Huertas crisis; cause, containment and cure, 2nd ed (2011)

Crisis: Cause, Containment and Cure 9780230_298316_01_prex.indd i 5/27/2011 6:31:41 PM Also by Thomas F Huertas CITIBANK, 1812–1970 (with Harold van B Cleveland) THE FINANCIAL SERVICES REVOLUTION (co-edited with Catherine England) 9780230_298316_01_prex.indd ii 5/27/2011 6:31:41 PM Crisis: Cause, Containment and Cure 2nd edition Thomas F Huertas 9780230_298316_01_prex.indd iii 5/27/2011 6:31:41 PM © Thomas F Huertas 2011 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988 First edition published 2010 Second edition published 2011 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN: 978–0–230–29831–6 paperback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Huertas, Thomas F Crisis : cause, containment and cure / Thomas F Huertas.—2nd ed p cm Includes bibliographical references and index ISBN 978–0–230–29831–6 (alk paper) Global Financial Crisis, 2008–2009 Financial crises Financial crises—Prevention Financial institutions—State supervision Economic policy I Title HB37172008.H83 2011 330.9Ј0511—dc22 2011016956 10 20 19 18 17 16 15 14 13 12 11 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne 9780230_298316_01_prex.indd iv 5/27/2011 6:31:41 PM Contents List of Figures vi List of Tables viii Acknowledgements ix Preface to the Second Edition x Introduction Part I Rational Exuberance Too Much of a Good Thing Part II Cause 15 Containment Conditional Containment Moving towards Meltdown Unconditional Containment 43 66 82 Part III Cure Better Macroeconomic Policy Better Resolution Better Deposit Guarantee Schemes Better Regulation 10 Better Supervision Conclusion 103 115 145 157 183 199 Notes 217 References 226 Index 239 v 9780230_298316_01_prex.indd v 5/27/2011 6:31:41 PM Figures I.1 1.1 1.2 1.3 2.1 2.2 2.3 2.4 2.5 2.6 2.7 II.1 II.2 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 5.1 5.2 Does monetary policy crank the asset cycle? The financial system as transmission mechanism Productivity parameters A high wire act: the world economy, 2004–07 The great search for yield: responses to the challenge of falling spread on investment grade names Shadow banking Securitisation structure protects investors and funds sponsor banks US securitisation issuance, 1996–2006 Credit derivatives, 2001–07 Money market mutual funds versus checkable deposits, United States, 2002–06 Dealer bank funding model A vicious cycle Containment of the crisis: three phases, 3-month, June 2007–December 2010 Crisis, what crisis? Official forecasts, fall 2007 Interest rate policy, Eurozone, UK and US, 2007–08 Conditional containment overview, August 2007– September 2008 Northern Rock Asset-backed commercial paper outstanding, July 2008– July 2009 Capital raised by 32 largest banks by type (cumulative), August 2007 to 15 September 2008 Moving towards Meltdown, 3-month, 15 September– 15 October 2008 Federal Reserve pumps out liquidity post-Lehmans, 10 September–1 October 2008 Unconditional containment, 3-month, October 2008– December 2010 The world economy goes into free fall – real GDP growth, advanced (OECD) economies quarter over quarter, annualised, 2007–09 13 16 17 19 20 23 26 36 41 42 44 45 46 50 54 55 67 72 82 83 vi 9780230_298316_01_prex.indd vi 5/27/2011 6:31:42 PM List of Figures vii 5.3 Governments prime the pump for further bank recapitalisations – capital raisings by 32 largest banks by type (cumulative) 15 September 2008–26 November 2009 5.4 A $13 trillion cheque 5.5 Central banks slash interest rates effectively to zero 5.6 Fed floods the market with liquidity – central bank liquidity operations, September 2008–October 2009 5.7 Massive fiscal stimulus – fiscal deficit/GDP, 2007–09 III.1 A cure requires a comprehensive and consistent framework 6.1 Eligibility criteria for bank borrowing from the central bank 6.2 Economic scenarios 7.1 Official resolution policy 7.2 Resolution in practice 7.3 Resolution via bridge bank 7.4 Resolution via bail-in 7.5 Bail-in via stay on investor capital 7.6 Bail-in via conversion 9.1 Regulation sets the stage for strategy at financial firms 9.2 The Basel Capital Reform Programme 9.3 Limiting and strengthening non-equity capital 9.4 Good remuneration practice: bonus should come after profit, not before 10.1 Strong supervision requires a proactive intervention framework C.1 Recovery and resolution plans C.2 SIFI surcharge should depend on systemic importance and resolvability 9780230_298316_01_prex.indd vii 87 89 93 95 97 101 107 111 119 120 129 133 135 136 158 161 167 172 188 202 203 5/27/2011 6:31:42 PM Tables 7.1 7.2 7.3 Probability of bail out determines risk Overview of resolution methods Bail-in via conversion: timing and decision-maker for conversion ratios 8.1 Total deposit guarantees available to each person, selected countries, April 2011 10.1 Macro-supervision of financial infrastructures 10.2 Possible macro-prudential policy tools C.1 Sunshine Banks: threshold and buffer conditions 116 127 137 146 196 197 214 viii 9780230_298316_01_prex.indd viii 5/27/2011 6:31:42 PM Acknowledgements Although the book does not necessarily represent the views of the Financial Services Authority, I am deeply grateful to my colleagues for discussion of the issues and for the opportunity to participate in the work of dealing with the crisis and laying the foundation for the future of financial regulation and supervision Similarly, the book does not necessarily represent the views of the European Banking Authority or its predecessor organisation, the Committee of European Banking Supervisors However, the book has certainly benefitted from discussion with colleagues in the EBA and CEBS, in particular the Expert Group on Prudential Requirements The book does not represent the views of the Basel Committee on Banking Supervision, although it has certainly benefitted from discussion with colleagues on that Committee Finally and most importantly, I would like to thank my wife and son for their continuous encouragement and support Without this, neither the original volume nor this second edition would have been possible April 2011 ix 9780230_298316_01_prex.indd ix 5/27/2011 6:31:42 PM 230 References Dewatripont, Mathias and Jean Tirole, 1994 The Prudential Regulation of Banks (Cambridge, MA: M.I.T Press) Dornbusch, Ruediger, Stanley Fischer and Richard Startz, 2004 Macroeconomics 9th (international) edn (Boston: McGraw Hill) ECOFIN, 2008 The Council of the European Union, ‘Immediate Responses to financial turmoil: 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20, 30–1, 33, 59, 69, 181 ABCP, see asset-backed commercial paper (ABCP) accounting rules, 33–5 ‘acquire-to-arbitrage’ business model, 15, 18, 35–8, 47 advance rate, 36 AIG, 68–9, 181 Alt-A mortgages, 31, 55, 56 Ambac, 60 ARS, see auction rate securities (ARS) asset-backed commercial paper (ABCP), 53, 54, 71 asset-backed securities (ABSs), 53–5 asset-price bubbles, 3–4, 5, 11, 104 asset prices, 5, 10–11, 13–14, 38 asset-protection schemes, 88–9 assets client, 179–80 as collateral, 107–8 Level III assets, 35 liquid, 169–70 auction rate securities (ARS), 62–3 audits, 185 Austria, 87 backstop leverage ratio, 165–6 bail-ins, 133–8, 142–4, 204, 205 bail-outs, 115–16, 132–3 bank deposits, 155 see also deposit guarantees Bank of America, 86, 89 Bank of England, 45, 51, 52, 57, 86, 94, 96, 105 bank recapitalisation, 84–7 bank regulation, see regulation(s) bankruptcy laws, 37, 39 banks see also central banks branches vs subsidiaries, 141–2 bridge, 129–32 capital raised by, 54–5 downsizing, 210–11 governance of, 175–6, 184–5 lending policy, 106–10 narrow vs broad, 142–3 new lending rules for, 92 simplifying, 211–12 special resolution regimes for, 123–6 stress testing, 90–2, 111–12, 175, 187 Barclays, 54 Basel Capital Reform Programme, 161 Basel Committee on Banking Supervision (BCBS), 159, 162, 168–9, 170 Bear Stearns, 47, 55–7, 66, 115 Belgium, 74–5, 78–9 Bernanke, Ben, BNP Paribas, 41 bond ratings, 29–33 bonds government, 105 GSE, 63–4 municipal, 59–60, 63 borrowing eligibility, 106–8 Bradford & Bingley, 76 branches, 141–2 ‘breaking the buck’, 70–1 bridge banks, 129–32 broad banks, 142–3 buffers capital conservation, 164 counter-cyclical capital, 164–5 liquidity, 169–70, 197 business cycle, 9, 10 business models, 15, 17, 18, 35–8, 190 capital core, 162–3 limiting and strengthening, 166–8 non-equity, 167–8 raised by largest banks, 54–5 Tier 1, 162–3, 165–8, 187, 196, 206, 213 239 9780230_298316_16_ind.indd 239 5/27/2011 6:28:11 PM 240 Index capital conservation buffer, 164 capital regulation, 159–68, 187 capital requirements, 160–4, 203, 215 Carlyle Capital Corporation, 56 carry trade, 35 casino banking, 143, 211–12 CDOs, see collateralized debt obligations (CDOs) CDO-squareds, 21 central banks eligible borrowers from, 113–14 interest rate policy of, 6, 9, 45, 93–4 liquidity infusion by, 57 liquidity support by, 69–70, 88 monetary policy, 11 open market operations, 104–6 central counterparty (CCP), 193 China, 7, 13 Citigroup, 54, 62, 79–80, 86, 89 clearing and settlement, 180–1, 195 client assets, 179–80 CLS Bank, 193 co-insurance, 147 collateral assets eligible as, 107–8 excess, 108–9 collateral management systems, 195 collateralized loans, 105–6 collateralized debt obligations (CDOs), 53–5 Committee of European Banking Supervisors (CEBS), 91–2 concentration risk, 174 conditional containment, 43–65 of auction rate securities, 62–3 of credit derivatives, 58 Fannie Mae and Freddie Mac, 63–4 Fed and, 56–7 limits of, 64–5 liquidity assistance, 48, 51, 53, 57 macroeconomic policy, 43–7 of monolines, 58–60 overview of, 46–7 reabsorbing shadow banking, 52–5 conduct regulation, 176–80 conduits, 28–9, 38, 52, 53, 54 constructive ambiguity, 118, 121–2 constructive certainty, 118, 122–3 9780230_298316_16_ind.indd 240 consumer awareness, of deposit guarantees, 152 consumer-only protection, 118, 119–20 consumer spending, 13 containment of crisis, 41–99 conditional, 43–65 phases of, 42 stabilisation of banking system, 84–92 unconditional, 82–99 contingency funding plans, 202 conversion, bail-in via, 135–8 core capital, 162–3, 166–8, 187 corporate bonds, 34 counter-cyclical capital buffer, 164–5, 197 counterparty risk, Countrywide, 47, 60–1 credit default swaps, 59 credit derivatives, 22–6, 58, 192–3, 196 credit easing, 94–5, 103, 104 credit protection, 18, 58–60 credit risk, 22 current account deficit, 13 dealer banks, funding model, 35–8 debt crisis, Greece, 98 debt deflation, 3, 11, 41–2, 104 default risk, 4, 6, 31–2 deflation, 6, 9, 11–12 Depfa, 75–6 deposit guarantees, 77, 145–56 co-insurance, 147 consumer awareness of, 152 eligibility for coverage, 145–6 as exclusive to bank deposits, 155 funding schemes for, 150–2 limit determination, 146–7 multiple, 152–4 payouts, 147–50 derivatives market, 180–1, 192–3, 196 Dexia, 74–5 diligence, 177–9 disclosure, 177–9 dot com bubble, 5, 45 ECOFIN, 84 economic collapse, 83–4 5/27/2011 6:28:11 PM Index economic crisis, 42 economic growth, 5, 6–10 economic stability, economic stress, 110–12 economy, pre-crisis, 5–15 emergency liquidity assistance (ELA), 112 euro, 98 European Central Bank (ECB), 45, 94, 98, 103, 105 European Economic Area (EEA), 80 European Financial Stability Fund (EFSF), 98 Fannie Mae, 31, 39, 47, 63–4, 209–10 FDIC, see Federal Deposit Insurance Corporation (FDIC) FDICIA legislation, 74, 86 Federal Deposit Insurance Corporation (FDIC), 61 Federal funds rate, 12, 45, 53 Federal Reserve, conditional containment by, 56–7 credit easing by, 94–5 eligible borrowers from, 113 interest rate policy, 11–13, 45, 94 liquidity support by, 69–70, 71, 72, 94–6 monetary policy, 9, 11–12, 105 policies of, leading to crisis, 3–4 rescue of AIG by, 68–9 response of, to crisis, 53, 56–7, 93–6 finance, as cause of crisis, 15–40 financial crises, costs of, 1–2 financial crisis (2007-) causes, 3–40 containment of, 41–99 costs of, 1–2 recovery from, 97–9 financial engineering, 15 financial guarantee insurance, 25–6, 58–60 financial intermediaries, 15 Financial Market Stabilisation Act, 87 financial regulations, 33–5 financial stability, 11 Financial Stability Board (FSB), 171 financial system, 9780230_298316_16_ind.indd 241 241 injection of liquidity into, 88 structure, 210–16 as transmission mechanism, 6, on verge of meltdown, 66–81 fiscal policy, 96–7 forecasts, 44–5 foreign exchange transactions, 193, 196 Fortis, 74–5, 78–9 France, 75, 87 Freddie Mac, 31, 39, 47, 63–4, 209–10 funding liquidity, 104 funding model, 35–8 funding ratio, 170 G-20, 93 G-7 finance ministers, 85 generally accepted accounting practices (GAAP), 33, 165–6 Germany, 47–9, 79, 87, 89 global economy in 2004–2007, 12–14 decline of, 83–4 growth of, 6–10 impact of financial crisis on, 1–2 global GDP, global liquidity support, 69–70 Goldilocks economy, Goldman Sachs, 73, 86 governance, 175–6, 184–5 government bonds, 105 government-sponsored enterprises (GSEs), 63–4, 209 see also Fannie Mae; Freddie Mac Great Depression, 83 Great Moderation, 9, 10 Great Recession, 1, 42 Greece, 98 Greenspan, Alan, 5, 9, 10–11 gross domestic product (GDP), impact of financial crisis on, gross leverage limit, 197 HBOS, 70, 85–6 hedge funds, 27–8 home ownership, promotion of, 39 house prices, 39–40 HSBC, 54 Hypo Real Estate (HRE), 75–6, 78, 79 5/27/2011 6:28:11 PM 242 Index Iceland, 80–1 IFRS, 165–6 India, Industrie Kreditbank (IKB), 47–8 Indy Mac, 47, 60–1 inflation, 5, 6, 9, 12 forecasts, 44 information and communications technology (ICT), 7–8 infrastructures, 195, 196 ING, 89 institutional investors auction rate securities and, 62 non-bank, 26–9 insured deposit pay-off/liquidation, 127–9 interest rate policy, 3, 4, 6, 9, 11–12, 45, 93–4 interest rates cutting of, 93–4 escalation of, 39–40 rise in, 12–13 short-term, 43, 103, 104–5 International Swap Dealers Association (ISDA), 22, 23, 180 investment banking, end of standalone, 73 investor capital, bail-in on, 134–5 Ireland, 98 blanket guarantee by, 77 JPMorgan Chase, 56, 74, 86 Landesbanken, 47–9 Landesbank Sachsen, 48–9 Lehman Brothers, 43, 66–8, 93, 179 lender of last resort, 112–13 lending commitments, 197 lending policy, 106–10 lending rules, 92 lending term, 109 Level III assets, 35 leverage ratio, 165–6 LIBOR, 53 LIBOR-OIS spread, 97 liquid assets, 169–70 liquidation, 127–8 liquidity, 15, 17, 104 buffers, 197 9780230_298316_16_ind.indd 242 Fed supported, 69–72, 94–6 funding, 104 global liquidity support, 69–70 infusion of, 53, 57, 88, 112–13 market, 104 regulation, 168–70, 187–8 tightening of, 55–7 liquidity risk, 18, 37, 169 Lloyds TSB, 70, 85–6, 89 loan to value ratios, 197 Lucas, Robert, 9–10 Luxembourg, 75 Maastricht Treaty, 98 macroeconomic policy, 3, 4, 9, 43–7, 103–14 lending policy, 106–10 pricing, 110 macroprudential supervision, 24 macro-supervision, 192–8 manufacturing, 13 market-based contingency funding plans, 202 market conduct, 190 market infrastructures, 180–1 market liquidity, 104 MBIA, 59, 60 Merrill Lynch, 54, 62, 73 micro-supervision, 184–92 monetary policy, 4, 6, 9–12, 103 approaches to, 104–6 during crisis, 92–6 interaction with resolution, regulation, and supervision, 110 money market mutual funds, 26–7, 70–1, 208–9 monolines, 25–6, 58–60 Morgan Stanley, 62, 63, 73, 86 mortgage-backed securities, 41, 56, 96 mortgage market, 96 mortgages Alt-A, 55, 56 default risk, 31–2 sub-prime, 31–3, 38–40, 53–4, 55, 59 municipal bonds, 59–60, 63 mutual funds, 26–7, 70–1 narrow banks, 142–3 Netherlands, 87 5/27/2011 6:28:11 PM Index new lending rules, 92 non-bank institutional investors, 26–9 non-equity capital, 167–8 non-executive directors, 176 Northern Rock, 47, 49–52 open market operations, 104–6 ‘originate-to-distribute’ business model, 15, 22, 35, 47, 49 output levels, 6, over-collateralisation, 19–20 Paulson, Henry, 71, 72 payments, 196 Peloton Partners, 56 Portugal, 98 pre-crisis economy, 5–15 prevention of financial crises, 101 deposit guarantees, 145–56 macroeconomic policy, 103–14 regulation, 157–81 resolution policy, 115–44 supervision, 183–98 price forecasts, 44–5 price stability, 9, 10 pricing, 110 Primary Dealer Credit Facility, 57 Primary Reserve Fund, 70–1 productivity, increases in, 708 parameters, quantitative easing, 94, 96 rating agencies, 20, 21, 29–33, 39, 59–60, 177–9, 181 real GDP, forecasts, 44 recessions, 10 recovery, from crisis, 97–9 recovery and resolution plans, 201–2 regulation(s), 33–5, 157–81 capital, 159–68, 187 of clearing and settlement, 180–1 of condition of banks, 159–80 conduct, 176–80 on credit derivatives, 58 of governance, 175–6 liquidity, 168–70, 187–8 9780230_298316_16_ind.indd 243 243 of market infrastructures, 180–1 monetary policy and, 110 objectives of, 157–8 reform, 157–9 of remuneration, 171–2 of risk management, 172–5 supervision and, 187 remuneration policies, 171–2, 185–6 repurchase agreements, 36–8, 105–6 re-securitisations, 21 resolution authority, 124–6, 204 resolution methods, 127–38 bridge banks, 129–32 deposit transfer, 128–9 insured deposit pay-off/liquidation, 127–8 temporary public ownership, 132–8 resolution plans, 138–43, 204 resolution policy, 4, 66, 110, 115–44 aims of, 117–23 constructive ambiguity, 118, 121–2 constructive certainty, 118, 122–3 consumer-only protection, 118, 119–20 legal/regulatory framework, 140–1 special resolution regimes for banks, 123–6 supervision and, 189 universal protection, 118 resolvability, 143–4 Rhineland Funding, 47–8 risk bail-outs and, 115–16 concentration, 174 credit, 22 default, 31–2 liquidity, 18, 37, 169 reduced, 10 systemic, 180–1, 193, 194, 195 warehousing, 21–2 risk management, 172–5, 185, 186, 195 risk premium, 10–11 Royal Bank of Scotland (RBS), 54, 85, 89 securitisation, 18–22, 31, 38, 49 September 11, 2001, settlement, 180–1, 195, 196 5/27/2011 6:28:11 PM 244 Index shadow banking, 15, 17–35, 47, 206–10 accounting and regulations, 33–5 credit derivatives, 22–5 financial guarantee insurance, 25–6 monolines, 25–6, 58–60 non-bank institutional investors, 26–9 rating agencies, 29–33 reabsorbing, 52–5 securitisation, 18–22 single stub investor (SSI), 213–15 SIVs, see structured investment vehicles (SIVs) Spain, 87 Special Liquidity Scheme (SLS), 57 special purpose vehicle (SPV), 19–20 stimulus, fiscal, 96–7 stress tests, 90–2, 111–12, 175, 187 structured investment vehicles (SIVs), 28–9, 38, 52–4 sub-prime mortgages, 31–3, 38–40, 53, 55, 59 defaults on, 53–4 subsidiaries, 141–2 sunshine banking, 199, 212–16 supervision, 110, 183–98 macro-supervision, 192–8 micro-supervision, 184–92 of SIFIs, 201–3 supervisory authority, 190–1 surcharge, on SIFIs, 203 Switzerland, 87 systemically important financial institutions (SIFIs), 199–206 systemic risk, 180–1, 193, 194, 195 TARP, see Troubled Asset Relief Program (TARP) Taylor rule, 3, 9, 10, 12 ‘tear-up’ procedures, 58 technological change, 7–8, 13 9780230_298316_16_ind.indd 244 technology gap, temporary public ownership, 132–8 Term Auction Credit, 57 term auction facility, 96 Term Securities Lending Facility, 57 Thornburg Mortgage, 56 Tier capital, 162–3, 165–8, 187, 196, 206, 213 ‘too big to fail’, 115, 143–4, 200–1 toxic assets, 88–9 trading books, 33–4, 160–2 transfer pricing, 174–5 Troubled Asset Relief Program (TARP), 71–2, 86, 91 passage of, 77–8 rejection of, by Congress, 76–7 UBS, 54, 55, 62, 63 unconditional containment, 82–99 United Kingdom, 57, 94 economic growth in, fiscal stimulus in, 97 Icelandic banks and, 81 Northern Rock, 49–52 stress testing in, 90–1 United States economic growth in, 7, fiscal stimulus in, 96–7 inflow of capital into, 13 stress testing in, 91 universal protection, 118 US Bankruptcy Code, 37, 39 valuations, 173–4 Wachovia, 74, 78, 79–80 warehousing risk, 21–2 Washington Mutual, 74 Wells Fargo, 79–80, 86 yield, search for, 15, 16 yield curve, 16 5/27/2011 6:28:11 PM ... FINANCIAL SERVICES REVOLUTION (co-edited with Catherine England) 9780230_298316_01_prex.indd ii 5/27/2011 6:31:41 PM Crisis: Cause, Containment and Cure 2nd edition Thomas F Huertas 9780230_298316_01_prex.indd... Congress Cataloging-in-Publication Data Huertas, Thomas F Crisis : cause, containment and cure / Thomas F Huertas. 2nd ed p cm Includes bibliographical references and index ISBN 978–0–230–29831–6 (alk... 5/27/2011 6:26:55 PM 12 Crisis: Cause, Containment and Cure (Greenspan 2003) To this end the Fed reduced the target rate for Fed funds from 1.5% to 1.25% in November 2002 and then from 1.25% to 1%