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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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Removal of tax subsidies for debt The tax system in many countries subsidizes the use of debt in many ways. For example, corporations including banks and other financial institutions use debt because interest is deductible for income tax purposes at the corporate level. This bias towards debt should be removed. If this means financial institutions are willing to use much more equity, then financial stability will be considerably enhanced. It is not clear what exactly is the public policy rationale for having interest deductibility at corporate level.

In the U.S. mortgage interest is tax deductible for individuals. These kinds of incentives for households to use debt are not desirable in a financial stability context. They should also be removed.

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A number of commentators have argued that the over-the-counter markets for many derivative contracts such as credit default swaps are opaque so that it is difficult to assess counterparty risk. The suggestion is that these markets should be moved onto exchanges so that the counterparty risk could be more systematically dealt with and eliminated. These suggestions have a lot of merit. The problem is whether socially valuable niche markets for derivatives that do not have sufficient volumes to trade on exchanges will be eliminated as a result of such measures. Reforms of over-the-counter markets should be carefully considered.

Competition policy should carefully implemented in the financial services sector There has long been a tension between competition policy and financial stability (see Carletti and Vives (2009)). It is only in recent years that competition policies have been implemented in many countries. Often for stability reasons, countries have avoided implementing competition in the banking sector as rigorously as in other sectors.

An interesting question that has been raised during the crisis is why is it that in normal times financial services firms make such large profits. One possibility is that it is because competition policy is not enforced properly. Although on the face of it financial markets are very competitive, the nature of deviations from perfect competition is rather different than in markets for goods. One example is “front running”. This is based on knowledge of order flow by brokers and other participants in the market, which is extremely valuable. For example, if a large buy order is executed then this will typically drive up prices because market participants will deduce that the buyer has good

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then it is possible to make money. Aggregated over time this front running can be extremely profitable. In the equity markets in the U.S. this is illegal. There are very careful records kept of when orders are received and brokers can’t trade on their own account before they execute the customers’ orders. However, front running is not illegal in the U.S. bond markets.2 The large investment banks have set up trading platforms for bonds that give them an advantage in terms of knowledge of order flow. This has the potential to allow large profits from front running.

It is important that deviations from perfect competition such as front running be carefully investigated and regulated. Front running in the bond markets should be made illegal just as it is in the equity markets. However, this is just one example where deviations from perfect competition are different in financial services. There are many others that need to be understood and prevented.

Capital adequacy regulation should be based on market capital as well as accounting capital Capital adequacy rules have an important role to play in preventing contagion and other problems. However, one aspect of their current implementation is that regulatory capital is based on accounting book capital. When Wachovia failed last year its accounting capital was well above regulatory limits even though the market was no longer willing to provide funds. This example underlines the importance of using market capital in regulation, in addition to accounting based regulatory capital.

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Financial institutions have traditionally used historic cost accounting for many of their assets. This is problematic if assets fall in value as they may able to hide this fact for significant periods of time. A good example is the S&L crisis in the U.S. in the 1980’s. This kind of episode encouraged a move to mark-to-market accounting in by the IASB and U.S.

FASB (see, e.g., Allen and Carletti (2008a) and Plantin, Sapra, and Shin (2008)). During the current crisis where it is not at all clear that market prices reflect fundamental values, markto-market accounting has come under severe criticism by financial institutions and has been relaxed by the FASB under political pressure from Congress as well as, even if partly, from the IASB.

How should the advantages and disadvantages of mark-to-market accounting be balanced? As long as markets are efficient, mark-to-market accounting dominates.

However, if as during times of crisis they cease to be efficient, market prices do not provide a good guide for regulators and investors. The key issue then becomes how to identify whether financial markets are working properly or not. Allen and Carletti (2008b) suggest that when market prices and model based prices diverge significantly (more than 2% say), financial institutions should publish both. If regulators and investors see many financial institutions independently publishing different valuations they can deduce that financial markets may no longer be efficient and can act accordingly.





A role for public sector banks in a mixed system Some countries such as Chile with its Banco Estado have a publicly owned

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expand and help stabilize the market as all market participants know that it is backed by the state and will not fail. At the moment, that's what the Fed is effectively doing by buying large quantities of commercial paper. They have in effect become one of the largest commercial banks in the world. But the officials in charge of the Fed do not have much expertise in running a commercial bank. The Fed does not know much about credit risk. It would be better to have expertise in the public sector which allows the state to perform commercial banking functions during times of crisis.

12. Concluding remarks If the speculation above that the most similar recent crisis to the current one is Japan in the 1990s is correct, the implication is that the after effects of the current crisis will be long lived. The problem is that when bubbles burst it is not just the effects on the financial system that are damaging. Prices have been wrong and finding the correct new prices can take a long time, particularly if the bubble was largely in real estate. During the adjustment period economic activity can be badly affected.

Many reforms in a wide range of areas are needed to prevent another crisis from occurring. Unfortunately, there is very little consensus on what was the cause of the crisis and what needs to be done to prevent another one occurring. In this paper we have outlined the view that the crisis was caused by loose monetary policy and global imbalances and have suggested a number of reforms. Much work remains to be done in detailing these policies.

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Adrian, T. and H. Shin (2009). “Liquidity and Leverage,” Journal of Financial Intermediation, forthcoming.

Allen, F., A. Babus, and E. Carletti (2009). “Financial Crises: Theory and Evidence,” Annual Review of Financial Economics 1, forthcoming.

Allen, F. and E. Carletti (2006). “Credit Risk Transfer and Contagion,” Journal of Monetary Economics 53, 89-111.

Allen, F. and E. Carletti (2008a). “Mark-to-Market Accounting and Liquidity Pricing,” Journal of Accounting and Economics 45, 358-378.

Allen, F. and E. Carletti (2008b). “Should Financial Institutions Mark to Market?” Bank of France Financial Stability Review 12, October 2008, 1-6.

Allen, F., E. Carletti and D. Gale (2009). “Interbank Market Liquidity and Central Bank Intervention,” Journal of Monetary Economics 56, 639-652.

Allen, F. and D. Gale (2000). “Bubbles and Crises,” Economic Journal 110, 236Allen, F. and D. Gale (2004). “Financial Fragility, Liquidity, and Asset Prices,” Journal of the European Economic Association 2, 1015-1048.

Allen, F. and D. Gale (2007). Understanding Financial Crises, Clarendon Lecture Series in Finance, Oxford: Oxford University Press.

Bernanke, B. (2008). “Opening Remarks,” Maintaining Stability in a Changing Financial System, 2008 Federal Reserve Bank of Kansas City, Jackson Hole Symposium, 1-12.

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Crisis Problem Growing More Severe?” Economic Policy, April 2001, 53-82 + Web Appendix.

Boyd, J., G. De Nicolo, and E. Loukoianova (2009). “Banking Crises and Crisis Dating: Theory and Evidence,” working paper, University of Minnesota.

Brunnermeier, M. (2009). “Deciphering the Liquidity and Credit Crunch 2007 Journal of Economic Perspectives 23, 77-100.

Carletti, E. and X. Vives (2009). “Regulation and Competition Policy in the Banking Sector,” in X. Vives (ed.) Competition Policy in Europe: Fifty Years of the Treaty of Rome, Oxford: Oxford University Press.

Greenlaw, D., J. Hatzius, A. Kashyap and H. Shin (2008). US Monetary Policy Forum Report No. 2.

Herring, R. and S. Wachter (2003). “Bubbles in Real Estate Markets,” in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies edited by W. Hunter, G. Kaufman, and M. Pomerleano, Cambridge: MIT Press.

Mayer, C., K. Pence, and S. Sherlund (2009). ''The Rise in Mortgage Defaults'', Journal of Economic Perspectives forthcoming.

Muellbauer, J. (2009). “Household Decisions, Credit Markets and the Macroeconomy: Implications for the Design of Central Bank Models,” working paper, Bank for International Settlements, Basel.

Nadauld, T., and S. Sherlund (2008). “The Role of the Securitization Process in the Expansion of Subprime Credit”, working paper Federal Reserve Board.

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Pandora's Box?” Journal of Accounting Research 46, 435-60.

Purnanandam, A. (2009). “Originate-to-Distribute Model and the Subprime Mortgage Crisis,” working paper, University of Michigan.

Reinhart, C., and K. Rogoff (2008a). “This Time is Different: A Panomaric View of Eight Centuries of Financial Crises,” NBER Working Paper 13882.

Reinhart, C., and K. Rogoff (2008b). “Banking Crises: An Equal Opportunity Menace,” NBER Working Paper 14587.

Reinhart, C., and K. Rogoff (2009a). This Time is Different: Eight Centuries of Financial Folly, Oxford and Princeton: Princeton University Press.

Reinhart, C., and K. Rogoff (2009b). “The Aftermath of Financial Crises,” American Economic Review 99, 466-72.

Taylor, J. (2008). “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” working paper, Stanford University.

Ziemba, W., and S. Schwartz, 1992, Invest Japan, Chicago, Ill: Probus.

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A Comparison of Foreign Exchange Reserves in Different Regions Source: IMF website.

Asia is the six East Asian countries China, Hong Kong, Japan, Singapore, South Korea, Taiwan – province of China.

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Dividends more important Number of firms surveyed: Japan, 68; United States, 83; United Kingdom, 75; Germany, 105;

France, 68.

Source: Masaru Yoshimori, “Whose Company Is It? The Concept of the Corporation in Japan and the West.” Long Range Planning, Vol. 28, No. 4, pp. 33{44, 1995.

44 %

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Japan May-2009 Jul-2009 Sep-2009

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