bank, swapping dollars for euro. The central bank can then invest in a European government bond, while being hedged against exchange rate risk (it effectively is still holding dollars). And the European bank can invest, making a real-estate-backed loan or buying an asset-backed security. It could of course also have bought a “safe” U.S. asset, but the flat yield curve made such straight-forward maturity transformation unprofitable. This shows up in the global data as a central bank purchase of European debt, and a private foreign purchase of U.S. corporate bonds— the fact that the private investor and the central bank have swapped the currency component of their respective returns is largely invisible. All these more complex chains of financial intermediation, in different ways, left traces in the U.S. balance of payments. All result in a rise in apparent private inflows to the United States at a time of record global dollar reserve accumulation. All in effect, combine private risk capital with dollars borrowed from the world’s central banks to support a portfolio composed of private U.S. bonds (Brender and Pisani). They thus map to the surge in foreign purchases of private label U.S. asset-backed securities from 2005 to the middle of 2007—back at a time when over 15% of all U.S. mortgages were subprime and thus not eligible for repackaging into a traditional agency security. These complex chains of financial intermediation collapsed in the crisis (Brender and Pisani 2009). In fact, several started to unravel well before the peak of the crisis in the fall of 2008. The first real sign of global financial distress came in the summer of 2007, when the investment vehicles of a couple of European banks ran into trouble. Over the course of that summer, foreign purchases of U.S. corporate bonds—the balance of payments category that includes asset-backed securities—more or less came to a complete halt.

102     B. Setser

Cross-border bank flows (a category that includes many of the activities of money market funds as well as direct bank flows) also slowed in late 2007, and then fully reversed during the crisis. This category is a difficult one to track in the balance of payments data, as there is a strong correlation between bank inflows and bank outflows, so the net flow is typically only a fraction of the gross flow. Nonetheless, the rise in gross bank flows from 2005 to 2007—which shows up clearly in a chart of cumulative flows—provided a leading indicator of growing financial complexity and rising leverage. The pro-cycle process identified by Adrian and Shin (Adrian and Shin 2010) left a clear mark in the balance of payments data. Global reserve growth remained strong—in part because the dollar remained relatively weak—even after the fall in private demand for U.S. asset-backed securities in the summer of 2007. At this time, the Federal Reserve was cutting rates to support a weakening U.S. economy, leading the dollar to fall against the euro—while many emerging markets still refused to allow their currencies to float freely against the dollar. Global reserve growth reached its all-time peak in the four quarters that ended in the middle of 2008.

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Over this period, the “Agencies” significantly increased their issuance. They remained under private ownership, but they were effectively providing policy support to the U.S. housing market. Increased Agency issuance in turn also helped to meet a portion of the rise in global demand for reserve assets during this period, as foreign demand for Agencies continued—albeit at a more modest pace than in early 2007—through the summer of 2008. But these inflows hinged on the credibility of the U.S. government’s backstop for the Agencies, not on a judgment that the Agencies had only backed solid mortgages or that the Agencies had enough capital of their own to provide foreign investors holding Agency bonds with protection against a deteriorating U.S. housing market. When foreign investors—notably China, which had been a huge purchaser of Agency mortgage-backed securities—and Russia—which held the bulk of its growing reserves in the short-term securities the Agencies issued directly—lost confidence in the federal backstop in the third quarter of 2008, foreign demand for Agencies truly came to a sudden halt. By the fall of 2008, losses on private label mortgage securities and fears of future losses paralyzed the private financial system. Lenders to the world’s banks realized, too late, that the world’s big banks lacked sufficient buffers of capital to clearly be able to absorb the potential losses on their suddenly illiquid private label asset-backed security holdings. The dollar’s rally after Lehman’s bankruptcy has attracted a great deal of attention, as it created the perception that foreign demand for U.S. financial assets rose in the midst of the U.S. financial crisis. The reality is more complicated. Private inflows into risky U.S. financial assets fell, as one would expect. In fact, private flows into U.S. bonds actually reversed—foreigners were net sellers of U.S. corporate debt in 2008 and 2009 and net sellers of Agencies from mid-2008 onwards. Foreign banks also reduced their lending to the United States. The inflow into the U.S. market came because U.S. banks—and other American shortterm lenders—reversed their global lending and brought their funds home. This repatriation, rather than a rise in private foreign demand for U.S. financial assets, accounts for the relative stability of the U.S. ­balance of payments amid the crisis. If this repatriation is excluded, the magnitude of the swing in foreign demand for U.S. corporate bonds and foreign bank lending to the

104     B. Setser

United States would be in line with the kind of swings experienced by emerging markets during a “sudden stop.” Total inflows into U.S. debt, including bank flows, from abroad fell from a peak of 14% of U.S. GDP in 2007 to through of negative 6% in early 2009, a swing of close to 20% of U.S. GDP.

After Three Sudden Stops, a Surge: The Crisis Driven Inflow into U.S. Treasuries There of course was one final, and important flow in the crisis—a surge in foreign demand for Treasury bills. This apparent inflow helped to offset the reversal of private inflows into long-term bonds. Much of the rise in demand for Treasury bills clearly came from official sources: China’s holding of short-term bills rose from close to zero to $200 billion; total central bank holdings of bills rose by $350 billion in the second half of 2008 and the first quarter of 2009. Central banks thus account for well over half of the total inflow into bills at the height of the crisis.

6  Capital Flows into the United States …     105

Lehman wasn’t just a shock to the U.S. financial account—it was a shock to the entire global financial system. Banks pulled back globally, putting pressure on most emerging economies. The crisis thus triggered a very sharp swing in reserve growth. Reserves actually increased by about $300 billion in q3 2008 (an annual pace of $1.2 trillion). In the fourth quarter, central banks reduced their reserves by $100 billion (annual pace of negative $400b). The net central bank inflows into Treasury bills in the fourth quarter ($200 billion) and the first quarter of 2009 ($80 billion) thus cannot be explained by a rise in global reserve holdings. Central banks were selling reserves and dollars at the same time when they were shifting funds into Treasuries. It consequently is clear that the flow into Treasuries primarily reflects a shift in central banks’ portfolios toward safety rather than a surge in demand for U.S. financial assets. The flow into Treasuries came as central banks moved out of the Agency market—there were $175 billion in foreign central bank sales of Agencies in the fourth quarter of 2008 alone. The BIS data also shows an almost $200 billion fall in central bank dollar deposits in global banks in q4 2008, and another fall of $100 billion in q1 2009. The big inflow into Treasuries attracted a lot of attention, as it was very visible. But there were equally large outflows from other dollar assets, which were no longer considered safe. Reserve managers broadly speaking acted like everyone else: they sought safety in the crisis. In fact, the surge in demand for Treasuries helps clarify one of the great mysteries in the pre-crisis balance of payments. From the end of 2005 to the middle of 2008, only about a third of estimated dollar reserve growth flowed into Treasuries and only about two-thirds flowed into Treasuries and Agencies. One-third didn’t appear in the U.S. securities data. The bulk of these missing reserves likely had been lent to the global banks either directly, as deposits, or indirectly, through cross-currency swaps. By the middle of 2009 that gap has largely disappeared, as the reserves that had flowed into dollar assets other than Treasuries before the crisis flowed back into Treasuries during the crisis. Between the middle of 2008 and the middle of 2009 foreign holdings of Treasuries rose by a remarkable $900 billion while global reserves were essentially flat.

106     B. Setser

The surge in demand for U.S. Treasuries in the crisis helped hold down U.S. rates even as the U.S. increased issuance. But the importance of this “stabilizing” flow shouldn’t be overstated, as the flow into Treasuries was the counterpart of instability in the market for Agencies and the broader global market for dollar funding. It took a series of dramatic actions by the U.S. government, in conjunction with the Treasuries and central banks of key European states, to stabilize the global financial system through a combination of equity injections and liquidity support. Foreign central banks, reasonably, sought safety in the crisis, even if that added to the risk of global instability—they didn’t act differently than private investors. After the violent swings of the crisis years, the United States settled into a “new normal” from 2009 onwards. The U.S. financial account in the years immediately after the global crisis actually looked a bit like the financial account back in 2003. Strong global reserve growth translated directly onto strong foreign demand for U.S. Treasuries. There was

6  Capital Flows into the United States …     107

very little foreign demand for any other types of U.S. bonds, and with no shortage of Treasury issuance, there was no need for complex chains of financial intermediation. These intervention and reserve driven flows continued, with a brief interruption at the peak of the Euro Area’s crisis, until the dollar rallied on the back of monetary policy divergences between the G-3 economies in the summer of 2014.

Without the need for complex chains of financial intermediation, gross financial inflows and outflows into the United States fell significantly. The sharp increase in gross flows during the period from 2004 to 2008 now looks like a blip rather than the irrevocable march of financial globalization and the start of a permanent decoupling of national savings from national investment.

108     B. Setser

Conclusion The U.S. crisis manifested itself as an old-fashioned run in the modern securities market—large pools of wholesale dollar funding no longer believed that the global banks and large broker dealers were safe, and no longer wanted to give the banks any funds to intermediate. The government had to step in—and eventually did, on an unprecedented scale. Yet even if the crisis didn’t follow the classic contours of a balance of payments crisis, the buildup of vulnerabilities that gave rise to the crisis left large traces in the balance of payments data. The rise in gross inflows and outflows from the U.S. indicated rising financial leverage, as in some sense the global financial system sought to find a home for the private housing risk that the United States’ main external funders— the world’s central banks—didn’t want to take. Gross debt inflows into the U.S. peaked at an incredible 15% of U.S. GDP in the middle of 2007. They subsequently have fallen back to a healthier 5% of U.S. GDP. There was a clue in this rise, one that unfortunately wasn’t well understood in real time. Rather than a sign of healthy globalization, the rise in cross-border flows—both absolutely, and relative to the U.S. ­current account deficit—was a sign of building systemic risk.

References Adrian, T., & Shin, H. S. (2010). Federal Bank of New York Staff Reports: Liquidity and Leverage (Satff Report No. 328). https://www.newyorkfed. org/medialibrary/media/research/staff_reports/sr328.pdf. Bernanke, B. S., Bertaut, C., DeMarco, L. P., & Kamin, S. (2011). International Capital Flows and the Returns to Safe Assets in the United States, 2003–2007. Brender, A., & Pisani, F. (2009). Global Imbalances and the Collapse of Globalised Finance. Concentrated Ambiguity. (2018). FX-hedged Yields, Misunderstood Term Premia and $1 TN of Negative Carry Investments. https://concentratedambiguity.

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Greenspan, A. (2007, October 21). Balance of Payments Imbalances. Speech, Per Jacobsson Foundation Lecture. Washington, DC. International Monetary Fund (IMF). (2017). United States: 2007 Article IV Consultation—Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion. CR/Issues/2016/12/31/United-States-2007-Article-IV-Consultation-StaffReport-Staff-Statement-and-Public-21239. Setser, B. W. (2009a). China’s $1.5 Trillion Bet. chinas-15-trillion-bet. Setser, B. W. (2009b). A More Balanced Economy Might Allow the World to Live with a Less Perfect Financial System. Thiruvadanthai, S. (2018). Current Account Imbalances, Debt Buildup, and Instability.

7 The Foreign Capital Flow and Domestic Drivers of the US Financial Crisis and Its Spread Globally Jeffrey R. Shafer

Introduction The collapse of subprime mortgages that began in the United States in mid-2007 developed into the biggest financial crisis in more than 75 years and made 2009 the first year since World War II in which global economic activity declined. The subsequent recovery was weak in the United States, and Europe entered a prolonged period of crisis. This paper focuses on the development of the conditions in which the crisis was triggered. It draws on the recollections of the author, who led a team charged with assessing the economic and political forces shaping the global business environment from within a financial institution at the center of the crisis as it unfolded. The objective is to sort through the multiple forces and actors that enabled such unstable ­conditions to develop.

J. R. Shafer (*)  JRShafer Insight, New York, NY, USA © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


112     J. R. Shafer

In looking at what led up to the crisis, one must be careful not to fall into the post hoc ergo propter hoc (after this, therefore because of this) fallacy. Some sequences of events clearly reflect a causal relationship, but others do not. And causation must be looked at in two senses for an event like the crisis. There are factors that created a fragile environment that was vulnerable to collapse, and there was a trigger for the most acute phase of the crisis—the bankruptcy filing of Lehman Brothers— that brought about a collapse just as the removal of one more block from a Janga tower that had become increasingly unstable can send it toppling. But the last block is not important. It might have been the one before, and, in the absence of this one, it would have been the next block or the one after that brought down the tower. The increasingly unstable Janga structure created by weakening at many points is the important thing. This paper focuses on the buildup to the crisis in the United States and then looks at how the collapse there affected the rest of the world.

The Buildup Monetary Conditions Were Relatively Easy The conditions for the crisis built up as confidence grew over several decades that monetary policy had been mastered with respect to ensuring both stable low inflation and stable financial conditions. For 25 years following the painfully-won triumph over inflation by the Federal Reserve, led by Paul Volcker, in the early 1980s, the US economy had enjoyed an unprecedented period of stability. Ben Bernanke, Chairman of the Federal Reserve Board at the time of the crisis, called this period “the great moderation.”1 The rate of inflation measured by the annual rate of change of the core (excluding food and energy)



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personal consumption expenditure (PCE) deflator, favoured as an indicator of inflation by the Federal Reserve, fell from more than 9% in 1980 to less than 2½% in 1993 and remained between 1½ and 2½% thereafter. The “headline” (without exclusions) inflation rate was nearly as well behaved. The unemployment rate declined from more than 10% in 1982–1983 to less than 7% in 1993 and remained well below this level for 15 years until the crisis took it back to 10%. There had been financial disturbances, notably the black Monday stock market crash on October 19, 1987 and the collapse of the dot-com bubble beginning in March 2000. But economic and financial spillovers were contained in both cases. The Federal Reserve became more activist following the mild inflation and deflation of the dot-com equity bubble and the shock of September 11, 2001 as it sought to sustain the Great Moderation. It directed policy to provide greater assurance of sustained growth amid concern about the risk of deflation, which had become entrenched in Japan. This became a theme in the public statements of Federal Open Market Committee (FOMC) members.2 Policy from 2002 to 2006 lagged on the easy monetary policy side of the Taylor rule.3 This rule stipulates the Federal funds interest rate that the Fed should set at each point in time, considering GDP and inflation, to stay close to or return to an inflation target. Analysts widely use it as an indicator of the extent to which monetary policy is on the easy or tight side, but it does not account for factors that may justify a bias on one side or the other. The focus of policy was on sustaining growth. This became known in the markets as the “Greenspan put”—an implicit option contract with the market that removed the risk of a steep decline in the economy or the markets. The expansionary thrust of Fed policy was reinforced by large Federal budget deficits produced by tax cuts in 2001 and the cost of the second Gulf War from 2003 on.


example, Bernanke (2002). (2007).


114     J. R. Shafer Cyclically Adjusted Budget Balance Federal, State and Local Governments
















Source: OECD Economic Outlook. Volume 2012 Issues 2 No. 92. © OECD 2012

Global Imbalances Were Part of a Distorted Pattern of Economic Activity From the mid-1990s through 2006, the current account imbalance widened between the United States and the rest of the world, most significantly with China and oil-producing countries. The United States was buying a lot more than it was selling and was financing this by building up debt owed to foreigners. This led to calls for more rapid exchange rate adjustment by China and to Chinese criticism of US budget deficits and low saving. But with steady growth in both countries, neither felt any urgency to address the imbalances. Such concern as there was focused on the sustainability of international capital flows and the demand for Treasury securities. The external imbalances did not point economists toward what would become the unsustainable piece of the global pattern: the financing of housing in the United States. The connection was largely indirect. But foreign central banks directly supported the US mortgage market by buying obligations of government-sponsored enterprises (Fannie Mae and Freddie Mac) that

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were major buyers and guarantors of home mortgages. Further support came from the purchase of AAA rated tranches of mortgage securitizations by a wide range of foreign investors, notably European financial institutions.




ϰϬϬ ϭϵϵϳ


















The global imbalance was seen to reflect a “global saving glut,” another description that Bernanke provided (2005), as strong saving from China and other East Asian countries flowed into the United States. The inflows were invested overwhelmingly in US Treasury and other “safe” securities, creating a supply shortage of highly rated paper despite US budget deficits boosted by tax cuts and wars. Treasury securities held by the US public declined by 3/5 relative to debt assets held in the financial system and by ¾ relative to debt assets held by households and nonfinancial business between the spring of 1993 and the eve of the crisis. Clearly, there was demand for more safe assets than were available. Innovation in housing finance responded to this demand for safe assets. The rising imbalance between China and the United States also reflected a rising flow of low-priced imports to the United States, which held inflation down while limiting growth in tradable goods.

116     J. R. Shafer

Consequently, the expansionary thrust of policy fell on sectors that did not compete with imports. Housing construction was a leading beneficiary.












Contrary to some of what has been written, the appetite for risk in the market was not historically strong in the run-up to the crisis. Portfolios filled up with securitized mortgages thought to be safe. Interest rates on bonds with significant credit risk (rated “BBB”—at the low end of investment-grade ratings) did not drop below past levels relative to US Treasury bonds than had prevailed in reasonably good economic times. Spreads of risky bonds over Treasuries had narrowed substantially in the years immediately before the crisis, but this was a return to normal rather than an appetite for more risk than had been seen before. Spreads had been elevated earlier in the decade by high-profile bankruptcies such as Enron, WorldCom, 3Com, Global Crossing, and other telecom companies.

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Complacency Infected the Markets and the Regulators Although the price of risk was not abnormally low in 2006 and early 2007, complacency among financial market participants was high. The potential for large adverse events was neglected. Talk about the “Greenspan put” was one indicator. Another indicator was the very low incidence of Google searches for the term “tail risk,” a well-established concept in risk theory, in the years before the crisis. It was as though no one was thinking of it. Once the crisis began to unfold, “tail risk” became a term frequently used in Google searches. The normalized frequency of searches for “tail risk” jumped from near zero to 40% in the spring of 2008—well before the Lehman Bankruptcy—and rose further to 100% in 2012. The Great Moderation fed a growing confidence that markets could be counted on to efficiently and rationally respond to information and adjust to changing conditions relatively smoothly. Regulation focused on correcting recognized market failures and creating a level playing field by, for example, ensuring full disclosure by issuers of securities, eliminating conflicts of interest and prosecuting insider trading. But systemic stability was pretty much taken for granted, and the trend was to relax and rely more heavily on rating agencies’ and banks’ internal risk assessments in setting capital requirements as the international ­regulatory community moved from Basel I to Basel II.

A Housing Boom Ensued While no serious inflation threat emerged in response to the Fed’s easy monetary policy, housing prices took off. The 12-month increase in the S&P/Case-Shiller 20 City Home Price Index rose at an average rate of nearly 16% in 2004 and 2005. The boom took the median price of a house in America, as measured by the National Association of Realtors, from 2.8x median household income at the beginning of the decade to 3.9x in 2005—an increase of more than one-third. In the previous three decades, the ratio had never risen as high as 3x.

118     J. R. Shafer

One reason that stimulative monetary and fiscal policy conditions had a stronger impact on housing than on most other sectors is that intense competition from abroad curbed growth in America’s tradable goods and services sectors despite strong consumer demand. Resources flowed into activities that did not face competition from abroad (but workers in housing and other nontradable sectors did face ­competition from a record inflow of immigrants). Other forces also contributed to a housing boom: • Long-standing government policy support for housing and homeownership got new impetus from both the Clinton Administration and the Bush Administration that followed. This especially favoured expansion of homeownership to those who would not have qualified for mortgages under earlier credit standards. The private sector responded to the demands for greater homeownership by developing mortgage products for those who did not meet the credit criteria for conventional mortgages—subprime and alt-A mortgages. Subprime mortgages swelled from only 6% of mortgage originations at the start of the 2000s to 25% by 2006.4 • Looser credit standards extended to the mainstream mortgage markets as down payments fell, refinancing to withdraw equity became common, and many homeowners drew on home equity lines of credit. Despite the increasing use of homes as piggy banks, homeowners’ equity share in housing continued to increase as rising house prices outstripped rising mortgage debt.5 This led to complacency about household financial strength among economic analysts. • Exploitation of earlier innovations in the retail mortgage-backed securities (RMBS) market enabled mortgages to be packaged in ways that facilitated management of interest rate and repayment risk while providing the market with a spectrum of credit ratings. The development of the RMBS market had played a critical role in filling the housing finance hole that the collapse of the savings and loan 4Federal 5Federal

Reserve Bank of San Francisco (2007), p. 8. Reserve Board of Governors.

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industry left at the end of the 1980s, and these securities had come to play a central role in housing finance. The highest-rated tranches (French for slices) of these securities would typically only suffer losses after lower tranches had been wiped out. This credit structuring helped fill the demand for safe assets created by the shrinking supply of Treasury securities. RMBS issuance, which had totalled about $100 billion per year in the second half of the 1990s, surged to more than $700 billion in 2005 and was close to that level again in 2006.6 • The packaging and distribution of RMBS was often accompanied by ratings from the credit rating agencies, many of which, in retrospect, appear to have been based on assumptions that failed to capture what eventually happened. Those assumptions were little questioned at the time, and indeed many were shared by those in the market and in the regulatory agencies, given the widespread view that housing prices were unlikely to decline steeply nationally. In addition, buyers and the rating agencies saw the structure of the securities as providing ample protection for the highly rated tranches. Analysts in both the private and public sectors began paying increasing attention to the risk of a housing price decline as the peak was approached in 2006, but an analysis of the effects of relatively large housing price declines did not point to large defaults on highly rated tranches of RMBS. For example, Standard & Poor’s published in September 20057 an analysis of the effects of a 20% national housing price decline with a 30% decline on the East and West coasts. This found no significant probability of downgrade, let alone loss, in the highly rated tranches of even subprime RMBS. The losses were expected to be absorbed by the speculative-grade tranches. An update in May 2006,8 just at the top of the housing market, simulated the effect of the same housing price decline along with a recession and continued high-interest rates. The analysis came to essentially the same conclusion—that highly rated tranches would withstand such a shock. Looking back


(2013). & Poor’s (2005). 8Standard & Poor’s (2006). 7Standard

120     J. R. Shafer

at what happened, the risk models that rating agencies and others in the industry used for the complex structured products were deficient, but the extent of the misrepresentation of mortgages’ characteristics on the part of borrowers and originators stands out. The defaults through the fall of 2013 on the “AAA” rated tranches of securities clearly labelled as subprime have been 5.4% of those outstanding on January 1, 2007, while those categorized as having higher-quality mortgages suffered higher default rates since the senior tranches were given less protection. Their performance suggests that the mortgages in the securitizations were much lower quality than represented.9 • The attractiveness of the top-rated tranches of mortgage-backed securities as substitutes for Treasuries was enhanced by the use of credit ratings in setting capital requirements for banks. For example, the rules then in effect in the United States gave a 20% weight to mortgage-backed securities carrying a “AAA” or “AA” rating, a 50% risk weighting to those with a “A” rating, and a 100% weight to those with a “BB” rating. This meant that capital requirements rose in jumps as ratings fell. Rules in Europe and elsewhere were similar. • Fannie Mae and Freddie Mac, privately owned but government-sponsored enterprises (GSEs that the market treated as government guaranteed), responded aggressively to loss of market share to private mortgage securitizations and expanded into lower- quality alt-A and subprime mortgages by issuing securities perceived to be close substitutes for sought-after Treasuries. This was done both by issuing “AAA” rated liabilities and investing the proceeds in mortgages and by guaranteeing mortgages bundled into asset-backed securities assembled by others, thereby giving them the GSEs’ valued “AAA” rating. The GSEs also became active purchasers of private subprime RMBS. Issuance of GSE debt, already a major source of top-rated bonds, doubled from the beginning of the decade to the third quarter of 2008. The GSEs either held or guaranteed


of the Standard & Poor’s database performed for the author by erkan Erturk.

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$5.3 trillion in mortgages when these institutions became distressed and were put into conservatorship with government backing then.10 • As the housing boom gathered momentum and the demand for mortgages to put into securitized products swelled, underwriting standards deteriorated markedly. Mortgage originators—often newly hired and half-trained agents working in storefront offices and compensated on a commission basis—became casual about documentation, leading to “liar loans” and “NINJA” loans (no income, no job or assets). Questions about borrowers’ debt-servicing capacity were swept aside by complacency that the value of the collateral (a house) would only go up. Originators also became increasingly aggressive in marketing products that were often not well suited to the borrower. The Federal Reserve Board, which had responsibility for consumer borrower protection, remained passive in the face of reports of questionable practices. But not all borrowers were innocent victims; many took on debt to buy property that they intended to “flip” with the intention of walking away if markets turned down. The nonrecourse mortgage laws in many states, which allow a borrower to walk away from a mortgage by giving up the house and nothing else, encouraged this. Of the four states with the biggest housing booms and busts, two have nonrecourse laws (California and Arizona), and Florida has homestead exemptions from bankruptcy that limited the exposure of other assets in bankruptcy. Of the four, only in Nevada were the other assets of a defaulting borrower at significant risk.11 What happened in the housing boom followed the pattern of credit booms and busts of the past: the opportunity for providing financing through a new channel is recognized, growth breeds optimism and a buildup of capacity in which market knowledge becomes diluted, regulators lag behind, and the market becomes overextended.


(2011). and Kudlyak (2009).


122     J. R. Shafer

A Fragile Financial System Over the period of the Great Moderation, four trends in financial markets led to the creation of an extraordinarily fragile system: • Rising leverage, which left the system much more sensitive to changes in the value of outside assets, such as housing. • Increasing maturity transformation—the financing of long-term assets with short-term liabilities—in securities portfolios. • More opaque financial instruments and markets generated by financial innovation, which resulted in an increase in information asymmetries— one side of the market with knowledge that the other side lacks. • Increasing intensity of incentive-based compensation in financial institutions. The first meant that when credit risk on mortgages increased, depositors and other creditors of the financial institutions and funds that held mortgages or mortgage-backed securities, including other financial institutions, had less of an equity buffer to protect their positions. They looked more quickly for an exit. The second meant that the exit could quickly become blocked as assets became unsellable except at firesale prices, leading to the inability of institutions or funds to meet their obligations. The third allowed a buildup of risk that was not recognized and intensified the flight to quality once events increased the uncertainty about the value of many assets. The fourth contributed to neglect among traders in financial institutions of small probability risks of large losses. Risk management systems failed to control for this. Incomplete data and the use of off-balance-sheet transactions masked the full extent of the trends that created the fragility. Some saw pieces of the growing fragility, but few, if any, saw the extreme vulnerability that was building up and the intensity of the collapse that would follow when the system shattered. The result was a systemic liquidity crisis that the Federal Reserve System could not contain, even with the support from the $700 billion TARP administered by the Treasury (of which $426 billion was disbursed) despite a series of actions as lender of last resort, which were extraordinary in their scale and unprecedented in their design.

7  The Foreign Capital Flow and Domestic Drivers of the US …     123

The Buildup of Leverage in the Financial System The rise in leverage ratios within the financial system was not universal. Large US commercial banks, constrained by capital requirements internationally coordinated in the Basel Committee, actually reduced their leverage modestly in the 1990s and the first half of the 2000s. But broker-dealers (both the independent investment banks like Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs and the investment banking subsidiaries of bank holding companies like Citigroup) boosted their leverage from an average of less than $10 of assets per dollar of capital in the 1980s to a ratio of 40 on the eve of the crisis.12 The SEC, whose principal mandate was investor protection and not safety and soundness, gave much less emphasis to capital adequacy than the banking regulators. It has been criticized for having loosened its Uniform Net Capital Rule in 2004, but the increase in leverage, including all affiliates of the broker-dealer which were not covered by the rule, had been climbing for 15 years before this. ZĂƟŽ



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Reserve Board of Governors (2018).

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Leverage also increased in other ways that were hard to observe then and impossible to fully document now. One example that contributed to the distress that followed was the growth of off-balance-sheet structured investment vehicles (SIVs) and other conduits that banks were obliged to support when they lost funding. These were funds that had narrow equity cushions and were financed largely through issuance of short-term paper. Another leverage magnifier was the explosion of derivatives. These increased exposures to market fluctuations to an unmeasured, but clearly huge, extent since their valuation on balance sheets bore no relationship to the risk that they entailed. The global market value of over-the-counter derivatives (surveyed by the Bank for International Settlements) increased 5.6 times from the end of 1999 to the end of 2007. It then doubled to $15.8 trillion as the crisis unfolded and prices moved by huge amounts in unexpected ways. The associated gross credit exposure from these positions grew even more explosively, reaching $3.9 trillion by the end of 2007, and rose further as prices in distressed markets became more and more distorted. The increasing exposure on derivatives was driving collateral calls, forcing asset sales when there were few, if any, buyers and pushing many institutions to the brink of failure, some over the brink.


















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The leverage of hedge funds had declined following the Long-Term Capital Management collapse in 1998 as both the lesson that bank counterparties learned and the pressure from the Federal Reserve led to more conservative financing of hedge fund positions. As a result, hedge funds, for the most part, stayed on the margins of the storm. At the other extreme was the Financial Products subsidiary of AIG, a holding company otherwise concentrated in insurance. AIG Financial Products was able to take on massive derivatives positions without posting collateral on the strength of its parent’s “AAA” rating. Keeping this operation afloat once AIG lost its very high rating, counterparties demanded collateral, and its funding was lost took Federal Reserve and US government support that reached $182 billion.13

Increasing Maturity Transformation For more than 150 years, conventional wisdom in the financial markets has been that institutions with long-term assets funded with short-term liabilities are vulnerable to runs. This maturity transformation created the risk that an institution, most often a bank with short-term deposits and longer-term loans, would lose funding and be unable to meet its obligations. Hence, maturity transformation entailed systemic risk. Most often this risk took the form of a flight into foreign assets or gold because confidence in the capacity of the government to stand behind its financial institutions was in doubt. But at times, when unexpected credit losses were followed by increased uncertainty about where there might be more losses and who might be exposed to them, institutions that would be considered sound in normal times could be subject to a run. When this happened, the losses could be many times the size of the initial shock. The financial crisis of 2007–2009 had some elements of previous liquidity crises, but its unimagined intensity was the result of the role that securities played on both sides of balance sheets—long term on the 13FCIR

(2011), p. 350.

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asset side and short term on the liabilities side. This led to a systemic liquidity crisis in a country with a very strong sovereign financial position, as evidenced by the flows into, not out of, dollars as the crisis escalated. The dollar appreciated, and US Treasury bond yields fell. The financing of securities portfolios did not receive close attention in the years before the crisis. It was becoming increasingly short term. Two instruments that were widely used as short-term financing vehicles were commercial paper and repurchase agreements (repos—overnight or other very short-term borrowing backed by securities). Neither was new, but the extent of their use was. Commercial paper that financial institutions issued directly grew only modestly from early 2001 (when the Federal Reserve data begin) to mid-2007, but asset-backed commercial paper (ABCP) issued by SIVs and other conduits more than doubled. Repos and Federal funds (usually overnight loans of funds on deposit with a Federal Reserve Bank by one commercial bank to another) exploded, increasing by more than 10 times from 1980 to 2000 and rising another 140% from then to mid-2007. On the eve of the crisis, $4.3 trillion of these short-term instruments were funding the financial sector—much of this debt taken on by funds holding mortgage securitizations. Few observers saw this short-term funding as a problem since the issuers held marketable assets that they could sell in case of need, unlike traditional banks which held loans that would be difficult to unload. But two developments proved this assumption wrong. One was that, as uncertainty grew about underlying values, potential buyers asked for larger and larger discounts on the value of the securities. The second was that, as the short-term funding dried up, everyone using these markets faced the need to raise cash. The number of sellers increased, and buyers disappeared. Even securities of unquestioned quality, except for US Treasury obligations, could be sold only at a steep discount.

Increasing Opacity of Financial Instruments and Markets Rapid financial innovation, beginning roughly in the early 1980s, stemmed largely from the development of powerful new tools for financial analysis and the emergence of IT as a means of obtaining and processing information. It was facilitated by regulations that reflected

7  The Foreign Capital Flow and Domestic Drivers of the US …     127

a positive view of innovation among policymakers. Regulators avoided creating obstacles in the absence of clear policy concerns. (One area of concern that did receive close policy attention was the expanding capacity to launder money and move funds to support criminal and terrorist activities.) Much of this innovation had a cumulative effect of reducing the transparency of markets, though the extent of this did not receive close attention until the crisis. Several forces were at work. More complex instruments were developed that may not have been fully understood by many who dealt with them, including those who designed them. Examples include exotic mortgages, structured RMBS, collateralized debt obligations (CDOs), and many derivatives. Buyers often lacked an understanding of what they were buying, and risk managers were poorly equipped to oversee activities within financial institutions in these instruments. Chains between ultimate obligor and ultimate risk bearer grew longer, resulting in a loss of information. For example, a mortgage banker in a storefront office would originate a mortgage. This would be passed to the firm’s central office, where it would be sold to another institution. This institution would place the mortgage in a complex structured RMBS. This could then become a part of a CDO, which could then be sold to a SIV. The SIV could then issue ABCP, which a money market mutual fund would buy. The fund shares would be held by an individual more than half a dozen steps removed from the person with the mortgage. Market participants relied on statistical models to compensate for lack of information about the ultimate credits. But these proved to have been built on wrong assumptions (about how effectively risk was being diversified) and failed to take adequate account of how mortgage origination practice was changing (the increase in irregular practices such as “liar loans”). New instruments and analytical techniques ended up having unanticipated consequences. This is an inescapable cost of innovation that is minimized by alertness and generally far outweighed by the benefits that innovation brings. Most often, an innovation does not reach a level where unanticipated consequences can be systemic before it is thoroughly tested by use. But the Great Moderation sustained conditions in

128     J. R. Shafer

which innovations in mortgage origination and distribution, risk management, and financial institution funding grew to have systemic consequences before they were well tested. The increased opacity of financial instruments and markets had two adverse consequences. The first contributed to the inflation of the housing bubble, and the second helped multiply its collapse once the crisis began. The loss of information in markets created an environment in which investment decisions had a weaker fundamental basis. Not only were poor decisions made, but the tendency to follow the herd also increased. Bad investment decisions cumulated and became systemic. Once the correction process began, market participants lost confidence in what they thought they knew. They questioned fundamentally sound instruments as well as those that were troubled. This contagion reinforced the implosion of liquidity and resulted in loss of value far beyond the underling losses that were unavoidable with a repricing of housing and consequent mortgage losses.








7  The Foreign Capital Flow and Domestic Drivers of the US …     129

Increasing Intensity of Incentive-Based Compensation Incentive-based compensation is as old as business—piecework payment to craftsmen and commission compensation for sales forces are the norms for these jobs. Extensive economic research shows that well-designed incentive-based compensation enhances productivity and efficiency. In recent decades, the breadth and intensity of incentive-based compensation has grown across the economy. In 1990, the equity-based share of senior executive compensation in US corporations was 20%. By 2007, this form of incentive-based compensation had risen to 70%.14 And incentive-based compensation has moved into areas far from finance and culture—public school teachers, for example. The key to effective incentive-based compensation is that the incentives be tightly linked to the desired behaviour. Thus, when the objective is to sell as much of a product as possible, a commission provides an incentive that is aligned with the objective. But when the incentive is not closely aligned with the objective, behaviour will be different from what was sought. If the incentive is very intense, the result can be costly. For example, academic research shows that teachers have a greater tendency to organize cheating on standardized tests when their positions or compensation are at stake.15 The shift toward incentive-based compensation was especially strong in finance where it had always played an important role. This was facilitated because the output of many finance professionals—sales people, traders, portfolio managers, loan officers, and investment bankers—can be measured in dollars. And rising competition for staff from alternative investment firms (private equity and hedge funds), which use very intense incentive compensation systems, pushed mainstream commercial and investment banks further in this direction. Concern about distorted incentives created by compensation systems in finance had been recognized: “The problem at Salomon Brothers has been a compensation plan that was irrational in certain crucial respects,” said Warren Buffett in 1991 about

14Desai 15Jacob

(2012). (2002).

130     J. R. Shafer

the investment bank in which he then owned a large stake.16 In the wake of the crisis, several incentive compensation issues have come to the fore. One seems overdone: that CEOs were given incentives to take on too much risk. Academic research suggests that CEOs’ risktaking behaviour was, if anything, restrained relative to the wishes of shareholders, although they may have underweighted the interests of debtholders and of the government as a backstop.17 Moreover, it is difficult to believe that the CEOs of Bear Stearns, Lehman Brothers, Citigroup, and other damaged firms would not have followed very different strategies if they had any inkling in time to get off the track of the freight train that was headed straight at them. Their losses of jobs, prestige, and money were immense. A systemic incentive distortion that may well have played more of a role in the crisis was the asymmetry of compensation structures within financial firms. Positive outcomes were rewarded in finance, and large positive outcomes were often rewarded very highly. But in the event of a loss, the worst one could experience is loss of a job and no compensation. The employee had a put option with the firm—the employee shared the gain and could put losses back to the firm. It could be no other way if rewards were going to be large. Few, if any, would have the financial capacity to sign up for a symmetrical compensation system that assessed employees for large losses as it gave high rewards. As a result, there was an incentive to take risk built into the compensation systems of financial institutions. Good luck as well as sound decision-making was rewarded. Bad luck carried a much smaller loss. Risk management functions in financial services firms were intended to play a compensating role, but they proved to be weak. The result was a buildup of risks, especially of tail risks of large losses that were expected to occur with small probability if they were recognized at all. Compensation structures have changed, but only on the margin, since the crisis. Acharya, Cooley et al., in a thoughtful early post mortem on the financial crisis, place the manufacture of tail risk at the center of the

16Eichenwald 17See,

(1991). for example, Fahlenbrach & Stulz (2009) and Cheng et al. (2010).

7  The Foreign Capital Flow and Domestic Drivers of the US …     131

crisis and attribute this to an important extent to incentive distortions faced by those within the business. But they give more weight than I would to institutional incentives created by the regulatory environment adding to the buildup of tail risk. I am inclined to give this less importance than the opacity of the structure that had developed, which left both senior managements and equity holders oblivious to risks that were being created under their noses. There may be more to be faulted in the knowledge and skills of CEOs and investors, which are very heavily weighted toward institutions with professional portfolio management, than in their intentions.

The US Toll The Housing Boom Was Followed by a Bust Booms have limits, and housing was no exception. Housing prices peaked in the summer of 2006. By the spring of 2007, one could reasonably expect, and many did, that a painful repricing of housing and housing debt lay ahead, and perhaps a recession, as home construction declined, and households adjusted their spending to declining home values. But looking at housing alone would not have led one to see the force of what would come.

The Financial and Fallout from the End of the Housing Boom Was Amplified by the Fragility of  the Financial System Whatever the causes of the housing boom and its deflation, and however badly forecasters missed the housing price decline that was to come, the tremendous impact on the financial system and the United States and global economies cannot be ascribed to the scale of the loss of value in residential real estate and debt secured by it. The loss of value in American homes of $5.8 trillion was large. But it was only two-thirds

132     J. R. Shafer

the size of the stock market decline in the early part of the decade when the IT bubble burst, and this was followed by 9/11. That led to a mild and brief recession, but no systemic financial distress. By contrast, the housing price adjustment triggered financial distress that spread across markets. Indeed, the eventual size of the US stock market decline during the 2007–2009 crisis, at $12.9 trillion, was more than twice as large as the home value decline.18 And a deep recession further magnified this decline. The result was the first global economic decline since World War II. The relatively easy monetary conditions and complacency engendered by the Great Moderation had some impact on the nonfinancial corporate sector, which increased its leverage during the years leading up to the crisis. But except for leveraged loans to finance buyouts by private equity firms, the financial strength of corporate America continued to be viewed as strong, as the resiliency of corporate credit through the deep recession that followed the crisis confirmed. By contrast, the financial system was becoming more fragile, and this amplified the housing downturn into a financial and economic calamity.

The Scale of Financial Distress in the United States Two measures highlight the impact of the crisis which reached its critical phase following the bankruptcy of Lehman Brothers on September 15, 2008. First is the scale of liquidity distress as measured by the TED spread (differential between three-month LIBOR and US Treasury yields).19


Reserve Board of Governors. revelations have called into question the setting of LIBOR, but the distortions that may have been introduce would not have been large enough to greatly distort the picture that it provides of a global banking system in deep distress. If anything, the extremes of the spread may have been even larger than shown. Indeed, at the time, one heard that very few, if any, transactions were occurring at the high reported spreads. 19Recent

7  The Foreign Capital Flow and Domestic Drivers of the US …     133

In normal times the TED spread had run well less than 50 basis points. It jumped to about 250 basis points at the first signs of systemic distress in August 2007, remained high and volatile for the ensuing year and then spiked to nearly 500 basis points after the Lehman bankruptcy. This was an indicator of the unavailability of funds in the interbank market and the need for them by banks and other financial institutions. This translated into a contraction of lending in the economy, but it was not huge—only a 6% decline in household and business debt over the following 3 years. But the liquidity distress led to fire sales that extended from debt markets to equity markets. The impact on economic wealth of the United States was immense— dropping by one-quarter. The impact on GDP was surprisingly moderate given this—a decline of 3.3% from peak to trough. Of course, automatic stabilizers and roughly $ 1 trillion in fiscal stimulus over 2008 and 2009 mitigated the GDP impact. Trade contracted much more sharply than

134     J. R. Shafer

GDP—US goods imports fell by 22% in volume over two quarters. The value drop was 29% as commodity prices plummeted. ĐŽŶŽŵŝĐĞĐůŝŶĞ ƚƌŝůůŝŽŶΨ

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The Global Spread The US mortgage crisis spread rapidly abroad once liquidity dried up globally, as well as in the US and the US went into recession. The spread of financial and economic distress was quick and powerful for several reasons. First, when dollar liquidity dried up it affected the world since the dollar was the key international currency. The TED spread is indicative of what banks with a dollar book faced globally if they had a dollar book, which any bank with international activities would have. Foreign banks did not have the large stable dollar deposit bases of US banks, and faced even more acute liquidity pressures. And their central banks did not have unlimited dollars to advance as a lender of last resort although some had substantial dollar reserves. The Federal Reserve moved to extend swap facilities to a widening circle of foreign central banks as the liquidity situation deteriorated. The first new swaps were

7  The Foreign Capital Flow and Domestic Drivers of the US …     135

arranged in December 2007 and were greatly expanded in September 2008. Second, for many European banks, the problem was more than a drying up of global liquidity. Losses on mortgage-backed securities, which had been loaded onto balance sheets of banks with lean capital brought down some banks and threatened many others. As the economic decline spread to Europe, reinforce by sovereign debt problems, bad loans built up and further strained undercapitalized banks. Europeans took a significant hit from the collapse of the US mortgage-backed securities market. They had been significant investors. Other sources of US capital inflows, which enabled the US housing boom, pretty much escaped. The Chinese, Japanese and other Asian reserve managers had extended beyond Treasuries for their US dollar investments, but they did not go far beyond agency securities. Neither had middle Eastern sovereign wealth funds although they did take fliers in some US banks that did not turn out well. Foreign official investors were fortunate that the US government bailed out FNMA and FHLMC (Fannie and Freddie). European banks had substantial AAA mortgage-backed security investments that were not bailed out. Third, the US as the world’s largest importer, had a significant direct effect on aggregate demand globally. The peak-to-trough decline in US imports amounted to more than 5% of GDP for the rest of the world. That is a big aggregate demand shock. Fourth, a commodities boom coincided with the housing boom. Commodity prices quadrupled from 2002 to the summer of 2008. Energy experienced the strongest bull market, but there were strong booms in everything but agricultural raw materials. Even these prices doubled in a period of low inflation. As with US housing, a commodity bust followed the boom as easy monetary conditions were replaced by crisis-induced tight financial conditions. Commodities markets are, of course global, and the demand strength followed by collapse was a global phenomenon. The all-commodities index dropped by 55% in 5 months. Energy prices fell most deeply—by 63%, but metals prices dropped nearly half. Finally, an unprecedented development stopped trade and constrained economic activity everywhere, but most strongly in emerging

136     J. R. Shafer

markets—trade finance dried up. I was told at the time by colleagues in the trade finance business that banks would not extend even trade collateralized credit because they would not accept the names of other banks as guarantors. This had not happened through waves of sovereign debt crises, but it happened in 2009. I have been unable to find data for this specific credit item, but an indication that this was occurring on a large scale can be gleaned from BIS data. They show that cross border bank credit to all sectors shrunk by 22% in the winter of 2008–2009 and that extended to other banks fell by 31%. World trade volume shrunk by 17% in two quarters under the force of the drying up of trade credit on top of the drop in US import demand. And for many countries the collapse of commodity prices added to the distress. Economic growth was affected everywhere. The Biggest hit was in The CIS where oil price declines hit Russia and others with limited shock-absorbing foreign assets. The EU with its banks at the center of the capital impairment process was almost as badly it. Emerging Europe was a bit less affected, as was Latin America. The middle East and North Africa did not experience a decline in GDP as their global wealth allowed countries to smooth the impact of lower oil and gas prices. The relative strength of Asia reflects the successful effort of China to stimulate domestic demand when exports markets shrank. The strength of Sub Saharan Africa is surprising given the importance of commodity exports for the region. It must reflect positive domestic developments and relative financial insulation. 'W'ZKtd, ϭϰ ϭϮ ϭϬ ϴ ϲ ϰ Ϯ Ϭ ͲϮ Ͳϰ











7  The Foreign Capital Flow and Domestic Drivers of the US …     137

References Acharya, V., Cooley, T., et al. (2009). Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009. Foundations and Trends in Finance, 4(4), 247–325. Bernanke, B. (2002, November 21). Deflation: Making Sure ‘It’ Doesn’t Happen Here. Remarks Before the National Economists Club, Washington, DC. Bernanke, B. (2004, February 20). The Great Moderation. Remarks at the meetings of the Eastern Economic Association, Washington, DC. http:// default.htm. Bernanke, B. (2005, March 10). The Global Saving Glut and the U.S. Current Account Deficit. The Sandridge Lecture, Virginia Association of Economists. default.htm. Cheng, I.-H., Hong, H., & Scheinkman, J. A. (2010, July). Yesterday’s Heroes: Compensation and Creative Risk-Taking (NBER Working Paper 16176). Desai, M. (2012, March). The Incentive Bubble. Harvard Business Review, 90(3). Eichenwald, K. (1991, October 30). Salomon Reduces Bonuses by $100 million. The New York Times. salomon-reduces-bonuses-by-110-million.html. Fahlenbrach, R., & Stulz, R. M. (2009, August). Bank CEO Incentives and the Credit Crisis (NBER Working Paper 15212). Fannie Mae. (2008, August 8). News Release: Fannie Mae Reports Second Quarter 2008 Results. Federal Reserve Bank of San Francisco. (2007). Annual Report. Federal Reserve Board of Governors. (2018). Financial Accounts of the United States. Accessed July 2018. The Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (FCIR). (2011). U.S. Government Printing Office, Washington DC, January 2011. Ghent, A. C., & Kudlyak, M. (2009, July 7). Recourse and Residential Mortgage Default: Theory and Evidence from U.S. States (Federal Reserve Bank of Richmond Working Paper No. 09–10).

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Jacob, B. A. (2002). Accountability, Incentives and Behavior: The Impact of High-Stakes Testing in the Chicago Public Schools (NBER Working Paper 8968). Mehra, Y. P., & Sawney, B. (2010). Inflation Measure, Taylor Rules and the Greenspan Bernanke Years. Federal Reserve Bank of Richmond Economic Quarterly, 96(2), 123–151. Nakamoto, M., & Wighton, D. (2007, July 9). Citigroup Chief Stays Bullish on Buy-outs. Financial Times. Poole, W. (2009, July 28). The Bernanke Question. Cato Institute Commentary. Securities Industry and Financial Markets Association (SIFMA). (2013). Database. Standard & Poor’s. (2005, September 13). Simulated Housing Market Decline Reveals Defaults Only In Lowest- Rated U.S. RMBS. Standard & Poor’s. (2006, May 15). A More Stressful Test of a Housing Market Decline On U.S. RMBS. Taylor, J. (2007). Housing and Monetary Policy. Paper Presented at the Federal Reserve Bank of Kansas City Jackson Hole Conference.

8 Financial Crises and Bank Capital Robert Z. Aliber

Introduction The US government’s decision to allow Lehman Brothers to close on September 15, 2008 was the costlier mistake in American financial history, measured both by the sharp decline in US GDP relative to the projected decline in August 2008, and by the surge in the indebtedness of the US Treasury. The US government sought a buyer for Lehman, but it was unwilling to commit taxpayer funds to facilitate the purchase by Barclays or by a consortium of US banks, even though the Fed had made a massive commitment to induce JP Morgan Chase to buy Bear Stearns. The Paulson-Bernanke claim that the US government did not have the authority to provide “taxpayer funds” so that Lehman could remain open was smoke; the Bush Administration had made a political decision that taxpayer money should not be used to enable Lehman to remain open. Richard Fuld the head of Lehman may have been the least popular banker on Wall Street and was not Paulson’s best friend. R. Z. Aliber (*)  Booth School of Business, University of Chicago, Chicago, IL, USA © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


140     R. Z. Aliber

The Bush Administration may have concluded that saving Lehman would lead to charges of nepotism. George Walker, President Bush’s first cousin, ran Lehman’s asset management decision. Richard Paulson the brother of the US Secretary of the Treasury, sold mortgage-backed securities for Lehman in Chicago. One analyst concluded that Lehman was solvent, and could have remained open without any permanent cost to the taxpayers. Lehman’s closing led to a freeze in the international credit market and to a surge in the demand for money; spending declined sharply. Paulson-Bernanke had greatly underestimated the costs of Lehman’s bankruptcy, which suggests that they did not understand the cause of the surge in property prices that had begun in 2003. The credit crunch revealed that the Fed and the Treasury had done little contingency planning to cope with the financial distress that would follow from the decline in property prices. The 2008 US financial meltdown was a systemic crisis. Between 2003 and 2006 the market value of US residential real estate increased from $12,000 billion to $23,000 billion. Much of the increase was in sixteen states that accounted for fifty percent of US GDP, so the percentage increase in prices in many local markets was much greater than one hundred percent. The first section of this essay reviews the taxonomy of bank failure; a few small banks fail because of idiosyncratic firm-specific factors. In contrast, when a large number of banks fail at the same time including some large ones that previously had been considered well-managed, the cause is a systemic shock that led to a large change in the relationship between the prices of two large asset classes. The second section provides an explanation of the surge in US real estate prices and those in many other industrial countries between 2003 and 2006; six of these countries including Britain, Ireland and Iceland also had banking crises. The third section asserts that the regulatory initiatives that have been adopted to forestall a repetition of the 2008 crisis ignore the significance of the variability of cross border investment on the prices of different asset classes and hence are likely to be irrelevant in forestalling a crisis. The fourth section proposes that a new government agency modeled on the Reconstruction Finance Corporation be established de-politicize

8  Financial Crises and Bank Capital     141

the re-capitalization of failing banks and to minimize the tendency toward the consolidation of banks when one fails. The new government agency—RFC II—would receive common stock, and preferred stock that would be convertible into common stock in exchange for its capital infusion. Hence the ownership interests of existing shareholders would be diluted as and the top managers would be scalped. Once the economic environment had been stabilized, the RFC II would sell its shares.

Why Banks Fail One reason banks fail is idiosyncratic or firm-specific and may reflect self-dealing by the top managers or the deterioration of the local neighborhood; the monetary system is stable. The major reason that a large number of banks fail at the same time is a systemic shock that leads to a sharp change in the price relationship between two assets classes— stocks and bonds, bonds and real estate, domestic securities and foreign securities, and short term securities and long term securities. A systemic shock often occurs after an extended episode when many investors had relied on money from new loans for interest payments on their outstanding indebtedness. Walter Bagehot, in his classic Lombard Street, advised that a central bank should provide unlimited credit to an illiquid but solvent bank; otherwise the bank would sell assets to enhance its liquidity, and the induced decline in asset prices might cause some otherwise solvent banks to become insolvent. Bagehot also wrote that a central bank should not assist an insolvent bank. This distinction is logically fallacious because the boundary between solvency and insolvency changes as asset prices fall. A bank often becomes illiquid because its peers are not one hundred percent confident that it is solvent—and will be solvent one month and three months from now. If a bank is not solvent, then the courts will require that its assets be sold to satisfy its creditors; the prices of these assets will decline, and the solvency of other institutions will be impaired.

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Central banks were established to provide “unlimited” liquidity; Bagehot advised that the loans from the central bank be at a penalty rate. Deposit insurance was adopted first at the state level and then at the national level to reduce the likelihood that depositors would “run for their money.” The United States has experienced four systemic shocks since the Federal Reserve was established in 1914. Each of these shocks was associated with a sharp change in the price relationship between two classes of assets. The first episode was during 1920 when agricultural prices declined sharply; farm land values had increased dramatically in the previous several years as food prices soared. The second was the Great Depression of the early 1930s, which followed both the sequential devaluation of many currencies that began in the late 1920s as countries stopped pegging their currencies to gold; the decline in the export earnings in these countries because of the Smoot Hawley tariff of 1930 led countries to reduce the prices of their currencies that contributed to downward pressure on the prices of agricultural goods. These declines in the prices of currencies led some investors to buy gold, which caused the banks to become more cautious lenders. The systemic crisis in the early 1980s was triggered in response to the move to an extraordinarily contractive monetary policy at the end of 1979 that led to a sharp increase in interest rates on short term securities relative to those on long term securities. The failure of more 500 banks in 2008 and 2009 and the decimation of the US investment banking industry followed from the sharp decline in real estate prices after four years when these prices had increased sharply. The US government took a benign neglect approach to the 1920 crisis; the Fed remained on the sidelines. The United States still was largely an agricultural country. Commodity prices declined by forty percent after rapid increases in the previous three years. Many hundred banks of closed; there was a brief sharp recession. The Reconstruction Finance Corporation was established in 1932 to provide capital to banks that had experienced large loan losses. 1300 banks had failed in the previous two years as a result of the decline in the price level and the increase in real interest rates. The US banks were squeezed between the decline in US prices of traded goods in response

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to the falls in the prices of foreign currencies and the increase in investor demand for gold. As US banks failed, home owners with mortgage indebtedness found that they could not re-finance maturing loans— then primarily five-year terms—and they became distress sellers of real estate. President Roosevelt nationalized American holdings of gold soon after he took office, which reduced the banks’ concerns about liquidity. The systemic shock in the early 1980s followed the adoption of a sharply contractive monetary policy in late October 1979, the Fed’s policy had been feckless in the previous several years and slighted investor concerns that the US inflation rate would accelerate. US short term interest rates surged relative to long term rates, and the interest rate yield curve became negative, with the result that the interest payments on the short term liabilities of thrift institutions climbed above the interest income on their long term mortgages. The capital of these firms was being depleted; the concern was whether the short term interest rates would decline significantly to reduce the bleeding before the firms failed. The US Government eased some regulations in the effort that the firms might be able to earn their ways out of their holes, which led to financial shenanigans as investors gamed the deposit insurance arrangement. The failure of more than 500 banks since 2007 reflects the sharp decline in home prices that began at the end of 2006, which lead to more than ten million foreclosures—nearly ten percent of the housing stock. The Greenspan Fed had adopted an expansive monetary policy in 2002, which contributed to the increase in real estate prices and the consumption spending boom financed with mortgage equity withdrawals. Prices peak toward the end of 2006. Various policies were adopted to dampen the impact of declining property prices, including the establishment of Maiden Lane One to facilitate JPMorgan Chase’s purchase of Bear Stearns and the establishment of Maiden Lane Two to enable AIG to remain in business. Then in October the US Congress approved the request for $700 billion—the Troubled Assets Relief Program or TARP—to enhance the capital of banks. Once property prices start to decline, the banks become more cautions lenders. Some borrowers will not be able to refinance maturing debt and they will become distress sellers of real estate, which could

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cause the price decline to accelerate. Without government intervention, the prices might decline below long run equilibrium values. Home prices in Florida declined below reproduction costs, which suggests— incorrectly—that the land had negative value. The imbalances that preceded the systemic crises of the early 1980s resulted from the feckless monetary policy of the late 1970s. The imbalances that preceded the 2008 crisis followed the sharp increase in investor demand for US dollar securities and the expansive monetary policy that the Greenspan Fed adopted in 2002 to stimulate the economy after stock prices had started to decline sharply.

The Early 2000s Global Surge in Real Estate Prices The US banking crisis of 2008 was a country-specific manifestation of a global event; four other countries—Great Britain, Iceland, Ireland, and Spain had crises at the same time. Greece and Portugal had sovereign debt crises about fifteen months later. Iceland’s banking crisis was triggered by its currency crisis when its banks defaulted on their foreign loans; for the previous five years the banks had relied on money from new loans for the interest payments on their outstanding indebtedness denominated in foreign currencies. The crises in these countries followed booms that were associated with increases in their external indebtedness; nearly twenty countries experienced real estate booms. The features of these 2008 crises were similar to the currency and banking crises in Thailand and Indonesia and other countries in Asia in 1997 and to the Mexican crisis during its presidential transition at the end of 1994. The likelihood that the 2008–2010 crises in seven countries were independent national events is trivially small. Moreover, the preludes to the sovereign debt crises in Greece and in Portugal were similar to those in the counties that had banking crises, the major difference was the identity of the borrowers. Every country that has had a banking crisis since 1980 previously had a boom; not every boom has been followed by a crisis but every crisis was preceded by a boom, which was induced in response to the

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increase in its capital account surplus; the boom in Japan was associated with a decline in its capital account deficit. (The first difference of the change in the Japanese capital account deficit was the same as the first differences in the changes in the capital account surpluses of the United States, Great Britain, and these other countries). The capital account surplus in each of these countries could not increase unless there was a contemporary increase in its current account deficit. The increase in their capital account surpluses led to consumption booms as prices of securities and real estate and hence of household wealth moved up. The external shock that led to the booms that preceded the 2008 global crisis was a sharp increase in the demand for international reserve assets, partly from the oil-exporting countries including Norway and Saudi Arabia and the United Arab Emirates, and partly from China. Soon after 2002, these countries experienced increases in their export earnings, about the time that China became a member of the WTO. They used part of the increase in their export earnings to buy off-theshelf securities available in the United States and Great Britain and other industrial countries, which meant that the capital account surpluses of the United States and these other countries increased. China and the oil exporting countries, and the United States and the other industrial countries were involved in a complex tango; the countries in the former group could achieve increases in their current account surpluses only if there were adjustments in the major industrial countries that would lead to counterpart increases in their current account deficits. The invisible hands were at work to motivate the increases in spending in the industrial countries; the principal factor was the surge in prices of real estate and of stocks that led to greater consumption spending. The increases in the prices of the currencies of these countries were associated with increases in their capital account surpluses. During the expansive phase, some borrowers relied on money from new loans to pay all of the interest on their outstanding loans. The Government of Greece relied on money from new loans for the interest payments on its outstanding loans. Once the foreign banks slowed their purchases of the IOUs of the Greek Government, it lacked the money for the interest payments.

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Iceland’s capital account surplus increased from one percent of its GDP in 2003 to a peak of eighteen percent in 2008. Iceland had a massive boom, stock prices increased nearly tenfold and real estate prices doubled. The increase in asset prices was a response to the surge in the supply of credit from two sources—one was the sharp increase in cross border investment inflows and the other was the dramatic increase in the domestic loans of the three Icelandic banks. (An increase in the growth of domestic credit by itself would have led to the increase in asset prices and in total spending, and the price of the Icelandic krona would have declined because of the increase in spending on foreign goods). The autonomous increase in the investor demand for Icelandic securities led to higher prices for Icelandic stocks that enabled the Icelandic banks to rapidly increase their domestic loans. The capital of the three Icelandic banks increased by sixty to seventy percent a year. Some of the borrowers from the banks used the money to buy goods, some used the money to buy real estate and stocks. The Icelandic banks took the initiative to sell more of the IOUs in foreign centers soon after they were privatized; they brought some of the foreign funds to Iceland which they converted to krona so they could increase their krona loans. They also lent some of the foreign funds to Icelandic households and business firms, who brought some of these funds to Iceland and also converted them to krona. Iceland could experience an autonomous increase in its capital account surplus only if there was a counterpart induced increase in its current account deficit. The principal factor contributed to this surge in consumption spending was the dramatic increase in household wealth, the secondary factor was the increase in the price of the Icelandic krona. The capital of the Icelandic banks increased as stock prices increased, which enabled them to buy more domestic loans; their assets and liabilities also increased by a factor of nine. (Note there is no special stash of securities called bank capital). The necessary condition for the banking crisis in Iceland was that the external liabilities of the Icelandic banks had increased by more than twenty percent a year for six years, which was much more rapid than the increase in its GDP; it was inevitable that at some stage, the lenders would become more cautious about buying Icelandic IOUs, and the

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price of the Icelandic krona would then decline. The sufficient condition was that the ratio of Iceland’s gross external liabilities to its GDP was in the range of ninety to one hundred twenty percent. (The increase in the ratio of the Iceland’s gross external liabilities to its GDP was substantially larger than the increase in its net international indebtedness; the difference was the increase in the net foreign assets of Icelandic firms and investors). When the foreign demand for Icelandic IOUs slowed, the price of the Icelandic krona would decline by at least thirty to forty percent, since Iceland would no longer be able to finance a trade deficit. The krona equivalent of the indebtedness denominated in a foreign currency of Icelandic households and business firms would increase. Some of the Icelandic borrowers with indebtedness denominated in a foreign currency then would sell domestic stocks and real estate to obtain the funds for their debt service payments and the prices of these assets would decline; other borrowers would default on their indebtedness. As the price of Icelandic stocks fell, the capital of the Icelandic banks would decline, and they would shrink their assets; they would sell stocks and they would not renew some maturing loans. The Icelandic banks then would reduce their loans to Icelandic borrowers, some of these borrowers would become distress sellers of assets and others would default. The US capital account surplus surged in the early years of each of the last four decades—the 1980s, the 1990s, the 2000s, and the 2010s; this surplus declined in the last several years of the first three decades. The increase in the US capital account surplus generally was associated with an increase in the price of the US dollar, except during the 2000s decade. The ratio of the US capital account surplus to US GDP increased by three percentage points from 2002 to 2006 as sovereign wealth funds and foreign central banks bought US securities. The massive increase in US real estate prices was induced by the increase in the US capital account surplus to ensure that there was an induced increase in the US current account deficit that more or less continually corresponded with the autonomous increase in the US capital account surplus. Japan experienced the “mother of all asset bubbles” in the second half of the 1980s, property prices and real estate prices increased by a factor

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of three. The background for the Japanese experience differed from those of most other countries, since Japan had a large but declining capital account deficit in the second half of the 1980s; during the first half of the decade, there was a surge in Japanese purchases of US dollar securities. By 1985, the US dollar had become overvalued; the incentives for Japanese investors to buy US dollar securities had greatly diminished. Instead Americans began to buy Japanese securities, motivated in part by the increase in the price of the Japanese yen and in part by the increase in the price of Japanese stocks. Japan then had to adjust to a decline in its capital account deficit, which could have occurred only if there was a counterpart decline in its current account surplus. The principal factor that contributed to the reduction in the Japan’s current account surplus was the sharp increase in the prices of real estate and stocks which led to a surge in consumption spending. The transfer problem process was at work in Iceland, the United States, and Japan, and in each of the other countries that experienced an autonomous increase in its capital account surplus. When a country’s currency is not anchored to a parity, the country cannot experience an increase in its capital account surplus unless there is a comparable increase in its current account deficit. Every country that has had a banking crisis previously had an asset price boom, and every one of these countries except Japan experienced an increase in its capital account surplus—which could have occurred only if there was a counterpart increase in its current account deficit. The intermediate argument was that asset prices increased by the amount necessary to ensure that consumption spending increased and the demand for imports increased to ensure that the increase in the country’s payments increased to match the increase in its receipts.

The Irrelevance of Dodd Frank Yogi Berra might have said, “If you don’t know where you started, you can’t get there from here.” One of the fascinating questions is that despite the one hundred fifty years since the publication of Lombard Street, the financial regulators in many countries do not understand the

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fallacy of composition. Home mortgage loans are collateralized by the real property in the United States, Japan and numerous other countries. If real estate prices increase, the banks can increase the amounts they can lend against the higher market value. Bank profits will increase as a result of the increase in the volume of transactions. (This cycle of higher real estate prices and larger bank profits is the mirror of Irving Fisher’s debt deflation cycle.) The regulators have not asked whether the market value of the real property was consistent with long term equilibrium based on household incomes and the rental rate of return. Maureen Dowd in the New York Times wrote, “We (Americans) let the corrupt bankers who ravaged our economy roam free with bigger bonuses, more lavish Hamptons houses and fresh risky schemes.” Some bankers profited greatly from the monetary ease of the 2002–2005 period, in part from the fees associated with the production and trading of asset-backed securities and mortgage-backed securities. The volume of these securities surged because of the massive increase in the supply of credit, partly from investment inflows and partly from domestic credit creation. The dominant view is that the 2008 crisis resulted from the shortcomings of regulation. The perimeter of regulation often is said to be too limited, with the implication is that too many lenders are not regulated; the term “shadow banking system” is invoked. Banks had specialized investment vehicles that could undertake transactions that the banks themselves could not undertake. Another criticism was that the scope of regulation was too limited; “derivatives” were not regulated. A third criticism is that the regulators were “asleep at the switch,” career regulators want a quiet life, like firemen in the desert. A competing view implicit in the previous section is that regulation is irrelevant when there is a surge in the credit supply. The United States had to adjust to an increase in investor demand for US securities; the US capital account surplus could have increased only if there were a comparable increase in the current account deficits. The primary factor that led to the increases in their current account deficits was the increase in prices of securities and in household wealth; the US consumption boom reflected that the inflow of foreign saving displaced domestic saving.

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The Wall Street Reform and Consumer Protection Act of 2010, more popularly Dodd-Frank (hereafter DF), is the most comprehensive attempt at financial regulation to avoid a crisis like the one in 2008. The theory of the cause of the crisis can be inferred from the set of measures adopted to reduce the likelihood of another meltdown like the one in 2008. The inference from increase in capital requirements and from limitations is that each bank failed because of idiosyncratic factors. Thus the implicit view is that the cause of the 2008 crisis was some sort for financial flu that hit more than 500 banks with the same symptoms at about the same time. DF ignores that bank failures are interdependent rather than independent events. DF provides that banks should be subject to stress tests; the practice is that Bank of America, Citibank, and Wells Fargo are subject to the stress test on successive days of the week Monday, Tuesday, and Wednesday. The regulators appear not to have asked whether Bank of America, Citibank, and Wells Fargo can pass the stress test on the same day. The United States has no established procedures to deal with a systemic shock that leads to a large decline in capital for all banks as a group or even for a large bank like Continental Illinois Bank. When this bank was failing in 1984, the Federal Reserve ensured that the bank would continue to function. No effort was made to re-capitalize the bank in a formal way, but the support of the Fed was an implicit capital injection for a brief period. DF does nothing to insulate the US economy from an increase in investor demand for US dollar securities and the temporary increase in US asset prices that occur as an integral part of the adjustment program. Moreover DF does not recognize the costs of financial regulation. Regulations incur costs, someone pays. An increase in the bank capital requirement increases the costs of financial intermediation and leads to the expansion of non-regulated financial firms. DF does not recognize that the US banking crisis of 2008 resulted from the variability of the US capital account surplus. The autonomous increase in this surplus induced a massive increase in the price of US real estate as an integral part of the adjustment process to ensure that the US current account deficit increased as the US capital account surplus increased. If his legislation been adopted in 2000 and the flow of investor funds to the United States is taken as a given, the US banks would

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have supplied less credit and some non-bank lenders would have supplied more credit. When the investor demand for US dollar securities slackened, US real estate prices would have declined. DF deals with a level problem, and the basic problem is that crisis in real estate resulted from the increase and the subsequent decrease in real estate values.

The Reconstruction of Finance Corporation The US Government regulation developed to prevent the failure of individual banks has been more extensive than the combination of regulations applied to firms in all other industries as a group. One motive is consumer protection; another is economic stability since failure of a bank can be devastating for a small community. A second motive is that the failure of a number of banks in a systemic crisis disrupts the national economy and leads to a much larger decline in GDP than in a traditional recession. Each of the four waves of banking crises since the early 1920s has been a response to a systemic shock. Hundreds of US banks failed in the early 1930s because of downward pressure on the US prices of tradeable goods that followed from the declines in the prices of foreign currencies and the rush for gold by American households. More than a thousand banks and thrift institutions failed in the early 1980s in response to the surge in interest rates that resulted from the sharply contractive monetary policy that the Federal Reserve adopted in October 1979 to crush anticipations of accelerating inflation. More than five hundred US banks failed after 2008 following the implosion of property prices, which had doubled at the national level in the four previous years. These dramatic increases could not have occurred unless there was as superabundance of credit. The irony is that the banks have been blamed for the 2008 crisis, even though they were the victims. Some bankers were villains, they bought mortgage loans from those who could not afford the monthly payments. The Greenspan Fed was unknowing about the impacts of the increase in the US capital account surplus on the prices of US real estate and US stocks.

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The traditional US approach has been to merge failing banks with healthier banks, a marriage that often is blessed by removing doggy assets. The ratio of the capital of the acquiring banks to its deposits inevitably declines. This approach leads to a consolidation of banking firms. There is not systematic approach to re-capitalizing failing or failed banks, so the process inevitably involves extensive political rather than administrative decisions. The failure to provide government capital so that Lehman Brothers could remain open was the costlier mistake by a US administration in the last two hundred years. The clichés “too big to fail” and “bailing out the bankers” dominated decisions about government investments that would assisted in economic stabilization during the systemic crisis. The US Congress should establish the Reconstruction Finance Corporation II to provide the funds to recapitalize failing and insolvent banks. The RFC was established in 1932 provide capital to failing banks and firms in other industries (Jones). RFC II would buy newly-issued common shares in any bank deemed to have too little capital; the ownership interest of the existing shareholders would be diluted. If the capital requirement for each bank is five percent of assets and loan losses reduce the capital to four percent, RFC II would write a check to the bank for the dollar amount required to bring capital to the five percent minimum, and RFC II would receive newly issued common shares so that it would own twenty percent of the bank. If instead the capital had declined to three percent, RFC II would receive the number of newly issued shares so it would become the owner of forty percent of the common shares. If the decline in capital was larger, the RFC II would write a check so that it would own fifty percent of the common shares, and the bondholders would be required to participate in a debt for equity swap. Once the RFC II had acquired common shares in a bank, it would become the controlling shareholder. The senior two or three officers would be removed, and the board of directors would resign. These RFC II banks would be managed as private enterprises on a care-taker basis; the thrust would be to prepare the banks to be privatized within three or four years. The objective of the proposal is to stabilize the US banking system in response to the impact of the variability of investor demand for US dollar securities on household wealth. An increase in this demand leads

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to a boom, a decrease leads to a bust. The current arrangement requires that bank assets adjust to the level of bank capital, which often has been declining; instead the proposal provides a low cost way to adjust capital to the value of bank assets. One advantage of this proposal is that it would sharply reduce the consolidation of banks that now occurs when the FDIC induces a strong bank to buy a failing bank. A second advantage of the proposal is that RFC II would be profitable; at least this is the inference from TARP, and Maiden Lane 1 and Maiden Lane II. The RFC II would be a classic vulture investor, and it would profit because it would acquire failing banks when their values were greatly depressed because of cyclical crash. A third advantage of the proposal is that it would de-politicize the extension of government support for failing banks, there would be well-publicized procedures for providing government capital. The cliché about the “bailing out the banks” might be trashed, the banks would be saved while the top bankers would be furloughed. A fourth advantage of the proposal is that the effectiveness of monetary policy would be enhanced; the Federal Reserve would no longer be concerned about the impact of increases in interest rates on financial stability. A fifth advantage of the proposal is that it would reduce the “tax” on banks from high capital requirements. These requirements have no advantage, they are irrelevant in preventing a systemic shock and in mitigating a shock. One potential criticism of the RFC II proposal is “moral hazard”; that the bank managers would take on riskier assets because the provision of government capital would guarantee that the bank would not fail. The bankers would lose control if they required government capital to remain open.

Conclusion The key idea of this essay is that US macroeconomic stability would be enhanced if the US Congress established a government agency to provide capital to failing and insolvent banks, which would stabilize the supply of capital to banks after a systemic crisis had led to large loan

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losses. The rationale is that if the supply of bank capital is not increased to compensate for loan losses, the debt deflation cycle described by Irving Fisher in the 1930 would apply, and bank liabilities would shrink to correspond with depleted capital. A few banks have failed for idiosyncratic or firm-specific reasons; most banks have failed including some very large ones because of systemic shocks. Many of these banks that failed at the same time previously had been considered well-managed. These banks have failed because a systemic shock led to a sharp change in the relationship between two different asset classes. There have been four systemic crises since the Federal Reserve was established in 1914; three were associated with a sharp decline in the price of real estate and one was associated with a sharp increase in short term interest rates. Hundreds of banks and thrifts institutions failed in each crisis; the early 1930s crisis and the 2008 crisis led to sharp declines in nominal and real GDP. The second section provided an explanation for the Global Financial Crisis of 2008, which reflected the surge in the export earnings and the trade surpluses of China and the oil-exporting countries; the increase in their demand for US securities led to higher prices for US real estate and stocks; similarly, the increase in their demand for securities in other countries led to higher prices for real estate and stocks in these countries. These increases in the prices of real estate and stocks were transient; these prices were likely to decline when the inflows fell. A crisis might develop if there were a sharp decline in real estate prices. The third section focused on Dodd-Frank, which extended the types of regulatory initiatives appropriate for dealing with bank failure because of idiosyncratic factors to deal with failure because of systemic shocks. The implicit premise of Dodd Frank is that the crisis resulted from the decisions by US banks to rapidly increase their purchases of risky securities rather than from a surge in the supply of credit from the combination of increases in the capital account surpluses of this group of countries and more expansive monetary policies. DF does nothing to dampen cyclical increases in investor demand for US dollar securities. Dodd Frank increases the cost of financial intermediation in the “good years” and reduces the perimeter of regulation while it does nothing to abate the severity of the systemic crisis.

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The Reconstruction Finance Corporation established in 1932 is a model of a government institution that provided capital to failing and insolvent banks. The proposed RFC II would acquire common shares and preferred shares in failing and insolvent banks; the ownership interest of the private shareholders would be diluted. The objective is to save the banks as functioning institutions while the senior managers would be replaced and the board of directors would be dismissed. The new managers would prepare the banks to be privatized once the macro economy had stabilized. One of the collateral benefits is that the banking system would be more competitive; the existing arrangement of merging failed banks with more robust competitors reduces the number of banks. This arrangement would be profitable; at least that is the inference from TARP and from the Federal Reserve’s investment in IG. Monetary policy would be enhanced, since it would no longer be constrained by the adverse impact on financial stability. The costs of bank intermediation in the good years would be reduced because bank capital requirement would be lower.

9 Three Reflections on Banking Regulations and Cross-Border Financial Flows Edwin M. Truman

Introduction In this paper, I reflect on three aspects of banking regulation and cross-border financial flows in today’s financially globalized world. First, I look at the incidence of banking crises and assess whether, considering the national and international financial reforms in the wake of the global financial crisis, we can reasonably expect an end to financial crises in the future. My answer is a qualified no. The business cycle, the poor, and financial crises will always be with us. The recent post-crisis financial reforms, if maintained, should contribute to some lessening of the incidence of such crises, but not to their elimination. The virulence of those financial crises that do occur may exceed the force of crises during the three decades before the global financial crisis because the new regulations may help to prevent smaller crises.

E. M. Truman (*)  Peterson Institute for International Economics, Washington, DC, USA e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


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Second, I consider the contribution of international capital flows to financial crises. Should we single out short-term cross-border financial flows as a unique source of vulnerability? If the answer is yes, should we encourage countries large and small, advanced and emerging market to use controls to manage such flows? My answers are yes and not as a rule for all countries in all circumstances. Yes, reversals of shortterm cross-border financial flows are often the proximate cause of crises, but they are rarely the underlying cause. In a banking or financial crisis, greed on the part of borrowers and lenders that switches to fear when a disturbance—economic, financial, or political—hits. Capital flow management measures, also known as controls, may be necessary or desirable but they are not a panacea. Countries may employ permanent structural measures to discourage short-term flows, but they will be hard-pressed to distinguish between good and bad types of banking flows. Over time any capital control measures will be evaded and become increasingly distortionary. Moreover, it is naïve to think that the regulatory and supervisory authorities in the recipient countries will turn off the spigot on such flows, taking away punch bowl just when the party gets going. Political economy considerations will likely dictate that controls will be too little and too late. Third, I examine the role of the prospects for international cooperation in the management of cross-border financial flows. It is often suggested that source as well as recipient countries should cooperate in the management of such flows. The principal, concrete suggestions for cooperation are that the monetary authorities in the major countries should communicate clearly their medium-term policy intentions and take account of the impact of their policies on other countries. The challenges are that (a) central banks do not want to lock themselves into policy straightjackets, and (b) their mandates address exclusively economic and financial conditions in their own economies. I have long wondered why we worry about the disruptive effects of cross-border financial flows when we tend to worry less about similar domestic financial flows. The conventional answer is that domestic flows occur within a unified regulatory, supervisory, and institutional framework. The key feature of the domestic framework is that it is backstopped by the central bank as the lender of last resort. In the

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international context, the analogy to a domestic lender of last resort is the GFSN. Today, the global financial safety net (GFSN) is at best incomplete.

Have We Abolished Financial Crises? Reforms in national and international financial regulation since the global financial crisis have not abolished crises. The Reinhart-Rogoff database lists at least one banking crisis in every decade of the twentieth century as well as several in the first decade of the twenty-first century. Figure 9.1 presents the Reinhart-Rogoff annual data on banking crises. Some crises started and finished in one year. Others continued for more than one year. Reinhart and Rogoff record 430 years with banking crises in 24 advanced countries and 47 emerging market economies in 31 years from 1980 to 2010, or about 14 per year and in about 20% of the countries. The number of years with crises peaked in 1995 and declined to the low single digits in the first decade of this century before the crisis-filled years of 2008–2010. For the entire 31-year period, banking crises averaged about 20% of the six types of crises that 70 60

Number and Percent

Banking Crises 50 Crises as percent of all crises 40 30 20 10

































Fig. 9.1  Incidence of banking crises (Source Reinhart and Rogoff (2009) database from This Time is Different )

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Reinhart and Rogoff categorize.1 Although the number of years with banking crises did not reach the previous peak during the global financial crisis years, their relative incidence far exceeded the previous peak. This is consistent with the narrative that banking crises drove other crises in these years rather than the other way around as sometimes is the case. Over the entire period, banking crises were more common in emerging market countries. However, the incidence of crises in those countries declined in the twenty-first century and rose in the advanced countries. The conventional wisdom associates financial crises with current account deficits. But this identification is false. On average for all six types of crises, almost 40% of all crises were preceded by current account surpluses in the crisis country, and a slightly higher percentage for the advanced countries. About a third of all banking crises were proceeded by current account surpluses in advanced countries and less than 30% of such crises in emerging market countries. Systemic banking crises are fuelled by weak supervision and regulation combined with alternating periods of greed and fear on the part of leaders of financial institutions. Supervision and regulation can reduce the incidence of such crises but not eliminate the swings of confidence or exuberance affecting banking and financial decisions. The post-crisis regulatory reform agenda has strengthened major banks and financial institutions. The regulatory reforms associated with Basel III, in particular, are a definite but qualified improvement. The IMF staff (2018, p. 53) point to several areas where final compromises fell short: the risk-weighted asset floor generated by internal models is lower than earlier proposed, the timeline for introducing this reform was extended, the phase-in of the cap on any increases is risk-weighted assets is slower, some of the risk weights are lower, reforms with respect to shadow banking will be delayed longer, resolution frameworks (especially for nonbanks) are incomplete, and sovereign risk has not been incorporated into the regulatory framework. Most telling is the

1In addition to banking crises, they identify currency, inflation, equity market, and external and domestic debt crises.

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observation that only a handful of 40 countries that have recently been assessed are in full compliance with the Basel Core Principles on independence and accountability of supervisors. The IMF staff (2018, figures 1.24 and 1.25) also report that on average banks in six major countries (Canada, France, Germany, Japan, United Kingdom, and Switzerland) have improved their ­dollar liquidity ratios since 2006, but their dollar stable funding ratios are unchanged.2 These banking systems still rely to a substantial extent on the foreign currency swap market which is vulnerable in a crisis. This latter situation would be a less of a risk if adjusted cross-border loans to non-banks, the denominator of the estimated stable funding ratios, had declined since the global financial crisis. The IMF staff’s Global Financial Stability Report presents a carefully crafted estimate of the trend in the denominator for the six countries; see Online Annex 1.2 in IMF (2018). It is not possible to replicate the underlying staff analysis because it relies in part on unpublished data compiled by the Bank for International Settlements. However, one can derive a proxy from the BIS banking locational statistics ( For the six countries together, estimated loans to non-banks in US dollars increased by 48% between the fourth quarter of 2006 and the first quarter of 2018. The increase was led by Canadian and Japanese banks where the increases were more the 100%. Loans declined for banks in Germany and Switzerland and rose for banks in France and the United Kingdom, but by less than in for banks in Canada and Japan.4 I conclude that crises in financial sectors broadly defined are not a thing of the past. That is the nature of financial systems. Even if the


respect to estimates of dollar liquidity ratios, the Japanese banking system is an exception; ratios for its banks on average have declined. With respect to stable funding ratios, the German and UK banking systems are exceptions; ratios for those countries have improved. The ratio for Canadian banks is unchanged. 3To create these estimates, I applied the US dollar share of outstanding cross-border claims to cross-border claims on non-banks. 4Except for banks in the United Kingdom, these results are consistent with the data presented in figure 1.25.6 of IMF (2018). My proxy shows an increase of 52% while the IMF staff record a small decline.

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strongest Basel III and related proposals were adopted and fully ­implemented, crises would occur in the future. Moreover, if all risk of crises were eliminated, the financial sector would have failed in delivering on its primary goal of incentivizing risk taking in our economies through maturity transformation. If the new regulations are conscientiously implemented and not further watered down, we can reasonably expect to have fewer brushfire financial crises, but larger conflagrations probably will occur. To cite the familiar seat-belt analogy, they help reduce the incidence of injuries in low-speed crashes but may encourage more high-speed driving and consequently crashes that are more destructive to human life.

Do Capital Flows Cause International Financial Crises? Twenty years ago, it appeared that the doctrine of free capital movements would take its place alongside the doctrine of free trade as the long-run objective of policies. Subsequently both doctrines have been under qualification if not outright attack. Critics castigate the United States and the International Monetary Fund for promoting open capital markets in the late 1990s. That is still the dominant narrative today even though it is not well-grounded. The facts are (a) that the US interest was primarily in gaining scope for the establishment of US banks in other jurisdictions subject to national treatment as in the United States, and (b) the Independent Evaluation Office of the IMF (IEO 2005) issued a report that concluded that as of the early 2000s the IMF did not have a consistent, coherent message on capital account liberalization that was delivered to member countries in discussions with IMF staff and management. Since the report was issued, the IMF has adopted an “institutional view” on capital flow management (IMF 2012) to guide its surveillance activities. I expressed support for the development of a coherent view on capital flow management both in form and substance starting more than a decade ago (Truman 2006, 2010a, 2011a). It is important to appreciate where the IMF consensus is today. Three of the principal developers of the IMF’s institutional view summarized

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the extensive research at the IMF on the pros and cons and costs and benefits of capital flow management in a major publication, Ghosh et al. (2017). They are strong, qualified advocates of capital flow management. They write: To begin with, certain types of flows—very short-term, highly speculative, hot-money flows—may be such that their costs (in terms of the imbalances and vulnerabilities that they are likely to engender) exceed their benefits. Provided such flows can be identified and targeted sufficiently precisely, it may make sense to have structural (i.e., noncyclically varying) capital controls to discourage them, thus tilting the composition of capital inflows toward more desirable forms of liabilities… That said, in practice the set of flows that can ex ante be identified as being more trouble than they are worth may be limited. (Ghosh et al. 2017, pp. 381–382)

Thus, the authors are two-handed economists in their policy prescriptions. Their cautions endorsement of capital flow management measures also initially abstracts from consideration of the political economy of imposing either structural or cyclically varying policy instruments. In addition, cyclically varying tools of capital flow management, once imposed, are not easily removed. The “temporary” controls imposed by Iceland in 2008 lasted a decade. The principal challenge in capital flow management is that they focus necessarily on short-term cross-border flows, but it is difficult, if not impossible, to distinguish beneficial short-term flows from dangerous short-term flows. Moreover, flows with an original maturity that once classified them as medium- or long-term become de facto short-term flows that in some circumstances may be difficult to roll-over and, consequently, are a potential drain on a country’s international reserves. Banks are in the business of maturity transformation, but they are not long-term investors. Consequently, when markets are disrupted by some political, economic, or financial event or just become more volatile, the focus is on banks because that is where the observed leakage (sudden stop) is manifested if claims are not rolled over. To illustrate, the consolidated international claims of banks in countries participating

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in the Bank for International Settlements (BIS) reporting at the end of March 2018 were $14.5 trillion ( ). Forty-six percent of those claims had remaining maturities of one year or less. Total claims were divided between claims on banks (23%), the official sector (19%), non-bank financial institutions (24%), and the rest of the private sector (35%).5 Between the fourth quarter of 2006 and the first quarter of 2018, total international claims rose 14% and claims with a remaining maturity of one year or less rose 10%. From 2006 to 2017, World GDP in US dollars rose 55% and that of the advanced countries 26%. These data suggest that the risk of runs on (or runs of ) banks was somewhat reduced since before the global financial crisis. Nevertheless, when the liquidity of short-term bank claims dries up or a run on a bank cuts off its own sources of short-term funding, the result is a crisis for the bank. If many banks are affected, a banking crisis results. I conclude that capital flows do not cause international financial crises. They are a necessary ingredient for crises because without capital flows there would be no crisis, but they are not sufficient by themselves to cause the crises. They are the tinder assembled by lenders and borrowers until a match is struck.

Can Cooperation Help? A commonly heard prescription for dealing with unwanted capital flows is that source countries should cooperate in the management of such flows. The content of such cooperation is rarely spelled out. The principal suggestions that have any operational relevance are that the monetary authorities in the major countries should (a) communicate clearly their medium-term policy intentions, and (b) take account of the impact of their policies on other countries. The challenges are two.

5As of the same date, foreign banks with operations in foreign countries had $12 trillion in claims in local currencies. In a crisis, they pose a different set of challenges if the parent institution decides to cut back its total exposure in the country regardless of its source of funding.

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First, whether the external effects of a tighter or looser monetary policy in a major country negatively impacts another country depends on the circumstances in that second country. Policymakers in some countries will welcome the effects of reduced or increased incentives for capital to flow toward their countries and downward or upward pressure on their own interest rates. Policymakers in countries in a different phase of the business cycle will not. Second, the mandates of central banks exclusively focus on domestic economic and financial conditions. Moreover, policymakers do not want to lock themselves into policy straightjackets constructed out of guidance that may be interpreted as a hard and fast commitment. At best they can provide guidance about their thinking. Thus, although clear communication is always better than garbled communication, it does not provide much comfort for those countries experiencing unwanted or insufficient capital inflows. What is it about the disruptive effects of cross-border financial flows that worries policymakers but that do not to worry them nearly as much with respect to similar domestic financial flows? The conventional answer is that domestic flows occur within a unified regulatory, supervisory, and institutional framework. The key feature of the domestic framework is that it is backstopped by the central bank as the lender of last resort. In the international context, the analogy to a domestic lender of last resort is the GFSN. However, the GFSN is at best incomplete. The IMF is at the center of the GFSN. To play this role the IMF (a) must also have adequate resources at a minimum to backstop temporary funding from other sources, and (b) must be the final arbiter of whether a country needs to adjust its policies if its ex ante policies prove insufficient to weather the shock. At the peak of the global financial crisis, the Federal Reserve provided a financial safety net for much of the international financial system. In December 2008, the Federal Reserve’s balance sheet included more than $1 trillion in advances to foreign central banks and to financial institutions that were chartered in other countries: $583 billion in swap lines with foreign central banks, $334 billion using conventional tools (repurchase transactions, discount window advances, and the

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term auction facility), and an unspecified amount under emergency, Section 13(3) authority, but 15% of the $693 billion outstanding in the last category would be a conservative estimate given that almost half of the conventional lending was to non-US institutions (English and Mosser 2018). In December 2008, total IMF financial resources were only $392 billion. In the fall of 2018, its financial resources are $1.4 trillion consisting of about $700 billion in quota resources and about $700 billion in potential borrowing from the New Arrangements to Borrow (NAB) ($265 billion) and from bilateral borrowing arrangements ($450 billion). But some of those resources are not available because they are derived from commitments by members whose financial conditions are not strong enough for them to advance funds through the IMF and because the IMF always retains sufficient liquid assets to be able to meet future needs, including those of members who need to access their unconditional drawing rights on the Fund. Moreover, from the perspective of the fall of 2018, the IMF’s total, available financial resources could well shrink early in the next decade. The IMF’s bilateral borrowing arrangements ($450 billion) will expire in 2020. The United States will withdraw from the NAB in 2022 unless the US Congress authorizes its continued participation ($41 billion). In a worse-case scenario, outlined by Sterland (2017) other participants in the NAB would follow the US lead and withdraw from the NAB. In this scenario and without new bilateral borrowing arrangements, total IMF resources would be cut in half. This amount would be insufficient in a crisis for the Fund to finance fully either of the two types of GFSNs: (1) large adjustment programs involving exceptional access or (2) providing unconditional short-term, unconditional liquidity support. The current bilateral borrowing arrangements could be replaced by an agreement to increase IMF quota resources. But the prospects in this area are not encouraging. The United States can block any agreement to increase IMF quotas and US Treasury Secretary Mnuchin in July 2018 (Mnuchin 2018) stated, “At this time, the United States finds that the IMF’s resources are adequate following the 2016 implementation of the 2010 Quota and Governance Reform.” The problem with this statement is that a judgment about the adequacy of IMF financial resources

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should not be based on estimates of the IMF’s needs in the present but in the future, in the decade after 2020. I have advocated (Truman 2018) that the United States should not block an expansion in the IMF’s quota resources but, instead, should step out of the way by either (a) maintaining the size of its current quota while allowing quotas of other countries to increase, implying that its voting share would fall below the 15% that allows the United States to block (veto) major IMF decisions, or (b) favouring an increase in the US quota and leaving it up to the US Congress to accept the increase and decide whether the United States loses its veto. Whatever happens with IMF quotas or to the availability of other resources the IMF can draw upon, moral hazard considerations will prevent potential-creditor member countries from providing the IMF with sufficient resources to fund fully the GFSN. They will prefer to rely on ad hoc measures in the form of bilateral lending to the IMF, but those arrangements cannot be established within a few days. Although the IMF has established a flexible credit line (FCL) facility for lending large amounts of money to countries over two-year periods, to date it has had only three clients: Mexico, Poland, Colombia. The Fund does not have a standing facility to provide very short-term liquidity to members. A modest proposal in 2017, involving prequalification via the Article IV process (IMF 2017), did not garner enough support in the IMF executive board for it to be put in place. Moreover, the suggested amount that each qualifying country could draw, which would have been equal to the normal maximum drawing in one year (145% of a member’s quota), was small relative to the amounts that four emerging market economies were eligible to draw from the Federal Reserve 2008–2009.6 I conclude that the GFSN must be funded in the first instance by central banks as was the case in December 2008. In a crisis, central banks are where the money is. 6Figure 8

in IMF (2017) is difficult to interpret. It purports to measure the amounts that countries could draw relative to large historical episodes of capital outflows. But that is the wrong metric; countries want to be able to draw more than enough. In addition, under the illustrative IMF staff proposal only Brazil and Mexico would have been able draw in 2018 close to the $30 billion that was potentially made available by the Federal Reserve in 2008. Korea’s potential would fall short by a third and Singapore’s by two thirds.

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It is an open question whether the Federal Reserve or other major central banks will step up in the next crisis. However, the need for them to do so was recognized in IMF (2018, 46): Central bank swap lines should be retained to provide foreign exchange liquidity in periods of systemic stress. This should help prevent foreign currency funding difficulties from spilling over to other parts of the financial system. Two necessary conditions for central banks to follow this advice are that the IMF (a) has sufficient resources to provide a financial takeout of the central banks, and (b) the drawing country must accept that utilizing this type of GFSN will mean that the IMF can exercise a policy takeout of the central banks, in other words impose conditions on the drawing country’s economic and financial policies if the country is unable to repay the initial drawing from the central bank or banks. Many mechanisms have been proposed that could meet the needs of the major central banks for a policy takeout and potentially induce them to be lenders of first resort in the GFSN. Truman (2010b, 2011b, 2013) has outlined several. Beatrice Weder di Mauro and Jeromin Zettelmeyer (2017) sketch another. In my view, two approaches dominate: (a) an ex ante procedure in which the IMF finds that a country’s policies are sufficiently strong that it would be eligible for an IMF FCL, or (b) a commitment by the drawing country that if it cannot repay within a set time period of, say, one year at a maximum, the country would ask for support from the IMF that would be associated with appropriate policy commitments to ensure that the country could repay the Fund for the financing it received and had used to repay the central bank or banks that initially advanced funds to it. A combination of the two procedures would be most appropriate. It is relevant that in 2008 in granting to the central banks of Brazil, Korea, Mexico and Singapore access to swap lines the Federal Reserve implicitly used both criteria (Sheets et al. 2018). The Federal Reserve staff presented an analysis of the policies and the recent policy history of these four countries (policy takeout) and determined that they were sound. The staff also argued that the reserves of these countries were sufficient to repay the Federal Reserve (financial takeout). The Federal

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Reserve’s announcement of these swap lines included a reference to the IMF’s Short-Term Liquidity Facility that was established at the same time. The IMF facility attracted no borrowers and it was terminated in 2009. The reasons are many, but they came down to the stigma associated with drawing on the IMF and the quality of the “seal of approval” by being granted a swap line with the Federal Reserve. I conclude that cooperation on the establishment of a more robust GFSN of the second (liquidity) type is possible if it is supported in the first instance by the major central banks. But necessary conditions are that the IMF be adequately financed (financial takeout) and that countries drawing on the safety net accept IMF policy conditionality if necessary (policy takeout). Both requirements are in doubt. These conditions are necessary but not sufficient. The major central banks also must make the policy judgment to lend. Unfortunately, the nature of their mandates dictates that the central banks are only likely to reach such a judgment in a major financial crisis and, then, as an instrument of crisis management that is only deployed once the crisis has reached the conflagration or panic stage. At present, countries must fall a long way before they may possibly be caught by the GFSN.

Discussion of Chapters 6–9 Alex Pollock began by citing Carmen Reinhardt and Kenneth Rogoff’s This Time is Different, particularly the 35- to 40-page appendix listing all crises since 1800. Pollock took the portion of the list spanning 1900– 2000, organised it by date, and found in that, one country or another— often many countries—a banking crisis began in 54 of the 100 years of that century. In short, there’s usually a banking crisis somewhere. Pollock then summarised the pattern described by Robert Aliber: Capital flows go in, asset prices go up, a Ponzi scheme is induced by which old debts can only be serviced by new borrowing, the Ponzi scheme implodes, asset prices fall, and losses are left to be distributed among the players. The question arises: Why is real estate so often at the centre of financial collapses? The size of the sector is a factor: Land and buildings are a huge asset in any economy, and they’re available to

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absorb investment. There has to be something big enough to do this, something that governments are interested in protecting and promoting, and something whose price can move in response to credit flows. An important point to remember, however, is that the collateral for any mortgage loan is not the underlying property but the price of that property. That price can rise or fall much more than most observers expect. This was a factor in the US real estate market collapse: many knew something very bad was in the offing, but no one anticipated how bad it would be and how much prices could fall. Robert Aliber also discussed Dodd-Frank and its irrelevance, positing that post-crisis banking regulation betrays a complete misunderstanding of the crisis, and that the villains in the piece were the macro managers, not the banks, as somebody had to adjust to the autonomous increase in foreign demand for USD securities. Aliber argued that capital requirements for banks should be low, about 5%, but that the government must have a supply of capital cash to shore them up if they go below that threshold. Government guarantees were important, particularly to central banks, which, as Brad Setser pointed out, wanted safe assets in which to invest their reserves. Setser posited that one source of financial risk was the increasingly complex financial chains of intermediation, where central banks wanted safe USD assets and put funds on deposit or reduced the available supply of safe assets, and private actors took the risk. Those safe assets can ultimately, through the functioning of the financial system, become embodied in quite risky assets, at least as it turned out ex post. This was exemplified in less developed countries in the 1980s: Oil producing countries’ assets were invested in what was viewed as safe assets, mainly the big US banks, and they were in fact safe because they were protected by the government. Also in the 1980s, the public would seek out safe assets, which they found in deposits at savings and loans, which were indeed safe, protected by the government—even though the losses were so large that they made insolvent not only the industry but also the government’s guarantee fund, the Federal Savings and Loan Insurance Corporation. Part of the problem, as Jeff Schafer noted, is short funding of long assets. In the GFC, this was embodied in structured investment

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vehicles (SIV), which produced assets that were deemed highly safe but turned out very risky. The SIVs kept the financing off the balance sheet. Indeed, in the US real estate sector, Fannie Mae and Freddie Mac essentially functioned as SIVs set up by the government to keep its financing off-balance sheet. Schafer also pointed out a strong tendency, even among very sophisticated investors, to outsource due diligence. When the crisis occurred, and everyone was protesting, “But this is AAA paper,” it was clear that investors had decided that since S&P and Moody’s had signed off on a product or provider, no further work was needed. The German banks were a prime example of this, having done it repeatedly through multiple crises: During the Korean crisis, it was German banks that had bought all of the Korean paper, assuming that since Korea was an OECD member, its sovereign paper must be low-risk. Edwin Truman focused, among other things, on the role of international cooperation, noting that the international global safety net was not functional during the GFC. He stressed the need for something at the centre of the system, observing that it was the US Federal Reserve that had effectively taken on that role, advancing over USD 1 trillion in credit to foreign central banks and financial institutions. The option of giving the IMF the resources to do this alone would not be feasible for moral hazard reasons, but the IMF should provide both a financial backstop and a policy backstop. In the latter case, a mechanism will be needed to get distressed countries from a liquidity crisis to a policy takeout with the IMF. This would require adequate IMF resources as well. Such a policy mechanism does not yet exist.

References English, W. B., & Mosser, P. (2018, September 11–12). The Use and Effectiveness of Conventional Liquidity Tools Early in the Financial Crisis. Preliminary Discussion Draft from Brookings/Yale Conference on Responding to the Global Financial Crisis: What We Did and Why We Did It. Available at Accessed 29 September 2018.

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Ghosh, A. R., Ostry, J. D., & Qureshi, M. S. (2017). Taming the Tide of Capital Flows: A Policy Guide. Cambridge, MA: The MIT Press. IEO (Independent Evaluation Office of the International Monetary Fund). (2005). The IMF’s Approach to Capital Account Liberalization. Washington: International Monetary Fund. IMF (International Monetary Fund). (2012, November 14). The Liberalization and Management of Capital Flows: An Institutional View. Available at The-Liberalization-and-Management-of-Capital-Flows-An-InstitutionalView-PP4720. Accessed 21 August 2018. IMF (International Monetary Fund). (2017, December 19). Adequacy of the Global Financial Safety Net—Considerations for Fund Toolkit Reform. IMF Policy Paper. Available at Accessed 29 September 2018. IMF (International Monetary Fund). (2018, April). Financial Stability Report, including Online Annex 1.2: Bank International Dollar Funding Methodology. Washington: International Monetary Fund. Available at Accessed 17 August 2018. Mnuchin, S. T. (2018, July 12). Statement of Secretary Steven T. Mnuchin Before the US House Committee on Financial Services. Available at https://home. Accessed 2 October 2018. Reinhart, C., & Rogoff, K. (2009). This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. Sheets, N., Truman, E. M., & Lowery, C. (2018, September 11–12). The Federal Reserve’s Swap Lines: Lender of Last Resort on a Global Scale. Preliminary Discussion Draft from Brookings/Yale Conference on Responding to the Global Financial Crisis: What We Did and Why We Did It. Available at Accessed 29 September 2018. Sterland, B. (2017, October). Economic Risk and Resilience in East Asia: What’s Changed Since the Asian Financial Crisis? What More Can Be Done to Improve Crisis Preparedness? (Global Economy and Development at Brookings Working Paper 109). Washington, DC: Brookings Institution. Truman, E. M. (2006, February). A Strategy for IMF Reform. Policy Analyses in International Economics 77. Washington: Peterson Institute for International Economics.

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Truman, E. M. (2010a, May 25). Dealing with Volatile Capital Flows: The Case for Collective Action. Realtime Economic Issues Watch. Peterson Institute for International Economics. Available at blogs/realtime-economic-issues-watch/dealing-volatile-capital-flowscase-collective-action. Truman, E. M. (2010b, October 12). The IMF as an International Lender of Last Resort. Realtime Economic Issues Watch. Peterson Institute for International Economics. Available at realtime-economic-issues-watch/imf-international-lender-last-resort. Truman, E. M. (2011a, April 20). Taking Stock of Volatile Capital Flows: Progress Despite the Noise. Realtime Economic Issues Watch. Peterson Institute for International Economics. Available at realtime-economic-issues-watch/taking-stock-volatile-capital-flows-progressdespite-noise. Truman, E. M. (2011b, December 16). Three Evolutionary Proposals for Reform of the International Monetary System. Extension of Prepared Remarks Delivered at the Bank of Italy’s Conference in Memory of Tommaso PadoaSchioppa, Rome, Italy. Available at altri-atti-convegni/2011-conf-memoria-padoa-schioppa/Truman.pdf. Truman, E. M. (2013, September 10). Enhancing the Global Financial Safety Net Through Central-bank Cooperation. Available at http://voxeu. org/article/enhancing-global-financial-safety-net-through-central-bank-cooperation. Truman, E. M. (2018). IMF Quota and Governance Reform Once Again (PIIE Policy Brief 18–9). Washington: Peterson Institute for International Economics. Available at Weder di Mauro, B., & Zettelmeyer, J. (2017, January). The New Global Financial Safety Net: Struggling for Coherent Governance in a Multipolar System (Vol. 4). Centre for International Governance Innovation Essays on International Finance 4. Available at

Part II Iceland and the 2008 Global Crisis

10 From a Capital Account Surplus to a Current Account Deficit Hamid Raza and Gylfi Zoega

Introduction This paper is about the causes of current account deficits in the run-up to a financial crisis. Financial crises have occurred in many countries following the collapse of the Bretton Woods system in 1971–1973 and the move towards floating exchange rates. There have been several waves of financial crises during these almost five decades as discussed by Robert Aliber in another chapter of this book. In most cases, there were both banking crises and currency crises. The first wave occurred in the early 1980s, affecting Mexico, Brazil and Argentina and ten other developing countries, the second wave affected Japan, Finland and Sweden in the early 1990s and a third wave occurred in 1997 when a crisis hit Thailand, Malaysia, Indonesia, the Philippines and South Korea. The recent H. Raza  Aalborg University, Aalborg, Denmark G. Zoega (*)  Department of Economics, University of Iceland, Reykjavik, Iceland e-mail: [email protected] © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


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Western crises in the US, the UK, Ireland, Spain, Portugal, Greece, the Baltic countries and Iceland constitute the fourth wave. The last wave may soon start in Argentina, Turkey and probably other emerging economies. In each of these countries, the crises were preceded by an economic boom that lasted several years and coincided with large current account deficits or, as in the case of Japan, a fall in the current account surplus. The question posed in this paper is whether the boom and the accompanying current account deficits can be traced to domestic causes or have a common cause in global capital markets that create capital inflows leading to a real exchange rate appreciation and a stock market boom. To this end, we will explore data from Iceland, a country that became a symbol of the Western crisis that started in 2008.

A Brief History of Iceland’s Boom and Bust Following the privatization of its banking system in 2003, Iceland experienced a credit boom from 2004 to 2008, fuelled by a combination of excess liquidity in world capital markets and the willingness of the owners of the banks to use a good credit rating—derived from the sovereign’s good rating—to borrow abroad to finance massive investment in domestic shares and foreign companies. The banking system expanded rapidly (from 1.74 GDP in 2004 to 7.44 GDPs at the end of 2007) and soon became too big to save and the country’s net investment position deteriorated. The assets of the three largest banks grew by between 50 and 60% annually during this period. The net investment position became negative amounting to one GDP but this statistic concealed vastly larger gross debt accumulation, gross debt being six times the country’s GDP in 2008. The expanding credit created an ­impressive stock market bubble that raised stock prices by a factor of ten and an increase of house price from 2004 to 2008. Household and business debt increased rapidly—private business debt mostly in foreign currency denominated debt—and consumption boomed creating a current account deficit of around 20% of GDP.1 1See

Benediktsdottir et al. (2011) on the crash in Iceland.

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145 125



Capital controls

Free capital mobility






45 25



PFI inflow

OI inflow

FDI inflow

2015 Q1

2014 Q1

2013 Q1

2012 Q1

2011 Q1

2010 Q1

2009 Q1

2008 Q1

2007 Q1

2006 Q1

2005 Q1

2004 Q1

2003 Q1

2002 Q1

2001 Q1

-35 2000 Q1


0 1999 Q1


share prices (left axis)

Fig. 10.1  Capital inflows to GDP and share prices (Note Gross inflows to annual GDP are calculated as four quarter moving averages)

For Iceland, the openness to capital flows took place at a time of increased financialization in global markets.2,3 Figure 10.1 shows that a large proportion of inflows into Iceland was in the form of portfolio investments (PFI) and bank borrowing (OI), while the proportion of FDI remained smaller in the initial years of liberalization.4 Iceland in the early 2000s borrowed by issuing fixed income securities in the international market and later in 2006–2007 by offering higher interest rates on its deposits in foreign currencies. High interest rates in Iceland also resulted in a large volume of short-term inflows (the carry trade), which made the ISK appreciate (ISK). The overvaluation and expected


has been argued that innovations in the financial markets have increased short-termism in the corporate sector, which has resulted in an increased volume of financial investments (see, e.g., Özgr Orhangazi [2008], Till Van Treeck [2008]). 3Financialisation here is defined as an increase in financial investment compared to the volume of real investments. 4There is an increase in FDI in Iceland during 2006–2008, where a large proportion of investment was in export projects (e.g. aluminum smelting). However, the scale of the current account deficit was far larger than the sums invested in these export projects.

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appreciation of the domestic currency and high domestic interest rates encouraged domestic borrowers to borrow in foreign currencies. Tradable-sector firms (e.g., fishing) borrowed in foreign currencies because their revenues and partly also costs were in foreign currencies, but unhedged parties such as local communities, businesses serving the home market and households also borrowed in foreign currency while their earnings were mainly in ISK. Figure 10.1 also shows that the episode of capital inflows coincided with the stock market boom. Apart from investors purchasing stocks, the banks also heavily relied on shares as collateral and regularly purchased their own shares in the market, which drove share prices above their true value. There is a close nexus between inflows, share prices and the exchange rate in Iceland. The channels through which capital inflows may interact with stock prices and real exchange rate are obvious, however, identifying the channels through which stock prices and real exchange rates are connected is more complicated. From a theoretical perspective, the interaction between stock prices and exchange rates is usually analysed from two perspectives, “flow oriented” models as in Dornbusch and Fischer (1980), and “stock oriented” models, as proposed by Frankel (1983) and Branson (1983). The flow oriented models tend to associate exchange rate depreciations with stock market booms. The argument is that exchange rate appreciation can make the current account balance deteriorate, which in turn can adversely affect the stock performance of firms. In these models, stock prices respond to movements in the exchange rate. Stock-oriented models, in contrast, associate rising stock prices with exchange rate appreciation via wealth effects. In these models, real exchange rates respond to movements in the stock market. The relationship in the empirical literature is also ambiguous, as some studies find a positive relationship between the variables while some found a negative relationship.5 Overall, it appears that the 5For example, Aggarwal (1981) found a positive effect of US exchange rate on stock prices. Diamandis and Drakos (2011) concluded a positive effect of real exchange rate on stock prices for Latin countries. On the other hand, Goodwin et al. (1992) and Soenen and Hennigar (1988) found a negative effect of US exchange rate on stock prices. Moreover, the results regarding direction of causality are also mixed (see, e.g., Granger et al. 2000; Pan et al. 2007, among others).

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relationship differs across the countries and also has a tendency to change over time within the same economy. We now proceed to investigate the nexus between capital inflows, share prices, and real exchange rate.

Empirical Analysis To explore the interaction between capital inflows, stock prices, and real exchange rate in Iceland, we use quarterly data from 1995Q1–2017Q4. First, we use the full-sample and then split it into the free capital mobility regime (1995Q1–2008Q3) and the capital controls regime (2009Q1–2017Q3). The variables used in the empirical section are the gross capital inflow to GDP (F), stock prices (S), and real exchange rates (R). Figure 10.2 shows the evolution of gross capital inflows to GDP, stock prices and the real exchange rate. There is a clear positive co-movement between gross capital inflows and stock prices from 1995 up to the financial crash in 2008. In particular, the co-movement in the boom years leading to the crisis is very strong. This coincides with the period in which the banks increased their lending for stock purchasing and in some cases directly accepted each other’s stocks as collateral. Gross capital inflows also seem to have a positive co-movement with the real exchange rate in the period of free capital mobility (i.e., 1995–2008). In the post-crisis period, in contrast, the two series no longer move together, indicating a major shift in the dynamics of the relationship marked by the implementation of strong capital controls.

Model We now formally investigate the interactions among variables using a Vector autoregression (VAR) model.6 The model is represented as follows. The reduced form VAR model in levels can be represented as: xt = µ0 + A1 xt−1 + A2 xt−2 + . . . + Ap xt−p + et , (t = 1, 2 . . . T ) (10.1) 6Before

estimating the model, we adjust all the variables for seasonal variations. We then test all the variables for a unit root finding that they are non-stationary.

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Fig. 10.2  Capital inflows, stock prices, and real exchange rate

where µ0 is a n × 1 vector of constants, xt is a n × 1 vector of variables in the model, Ap is a n × 1 matrix (with i = 1,..p ) of parameters, et is a n × 1 vector of error terms. Since, we estimate our model in first differences, the vector of our endogenous variables takes the following form: xt = [F, lnS, lnR]′

10  From a Capital Account Surplus …     183

F represents gross capital inflows to GDP.7 S represents the stock prices. R represents the real exchange rate. The structural VAR (SVAR) model in its general form can be written as: Bxt = µ0 + B1 xt−1 + B2 xt−2 + . . . + Bp xt−p + εt , (t = 1, 2 . . . T ) (10.2)

where B is a contemporaneous matrix. Note that multiplying Eq. (10.2) with the inverse of B will result in reduced form VAR as represented in Eq. (10.1), i.e., Ai = B−1 Bi (for i = 1,..p ). We follow Cholesky decomposition to identify our shocks by ­imposing restrictions on the contemporaneous matrix B as follows:   F 1 0 0 B = S  ∗ 1 0  R ∗ ∗ 1 The ordering of the variables implies that capital inflows shocks contemporaneously affect stock prices and real exchange rates while shocks to stock prices and real exchange rates affect gross capital inflows with a lagged effect. Our ordering regarding capital inflows preceding other variables is in line with economic theory. The argument, as also discussed earlier, is that gross capital inflows make the real exchange rate appreciate and increase the demand for assets, which increases asset prices. Regarding the interaction between stock prices and real exchange rates, there is no general consensus on how should they be ordered. For example, the flow-approach would require placing the real exchange rate before stock prices in a VAR model, however, stock oriented models would require placing stock prices before the real exchange rate. Given, Iceland’s experience, it is natural to assume that the stock model approach is suitable for modelling this interaction as the episode of stock price boom coincides with a real exchange rate appreciation. However, before


use trend of annual GDP in order to normalize our measure of capital inflows.

184     H. Raza and G. Zoega

explaining our main results we relax this assumption and change the ordering of stock prices and real exchange rates. We find that the ordering has some effect on the magnitude of the shock, i.e., the shock tends to be relatively stronger in magnitude when contemporaneous effects are incorporated but the impulse responses are robust in their shapes. Overall, the ordering assumption does not alter our results in any fundamental way.

Results and Discussion The results of our structural VAR model are presented in Fig. 10.3, which shows the cumulated impulse responses. Focusing on the effects of capital inflows, the results indicate that capital inflows shocks increase stock prices as well as making the real exchange rate appreciate. The effect of the shock in both cases lasts for one year. There is also a significant feedback effect from stock prices to capital inflows, i.e., shocks to stock prices induce capital inflows. This effect lasts for 1–2 quarters. A shock to stock prices also makes the real exchange rate appreciate, which is consistent with the wealth effects of the equity market. A shock to real exchange rate increases stock prices but has no significant effect on capital inflows. There are significant differences between the regimes of free capital mobility and capital controls. The cumulated impulse responses reported in Fig. 10.4 show major differences in the results. The results indicate a strong interaction between capital inflows, stock prices and the real exchange rate in the period of free capital mobility but the interaction appears to have vanished in the capital controls regime. In particular, our results indicate that a shock to capital inflows increases stock prices and makes the real exchange rate appreciate in the period of free capital mobility but the effect is zero in the period of capital controls. There is also a significant feedback effect from stock prices to capital inflows, indicating that a booming stock market encouraged capital inflows. Overall, we find that the effects of all shocks in the capital control regime are statistically not different from zero.

10  From a Capital Account Surplus …     185

capital inflows: stock prices

capital inflows: real exchange rate



0.04 0.01

0.03 0.02


0.01 0

0 1



13 17 21 25


stock prices: capital inflows



13 17 21 25

stock prices: real exchange rate

50 1










0 1








real exchange rate: capital inflows







real exchange rate: stock prices











-20 -40

0 1














shock: response Fig. 10.3  Cumulated impulse responses for period 1995Q1–2017Q3 (Note The structural shocks are plotted with 90% confidence bands)

186     H. Raza and G. Zoega capital inflows: real exchange rate

capital inflows: stock prices 0.015

0.006 0.005


0.004 0.005

0.003 0.002

0 -0.005

0.001 0 1



13 17 21 25




13 17 21 25

free capital mobility

free capital mobility

capital controls

capital controls

stock prices: capital inflows 60

real exchange rate: stock prices



20 0


-20 -0.5








-40 1






free capital mobility

free capital mobility

capital controls

capital controls

stock prices: real exchange rate


real exchange rate: capital inflows

0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2

100 50 0 -50 1











13 17 21 25

free capital mobility

free capital mobility

capital controls

capital controls

Fig. 10.4  Cumulative impulse responses for different regimes (Note The solid indicates that the shock is significant whereas dotted line indicates that the shock is insignficant using 90% confidence bands)

10  From a Capital Account Surplus …     187

Conclusion We have found that the capital inflows may have caused the appreciation of the real exchange rate as well as the stock market boom. Iceland’s newly privatized bank’s access to international capital flows may have made them choose riskier behaviour as discussed in the chapter by Michael Dooley in this volume. In essence, the risky asset choice could be leveraged in the international capital market by attracting capital from an unlimited pool of bond issuers and depositors. Our empirical results are also consistent with the thesis of Robert Aliber in another chapter of the volume that current account surpluses in other countries may create capital outflows that cause inflows into small open economies. These inflows then generate a credit-driven boom and a subsequent bust when the inflows come to a sudden stop. The policy implications of our results are clear. A country should try to limit the volume of PFI by foreign investors, especially investments in the market for government bonds, corporate bonds and bank deposits. Such carry trade can, as we have shown, have large destabilizing effects on asset prices and economic activity of the recipient country. This has been the policy of Iceland’s central bank since the summer of 2016 when a reserve requirement was imposed on the portfolio investment (defined as investment in listed bonds and deposits) of foreign residents. This policy requires investors to put a fraction of the amount invested (currently 20%) into an interest-free account at the central bank for one year. The policy has been very effective and helped preserve monetary policy independence and also maintain current account surpluses in spite of interest rates being higher than in the large economies. The system of floating exchange rates and perfect capital mobility has shown itself, again and again, to be unstable. However, wave after wave of financial crises have not convinced international organizations, such as the IMF, and policy makers at the country level to adopt policies aimed at limiting speculative capital flows. Financial crises did not occur during the Bretton Woods period while economic growth was impressive. There is a need for reforming the international monetary system (if it can be called a system), meanwhile each country has to fend for itself.

188     H. Raza and G. Zoega

Appendix stock prices: real exchange rate

real exchange rate: stock prices


4.5 4




3 2.5




1.5 1




0 1













∆F - ∆lnS - ∆lnR (benchmark model)

∆F - ∆lnS - ∆lnR (benchmark model)

∆F - ∆lnR - ∆lnS

∆F - ∆lnR - ∆lnS


Fig. 10.5  Impulse responses from different ordering

References Aggarwal, R. (1981). Exchange Rates and Stock Prices: A Study of the U.S. Capital Markets Under Floating Exchange Rates. Akron Business and Economic Review, 12, 7–12. Benediktsdottir, S., Danielsson, J., & Zoega, G. (2011). Lessons from a Collapse of a Financial System. Economic Policy, 26, 186–235. Branson, W. H. (1983). Macroeconomic Determinants of Real Exchange Rate Risk. In R. J. Herring (Ed.), Managing Foreign Exchange Rate Risk. Cambridge, MA: Cambridge University Press. Diamandis, P. F., & Drakos, A. A. (2011). Financial Liberalization, Exchange Rates and Stock Prices: Exogenous Shocks in Four Latin America Countries. Journal of Policy Modeling, 33(3), 381–394. Dornbusch, R., & Fischer, S. (1980). Exchange Rates and the Current Account. The American Economic Review, 70(5), 960–971. Frankel, J. A. (1983). Monetary and Portfolio-Balance Models of Exchange Rate Determination. In J. S. Bhandari & B. H. Putnam (Eds.), Economic Interdependence and Flexible Exchange Rates. Cambridge, MA: MIT Press.

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Goodwin, T. H., Farsio, F., & Willett, T. D. (1992). The Dollar and the Dow. Rivista Internazionale di Scienze Economiche e Commerciali, 39, 899–906. Granger, C. W. J., Huang, B. N., & Yang, C. W. (2000). A Bivariate Causality Between Stock Prices and Exchange Rates: Evidence from Recent Asian Flu. The Quarterly Review of Economics and Finance, 40, 337–354. Orhangazi, Ö. (2008). Financialisation and Capital Accumulation in the Non-financial Corporate Sector: A Theoretical and Empirical Investigation on the US Economy: 1973–2003. Cambridge Journal of Economics, 32(6), 863–886. Pan, M.-S., Fok, R., & Liu, Y. (2007). Dynamic Linkages Between Exchange Rates and Stock Prices: Evidence from East Asian Markets. International Review of Economics and Finance, 16, 503–520. Soenen, L. A., & Hennigar, E. S. (1988). An Analysis of Exchange Rate and Stock Prices—The U.S. Experience Between 1980 and 1986. Akron Business and Economic Review, 19, 7–16. Van Treeck, T. (2008). A Synthetic, Stock–Flow Consistent Macroeconomic Model of Financialisation. Cambridge Journal of Economics, 33(3), 467–493.

11 Lessons from the Icelandic Financial Crisis Sigridur Benediktsdottir, Gauti Eggertsson and Eggert T. Thorarinsson

Introduction Iceland is a tiny economy with many unusual features. It is tempting to write off its banking crisis as a one-off saga, a frenzy that would be unlikely to be repeated anytime soon anywhere else. A frenzy it was, but we think important lessons can be learned. In this short paper, we will revisit some of the lessons we put forth in a Brookings paper in 2017, emphasizing some of the lessons learned.

These lessons are based on the brookings paper Benediktsdóttir et al. 2017.

S. Benediktsdottir (*)  Yale University, New Haven, CT, USA e-mail: [email protected] G. Eggertsson  Brown University, Providence, RI, USA E. T. Thorarinsson  Central Bank of Iceland, Reykjavik, Iceland © The Author(s) 2019 R. Z. Aliber and G. Zoega (eds.), The 2008 Global Financial Crisis in Retrospect,


192     S. Benediktsdottir et al.

Fig. 11.1  Large banks liabilities

After the East Asian crisis of the 1990s, when excessive capital flows and increasing leverage also culminated in a banking crisis, there was a tendency for economists to treat such a crisis as a special case, unlikely to be echoed in more developed economies. There was even a special term used to describe those economies: “crony capitalism” (Kang 2002). Presumably, this was meant to separate these economies from “regular” advanced capitalist societies. Iceland was touted as not being one of those countries. Iceland’s banks grew too fast, and they became too large on the backs of both implicit and explicit government guarantees. The liabilities of the three largest banks grew from little over the gross domestic product in 2003 to over nine times the gross domestic product mid-year 2008, Fig. 11.1. The Icelandic banking system grew from one of moderate-sized banking systems in relation to the country’s GDP in Europe to the largest. Even larger than the Swiss banking system, Fig. 11.2. The growth of the Icelandic banks was initially largely funded in international financial markets and later by international deposit collection. These funds were then funnelled into loans, which to a disproportionate extent were made to the same groups of related parties and to insiders—that is, to the banks’ owners. In hindsight, the evidence suggests that universal rules about large exposures, which are meant to

11  Lessons from the Icelandic Financial Crisis     193

Fig. 11.2  Banking system size

limit concentration risk and are crucial to banks’ viability, were broken for years before the banks’ failure. The banks themselves always reported large exposures within regulatory limits, while an employee of the FSA notified the director general of the FSA as early as 2004 that he thought that the banks were not correctly connecting together large exposures. The employee used Baugur Group and related parties as the main example (see Fig. 11.3.) The FSA did not follow up on that work and lending to the group grew exponentially in the following years. Additionally, the banks’ owners had too much access to the banks’ funds, despite rules on insider borrowing. Hidden to a large extent by a large web of firms with opaque ownership. Pointing to Fig. 11.3 again, Baugur Group bought a large stake in Glitnir in February 2007, marked by the red line. Consequently, the loans to the Baugur group of related parties, who were now insiders, almost doubled from 1 billion euros to about 2 billion euros in less than a year. Figure 11.4 shows insider lending, that is lending to six groups of large stakeholders of the banks, by all three large banks. When the banks failed, lending to these six groups corresponded to over 20% of the loan book of the parent banks.

194     S. Benediktsdottir et al.


Fig. 11.3  Glitnir large exposure




















Fig. 11.4  Loans to large related parties that had large ownership in the banks

11  Lessons from the Icelandic Financial Crisis     195

Fig. 11.5  Banks reported CAD ratio, percent

Lesson 1. We need transparent firm ownership to facilitate supervision of insider lending and large exposures. Firm ownership is still not transparent in Iceland despite the well-documented abuses of rules and regulations which took place in the shadow of opaque ownership. The large banks in Iceland funded their own shares excessively, weakening greatly the shock absorbing capability of their equity and hence increasing systemic risk. By the middle of 2008, each bank was funding on average 25% of its own shares and if cross funding of shares is included this amounts to 33% of the shares in the three large banks. This totalled about 4 billion euros. These loans became worthless when the banks failed, giving the equivalent outcome for depositors and other creditors as if that equity had never been there as a buffer against losses. The capital adequacy ratio for the banks was hence overestimated in the middle of 2008. Loss absorbing capital buffer was only about 8% rather than the 11% reported, see Figs. 11.5 and 11.6. Lesson 2. We need strict rules against lending against own banks shares, and also against lending with collateral in other financial

196     S. Benediktsdottir et al. ď͘Ŭƌ͘ ϰϱϬ


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