Sunday, June 29, 2008

Three schools of thought on crisis prevention

A few months ago Bill White, chief economist of the Bank for International Settlements (BIS), made an interesting speech stressing that "the first and crucial point" for proposing solutions to the credit crisis is "agreement on the nature of the problem". I think that the lack of such agreement is one of the reasons the credit crisis still lingers on. It also tells us that the risk is great the crisis will not be tackled in a fundamental way -- not even in the moderate way suggested by Bill White and some of his colleagues at BIS.

What are the underlying causes of the current financial turmoil? Bill White sees at least two schools of thought: one that asks itself "what is different", and the other, "what is the same". Most analysts follow the first school of thought, but Bill and some of his colleagues at BIS see more value in the second school. Why? Because the financial system "is inherently procyclical and thus chronically prone to bubble-like behaviour", argues Bill. To remedy this procyclicality we need a "new macrofinancial stability framework" (see also Bill's chapter in a recent Fondad book, "The Need for a Longer Policy Horizon: A Less Orthodox Approach").

Bill White observes that the school of "what is different" focuses on new developments in financial markets. Emphasis is put on the massive expansion of the subprime mortgage market in the United States, the growing use by banks of the originate and distribute model, the reliance on off-balance sheet vehicles, the development of new structured products, and the reliance on ratings agencies in marketing them.

"These new elements, originally thought likely to produce a welcome spreading and diversification of risk bearing," observes Bill White, "seem instead to have materially reduced the quality of credit assessments and also led to increased opacity. The result has been the generation of enormous uncertainty both about how large the prospective losses from defaults might be, and about where those losses might be concentrated. In this environment, everyone has become suspect, including the large banks at the heart of the financial system. Market liquidity and funding liquidity dried up, and the interbank term market effectively closed down. Moreover, there were significant knock-on effects, initially on other markets that rely on the interbank market for price fixing, but subsequently on a whole host of other markets where asset prices were considered to be richly valued."

"If it is these new market developments that have been responsible for the observed turmoil," says Bill, "then this suggests solutions that seek to preserve the benefits of the new products while reducing the unwelcome side effects. In the short term, this would imply injections of liquidity by central banks, and potentially other government agencies, to reliquify markets."

Bill's concern is that, in the aftermath of most historical bubbles, the focus of attention shifted to new instruments and techniques and the role they played in the process, while the key factor - leveraged speculation - was commonly ignored. "Evidently, it is more comfortable for all concerned to blame the essentially unpredictable side effects of new developments than to admit to having failed to see the build-up of all too traditional exposures."

Following the second school of thought Bill White asks himself what is the same about the current market turmoil compared to previous financial crises. His answer is "that in virtually every case, the crisis was preceded by very rapid credit expansion, which manifested itself in part in higher asset prices." These gains provided the collateral to justify even more lending and increased the appetite for risk-taking, on the side of both lenders and borrowers. As a result, leverage increased even as the general quality of credits deteriorated, and investment and consumption went beyond long-term trends. "At a certain point, usually when earlier expectations about profits or future income growth began to look unrealistic, this whole endogenous process went into reverse. In effect, boom turned to bust."

Based on the historical evidence
Bill makes two observations. "The first is that the moment of change generally arrived completely unexpectedly, with the trigger for the event commonly being far too inconsequential to explain the resulting mayhem. This is precisely because a "trigger" is not the underlying "cause" of the problem. A second observation is that the turning point was almost never preceded by any significant degree of inflation. In particular, prices were falling in the United States in the late 1920s, were rising only very slowly in Japan in the late 1980s, and averaged only around 4% in Southeast Asia when that crisis hit in 1997."

What are the characteristics of the "new macrofinancial stability framework" suggested by Bill White?

"The first characteristic of such a framework would be a primary focus on systemic developments. In particular, attention would be paid to the dangers associated with many people and institutions having similar exposures to possible common shocks. The recognition of endogenous forces with potentially non-linear outcomes would be a further important theme. Evidently, this would not reduce the attention paid to the good health of individual institutions, but it would put such concerns into a broader context.

A second characteristic would be still closer cooperation between central bankers and regulators in assessing the build-up of systemic risks and in deciding what to do to mitigate them. What is needed is to find the point of optimal interaction between the more top-down approach of central bankers and the traditionally (though this is changing) more bottom-up approach of the regulators. Each perspective has much to offer. As an aside, such closer cooperation need not, though it could, imply a reversal of recent trends towards setting up independent regulatory agencies with responsibilities for both financial institutions and financial markets.

A third characteristic would be a much more "symmetrical" or countercyclical use of policy instruments. In this regard, the new framework would simply mirror the accepted wisdom for the conduct of fiscal policy: namely, that the good times should be used to prepare for the bad.

More specifically, monetary policy would lean against "booms" in the growth of credit and asset prices, particularly if accompanied by distorted spending patterns that opened up a real risk of subsequent reversal. This latter point is crucial if we are to distinguish between what is being recommended here and the quite different proposition of "targeting asset prices". Regulatory policy would have a similar bias, with risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being built up in good times and run down in bad."

Hervé Hannoun, the deputy general manager of BIS, added in a recent speech that there are three schools of thought on financial crisis prevention:

– The first school of thought considers that it is illusory to "lean against the wind". Asset price and credit booms are not preventable, and the real policy issue is to be ready to "clean up the mess" when the bubble bursts.
– The second school of thought considers that it is desirable to lean against the buildup of serious financial excesses. But monetary policy cannot deal with financial bubbles and asset price exuberance. Prudential and supervisory policy is instead the right tool for that.
– The third school considers that both monetary policy and macroprudential policy can and should be used to lean against the wind. A macrofinancial stability framework should be implemented to pre-empt financial excesses and "serial bubbles".

Hannoun emphasises that the third school of thought, the "macrofinancial stability framework" school, recommends leaning against the wind by making use of both monetary and supervisory instruments to pre-empt serious financial excesses.

"In this conception, macroprudential policy (the supervisory tool) has a crucial role to play in reducing the procyclicality in the financial system. But monetary policy also has a role to play in that respect. The recent financial turmoil suggests that monetary policy may have to counteract excessive credit expansion and asset price booms even if price stability were achieved. The key argument is that central banks should not rule out leaning against the wind by raising interest rates to stop asset price bubbles and credit booms from getting out ofhand: in other words, prevention is better than cure."

Bill White warns that the difficulties we face today in financial markets, with their potential to have significant effects on the real economy, indicate clearly that the costs of not having a new macrofinancial stability framework could be large.