Three Reflections on Banking Regulations and Cross-Border Financial Flows

Abstract

Edwin Truman discusses the incidence of banking crises and concludes that there is no reason to expect an end to financial crises in the future. Moreover, he argues that financial reforms in recent years may have had the effect of increasing the severity of those crises that will occur by preventing the occurrence of smaller crises. Second, he finds that capital controls can be of use but not as a rule for all countries in all circumstances. Although a sudden stop of capital flows often precede crises they are not the underlying cause. Instead, there is greed on the part of borrowers and lenders that turns into fear when a disturbance occurs. Thus capital flow management controls, although often desirable, are not a panacea. Moreover, the authorities may find it difficult to distinguish between good and bad types of banking flows and over time capital controls will be evaded and become distortionary. Finally, Truman explores the possibility of major countries taking into account the effect of their policies on others but is not hopeful that central banks can deviate much from the local mandates.

Discussion of Chapters 6–9

Alex Pollock began by citing Carmen Reinhardt and Kenneth Rogoff’s This Time is Different, particularly the 35- to 40-page appendix listing all crises since 1800. Pollock took the portion of the list spanning 1900–2000, organised it by date, and found in that, one country or another—often many countries—a banking crisis began in 54 of the 100 years of that century. In short, there’s usually a banking crisis somewhere.

Pollock then summarised the pattern described by Robert Aliber : Capital flows go in, asset prices go up, a Ponzi scheme is induced by which old debts can only be serviced by new borrowing, the Ponzi scheme implodes, asset prices fall, and losses are left to be distributed among the players. The question arises: Why is real estate so often at the centre of financial collapses? The size of the sector is a factor: Land and buildings are a huge asset in any economy, and they’re available to absorb investment. There has to be something big enough to do this, something that governments are interested in protecting and promoting, and something whose price can move in response to credit flows. An important point to remember, however, is that the collateral for any mortgage loan is not the underlying property but the price of that property. That price can rise or fall much more than most observers expect. This was a factor in the US real estate market collapse: many knew something very bad was in the offing, but no one anticipated how bad it would be and how much prices could fall.

Robert Aliber also discussed Dodd-Frank and its irrelevance, positing that post-crisis banking regulation betrays a complete misunderstanding of the crisis, and that the villains in the piece were the macro managers, not the banks, as somebody had to adjust to the autonomous increase in foreign demand for USD securities. Aliber argued that capital requirements for banks should be low, about 5%, but that the government must have a supply of capital cash to shore them up if they go below that threshold.

Government guarantees were important, particularly to central banks, which, as Brad Setser pointed out, wanted safe assets in which to invest their reserves. Setser posited that one source of financial risk was the increasingly complex financial chains of intermediation, where central banks wanted safe USD assets and put funds on deposit or reduced the available supply of safe assets, and private actors took the risk.

Those safe assets can ultimately, through the functioning of the financial system, become embodied in quite risky assets, at least as it turned out ex post. This was exemplified in less developed countries in the 1980s: Oil producing countries’ assets were invested in what was viewed as safe assets, mainly the big US banks, and they were in fact safe because they were protected by the government. Also in the 1980s, the public would seek out safe assets, which they found in deposits at savings and loans, which were indeed safe, protected by the government—even though the losses were so large that they made insolvent not only the industry but also the government’s guarantee fund, the Federal Savings and Loan Insurance Corporation.

Part of the problem, as Jeff Schafer noted, is short funding of long assets. In the GFC, this was embodied in structured investment vehicles (SIV), which produced assets that were deemed highly safe but turned out very risky. The SIVs kept the financing off the balance sheet. Indeed, in the US real estate sector, Fannie Mae and Freddie Mac essentially functioned as SIVs set up by the government to keep its financing off-balance sheet. Schafer also pointed out a strong tendency, even among very sophisticated investors, to outsource due diligence. When the crisis occurred, and everyone was protesting, “But this is AAA paper,” it was clear that investors had decided that since S&P and Moody’s had signed off on a product or provider, no further work was needed. The German banks were a prime example of this, having done it repeatedly through multiple crises: During the Korean crisis, it was German banks that had bought all of the Korean paper, assuming that since Korea was an OECD member, its sovereign paper must be low-risk.

Edwin Truman focused, among other things, on the role of international cooperation, noting that the international global safety net was not functional during the GFC. He stressed the need for something at the centre of the system, observing that it was the US Federal Reserve that had effectively taken on that role, advancing over USD 1 trillion in credit to foreign central banks and financial institutions. The option of giving the IMF the resources to do this alone would not be feasible for moral hazard reasons, but the IMF should provide both a financial backstop and a policy backstop. In the latter case, a mechanism will be needed to get distressed countries from a liquidity crisis to a policy take-out with the IMF. This would require adequate IMF resources as well. Such a policy mechanism does not yet exist.