The Global Financial Crisis: Predictions, Causes, Effects, Policies, Reforms and Prospects

The Global Financial Crisis: Predictions, Causes, Effects, Policies, Reforms and Prospects Dominick Salvatore1 Fordham University Abstract. The paper examines the causes, effects, policies, and the prospects for rapid recovery and growth after the deepest world financial and economic crisis since the Great Depression. The paper then examines the regulatory and supervisory systems in the United States and Europe before the crisis, the proposed reforms of those systems, as well as reforms of the entire world financial system, and the likelihood that those reforms will succeed in preventing future financial crises. JEL Classification: E31, E32, F44 Keywords: Financial crisis, Contagion, Stimulus package, Exit strategy, Bank stress tests, Financial reforms

1. Introduction Advanced countries faced a serious financial crisis and deep economic recession in 2009 and are now experiencing an anemic recovery. Most emerging markets also experienced a recession or a growth slowdown. In this paper, I will examine predictions of the crisis, its causes, effects, policies, reforms and prospects. 2. Predicting the Financial Crisis The economic profession has failed society by not having predicted the most serious financial crisis and deepest recession of the post war period. Had the coming crisis been predicted, policies could have been adopted to prevent the crisis or at least to soften its impact. Some economists claim to have predicted the crisis. Nouriel Roubini is one of them. But he had been predicting a crisis for several years before it actually came and kept changing the cause of the crisis. As Anirvan Banerji, economist with the New York-based Economic Cycle Research Institute, put it as follows in October 2008: “Roubini started predicting a recession four years ago and saying it was imminent. He kept changing his justification: first the trade deficit, the current account deficit, then the oil price spike, then the housing downturn. But the recession actually 1

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did not arrive”.2 When the crisis did come it was for the last of the several causes that Roubini had specified over time. To be correct and useful, a forecast must specify the time and the cause of the crisis. If I had said at the end of 2008 that the crisis would end, without specifying when and how, I would have been correct, but I could not have claimed to have forecasted the recovery. All crises, for whatever reason, eventually do come to an end. Alan Greenspan worried aloud in 2000 that the United States faced a resurgence of rapid inflation, when in fact it was growth that was collapsing under his very eyes (in fact, the United States fell into recession in 2001).3 Joseph Stigletz, Jonathan Orszag and Peter Orszag wrote 2002 that on the basis of historical experience, “the probability of either Fannie Mae or Freddie Mac defaulting would be close to zero” (2002, p. 5). Paul Krugman stated in 2002 and again in 2003 that the United States, which had experienced a recession in 2001, would fall into “double-dip” recession – which also did not happen.4 Jean-Claude Trichet, the Governor of the European Central Bank, increased the interest rate from 4 per cent to 4.25 percent in July 2008 believing that the European Union would avoid the crisis.5 Making a wrong forecast is dangerous because it could lead to wrong business decisions and government policies. But forecasting a crisis without clearly specifying the timing and the reason is not useful. In fact, it is not forecasting all. 3. Causes of the Financial Crisis The present financial crisis started in the U.S. sub-prime mortgage market in 2007 and then spread to the entire financial and real sectors of the U. S. economy in 2008, and from there to the rest of the world. The initial causes of the financial crisis are clear: huge and increasing amounts of home mortgages – often based on weak underwriting including no down payment or checking credit histories – were given to individuals and families that clearly could not afford them. These mortgages were made at variable rates when rates were the lowest in 50 years. It was only to be expected that a rise in interest rates would cause many homeowners to be unable to make their mortgage payments and default. The crisis could only have been avoided if housing prices had continued to rise at the unrealistic high rates of 2000-2005. These sub-prime home mortgages were then repackaged into mortgagebacked securities (MBS) and sold to credit market investors. Rating agencies, such as Moody’s and Standard & Poor, gave some of these financial instruments triple A ratings. Finally, the Securities and Exchange Commission (SEC), which was to regulate this market, was in fact not highly involved in these transactions. Although the problem of sub-prime mortgages greatly expanded during the presidency of George W. Bush, the practice started in 1999 during the Clinton Administration when Fannie May and Freddie Mac were encouraged to grant home mortgages to people who clearly could not afford these mortgages in order “promote the American dream” of owning a home.

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Two additional and crucial inter-related causes of the sub-prime mortgage crisis were the easy monetary policy of the Fed and the export–based growth strategies of some Asian countries, including China, which allowed the Fed to maintain interest rates at very low levels during the period 2002-2006, enabling excessive risk-taking and encouraging asset-price bubbles. Undervalued exchange rates further encouraged financial investment in the United States by Asian economies, further fueling asset-price bubbles.6 Some economists blame deregulation as the primary cause of the crisis. Indeed, the repeal of the depression-era Glass-Steagall Act in 1999 (pushed by Alan Greenspan and Robert Rubin when Larry Summers was Treasury Secretary during the Clinton Administration) ended the separation of commercial banking from other financial activities, such as insurance, underwriting and investment banking, and made possible some of the financial excesses that led to the present crisis. And it was Greenspan, Rubin and Summers who in 1998 objected to the imposition of any regulation on credit default swaps (CDS) – which the famed investor Warren Buffett once called “weapons of financial mass destruction”. We can thus say that the present financial crisis was caused by deregulation or inadequate regulation of investment banking, by the inadequate application of regulations that were already on the books (i.e., by rating agencies and the SEC), by unfortunate economic policies (granting home mortgages to people who could not afford them), by too easy monetary policy by the Fed and undervalued exchange rates by some Asian economies, by economic greed (financial firms caught in a gigantic profit-seeking scheme with insufficient risk management), and by outright fraud (such as the incredible $65 billion Bernard Madoff Ponzi scheme). 4. Contagion – The Spread of the Financial Crisis Around the Globe There was then contagion, by which the crisis in the United States spread first to other advanced countries through the global financial system and finally to emerging markets when the former fell into recession and sharply reduced their imports from and capital investments in the latter. However, contagion would not have occurred so quickly through the financial sector in Europe if some even bigger excesses than in the United States had not occurred in Europe. For example, bank leverage (measuring the risk that a bank faces) was 31 for Lehman Brothers at the time it failed in March 2008 and 38 at Citigroup the weakest of the largest U.S. banks, but it was at 42 at UBS, 56 at Deutsche Bank, and 63 at Barclays. On average, bank leverage was 35 for the largest 12 European banks as compared with 12 for the largest 12 U.S. banks. The housing bubble was also even greater in some European countries than in the United States. For example, between 2004 and 2007, the peak housing prices were 2.58 times higher than their long-run (German) trend in Ireland, 2.10 times in the United Kingdom, 1.92 times in Spain, as compared with 1.76 times in the United States (see Figure 1). Yes, the crisis started in the United States but Europe faced

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even greater excesses in some sectors, otherwise contagion would not have occurred as rapidly and as strongly as it did through the financial sector. Figure 1: Housing Bubble in the United States, United Kingdom, Spain and Ireland Price-Rent Ratio (1997=1)

1987 1990

1994

1997

2000

2004

2007

2009

Source: OECD Databank (2005-2010). The crucial event that triggered the crisis was, of course, the failure of Lehman Brothers in September 2008. Lehman was allowed to fail presumably because its assets were less solid than those of Bear Sterns (which was acquired by J.P. Morgan Chase the previous March to prevent its failure) and there were no buyers after Treasury Secretary Paulson refused to provide $60 billion of loss guarantees to Barclays and Bank of America that had shown interest in acquiring Lehman. It is more likely that Secretary Paulson wanted to use the failure of Lehman Brothers to avoid the accusation of falling into the moral hazard trap (the situation where profits are private and losses are public) and to teach a lesson to financial markets. However, he subsequently admitted to having underestimated the size of Lehman and the problem that its failure would create in the United States and around the world. At the time of its failure, Lehman had sold nearly $700 billion in bonds and derivatives, of which about $160 billion was unsecured. Rescuing Lehman, however, would only have postponed the crisis, not prevented it.

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Some economists blame the operation of the international monetary system for the crisis. The present crisis, however, is for the most part domestic and not international in origin. A more efficient and effective international monetary system (one that exposes financial excesses and excessive risks thus reducing speculative international capital flows) would not have prevented contagion across the world because, as we have seen, some even greater financial excesses than in the United States had occurred in Europe, Japan and elsewhere. To be sure, China’s exports of huge amounts of capital primarily to the United States (as the counterpart of its huge trade surplus with the United States) facilitated and reinforced the financial bubble that was developing in the United States. Chinese families save a very high percentage of their income because they have little or no provision of public unemployment insurance and old age pension. Since China’s financial sector is still rather underdeveloped and cannot absorb a great deal of its savings, a huge amount of Chinese savings sought foreign (primarily U.S.) investment outlets (Salvatore, 2010). This supplied excess liquidity to the United States, which facilitated the financial bubble and increased its size. But a well-functioning financial sector in the United States could have discouraged such an inflow and prevented it from further reinforcing the bubble that was developing. 5. Effects of the Crisis The major effects of the crisis are the following: 1.

Stock markets crashed all over the world during 2008, with declines ranging from 31 percent in the United Kingdom to 50 percent in Italy (in the U.S. it was 34 percent) among advanced countries, and from 24 percent in Mexico to 65 percent in China and Russia among emerging markets.

2.

The capitalization of banks was cut by more than half from more than $8 trillion at the end of 2007 to $4 trillion at the end of 2008. As we will see later, between March and September 2008, the entire U.S. investment banking sector, as we had known it, disappeared. Going forward, investment banking in the United States will be conducted mostly by commercial banks under more highly regulated and less speculative conditions permitted under the Dodd-Frank law signed by President Obama in July 2010.

3.

All advanced countries fell into the “great recession” (the deepest of the post war period) with real GDP falling by 2.4 percent in the United States, 4.1 percent in the Euro Area, 4.9 percent in the United Kingdom, and 5.2 percent in Japan in 2009 (we will come back to this later).

4.

All the most important and largest emerging market economies, with the exception of China, India and Indonesia fell into recession with real GDP falling from 0.2 percent in Brazil to 6.6 percent in Mexico and 7.9 percent in Russia in 2009. On the other hand, between 2008 and 2009, the growth rate of real GDP only slowed down from 9.6 to 9.1 in China, from 7.3 to 5.7 in India, and from

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6.0 to 4.5 in Indonesia. While impressive, it must be pointed out that China, India and Indonesia need very high rates of growth to absorb into the market economy the still significant segment of their population living at subsistence level (we will return to this in Section IX). 5.

While the financial crisis spread quickly from the United States to other advanced countries through the financial sector, the crisis spread to emerging markets with about a half-year lag primarily through the real sector (i.e., from the reduction of imports of recessionary advanced countries from emerging market economies and the sharp fall in cross-border capital flows – see Figures 2 and 3). Figure 2 shows that at the bottom of the recession in advanced countries in the first quarter of 2009, the growth of real GDP was about minus 2 percent while world trade was down by almost 9 percent. Figure 3 shows that the net private financial flows to emerging and developing countries declined from over $700 billion in 2007 to $200 billion in 2008.

6. Monetary Policies, Increased Liquidity, and Bank Rescues The United Stated and Europe did almost everything possible to avoid the recession, but their efforts only succeeded in preventing a deeper recession or depression. At the beginning of 2008, the United States introduced a $168 billion dollar stimulus package, which contributed to a 2.8 percent growth of real GDP in the second quarter of last year, but its effect soon faded away. The United States lowered its interest rate from 5.25 percent in September 2007, to 1 percent in October 2008, and to practically zero in December 2008. The ECB cut its key policy rate to 1.0 per cent in October 2008 also translated into a fall in the EONIA -- an overnight (interbank) market rate that is the central focus of market participants -- to a range of 0.30 to 0.40 per cent. In addition, the ECB provided liquidity to banks in fixed-rate, full-allotment operations for as much as one year. (These operations are still available for 3 months’ duration). In other words, banks could obtain as much liquidity as they wanted (provided they had the necessary collateral) at a fixed-rate from the Eurosystem, a policy consistent with the central role of the banking system in the monetary-policy transmission mechanism of the euro-area (in contrast to the U.S., where capital markets play the central role). Finally, the ECB embarked, for the first time ever, in purchases of government securities, a policy still in effect. That is, needing more stimulus, the Fed also flooded the market with liquidity, as evidenced by the increase in its balance sheet (and reserves of commercial banks held at the Fed) from $900 billion in the summer of 2008 to over $2 trillion in 2010. This could potentially generate an explosive rise in future bank lending and in the money supply, and thus lead to a huge inflationary spiral.

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Figure 2: Growth of World Real GDP and World Trade, 2007-2009 ____________________________________________________________________

____________________________________________________________________ Source: IMF (2010a) and WTO (2010). Figure 3: Net Private Financial Flows to Emerging and Developing countries, 1985–2011

Source: IMF (2010b).

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In March 2008, the Fed helped J. P. Morgan Chase acquire Bear Sterns at a deeply discounted price (to avoid the accusation of moral hazard -- a situation where profits are private and costs or losses are public) with a $29 billion debt guarantee; in May the Treasury acquired a $100 billion of (nonvoting) stock of Fannie Mae, $100 billion of Freddie Mac, and from May to December a total of $185 billion from American Investment Group (AIG); in September, it encouraged and facilitated the acquisition of Merrill Lynch by Bank of America and it approved the conversion of Morgan Stanley and Goldman Sachs into commercial banks. In October it increased insurance on bank deposit to $250,000 (up from $100,000) and it adopted a $700 billion bank rescue plan, with half of the money spent by the end of the year to recapitalize the banking sector and purchase money and commercial paper from firms to make up for the drying up of this crucial lending activity by commercial banks. Then in November 2008, the U.S. Treasury injected another $20 billion of new capital (on top of the $25 billion provided in September) to Citigroup and together with the Fed provided guarantees against excessive losses on $301 billion of toxic assets (mostly sub-prime personal and commercial loans owned by Citigroup) to prevent its collapse. In January 2009, the Treasury injected another $20 billion of new capital (on top of the $25 billion injected in September) to Bank of America and Merrill Lynch, and together with the Fed provided guarantees against excessive losses on $100 billion of toxic assets to prevent Bank of America from withdrawing from the purchase of Merrill Lynch after it discovered that the latter had even more toxic assets than it realized at the time Bank of America initially agreed to purchase it. Then, at the end of February, the U.S. government agreed to become the biggest single shareholder of Citigroup by taking a 36% stake of the troubled lender to prevent its collapse. At the same time, many European countries adopted similar but less ambitious policies to stimulate their economies. In January 2009, the European Central bank cut the interest rate from 4.25 in July 2008 to 1.0 percent in April 2009, but indicated that it would not follow the U.S. and Japanese counterparts down the path of practically zero interest rate. The Bank of England cut the interest more drastically from 5 percent in October 2008 down to 0.5 percent in April 2009 (the lowest since its creation in 1694). All of these measures, however, did not prevent an even deeper recession in Europe than in the United States.

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7. Exit Strategy and the Danger of Inflation With the resumption of growth, the potential for inflationary explosion becomes a serious danger. Indeed, the fear in the market that the Fed would not be able to reverse course in unwinding its huge unconventional monetary stimulus, prompted Ben Bernanke to outline the Fed’s exit strategy in July 2009. This calmed markets and led to a sharp decline in U.S. Treasuries. Bernanke testified that he expected the U.S. economy to start growing again at the end of the year but, with unemployment likely to reach nearly 10 percent, growth would very likely be slow through 2011, so that the economy would face little inflationary pressure. When necessary, Bernanke indicated that an exit strategy could be established very quickly to mop up the excess liquidity by letting emergency lending programs wind down or expire, raising the short-term interest rates paid on reserve balances (to help set a floor under interest rates), letting short-term credits expire, and selling longer-term assets to the public. He acknowledged that, as always, the difficulty will be deciding the precise timing to begin to tighten and set the appropriate pace of the tightening effort. At the same time, Bernanke warned Congress and the White House to get budget deficits under control or risk damaging the recovery. Some economists, including Alan Metzler (2009) of Carnegie Mellon, have deeper concerns. They believe that it takes about two years for an anti-inflationary policy to work, which would mean that the Fed needed to implement a policy in 2009 and stick with it. This concern seemed overdone, however because the U.S. economy is likely to grow well below its potential at least through 2011 so that demand-pull inflation does not seem a serious threat. Only with another flare up in the price of petroleum and other primary commodities is inflation likely to become a serious problem. Be that as it may, it is most unlikely that the Fed and the other major Central Banks will not start tightening before spring 2011– they stated as much at their meeting at Jackson Hole, Wyoming in August 2010. Figure 4 shows that inflation is not now and is not expected to be a serious problem in advanced countries at least through 2011. 8. The U.S. Stimulus Package, Health Care and Governments’ Indebtedness In mid-February 2009, the U.S. Congress passed a $789 billion stimulus package of increased expenditures on infrastructure, education, health, and the environment, as well as a tax reduction (demanded by Republicans). Together with the hugely expansionary monetary and other policies, it probably prevented the U.S. economy from falling into a depression, reminiscent of 1929. The U.S. Administration pushed through a very ambitious health care reform plan to provide universal coverage and contain future health care costs by eliminating waste and introducing more competition (potentially including a government health plan to keep private health insurance costs down). The cost is

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Figure 4: Consumer Price Index in Advanced Countries, 2005-2011

Source: OECD (2010). expected to be paid mostly by tax increases on high-income earners (defined as those earning more than $250,000). But as pointed out by the Congressional Budget Office (CBO) in July 2009, the proposed health care bill could cost from $200 to $300 billion more than the $1 trillion Congressional estimate, and is likely to lead to higher taxes on all but the lowest income people to pay for it. A strong grassroots backlash regarding the government option and its cost has also developed, and so the plan was scaled down to ensure passage. But even without factoring in the inevitable higher costs and taxes from potential health care reform, the stimulus package and all other expenditures to bail out the banking sector will lead to much higher U.S. government debt and taxes in the years to come. Balancing the CBO-projected out-year budget would require a 44 percent increase in everyone’s taxes. Without an increase in taxes, the U.S. government debt as a percentage of GDP is expected to increase from 40 in 2008, to 65 in 2010, 70 in 2012, and 103 in 2017. Faced with a drastic decline in their wealth as a result of the deep recession, and anticipating much higher taxes in the future to pay for the stimulus package and the other huge government programs to overcome the crisis, business are investing less and individuals and families are saving more and spending less, leading to a very low multiplier (barely above one) for every stimulus dollar spent. Europe and Japan generally have smaller stimulus packages in the relation to their GDP than the United States because of their stronger social welfare net and in order to curtail the growth of their already very high government debts. Despite

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Figure 5: Budget Deficits as a Percentage of GDP, Advanced Countries, 2005-2011

Source: OECD (2010). this, the national debt of most advanced countries continues to rise due to still large (even if declining) budget deficits (see Figure 5). Indeed, it was excessive budget deficits that got Greece, Ireland, Spain and Portugal in trouble in 2010, with Greece having to be rescued from bankruptcy by a huge EU financial package. 9. Deep Recession and Slow Recovery in Advanced Countries Despite the extraordinarily expansionary monetary policy and large fiscal stimuli, the recovery in most advanced nations is rather slow (see Table 1 and Figure 6). This is unusual. After previous deep recessions, there was a rapid resurgence of growth in the year or two after the recession. Not this time. Only Germany grew relatively fast in the first half of 2010 based primarily on the rapid expansion of its exports due a low euro and contained labor costs. Growth, however, is slowing down in the second half of the year. In fact, growth is now (January 2011) expected to be even slower than indicated in Table 1 and Figure 6 in 2010 (especially in the United States) and unemployment is expected to remain high (see Figure 7).

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Table 1 Real GDP Change in 2009 and Forecasts for 2010-2011, Percentages, Large Advanced Nations Forecasts__ 2010 2011

Nation/Area

2009

United States

-2.4

2.7

2.5

EURO AREA

-4.1

1.7

1.4

Germany

-4.9

2.8

1.6

France

-2.5

1.4

1.5

Italy

-5.0

1.0

1.1

Spain

-3.6

-0.5

0.6

United Kingdom

-4.9

1.5

2.0

Japan

-5.2

1.9

1.8

Canada

-2.5

3.3

2.4

OECD

-3.3

2.7

2.8

Source: OECD, IMF and European Commission Databank (2010). Figure 6: Growth and Growth Prospects in OECD Countries, 2005-2011

Source: OECD (2010).

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Figure 7: Past and Expected Unemployment Rates in Advanced Countries, 20052011

Source: OECD (2010). In most large emerging markets (those in the G-20 group) the situation is different. As Table 2 shows, Russia, Mexico and Turkey faced a deep recession in 2009 with real GDP falling, respectively, by 7.9 percent, 6.6 percent and 4.9 percent. On the other hand, there was no recession in China, India and Indonesia -- only a slowdown of rapid growth. The forecast for 2010 and 2011 is for rapid growth to resume in most countries listed in the table, especially for China and India, but also for Brazil, Turkey and Indonesia. 10. Bank Stress Tests in the United States and Europe In order to reassure financial markets on the stability of the U.S. banking system, the Federal Reserve System conducted a stress test in 2009 in order to determine how well capitalized and stable the largest 19 American banks were or how much additional capital each needed to be able to withstand the financial crisis without possibly collapsing. The result of the banking stress test made available in May 2009 is shown in Table 3.The second column of the table shows that Bank America needed $33.9 billion to be adequately capitalized, Wells Fargo needed $13.7 billion, GMAC $11.5 billion, Citigroup $5.5 billion, and smaller amounts for 6 other large banks, for an overall total of capital needed of $74.6 billion. The remaining 9 of the 19 large banks large

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Table 2: Real GDP Change in Emerging Markets in G-20 in 2009 and Forecasts for 2010-2011 (Percentages) NATION/AREA

2009

FORECASTS 2010 2011

China

9.1

10.5

9.6

India

5.7

9.4

8.4

Russia

-7.9

4.3

4.1

Brazil

-0.2

7.1

4.2

Korea

0.2

5.7

5.0

Indonesia

4.5

6.0

6.2

Mexico

-6.6

4.5

4.4

Argentina*

0.9

3.5

3.0

Turkey*

-4.9

6.8

4.5

South Africa*

-1.8

3.3

5.0

Saudi Arabia*

0.1

3.7

4.0

Source: IMF, July 2010; * May 2010. banks examined 9 were regarded to be already well capitalized to withstand the normal evolution of the financial crisis. The third column of Table 3 shows instead how much each of the 19 large U.S. banks would need if the financial crisis became much deeper in 2009 and continued in 2010. In that case, all 19 large banks would need additional capital for an overall total of $599.3 billion ($411.9 billion for the 10 banks indicated in the table plus $187.4 billion for the 9 banks that were regarded as well capitalized if the financial crisis did not become deeper than it was). The two banks that would need the largest infusion of capital to be able to withstand the worse-case scenario, were Bank America (which would need $136.6 billion) and Citigroup needing $104.7 billion. The last column of Table 3 shows Tier 1 common capital ratio.

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Table 3: Stress Test of U.S. Banks (Billion Dollars, May 2009) Bank/Financial Institution

Capital Needed

Loss: More Adverse Scenario

Tier 1: Common Capital Ratio (%)

Bank of America

33.9

136.6

4.6

Wells Fargo

13.7

86.1

3.1

GMAC

11.5

9.2

6.4

Citigroup

5.5

104.7

2.3

Regions Financial

2.5

9.2

6.6

SunTrust

2.2

11.8

5.8

Morgan Stanley

1.8

19.7

5.7

KeyCorp

1.8

6.7

5.6

Fifth Third

1.1

9.1

4.4

PNC Financial

0.6

18.8

4.7

74.6

411.9

Av.: 4.9

Total All Other 9 Banks

0.0

Total: 187.4 (599.3)

Average: 8.7

Source: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf. With the financial crisis not deepening in 2009 and not expected to become deeper in 2010, and with the 10 U.S. banks needing additional capital actually raising that amount of capital by the end of 2009, financial markets became reassured of the stability of the U.S. banking sector and so that we can say that the stress test accomplished its aim. The situation was different in Europe. There, banking regulators originally intended to have each country conduct its own bank stress test with the results not made public (for fear of causing a run on the large banks if they were shown to be inadequately capitalized and weak). Only when financial markets became very concerned that bank regulators were trying to hide serious banking weaknesses, it was decided to conduct a European-wide stress test on the 91 largest banks and that the results would be made public. Table 4 shows the result of the bank stress test in Europe. The table shows that only seven of the 91 largest European banks examined failed the stress tests designed to show whether they could withstand a moderate recession and a fall in the value of the government bonds they held. Banks whose Tier 1 capital ratio was

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Table 4: Stress Test of European Banks (Million Euros, July 2010) Bank/Financial Institution

Country

Capital Needed

Tier 1: Common Capital Ratio (%)

Diada

Spain

1,032

3.9

Cajasur

Spain

208

4.3

ATEBank

Greece

242.6

4.36

Unnim

Spain

270

4.5

Germany

1,245

4.7

Banca Civica

Spain

406

4.7

Espiga

Spain

127

5.6

3,530.6

Av.: 4.58

Hypo Real Estate

Total

Source: http://stress-test.c-ebs.org/documents/Summaryreport.pdf. below 6 percent under the test criteria were deemed as having failed the test and needing to raise more capital. But only 3.5 billion euros ($4,51 billion at the average exchange rate of 1 euro equal 1.278 dollars in July 2010) were needed to make the seven banks that failed the stress test be adequately capitalized. This was much less than the $75 billion that the 10 undercapitalized American needed in May 2009. Markets, however, remained skeptical about the rigor of the bank stress tests in Europe as evidenced by the high premia that Greek, Irish, Portuguese and Spanish banks had continue to pay to borrow fund to increase their capitalization -even after European leaders and the International Monetary Fund agreed in May 2010 to a three-year loan package of €110 billion (about $140 billion) to Greece to avoid default, and the subsequent establishment of a huge special EU-IMF rescue fund of €750 billion (about $960 billion) raised by selling bonds guaranteed by eurozone governments to be used to lend money to (i.e., ECB buying bonds of) any crisis-hit EU government. All this defused the panic but did not snuff the crisis: unsustainable borrowing continues to pose huge challenges even after the joint EUIMF joint rescue operations of Greece in May and in Ireland in November 2010. 11. Financial Reforms to Prevent Future Crises Many important financial reforms have been introduced or proposed in the United States, Europe, and at international organizations in order to strengthen the banking and financial system and prevent future financial crises.

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In the United States, the Wall Street Reform and Consumer Protection Act (Dodd Frank Act) was passed in July 20107. This is the most sweeping overhaul of Wall Street regulations since the 1930s. It has three major components, as follows: 1. Systemic Risk (Macro-Prudential Regulation). This involves the creation of a Resolution Authority to deal with the problems created by financial institutions “too big to fail”. These are financial institutions that in the pursuit of higher profits undertake excessive risks in the belief that if something goes wrong and they instead face huge losses that could cause the institution to fail, national monetary authorities will come to their rescue to avoid through contagion the risk of collapse of the entire financial sector of the nation. To this end, the Fed is to monitor all large financial firms for systemic risk and given the authority to shut down failing institutions and recoup the cost from creditors, not taxpayers, by having banks and other financial institutions hold a new form of capital, known as contingent capital, to cover losses if the firm is shut down. In addition, more stringent capital requirements for financial institutions are to be negotiated at Basle III, but with national flexibility in their application, in order to establish a level-playing field. 2. Market Regulation (Micro-Firm Supervision). The Fed is also to oversee the establishment of central clearing of over-the-counter (OTC) derivatives (such as credit default swaps or CDS) to provide transparency; hedge funds and investment advisors must register with the Security and Exchange Commission (SEC); and credit rating agencies must improve their operation. Furthermore, the so-called Volcker rule, which prohibits U.S. banks (and U.S. branches of foreign bank)from engaging in proprietary trading and investing or sponsoring private investment funds, will be enforced. 3. Consumer Protection. A Consumer Financial Protection Agency is to be established to regulate and protect consumers from abuses by financial institutions in the provision of mortgages, credit cards, and other consumer financial products. Some of these reforms may take years to implement and may be watered down in their applications. The banking sector, having lost the battle to weaken the Reform Act, is now planning to take action to slow down the application of the Act and weaken its provisions. In Europe, EU finance ministers approved in September 2010 the proposed overhaul of the bloc’s patchy system of financial supervision rules by creating three new EU-wide supervisory authorities for banking, insurance and securities market, as well as a European Systemic Risk Board housed in the European Central Bank to warn about threats (such the rise of asset bubbles) to financial stability. The new rules are to be formally approved by EU member states and the European parliament

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before the end of 2010 and to take effect by mid to late 2012. The banking agency is to be based in London, the insurance regulator in Frankfurt, and the market trading watchdog in Paris. The EU must also agree on rules governing hedge funds and short selling (both of which contributed significantly to the financial crisis), and on whether to establish European-based credit rating agencies to counter the dominance of American companies. Standard OTC derivatives are to be processed through clearing houses and disclosure of short selling (where traders bet on the fall in the price of a security or share) are to be increased. These proposals will closely align the EU with the new financial regime which is coming in force in the United States. Global financial system reforms. There is a growing recognition that the financial system is global and so it requires global regulations for its smooth operation. To this end, at its September 12, 2010 meeting, the Basel Committee on Banking Supervision announced new capital requirements for banks to be presented to the Seoul G-20 Meeting in November 2010. The Basel III Accord proposes to increase the amount of reserve capital that banks must keep from 2 percent to 4.5 percent by January 2015. In addition, banks will be required to hold a “capital conservation buffer” of 2.5 percent to withstand future periods of stress bringing the total common equity requirements to 7 percent of their total assets by 2019. Basel III also seeks to transfer OTC derivatives to organized exchanges and to limit short selling. Although is difficult to establish global consistent financial regulations, especially now that new financial centers are arising and financial and economic power is shifting to some of the most dynamic emerging markets, they are essential to establish a level-playing field and avoid regulatory arbitrage and fragmentation. Unsustainable structural imbalances – primarily between the United States and China – must also be reduced before they lead to a new global financial crisis. The United States has to stop living beyond its means by reducing consumption and increasing savings, while China must revalue its currency an increase domestic consumption. Otherwise, the dollar may collapse in the face of continued unsustainable U.S. trade deficits financed by financial capital inflows from China (which continues to accumulate huge amounts of dollar reserves) and trigger a new global financial crisis. 12. Can Financial Crises Be Prevented? During the past 25 years, there have been many financial crises. World Stock markets collapsed in October 1987; the U.S. faced the dot.com crisis in 2001 and the current crisis triggered by sub-prime home mortgages in 2007-2008, which then spread to most of the rest of the world. The U.S. also faced the saving & loans crisis in the late 1980s. There have also been several financial crises in emerging markets during the past two decades, with serious repercussions in advanced countries as well. There was a financial crisis in Mexico in 1994-1995, South East Asia 1997-199, Russia in summer

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1998, Brazil in 1999, and Turkey and Argentina in 2001-2002 (see, Reinhart and Rogoff, 2010). Are financial crises inevitable? Are we set for another crisis before the end of this decade? Of course, this is what the new Basel III regulations are trying to prevent. But it will take years before the new regulations are put in place and banks will have satisfied the higher capital requirements – and a new financial crisis may occur before then. There is also the danger that reforms of the international financial system may take steps that would have prevented or minimized past crises, but will not be able to anticipate and prevent future crises, which will be different and arising from different quarters. The Maginot Line would have been useful in World War I but was useless in World War II. Reforms seem more successful in punishing, not preventing, financial excesses and fraud after they occur. Thus, financial reforms must be broad, but general. Broad, because they must encompass the entire financial sector. The current crisis arose in the less regulated investment banking sector, not in the better regulated commercial banking sectors. Financial reforms also need to be general and subject to interpretation by financial regulators, rather very specific and pointed. The reason is that money is fungible – closing one avenue leads brilliant financial operators to find other ways around the specific regulations in trying to earn large profits. Are financial crises then unavoidable? Are they the price that we must pay to obtain all the benefits of financial liberalization and innovation? In the end, the ability of the banking system to avoid a new crisis will depend, in part, on whether regulators are able, not only to keep up, but to be one step ahead of new financial innovations – which are often created primarily to avoid capital restraints. Perhaps, the best that we can hope is for better financial regulations to prevent some crisis and reduce the severity and cost of others.

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Notes 1. Dominick Salvatore is Professor of Economics at Fordham University. Comments from the participants at the 10th Biennial Conference of the Athenian Policy Forum at the German Bundesbank and of an anonymous referee are gratefully acknowledged. Dominick Salvatore. Fordham University, New York 10458, [email protected] 2. See: http://business.timesonline.co.uk/tol/business/economics/article5014463.ece. 3. See: http//www.fff.org/comment/ed0500d.asp. 4. See: http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html. 5. See: http://www.ecb.int/press/pressconf/2008/html/is080703.en.html. 6. George Kaufman makes the same points in his excellent paper “The Financial Turmoil of 2007-2009: Sinners and Their Sins,” also presented at 10th Biennial Conference of APF Bundesbank, Frankfurt, July 28-31, 2010. 7. http://www.govtrack.us/congress/bill.xpd?bill=h111-4173.

References Congressional Budget Office (2009) “Lawmakers Warned About Health Costs,” The Washington Post, July 17, 2009, 1. IMF (2010a), International Financial Statistics (IMF, Washington, D.C.). IMF (2010b), World Economic Outlook (IMF: Washington, D.C.), April. Kaufman, George (2010), “The Financial Turmoil of 2007-2009: Sinners and Their Sins,” Paper presented at the 10th Biennial Conference of APF Bundesbank, Frankfurt, July 28-31, 2010. Metzler, Allan (2009), http://www.econtalk.org/archives/2009/02/meltzer_on_infl.html Reinhart, Carmen M. and Kenneth S. Rogoff (2010), This Time Is Different: Eight Centuries of Financial Folly (Princeton, N.J.: Princeton University Press, 2010). Salvatore, Dominick (2010), “China’s Financial Markets in the Global Context,” The Chinese Economy, November-December, 8-21. Stiglitz, Joseph, Jonathan M. Orszag and Peter R. Orszag (2002), “Implications of the New Fannie Mae and Freddie Mac Risk-based Capital Standard," Fannie Mae Papers, Volume 1, Issue 2, March. WTO (2010), International Trade Statistics (WTO, Geneva). OECD (2005-2010), OECD Economic Outlook (OECD, Paris).