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«Abstract What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large ...»

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A good example of what happens if there is not a clear idea of the benefits and costs of regulation is the Basel Agreements. It is not clear what problem the agreements are trying to solve from the documents. Similarly, there is no explanation as to why the capital requirement ratios are set at the level they are. It seems rather that they have been set at the ratios that banks had used in the past. Banks and governments have spent billions of dollars designing and implementing the agreements. Not surprisingly, however, the agreements did not prevent the crisis and seem to have had very little effect in reducing its severity.

What are the market failures in banking? There are three main ones in our view.

1. The inefficient provision of liquidity.

2. Persistent mispricing of assets due to limits to arbitrage.

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Allen and Carletti (2006) and Allen, Carletti and Gale (2009)). Throughout the current crisis we have seen that the financial markets have not been providing liquidity effectively. That is why central banks have been stepping in and designing many programs trying to provide liquidity to the banking system as well as to individual institutions in difficulty. Going forward it is necessary to have a better understanding of why is it that markets don't provide liquidity properly. The basic problem is that liquidity is costly to hold. The only way to get people to hold it in a financial system without government intervention is if there is significant price volatility. But it is price volatility that causes crises. When prices fall to low enough levels this can bankrupt financial institutions.

The second market failure, which is a very important one, is persistent mispricing of assets due to limits to arbitrage. One of the big issues in the current crisis is how much the mortgage-backed securities, and securitized assets more generally, are worth, since the market does did not seem to price them correctly for long periods of time. If markets are efficient, market prices can be trusted as they reflect asset fundamentals correctly. The basic idea behind market efficiency is that if something becomes underpriced, there is a profit opportunity. Investors can buy the underpriced security and make a profit. That incentive provides the arbitrage mechanism to make sure that prices rise to the correct level. In the crisis this mechanism appears to have broken down. In particular, it seems that there were limits to arbitrage. A good example is what happened in the fall of 2007. The prices of the mortgage-backed securities went down. Some investment banks and hedge funds thought the securities were cheap and bought more. But the problem was that the prices kept on going

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securities. The mispriced securities became the so-called “toxic assets.” The same phenomenon of limits to arbitrage occurred in the dotcom bubble: The prices of many securities, particularly those involved with the internet, were too high but investors did not short them. The reason was that if investors had shorted them in 1997 or 1998, when their prices were high, they would have been bankrupted because prices kept on going up. This excessive risk from taking such positions is what we mean by limits to arbitrage. It is necessary to understand these limits much better than we currently do and to have mechanisms for overcoming them so that markets are always efficient and market prices can be trusted.

The third market failure is contagion (see, e.g., Allen, Babus, and Carletti (2009) for a survey). This is the failure that central banks often use to justify intervention, as, for example, in the case of the arranged takeover of Bear Stearns in March 2008. As Chairman Bernanke stressed in his speech at Jackson Hole in August 2008 (Bernanke (2008)), Bear Stearns would have defaulted if the Federal Reserve had not saved it. That would have led to a whole chain reaction where many other financial institutions would have gone bankrupt.

There might have been a complete collapse of the financial system. Probably, given the circumstances the financial system was in at the time and the uncertainty about the degree of interconnectedness of Bear Stearns, it was the right decision to save it.

Immediately after the arranged takeover of Bear Stearns, the Federal Reserve opened up the discount window to the investment banks. The quid pro quo for this was that they would allow Federal Reserve teams to inspect their books find out their positions. Six months later in September, the Fed had a much better idea of the interconnectedness of these

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ultimately decided to let it fail as it presumably expected that its failure would not generate the classic kind of contagion. In fact there was contagion but it was quite complex.

The first thing that happened was that Reserve Capital, the oldest money market mutual fund holding a significant amount of Lehman debt, “broke the buck.” In other words, the value of Reserve Capital’s shares fell significantly below the mandated level of one dollar a share. Investors in other money market funds realized that there could be a wave of similar problems and started withdrawing their funds. Within a few days the government was forced to provide a guarantee of all money market mutual funds.

In addition to these direct contagion effects, there were very damaging indirect effects. The realization that the government might allow a financial institution to fail caused a loss of confidence in many financial services firms. The volumes in many important financial markets fell significantly and there was a large spillover into the real economy.

Figure 4 shows how GDP fell significantly in the fourth quarter of 2008, particularly in Japan and Germany. This underlines the importance of the process of contagion. At the moment, however, our understanding of the indirect contagion effects is rather limited. A much better understanding of the many different aspects of contagion is needed.

Going forward it is important that banking regulation is structured to solve the market failures that are present in the financial system. It is necessary to understand the best way for central banks to intervene to restore liquidity in crucial markets like the interbank market.

Market structures need to be designed to try to make them as efficient as possible so as to avoid extended episodes of mispricing of assets. Finally, regulations have to be designed in

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important role to play in this respect.

8. How will the crisis evolve?

The crucial question now is what is going to happen going forward. One often hears it states that the recent crisis shares many similarities with the Great Depression. Although this is true in many respects, it is difficult to draw meaningful comparisons as institutions, technologies, and many other aspects were very different in the 1930s from how they are today. Looking at more recent times, the most similar crisis to the current one is the crisis that occurred in Japan in the 1990s. As in the current crisis, Japan experienced an enormous bubble both in stock prices and in property prices. In the mid-1980s, the Nikkei was around 10,000. By the end of the decade in December 1989, the Nikkei peaked at just under 40,000.

That was almost 20 years ago and yet in most of 2009 the Nikkei has traded in the range of 7,000 to 11,000. In other words, it was around a quarter to a fifth of where it was 20 years ago. That suggests there was a bubble in 1989.

As for the bubble in real estate, the extreme example is that at the peak of the boom, the few hundred acres where the Imperial Palace stands in Japan had the same value as all the land in Canada or California (see Ziemba and Schwartz (1992), p. 109). Real estate prices fell 75 percent over 15 years. This fall caused enormous problems in the real economy and Japan went from having one of the most successful and the fastest growing economies in the world, to having one of the slowest growing.

The question is whether the burst of the bubble in real estate in the U.S. will have as bad consequences as in Japan. Many people argue that the bubble in the U.S. was not as

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the very high absolute levels seen in Japan. Stock prices in many countries fell to around a half of what they were at the peak at the end of 2007. Since then they have recovered substantially. Whether the decline will be a long-lived phenomenon, like in Japan, or just a liquidity problem so that prices return to where they were in a year or two as they did after the crash of 1987 is still unclear.

A number of experts argue that in the U.S. property prices were about 25 percent above trend. Using the Case-Shiller indices property prices were about a third down at the minimum. This does not necessarily mean, however, that the price adjustment is finished and the economy will start to return to normal as it did eventually in Japan. The reason is that Japan has a very different kind of economy. The way that firms and banks are governed and react to shocks is very different from the U.S. In Japan firms are much more stakeholderoriented so that they don't care so much about the shareholders. They care about the workers, the suppliers and other stakeholders.

There are surveys confirming this view. For example, managers of large companies in Japan, Germany, France, the U.S., and the U.K. were asked what firms should do if hit by an adverse shock. Should firms cut dividends and keep stable employment or maintain dividends and lay off workers? The answers were quite different across countries. Figure 5 shows that in Japan, the vast majority of managers agree that firms should cut dividends and maintain employment in bad times. In Germany and France, it is not quite as extreme, but clear majorities believe that too. In the U.S. and the U.K., it is the complete opposite: even in bad times firms should lay off workers and maintain dividends.

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U.K. because it has allowed resources to be reallocated in the economy very quickly. If resources were being used inefficiently somewhere, they could be transferred to other firms.

In Japan in the 1990’s and 2000’s, the firms weren't able to do that. Similarly, in the European economies resources do not seem to be reallocated very easily. How these two different corporate governance structures will perform in recessionary times though is not clear. Since the start of the crisis, firms in the U.S. have laid off many workers and, as shown in Figure 6, unemployment has increased from 4.7 percent to 10.2 percent. This significant increase in unemployment, and the consequent fear of further unemployment that this triggers, has already had is likely to continue to have serious macroeconomic effects going forward.

How does what happened in the U.S. compare to what happened in the other countries? The aggregate statistics for unemployment in Figure 6 show that U.S.

unemployment has gone up significantly more than in the other countries. In Germany, unemployment is little changed from the start of the crisis. Workers do not feel as threatened and their consumption has not fallen as much as in the U.S. A similar pattern has occurred in France. Japan is an interesting case. Although, as mentioned above, the Japanese have traditionally had a great commitment to full employment, a few years ago, they introduced a temporary worker category. All these temporary workers have now been laid off and many have suffered significantly as a result. For example, many lived in company housing that they were forced to leave.

To summarize, focusing on value creation for shareholders works well for the efficiency of the economy in boom times as it facilitates the reallocation of resources to their

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macroeconomic instability. A rapidly rising unemployment rate can cause significant feedback effects. A critical issue when comparing Japan’s experience in the 1990’s with U.S. experience now is how big these feedback effects will be in the U.S. Japan had a lost decade with slow growth but did not have a large contraction in GDP and increase in unemployment. In the U.S. it is too soon to say how large the feedback effects will be in the end.

9. Excessive risk taking in the private or public sectors?

Going forward, what should governments do to minimize the risk of a future financial crisis? What reforms in addition to changes in banking regulation should be undertaken?

There has been a tremendous focus on the private sector and what the private sector did wrong in terms of taking excessive risk. However, if the basic cause of the crisis was the real estate bubble and central banks played a role in creating that, it is really the public sector that took the main risks. If there had not been a bubble in real estate prices there would not have been a problem with subprime mortgages. If property prices had remained stable or continued to rise at a slower rate the default rate would have been at manageable rates. It is therefore important to try to prevent central banks from creating a similar problem going forward. In particular, we need to develop a system that provides a check on central banks to lessen the chance that they take risks in the way that the Federal Reserve did when it set interest rates so low in 2003 and 2004.

After the inflationary experiences of the 1970s, many countries made their central banks independent. The rationale was that if they are independent, they will not succumb to

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election. This independence has worked very well for preventing inflation. However, this crisis has demonstrated that central bank independence may not be good for financial stability. There are a few people making decisions that are very important and there is very little in the way of checks and balances. For example, it seems that one person, Alan Greenspan, played a large role in the decision to cut interest rates to one percent in 2003 and to maintain them there until 2004 so as to minimize the effects of the recession. According to reports at the time there was not much dissension within the Board of Governors in terms of votes against the position he took. The low interest rate policy worked in the short run, but at the cost of an enormous recession several years later. There should at least have been more public debate about the wisdom of the low interest rate policy at the time.

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