The Financial Crisis: Lessons for Developing and Emerging Market Countries

1. The Financial Crisis: Lessons for Developing and Emerging Market Countries Ugo Panizza

2. Outline • Was it a surprise? • The role of financial innovation • 7 lessons for financial regulation

3. The roots of the crisis • "I think this economy is down because we built too many houses" • What really went wrong: • Weak regulatory regime • J. Stiglitz said: this is the not surprising consequence of appointing as regulators people who don't believe in regulation.

4. A Crisis Foretold • If each crisis is different from the previous one we risk of fighting the last crisis • But are they different?

5. Was it a surprise? • Certainly some new elements • Originate and distribute model • Financial derivatives • Shadow banking system • But the basic mechanism is always the same (described by Kindleberger and Minsky)

6. Was it a surprise? • A positive shock leads to high growth, low volatility, and low risk aversion • This leads to an increase in leverage which further boosts asset prices and leads to even more risk taking • People start thinking that asset prices can only go up • People who say that the situation cannot continue forever are made fun of and marginalized • The standard answer is "This time is different" • If they are in the financial sector they lose their jobs • “The trend is your friend”

7. Was it a surprise? • Of course things are never different • Each time the instrument is different (Tulips, Inexistent countries, Railways, Internet stocks, Houses) • Nobody knows what will come next (for sure not subprime mortgages) • But the mechanism will be the same

8. Was it a surprise? • Research by Claudio Borio of the BIS shows that two or three variables (credit growth, stock prices growth and housing prices growth) can predict financial crises 2-4 years in advance with considerable precision • (not the exact time of course) • A few people (Robert Shiller, Nouriel Roubini) and institutions (UN, BIS) were screaming, but nobody listened to them

9. Was it a surprise? • Policymakers did not do anything because the operated under the assumption that markets know best • I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such is that they were best capable of protecting their own shareholders and their equity in the firms. It shocked me. I still do not fuIly understand why it happened… • They also thought that cleaning up the mess was easy and cheap

10. Was it a surprise? • Academic economists where seduced by policymakers • …we were in sync with policymakers… lured by ideological notions derived from Ayn Rand novels rather than economic theory. And we let their... rhetoric set the agenda for our thinking and … for our policy advice. Acemoglu (2008) • Incentives also matter, both in business schools and econ departments (Eichengreen, 2008)

11. Was it a surprise? • So, it should not have been a surprise • Ideology • Incentives

12. Outline • Was it a surprise? • The role of financial innovation • 7 lessons for financial regulation

13. The role of financial innovation in the subprime mess • How did NINJAs get all these loans? • In the old system, bankers carefully evaluated loan applicants and used a lot of soft information • With securitization, bankers can sell the loans and care less and less about creditworthiness, soft information became irrelevant • (This is both good and bad: less racial bias but also less information) • But why would anybody buy bad loans? • Some people thought that financial innovation could do the trick (especially the 'pooling' and 'tranching' of CDOs) • However, even these sophisticated instruments were only sustained by excessive optimism

14. Crazy assumptions • FPA: “What are the key drivers of your rating model?” • Fitch: "FICO scores and home price appreciation of low single digit or mid single digit…" • FPA: “What if home price appreciation was flat for an extended period of time?” • Fitch: "Our model would start to break down." • FPA: “What if home price appreciation were to decline 1% to 2% for an extended period of time?” • Fitch: "The models would break down completely." • FPA: “With 2% depreciation, how far up the rating’s scale would it harm?” • Fitch: "It might go as high as the AA or AAA tranches." Conference call between First Pacific Advisor (FPA) and Fitch Rating (Coval, Jurek and Stafford, 2008)

15. Crazy assumptions

16. But at least the banks were safe… • Not really because they went back in the game with lightly regulates SIV • (more on regulatory arbitrage later)

17. Who was right? • “There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors … has helped make the banking and overall financial system more resilient … commercial banks may be less vulnerable today to credit or economic shocks” IMF Global Financial Stability Report, Spring 2006, • “Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know.” BIS 77th Annual Report, June 2007

18. The lighter side of the story • PG13 • It contains strong language