I attended a conference earlier today and talked about the lessons to be learnt from the global financial crisis. There are so many lessons, big and small, that one can draw from the crisis and I would like to share with readers my personal views on the more important ones.
Lesson Number One : Financial Crises Do Occur Frequently
Financial crises tend to occur frequently - Barro and Ursua have identified 148 crises since 1870 in which a country experienced a cumulative decline in GDP of at least 10%.1 Reinhart and Rogoff also identified 104 banking crises across the world since World War II.2 What is the explanation for such frequent occurrence of financial crises?
- people do not learn from past mistakes, e.g. in September 1998 the collapse of the LTCM led to calls for revamping the financial system, but within one year all the momentum was lost because the markets had returned to normal and it was "business as usual"; or
- people learn the wrong lessons and therefore apply the wrong medication.
While no two financial crises are exactly the same, the basic underlying causes are usually rather similar: human greed leading to excessive risk taking that pushes up asset prices, made possible by excessive leverage that subsequently collapsed.
Lesson Number Two: The Bigger the Mistake the Heavier the Punishment
Usually markets are very good in punishing mistakes. The bigger the mistake, the heavier the punishment is. Asian economies made some mistakes in the 1990s, and they were punished heavily in the Asian Financial Crisis. However, this latest round of financial crisis differs from past crises after World War II in that it happens in the very core of the global financial system. As the scale and severity of the mistakes are unprecedented, the crisis has led to an even more devastating punishment3.
Lesson Number Three: Financial Innovation Has Not Led to Greater Financial Stability
Surprisingly, financial innovation or financial engineering in the last twenty years has not led to greater financial stability. Rather it has become a source of financial instability. This is in stark contrast with other forms of engineering innovations that we know of. Clearly lending to sub-prime borrowers, who cannot afford to pay back the money unless property prices keep on rising, was a breakdown of basic risk management principles. However, through securitisation and clever financial engineering, it was possible to package and distribute securitised sub-prime mortgages or other low-quality loans into top-grade investment instruments, using what we now know to be flawed assumptions and modelling.
At the same time, the creation of very complex financial derivatives such as CDS and CDO/CDO Squared enabled firms, financial and non-financial, to take excessive risks without adequate support of capital, as high leverage was embedded in these instruments that could easily be hidden as off balance sheet items.
As these complex financial derivatives were traded over-the-counter, there was almost total opaqueness in the size, volume and concentration of the derivative markets. If the senior management of many financial institutions did not fully understand the true leverage and risks embedded in these complex and opaque financial derivatives, it was not surprising that regulators had a hard time in coming to grips with these instruments and the risks they would pose to the financial system.
Lesson Number Four: The Growth of Shadow Banking System Contributing to Financial Instability
In the US, the development of a shadow banking system, in which money market funds played a major role, was another factor contributing to the severity of the latest crisis. The money market funds, which were subject to much lighter regulation, reached a mammoth size of US$3 trillion in 2007, roughly half the size of the total bank deposits in the US. Following the collapse of Lehman and two major money market funds, there was a run on this shadow banking system, resulting in a huge liquidity squeeze on the rest of the financial system. This would have caused a collapse of the entire system if not for the US Government's rescue.4 While there is now strong international determination to improve the safety and robustness of the banking system, mainly through the strengthening of capital and liquidity requirements, one must not lose sight of the risk of pushing even more financial intermediation activities to the unregulated sector of the financial system, resulting in further undesirable "regulatory arbitrage".
Lesson Number Five: Breakdown of Self Regulation / Correction of Financial Markets
Given the many traumatic events that happened in the last two years, it is now widely recognised that self-regulation or self-correction of financial markets was not enough to prevent excesses and malpractices in the system. Many supporters of market self-regulation have been disappointed and disillusioned by the failure of the market-based "gatekeepers", such as internal and external auditors, rating agencies and analysts, in warning against deficiencies and problems, let alone preventing them from happening. Going forward, tighter regulation of the financial system and its participants is therefore needed.
Lesson Number Six: Quality of Regulators Is as Important as Regulatory Structure
Given that the global financial crisis has hit so many developed economies with different regulatory structures, such as the centralised mega regulator model in the UK or the decentralised model in the US, it adds credence to the argument that no single regulatory structure is inherently superior to other structures and sufficient to prevent systemic crises from happening. There is no doubt that each economy must learn from this crisis and do whatever necessary in closing the gaps in their regulatory structure that have been identified. However, no matter what structure one would go for, it is equally, if not more, important for the regulatory agencies to have the right people with the necessary professional expertise and weaponry to do the job.
Lesson Number Seven: Financial Stability Work Must Not be Allowed to Fall Between Cracks
While there is general agreement that financial crises can have serious disruption to economic growth and employment, there is yet no consensus on whether and how central banks should take into account financial stability or asset prices in determining monetary policy. The latest crisis demonstrates clearly that consumer price stability can exist even when significant financial imbalances are building up. Trends in globalisation in the last 20-30 years - such as the entry of China, India and Eastern Europe into the global market economy which doubled the world's labour supply - have allowed central banks to maintain lower consumer price inflation than it would have been possible when domestic factors alone were in play.
In my view, central banks should take into account financial stability as part of their mandate. If a central bank, for whatever reasons does not feel it should have such a mandate, someone else must be given this mandate and the necessary tools to do a proper job. I hope people will learn from the latest crisis that the economic and social costs of losing financial stability, which is not a phenomenon confined to the emerging market economies, could be so enormous that we must do all we can to prevent it from happening and, failing that, reduce the damage it would inflict when it occurs.
Norman T. L. Chan
Chief Executive
Hong Kong Monetary Authority
24 March 2010
1 Barro and Ursua (2008),"Macroeconomic crises since 1870", NBER Working Paper No. 13940.
2 Reinhart and Rogoff (2009), This Time is Different. Princeton University Press.
3 In 2009, over 20 and 200 banks or financial institutions in the UK and the US respectively collapsed or experienced financial difficulty, requiring the governments to inject over 125 billion pounds and 160 billion US dollars into the banking system. (Sources: SIGTARP, "Quarterly Report to Congress, January 2010", US Fed; National Audit Office, "Maintaining financial stability across the United Kingdom's banking system", December 2009).
4 The US Treasury Department announced on 19 September 2008 the Temporary Guarantee Program for Money Market Funds. Under this program, the US Treasury Department temporarily guaranteed the share price of publicly-offered eligible money market funds with net asset value of $0.995 per unit or more on 19 September 2008 to maintain a unit price of at least $1. The program expired on 18 September 2009.
