Gerhard Illing, University of Munich, September 21st 2007
Implementing monetary policy has been a pretty boring job during the last couple of years. This changed dramatically since August 9th 2007 when the ECB provided €95 billion (at that time $131 billion) of additional funds to the money market, initially just for one day. That was even more than it had supplied on September 12th, 2001 in the aftermath of terrorist attacks. It followed this up with a further shot of €61 billion the next day. Since then, many other central banks followed the same procedure, except for the “Old Lady of Threadneedle Street,” the Bank of England. For quite some time, she refused to inject more liquidity.
Despite the massive injection of additional liquidity which is going on until now, money markets did not calm down during the last weeks. There has been an unprecedented freeze on the money markets worldwide, with Libor rates hiking up dramatically. At the same time, the effective Federal Funds Rate did undershoot the target rate quite dramatically. Over the last years, lots of people have talked a lot about excessive liquidity. Suddenly, liquidity dried out nearly completely.
What went wrong? What should be done?
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Central banks really do not have many options at that stage. But for exactly that reason the moral hazard problem needs to be addressed in other ways – by stronger regulation or some alternative instruments. At a Bundesbank Conference on Financial Stability and Globalisation back in June 2004 I gave a talk on How to escape contagion (PDF 698 KB) in the interest rate trap. I concluded:
"Central banks… should not prevent an orderly unwinding of imbalances – in contrast, they should contribute to make the unwinding orderly. But this strategy poses a serious risk: a policy limited trying to soften ex post the impact of negative systemic shocks may contribute itself to building up new structural imbalances. If that is the case, the solution of the underlying problems would simply be postponed in the future.Even worse: It may encourage building up even more serious imbalances, thus aggravating the underlying risks. So the challenge for policy and for future research is to try to identify instruments for economic policy which help to prevent the building up of imbalances right from the beginning."
Just as in standard dynamic consistency problems, the right approach is to tackle the externalities directly. It was a humiliating experience to see the credibility of the Bank of England being smashed by a Northern rock. It would be disastrous if Mervyn King would be forced to quit after giving in.
This year at Jackson Hole, James Hamilton joined in for the call for regulatory and supervisory reforms, pointing to significant negative externalities that have been created. The key question, of course, is how to design adequate mechanisms to address the underlying externalities. Within Europe, there has been an urgent call for regulatory and supervisory reforms for quite some time. Driven by the fear of the LTCM crisis, Hans Tietmeyer, at that time president of the Deutsche Bundesbank, suggested establishing the Financial Stability Forum as a base for reforms. This spring, the German Finance Minister Peer Steinbrück tried to push for more transparency in the global hedge funds industry at this year’s G8 meeting in Heiligendamm. The simple idea was to reduce risk by forcing hedge funds to adhere to stricter reporting requirements - see Wolfgang Münchau or Ken Rogoff.
All these initiatives hit upon strong resistance within the financial community. Resistance has been particularly strong in the US. The reason is presumably the bad experience with hasty changes in legislation under urgent political pressure. After the depression, crazy regulations have been imposed on the US banking industry, limiting sound banking activities across states for quite a long time. The Sarbanes-Oxley Act of 2002 imposed by Congress after the Enron scandal gave Wall Street the feeling that it is losing part of its business to other financial centres abroad.
Such fears have to be taken seriously. The more so, it is crucial to design clever changes in the regulatory framework, creating efficient incentive schemes. The challenge is to provide adequate incentives to internalise the externalities created by recent innovations in financial markets, but at the same time make sure that the benefits of these innovation will not be lost.
What about the benefits? Securitisation is said to allow more efficient spreading of risks to those who are most able to bear it. But we need to take a closer look whether this is indeed true. In a couple of papers, my colleague Jan Pieter Krahnen from Center for Financial Studies at Goethe University Frankfurt has shown that empirically, credit securitizations tend to go hand in hand with an increase in the issuer's systematic risk. At first sight, this seems puzzling: Collateralized debt obligations (CDOs) allow the issuing banks to shift credit risk to other investors, so it is supposed to decrease its exposure to systematic risk. In order to provide sufficient monitoring incentives for the issuer, the first loss piece with the highest risk should be retained by the issuing institution, whereas the senior, less risky tranches are sold to the market.
The idea is that senior tranches will go sour only in extreme cases, when really bad, macro driven shocks happen. So securitisation seems to allow to separate idiosyncratic from systemic risks in an elegant way, indexing debt contracts against macro shocks: Rare systemic macro shocks can be transferred to the market, whereas idiosyncratic risk is borne by the issuing bank. In order to avoid taking excessive risks, the bank should take all efforts to carefully monitor its own loans.
As Jan has shown, alas in reality this turns out not to be true. The basic mechanism is pretty straightforward: First, idiosyncratic risk is highly correlated with macro shocks – much more subprime loans turn sour when the economy is tumbling. Second, those firms engaging in securitizations in order to circumvent regulatory pressure are likely to reinvest the funds obtained by selling their loans. By investing these funds again they issue even more credit, thus raising systemic exposure. Obviously, these effects will be compounded if – as seems to be the case in the US subprime market - even the first loss piece is sold to the market to institutions highly leveraged at banks. Even first year students should realise that such an arrangement is just the opposite of an optimal second best incentive contract.
Evidently, unregulated markets seem to have a tendency to engage in trading strategies creating high systemic risk exposure. It is a daunting challenge to design optimal second best arrangements. But it is naïve to trust that free markets will sort out the adequate arrangements on their own. Turbulence having spread world wide now there seems to be a unique chance to implement some serious changes in the international financial architecture. In my view, the BIS and the IMF deserve to play the decisive role in that process.
Some - as James Hamilton - suggest that the Fed should play the key role. There are very clever people working at the Fed – some of the best economists worldwide. But looking at their recent track record, I have serious doubt that they are really up to the challenge. My impression is that they screwed it up, blinded by fascination about the new age of financial innovation, driving markets closer to the wonderful world of an Arrow Debreu economy. Just before he raised interest rates, Alan Greenspan gave the best ad for mortgage brokers of subprime loans in his speech Understanding household debt obligations on February 23, 2004:
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.
In an economy with incentive and commitment problems, you will never come close to an Arrow Debreu economy. If you don’t get used to think about second best outcome, you are likely to screw it up. For some mysterious reasons, people at the Fed seem to have an obsessive aversion against any sensible form of regulation. The real danger is that, once central banks start cutting interest rates, everything will look bright and sunny again, and financial markets will claim that the current crisis has simply been caused by irrational exuberance. Strange that you are not able to notice exuberance on the way up, but it seems so easy to smell it on the way down. If the Fed lowers interest rates sufficiently, even toxic waste may turn into gold again. If that will indeed be the outcome, convergence arbitrage on risk spreads promises to be even more fun. Since central banks cannot commit to take away the punch bowl when the party is going, we need other means to stop getting the party out of control.
In my hometown Munich, around 1870 Adele Spitzeder promised poor farmers amazingly high returns. Initially, she indeed paid out, financed by tons of money flooding in. Finally, she ended up in prison, having caused the big Munich banking scandal in 1872. She wrote her memoirs in prison, explaining the soundness of her strategy. Charles Ponzi was just one of many others who repeated her strategy. He did it in Boston around 1920. Again, the guy ended in prison, but at least he really became famous: Today, a reference to Ponzi schemes can be found in nearly any textbook. The No Ponzi game condition is taught in all advanced macro PhD courses. Nevertheless, nowadays it somehow seems as if investment bankers playing similar schemes (willing to finance fat private equity deals without any covenant), rather than ending up in prison end up getting additional money from the Fed.