Abstract
This paper provides a perspective on the causes of the current financial crisis by comparing it to the international debt crisis of the early 1980s. It argues that competition and innovation can lead to unsustainable debt build-ups as risk is consistently underestimated and underpriced. This has important implications for policies for crisis prevention.
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Notes
A Eurodollar was defined by the Bank for International Settlements in 1964 as ‘a dollar that has been acquired by a bank outside the United States and used directly or after conversion into another currency for lending to a non-bank customer’ (BIS 1964, p.127). The market for Eurodollars was largely based in London.
These are based on figures for foreign currency assets vis-à-vis non-residents of banks reporting to the BIS (Source: BIS Annual Reports).
The interest rates on the loans were usually stated in terms of LIBOR (the London InterBank Offer Rate for dollars) plus a fixed spread.
This market accounted for 70–80% of the total size of the Eurodollar market in London the 1970s/1980s (own calculations from data from Bank of England Quarterly Bulletin). The Federal Funds interbank market of that time amounted to some 12.5% of aggregate liabilities.
The spreads are on dollar syndicated loans to sovereign borrowers or borrowers with a state guarantee. The data was collected from “tombstones” advertising loans negotiated and placed in Euromoney between 1977 and 1985.
In the presence of asymmetric information, it would be expected that credit limits would be set to control exposure risks (Stiglitz and Weiss 1981). However, such limits are not published by banks to allow an analysis of either their appropriateness or their level compared to the lending that actually took place.
See ECB (2008) for a comprehensive account of the development of this model.
Spreads are calculated relative to the average coupon on an index of 1–3 year US government debt; the coupons on asset-backed securities are on asset-backed securities indices compiled by Barclays. All data is taken from Datastream.
Spreads are from J P Morgan Emerging Market bond indices and are calculated relative to US Treasury yields. All data is taken from Datastream.
References
Bank for International Settlements (1964) Annual reports
Cline WR (1984) International debt: systemic risk and policy response. Institute for International Economics, Washington DC
ECB (2008) The incentive structure of the “originate and distribute” model. ECB, Frankfurt
Gibson HD (1989) The Eurocurrency markets, domestic financial policy and international instability. Macmillan, London
Gibson HD, Thirlwall AP (1989) An analysis of changes in the debt service ratio for 96 countries: 1986–90. Banca Nazionale del Lavoro Quarterly Review 184:31–47
Meltzer AH (1967) Major issues in the regulation of financial institutions. J Polit Econ 482–501 August
Stiglitz JE, Weiss A (1981) Credit rationing in markets with imperfect information. Amer Econ Rev 71:393–410
Acknowledgments
I would like to thank Chrysa Glystra for research assistance. The views expressed here are personal and should in no way be attributed either to the Bank of Greece or the Eurosystem.
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Gibson, H.D. Competition, Innovation and Financial Crises: A Perspective on the Current Financial Market Turmoil. Open Econ Rev 21, 151–157 (2010). https://doi.org/10.1007/s11079-009-9145-5
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DOI: https://doi.org/10.1007/s11079-009-9145-5