evanoff et al (eds.) - international financial instability; global banking and national regulation (2007)

2 International Financial Instability: Global Banking and National Regulation edited by Douglas E.. 2 INTERNATIONAL FINANCIAL INSTABILITY Global Banking and National Regulation... Cross-

Mitsuhiro Fukao, Keio University, Tokyo, Japan Robert L Howse, University of Michigan, USA Keith E Maskus, University of Colorado, USA Arvind Panagariya, Columbia University, USA

Published

Vol 1 Cross-Border Banking: Regulatory Challenges

edited by Gerard Caprio, Jr (Williams College, USA), Douglas D Evanoff (Federal Reserve Bank of Chicago, USA) & George G Kaufman (Loyola University Chicago, USA)

Vol 2 International Financial Instability:

Global Banking and National Regulation

edited by Douglas E Evanoff (Federal Reserve Bank of Chicago, USA)

George G Kaufman (Loyola University Chicago, USA) &

John Raymond LaBrosse (Int’l Assoc of Deposit Insurers, Switzerland)

Forthcoming

Risk Management and Value: Valuation and asset Pricing

edited by Mondher Bellalah (University of Cergy-Pontoise, France)

Globalization and International Trade Policies

by Robert M Stern (University of Michigan, USA)

Emerging Markets

by Ralph D Christy (Cornell University, USA)

Institutions and Gender Empowerment in the Global Economy: An Overview

of Issues (Part I & Part II)

by Kartik C Roy (University of Queensland, Australia) Cal Clark (Auburn University, USA) &

Hans C Blomqvist (Swedish School of Economics and Business Adminstration, Finland)

The Rules of Globalization (Casebook)

by Rawi Abdelal (Harvard Business School, USA)

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA In this case permission to photocopy is not required from the publisher.

Copyright © 2007 by World Scientific Publishing Co Pte Ltd.

Printed in Singapore.

World Scientific Studies in International Economics — Vol 2

INTERNATIONAL FINANCIAL INSTABILITY

Global Banking and National Regulation

Both the conference and this resulting volume represent a joint effort ofthe Federal Reserve Bank of Chicago and the International Association ofDeposit Insurers Numerous people at both organizations aided in theirpreparation and successful execution The three editors served as the prin-cipal organizers of the conference program and are indebted to the assis-tance of many people who contributed at various stages of the endeavor

At the risk of omitting some, they wish to thank John Dixon, Ella Dukes,Jennie Krzystof, Hala Leddy, Loretta Novak, Elizabeth Taylor, JuliaBaker and Wempy (Ping) Homeric

Special mention must be accorded Regina Langston and Pam Suarez,who shared primary responsibility for administrative duties, and KathrynMoran, who compiled the information for both the program and thisconference volume

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Cross-border banking in the form of international branches or subsidiaries

is increasing rapidly, but prudential regulation of banking — supervision,deposit insurance, lender of last resort facilities, insolvency resolution —remains primarily national This mismatch raises concerns about the abil-ity of regulators to stem banking crises and financial instability both frombeing ignited and from spreading rapidly across national boundaries Thepapers published in this volume describe the existing structure of bothcross-border banking and prudential regulation, identify the vulnerabili-ties in that structure, analyze the implications for the safety, soundnessand efficiency of the international banking system, and make recommen-dations on how to improve the existing structure to enhance the safety andsoundness of the banking system without reducing efficiency Shouldthere be greater emphasis on international cooperation, harmonization ofregulations and supranational regulatory agencies, or is the current system,with minor country-specific regulatory adjustments, sufficient to avoidfinancial crises?

These issues were explored at a conference cosponsored by theFederal Reserve Bank of Chicago and the International Association ofDeposit Insurers at the Federal Reserve Bank on October 5–6, 2006 Theconference was the ninth in a series of annual international banking con-ferences sponsored by the Federal Reserve Bank of Chicago that focus

on important current issues in global economics, finance, and banking.Keynote speakers, paper presenters and discussants are internationallyrecognized experts in their areas Speakers and audience members com-bined represented a wide array of countries, philosophies, experiences andaffiliations, including bankers, bank regulators, and academics In total,more than 40 countries were represented, reinforcing the term “interna-tional” in the title of the conference series

The papers in this volume, as well as the comments of the discussants

of the papers, are intended to bring the ideas that were discussed at theconference to the attention of a larger and more diverse audience In the

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process, this may contribute both to increasing attention to some of theproblems identified in the papers and to searching for solutions Thus, wehope this volume will contribute to enhancing global financial stability.

John Raymond LaBrosse

International Association of Deposit Insurers

Jean Pierre Sabourin

II Landscape of International Banking and Financial Crises 37

Dirk Schoenmaker and Christiaan van Laecke

Carl-Johan Lindgren

Sander Oosterloo, Jakob de Haan, and Richard Jong-A-Pin

Discussion of Landscape of International Banking 97and Financial Crises

Luc Laeven

ix

III Causes and Conditions for Cross-Border Instability 107Transmission and Threats to Stability

Cross-Border Contagion Links and Banking Problems in 109the Nordic Countries

Bent Vale

Currency Crises, (Hidden) Linkages, and Volume 125

Max Bruche, Jon Danielsson, and Gabriele Galati

What Do We Know about the Performance and Risk of 139Hedge Funds?

Triphon Phumiwasana, Tong Li, James R Barth,

and Glenn Yago

Remarks on Causes and Conditions of Financial 167Instability Panel

Garry Schinasi

Home Country versus Cross-Border Negative Externalities 181

in Large Banking Organization Failures and How to

Bagehot and Coase Meet the Single European Market 241

Vítor Gaspar

Banking in a Changing World: Issues and Questions 257

in the Resolution of Cross-Border Banks

Michael Krimminger

International Banks, Cross-Border Guarantees, and Regulation 279

Andrew Powell and Giovanni Majnoni

Deposit Insurance, Bank Resolution, and Lender 299

of Last Resort — Putting the Pieces Together

Thorsten Beck

Cross-Border Resolution of Banking Crises 311

Rosa María Lastra

Bridge Banks and Too Big to Fail: Systemic Risk Exemption 331

David G Mayes

Prompt Corrective Action: Is There a Case 355for an International Banking Standard?

María J Nieto and Larry D Wall

Insolvency Resolution: Key Issues Raised by the Papers 373

Peter G Brierley

VII Cross-Border Crisis Prevention: Public and 385Private Strategies

Supervisory Arrangements, LOLR, and Crisis Management 387

in a Single European Banking Market

Arnoud W A Boot

Regulation and Crisis Prevention in the Evolving Global Market 407

David S Hoelscher and David C Parker

Derivatives Governance and Financial Stability 423

David Mengle

Cross-Border Crisis Prevention: Public and Private Strategies 439

Gerard Caprio, Jr.

Cross-Border Banking: Where to from Here? 445

Mutsuo Hatano

Andrey Melnikov

The Importance of Planning for Large Bank Insolvencies 453

I SPECIAL ADDRESSES

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Cross-Border Banking Regulation — A Way

Forward: The European Case

to minimize the externalities that arise if banks actually fail At thenational level, many countries — including my own — still need to imple-ment regulations to ensure that these risks are fully mitigated

Let me also take this opportunity to congratulate the organizers ontheir choice of subject for this conference The importance of the interna-tional dimension of the regulatory setup is growing steadily It is only nowthat many banks are becoming truly cross-border, with substantial retailactivities in several countries At the same time, banking regulation, interms of supervision, oversight, deposit guarantee schemes and responsi-bility for financial stability, remains predominantly national This imposesadditional challenges for financial regulators These challenges are partic-ularly acute in Europe given the rapid growth of cross-border banks onthat continent However, the issues raised are of global concern

With this in mind, let me start out by stating my main message, but,before doing so, let me stress that these are my personal views and do notrepresent the official opinion of any institution In my view we need toplan for a special body — let us call it a European Organization forFinancial Supervision (EOFS) — to gather information and produce a

3

*Stefan Ingves is Governor of Sveriges Riksbank (the Central Bank of Sweden).

coherent and consistent assessment of the risks in the major cross-borderbanks in Europe

As you all know, a separate regulatory framework for banks is basedboth on consumer protection arguments and on financial stability consid-erations Banks provide fundamental services to the economy but could besubject to bank runs There are also large contagion risks in banking activ-ities so that problems in one bank could easily spread to other banks.Here, I will concentrate on the financial stability perspective

2 Banking Developments in the European Union

Until not so long ago, most banks had a clear national (or local) characterwith most of the activities limited to one country Sure, many banks havehad international operations for many decades but that has typically beenlimited to wholesale markets and services to large corporations Financialservices to retail customers and small- and medium-sized companies(SMEs) have been provided on a national or local basis In this setting, thenational character of the regulatory framework has been appropriate Nowthis is rapidly changing, not only in Europe — but also elsewhere First, banks in different countries are increasingly merging and creat-ing some genuinely cross-border banking groups, targeting retail cus-tomers and SMEs in several countries There are now about 40 bankinggroups with substantial activities in more than three countries in Europe.Just to take few examples: Unicredit Group has, after the merger withGermany’s HypoVereinsbank, a market share of at least 5 percent (interms of total assets) in Italy, Germany, Austria, Bulgaria, the CzechRepublic, Hungary, Poland, Luxembourg, Slovenia, as well as Slovakia.Barclays and Grupo Santander are major players in both Spain and the

UK Fortis and ING are both important in the Benelux region Erste Bank

is large in Austria, the Czech Republic, Slovakia and Hungary; KBC inBelgium and a number of eastern European countries Nordea is central tothe banking market in Sweden, Denmark, Finland and Norway

Second, banks are increasingly dependent on the international cial markets for funding, risk management, etc The inter-linkages andcontagion risk between banks are probably increasing even for the banksthat stick to a purely national focus

finan-Third, many of the cross-border banks are progressively ing various functions, such as funding, liquidity management, risk man-agement, internal controls, compliance, credit decision-making, auditing,

concentrat-etc., to various centers of competence As a consequence, cross-borderlinkages are rising.

Fourth, with the increased cross-border specialization, the distinctionbetween a branch and a subsidiary is becoming increasingly blurred.Subsidiaries are becoming less self-contained If the parent bank of across-border banking group defaults, it is getting more and more unrealis-tic to assume that the foreign subsidiaries could continue their business asusual It takes time to establish all the necessary competencies to trans-form such a subsidiary to an independent bank Also, the possibilities forthe host country to successfully ring-fence the assets are diminishing,given the speed at which funds can be transferred across borders Whenthere still is a clear legal difference between branches and subsidiarieswith clear consequences for supervision, the distinction becomes lessimportant both in practical and in economic terms

Fifth, and as a consequence of this merger activity, the banking ket in some countries is dominated by foreign banks In the 10 newEuropean Union (EU) member states, about 70 percent of the bankingsectors are foreign owned In Estonia, foreign groups account for morethan 90 percent of all lending

mar-My worry is that the next financial crisis in Europe could have ous cross-border implications and not be bounded by national borders As

seri-a centrseri-al bseri-anker, I see it seri-as seri-a mseri-ajor responsibility to be prepseri-ared for such

an event, both in terms of handling the acute problem and in finding morelong-term solutions

One reason why this cross-border development is more pronounced inEurope than in many other parts of the world is the long-term project ofcreating a single market for financial services in Europe Let me be clearhere I strongly support this project It has freed banking from its nationalrestrictions and fostered a more efficient financial sector It has created anenvironment to support greater economic growth Cross-border bankingshould not be seen as an economic problem but rather a challenge for theregulators and supervisors The problem is that the regulatory frameworkfor ensuring financial stability has not adapted as quickly and as thor-oughly as needed

Let me stress that historically, regulatory and supervisory convergenceacross borders has taken time It cannot be expected that the optimal regu-latory setup will emerge immediatly when market conditions change Thesingle market for financial services in Europe has definitely changed themarket environment for financial firms Now, it is up the regulators to dotheir bit

3 Regulatory Challenges

The question is then how the regulatory and supervisory framework could

be adapted to face up to a situation where some banks play important roles

in providing banking services in several countries

Let me — for the sake of argument — assume that a problem occurs

in a major cross-border bank under the present framework in Europe.Apart from the challenges to solve a problem in a purely national bank, itbecomes both more important and more complicated to address such a cri-sis in an international framework There are a number of challenges The first challenge concerns the sharing of relevant information For across-border banking group, the number of authorities involved multiplies

As a consequence, information sharing may be slowed down Also, pared to purely national banks, many cross-border banking groups have amore complex structure This makes the analysis and information gatheringmore difficult The functional specialization of cross-border banks also com-plicates supervision and information gathering If a cross-border bankinggroup concentrates all its credit assessments in one country, it will be diffi-cult for the supervisor in another country to assess the risk of the bank in thatcountry without efficient supervisory cooperation and exchange of informa-tion Further, if the bank puts all its liquidity management in a third country,extensive information sharing will be needed in order for any supervisor toget the full picture of the group’s total risks In principle, the parent bank —and therefore the parent bank’s supervisor — should have a full overview,but in a crisis, positions may change quickly and thus complicate the collec-tion of all relevant information Such extensive information sharing becomesacute in a crisis but is also necessary in the day-to-day supervision

com-A second challenge is that conflicts of interest multiply Bankingproblems can be very costly and the ultimate guarantee for financial sta-bility can only be given by the government, since only the government hasthe power to tax In most countries, the deposit guarantee schemes areonly able to finance the problem if it is confined to minor banks For sys-temic problems, the government would have to intervene With predomi-nantly national banks, how this is done is fairly straightforward

With the emergence of truly cross-border banks the question is how toshare the burden To what extent would the taxpayers in one country bewilling to support the depositors in another country? And to what extentwould the depositors in the second country be willing to rely on the poten-tial future support of the taxpayers in the first country?

A similar problem applies when a central bank considers providingemergency liquidity assistance to a cross-border bank Such funding isinherently risky If it were not, the market would typically be able to pro-vide the funding Such assistance is also likely to affect the entire bankinggroup What happens if a bank is systemically important in one smallercountry but not in another perhaps larger country? The smaller countrywill probably have greater incentive to save the bank but may end up pay-ing for the entire group, if the larger country refuses

Also, there are conflicts of interest if the bank is reconstructed Anysuch reconstruction is risky and it is therefore uncertain whether the tax-payers would be willing to take these risks in another country

A third challenge is how to achieve joint assessments In Europe,there is an agreement to share views and assessments if there is a crisis.However in my opinion, that is not sufficient In a crisis, most countriesare likely to present assessments that support their national interests Withthe present supervisory setup, there is, unfortunately, a risk that it will betime-consuming to achieve joint assessments, and time is a scarceresource, especially in crisis management

A fourth challenge is how to coordinate decisions by the authorities Thecentral bank must decide whether to grant emergency liquidity assistance ornot and occasionally a bank may have to be placed under public administra-tion All of these decisions have to be made at short notice and typically withlimited information For this to be effective, there is a need for a clear line ofcommand For cross-border banks where many supervisors, many centralbanks and many ministries of finance are involved, this is complicated toachieve Without prior agreements on responsibilities, this is going to beeven more complicated, and may very well lead to suboptimal solutions.The potential inefficiencies are probably enhanced by the differences

in language and legal structure The problem is further inflated by theinterdependencies between the different countries The decisions by oneauthority will typically have repercussions in many other countries

To alleviate these problems there are today many Memoranda ofUnderstanding (MoUs) between the authorities in the different countries —both regional and on an EU basis Such MoUs are important to fostercooperation and information sharing but are, in my view, not sufficient.They are not legally binding and address neither the need for joint assess-ments nor the underlying conflicts of interest Instead they should be seen as

an important first step in facilitating the handling of cross-border tions However, we need to go further

spe-The second is to enhance the home country’s responsibility by givingthe home supervisor additional powers not only for the group but also forall its foreign subsidiaries One agency would thus get the responsibilityfor assembling information, formulating a joint assessment and coordi-nating decisions for all subsidiaries as well as the group level A generalproblem with this solution is that it does not address the conflicts of inter-est Will the home country authorities take the situation in the host coun-tries fully into account in their decisions? How will host countries that donot share the assessment or disagree with the decision act? Also, will theauthorities in a host country be willing to delegate such responsibilities to

an authority in another country?

A third proposed solution is an extension of the second alternative Inaddition, the home country will get an explicit EU-mandate to take theinterest of the other relevant countries into account in its assessments anddecisions, but it is not clear how this will work in practice There is also

an accountability problem with this solution National authorities are bothappointed by and accountable to the national governments and in exten-sion to the national electorate It may be difficult for a host country to holdthe authorities in a home country responsible for a specific decision, even

if its main effect is in the host country

A fourth possibility is the pan-European solution where both the date and responsibility for supervision are transferred from the nationallevel to the EU-level This would imply the creation of a European FinancialServices Authority (FSA), as well as granting the European Central Bank(ECB) a role as lender of last resort for cross-border banks This solutionraises a number of difficult political considerations It basically means

man-handing over a part of the sovereignty to the EU-level Also, at present the

EU has no supra-national taxing power, so some other formula on burdensharing would have to be found Presumably the political obstacles forthis solution are large At least in the short run, this fourth solution is notrealistic

5 Another Approach

With this background, I draw three conclusions First, the present situationwith a growth of cross-border banks — with some clear examples in theEuropean region — combined with national responsibility for supervisionand financial stability is not satisfactory If we are hit by a critical crisis inone or more of the major financial institutions today, the regulatory andsupervisory framework is not sufficient Second, we need to move for-ward and find a modified framework before problems arise My experi-ence is that if a crisis hits an unprepared authority, the choice of solutionwill suffer Third, we should move ahead gradually, since there are obvi-ous political difficulties and it is uncertain what the first-best solutionwould look like In a political world, it is difficult to achieve first-bestdirectly Instead we have to move stepwise and ensure that we have ourcompass firmly in our hands to ensure a move in the right direction

To solve some of the problems of coordination of information andassessments, I propose the establishment a new pan-European body, aEuropean Organization for Financial Supervision (EOFS) The idea is tocreate a separate agency to follow the major cross-border bankinggroups in Europe The EOFS should only focus on the presently about

40 truly cross-border banking groups and not deal with some 8,000European banks with a predominately national character The EOFSshould have three tasks: It should gather information about the bankinggroups and their activities in different countries Importantly, it shouldalso create unified risk-assessments of each cross-border banking group.Finally, it should also oversee the activities and risks of these bankinggroups

To achieve these tasks, there is a need for a separate agency, staffedwith a sufficient number of competent employees Initially, these employ-ees could, of course, be recruited from the existing national supervisors.Also, the staff of the EOFS would have to cooperate with the nationalsupervisors

I also want to stress that the EOFS should be an independent agency.This independence is important to achieve a division of labor and power.

It should not be part of the European Commission and not of the ECB.One possible solution is therefore that EOFS is established directly by the

EU countries and with an obligation to report to the European Parliament

My proposal is therefore quite different from the existing structure which is part of the Lamfalussy regulatory framework in the EU.Although some of the EOFS’s tasks would overlap with those of CEBS,the focus is different CEBS’s main tasks are to advise the EU Commission,

CEBS-to enhance supervisory cooperation, and CEBS-to contribute CEBS-to convergence ofMember States’ supervisory practices CEBS is therefore a regulator andnot a supervisory agency The EOFS would be much more of a supervisorwith as main task to produce coherent assessments of the risks and vul-nerabilities of cross-border banking groups

In my view and to start out with, the EOFS need not have formal ers, with the exception that it should have the right to require cross-borderbanks to submit information Formal supervision could still rest with thenational supervisors according to the existing home–host arrangementsand potential sanctions be decided by the national supervisors In thisrespect, the EOFS should be limited to suggesting actions to the nationalsupervisors Furthermore, the work conducted by the EOFS does notreplace the oversight by the national central banks They still need to over-see the banks as a part of their mandate on financial stability

pow-The creation of an EOFS could, if the organization is successful, beseen as the embryo to a full-fledged European supervisor — a futureEuropean FSA It is much too early to tell whether such a development isfeasible First the EOFS would have to prove that it can produce added-value in terms of information gathering and assessments with real super-visory resources beyond that of a talk shop

To be honest, my approach is not without problems either It wouldmake the regulatory structure somewhat more complex, and it wouldincrease the regulatory burden on the cross-border banks by adding a newagency for reporting However, in my view, we need to achieve a greatercoordination of the information gathering and assessments Sometimes,you need to settle for the second-best solution when the best is notpossible

Given the problems that I have sketched, a natural question is why

my proposed solution has a purely European focus The growth of border banking is not unique to Europe, even if the development of truly

cross-cross-border banks is accelerating fast in Europe — perhaps faster than inother regions The reason for my European focus is that there is, withinthe EU, a common regulatory framework, which includes the establish-ment of joint organizations One example is the European MonetaryInstitute, which was the forerunner to the ECB There is also a tradition ofusing a gradual approach One of the underlying long-term principles inthe EU is the ever-increasing integration through small successive steps.Therefore Europe is likely to be a good starting point for the establishment

of such a supranational supervisory framework for cross-border banks In

my view though, the underlying challenge is of global nature My forecast

is therefore that the timely subject of this conference will be relevant alsofor future conferences

Thank you

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Remarks Before the Conference on International

Financial Instability

Sheila C Bair*

Federal Deposit Insurance Corporation

Good evening It is a pleasure to be here tonight I would like to thankPresident Moskow and Chairman Sabourin for inviting me to speak thisevening I would also like to thank Doug Evanoff and George Kaufmanfor putting together an excellent program

The topics of this conference — cross-border banking and nationalregulation — affect financial stability and public confidence, two thingsthe Federal Deposit Insurance Corporation (FDIC) stands for at home andseeks to foster abroad Tonight I would like to talk about three areas theFDIC views as critical for ensuring global stability and confidence: stronginternational capital standards, credible deposit insurance systems and aninternational strategy for large bank resolution

Significant progress has been made in improving international dards for effective prudential supervision These improvements have not,however, eliminated the potential for banking crises to occur When crisesarise, such as the Asian crisis of 1998, the economic costs and dislocationare significant, with implications for growth and stability not just in theregion, but around the globe For example, in Indonesia, the country per-haps the hardest hit by the Asian crisis, 83 out of their 228 banks wereclosed and, by the end of 1998, nonperforming loans peaked at 57 percent

stan-of total loans As a consequence, Indonesia experienced a 7-percentdecline in its gross domestic product (GDP)

In addition, banking crises in one country can spill over to others.For example, in 2001, the financial system in Uruguay was not initiallyaffected by the exchange rate crisis in neighboring Argentina However,when severe withdrawal restrictions were imposed on bank customers

13

*Sheila C Bair is chairman of the Federal Deposit Insurance Corporation.

in Argentina, many turned to their accounts in Uruguay, precipitating abank run there The subsequent collapse of the banking system in Uruguayultimately led to widespread unemployment and a 20 percent decline inthe country’s GDP.

As these experiences illustrate, banking crises have very real effects

on domestic economies and the global marketplace Crisis prevention andcontainment depends on strong national regulation and internationalcooperation and coordination The first place to start is with capital

1 Basel II and the Importance of an International

Capital Standard

For the past three days, I have been in Mexico attending the biennial ference of national banking supervisors The conference focused on thecore principles for effective banking supervision and their importance inprotecting banking safety nets worldwide So of course, we spent a lot oftime talking about capital

con-As you know, on September 5, the FDIC board of directors, alongwith the other federal banking regulators, voted to publish the Basel IINotice of Proposed Rulemaking (NPR) for public comment In conjunc-tion with Basel II, US bank and thrift regulators also are developing amore risk-sensitive capital framework for non-Basel II banks, known asBasel IA, which we hope to publish for comment in the near future

It is appropriate and necessary that we move forward with the Basel IIprocess While views and opinions differ about the changes that may beneeded, there is one area where I believe there is much common ground:The implementation of Basel II must not result in significant reductions incapital or in the creation of competitive inequities among different types

of insured depository institutions

I look forward to receiving the comments on the NPR, and I willapproach them with an open mind I am particularly interested in com-ments on the question of whether the regulators should allow alternatives

to the advanced approach The US is the only country proposing to makethe advanced approaches mandatory for some banks Several large bankshave asked to be allowed to use the Basel standardized approach for cal-culating their requirements

The standardized approach links risk weights to external ratings andincludes a greater array of risk classes than are included in the current rules

It is simpler and less costly to implement than the advanced approach In

addition, because there is a floor for each risk exposure, it does not providethe same potential for dramatic reductions in capital requirements and there-fore would not pose the same issues about competitive inequity On theother hand, there is the argument that only the advanced approach provides

an adequate incentive for strengthening risk-measurement systems at ourlargest banks Whether our largest banks should be required to use theadvanced approach is an important policy issue

I will support implementing the advanced approach only if I candevelop a comfort level that strong capital levels will be preserved Inaddition, I have an open mind regarding the possibility of allowing a USversion of the standardized approach as an alternative option for imple-mentation of Basel II in the US

In my view, no discussion of capital can be complete without a fewwords about the leverage ratio The FDIC has consistently supported the ideathat the leverage ratio — a simple tangible capital to assets measure — is

a critically important component of our regulatory capital regime I ampleased that all the US bank regulators have expressed their support forpreserving the leverage ratio I appreciate that banks in most other BaselCommittee countries are not constrained by a leverage ratio and thateffective capital standards around the world vary widely as a result.Indeed, if large European banks were subject to the leverage ratio man-dated by US prompt corrective action standards, several would be catego-rized as undercapitalized

For this reason, in testimony before the Senate Banking Committeeand during the meetings this past week in Mexico, I raised with my col-leagues the issue of international supplemental capital measures, such as

a leverage ratio The leverage ratio provides US supervisors with comfortthat banks will maintain a stable base of capital in both good and badtimes I appreciate that other countries have different approaches to sup-plemental capital measures, and I look forward to learning more aboutthem Several countries face the prospect of double digit drops in risk-based capital for many of their large banking organizations under BaselII’s advanced approaches As Basel II moves forward, the question of sup-plemental capital measures such as a leverage ratio will assume greaterimportance I look forward to further discussions with the BaselCommittee and the larger international community on this question.Deposit insurers, in particular, should be part of this debate, given theimportance of capital as a first line of defense against bank failures Weneed a minimum cushion of capital for safety-and-soundness throughoutthe global banking system

2 The Importance of Establishing a Deposit Insurance System

While capital can help prevent a financial crisis, an effective depositinsurance system can mitigate its effects The lessons of past bankingcrises have demonstrated the importance of developing legal proce-dures for efficiently closing banks and having a system in place forpaying off depositors and creditors These are some of the most impor-tant and least recognized benefits of establishing an explicit, limitedcoverage deposit insurance system Countries without systems in placetend to resort to ad hoc strategies when banks fail In these cases, coun-tries are often faced with unfortunate options, such as providing guar-antees to all depositors and creditors, usually at 100 percent; delayingproblem bank resolution to the point where a single bank failure istransformed into a larger event; or forbearing on problem bank resolu-tions and thereby increasing moral hazard and the likelihood of futurecrises

3 Coordination and Cooperation among Deposit Insurers

When it comes to designing and maintaining effective and efficient depositinsurance systems, countries can benefit from the collective knowledgeand experience of two important groups: the International Association ofDeposit Insurers (IADI) and the European Forum of Deposit Insurers.Both were formed in 2002 to enhance deposit insurance effectiveness andpromote cooperation among deposit insurers and other safety net players.Currently, these associations have a combined membership of 94 depositinsurers

Over its short existence, IADI has set out much useful guidance —taking into account each country’s different circumstances, settings, andstructures It has facilitated the sharing and exchange of expertise andinformation on deposit insurance issues through training, development,and educational programs And IADI has undertaken specialized research

on operational issues relating to deposit insurance

As you can see, what IADI brings to our efforts on crisis preventionand response is unique: the collective experience and hands-on learning ofthe world’s deposit insurance practitioners This is scarce knowledge that

we cannot afford to ignore

4 Cross-Border Risks and Resolution Issues

The final key to global stability and confidence is an international egy for large bank resolution I would like to take a few minutes to talkabout the challenges involved in resolving large bank failures and ourefforts to address them

strat-Banks are taking advantage of technology and increasing tional trade to expand their businesses and geographically diversify theirrisks As many speakers at this conference have noted, this increase incross-border banking could present significant deposit insurance and bankresolution issues

interna-Currently, there are few formal agreements between countries on how

to deal with the failure of a large international bank If a failure occurs, an

“every country for itself ” scenario could easily be envisioned Legallybinding multilateral agreements on the treatment of failed bank creditorscould be useful in a crisis but may be difficult to attain Progress can bemade by working cooperatively at the staff level of relevant agencieswithin each country These discussions can be used to acquaint each partywith the relevant laws and procedures in other countries and, potentially,

to yield agreements between countries regarding the exchange of mation and protocols that can be used during a crisis

infor-5 Concluding Remarks

Financial stability and public confidence are two things that are easy totake for granted until they are tested Strong and fair international capitalregulation, well-constructed deposit insurance systems, and an orderlyand collaborative approach to a large international bank failure are threecornerstones to preserving stability and confidence on the global stage

I look forward to working with all of you to reduce the likelihood of abanking crisis and to improve our collective ability to respond to one

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Benign Financial Conditions, Asset Management, and Political Risks:

Trying to Make Sense of Our Times

Raghuram G Rajan*

International Monetary Fund

Good afternoon The Dow Jones Industrial Average has been scaling newheights recently Risk premia and measures of risk aversion are atextremely low levels All this, even while the housing market is slowingsharply, and the US economy is slowing With the equity markets antici-pating strong earnings growth, credit markets foreseeing low defaults, andthe bond markets expecting little inflation, one has to ask: Isn’t anyonepricing in risks? If not, what is going on?

In what follows, I will argue that we might be seeing the confluence

of two strong forces — first, a widespread surge in productivity across theworld, with the associated domestic demand varying country by countrybased on the strength of domestic financial markets; and second, theincreasing institutionalization of, and competition within, advanced finan-cial markets for savings While the world has grown strongly as a result

of both these forces in recent years, risks have built up, and there is noguarantee that the future will be as rosy as the recent past Some of therisks are cross-border, and financial — central to the theme of this con-ference — but I will focus, not so much on the risks to financial stability,which have been widely discussed, but the associated political risks.1Given the limited time, I will start by skipping the lunchtime jokes

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1 See, for example, Borio, Claudio, 2006, “Monetary and Prudential Policies at a Crossroads: New Challenges for a New Century”, BIS, working paper; White, William, 2006, “Is Price Stability Enough?”, BIS working paper; Rajan, Raghuram, 2006, “Has Financial Develop- ment Made the World Riskier”, NBER, working paper.

*Raghuram G Rajan is economic counselor and director of research at the International Monetary Fund The following reflects his views only and are not meant to represent the views of the International Monetary Fund, its management, and its board The author thanks Charles Collyns and Laura Kodres for helpful comments.

1 The Productivity Revolution

We are now in the fourth year of strong world growth, growth that hasbeen maintained in the face of headwinds such as soaring commoditiesprices In my view, productivity growth, fostered in part not only by therevolution in information technology, but also in part by the rationaliza-tion of production through the creation of global supply chains, has played

a critical role in this expansion While much attention has been focused onthe extraordinary surge in US productivity since 1995, equally impressiveproductivity growth in emerging markets has been little commented upon.Taken together, rapid, and largely unexpected, worldwide productivitygrowth can explain why the demand for commodities is so strong, howemerging markets have weathered commodity price increases without aserious slowdown in investment, why inflation is still largely containeddespite the unprecedented rise in raw material costs, and why both house-hold incomes and corporate profits are buoyant at the same time

The reaction of domestic demand to rising productivity growth hasvaried across countries, in part based on the sophistication of their finan-cial sector In the United States, for example, the surge in productivity led

to a boom in investment in the late 1990s, financed by deep financial kets Not all the investment was wise, but the debris created by the bustwas quickly cleared by the financial markets Growth and investmentpicked up again In addition, though, the United States’ strong arm’s-length financial system allowed consumers to borrow against futureincomes and consume immediately Indeed, the expectation of higherfuture incomes coupled with accommodative monetary policy and lowinterest rates may have fueled the housing boom, which expanded con-sumption even more as the financial system allowed borrowing throughvehicles such as home equity loans Thus, the United States’ financial sys-tem translated productivity growth into strong domestic demand and a

mar-large current account deficit (also see International Monetary Fund, World Economic Outlook, September 2006)

Emerging markets countries with less sophisticated financial systemsdid not have the capacity to reallocate resources effectively to the newlyproductive areas Some, for example in East Asia, allocated resourcesindiscriminately, leading to investment booms and very severe busts.Experience brought more circumspection in investment Others, realizingtheir limitations, were more circumspect from the outset Regardless ofthe path, barring some notable exceptions like China, investment in

emerging markets has been relatively muted in recent years (see

International Monetary Fund, World Economic Outlook, 2005) even in the

face of strong growth Moreover, because of the limited availability ofhousing and retail finance, households in these countries have not beenable to expand consumption through borrowing Thus, domestic demand

in these countries has been relatively muted, and these countries have erated net savings or current account surpluses

gen-Finally, to complete this sketch, a number of advanced countries likeGermany have not experienced much increase in productivity Given lowexpectations of wage growth, impending population aging and safety netsthat are likely to prove inadequate absent reform, consumption hasremained muted and savings high

2 The Savings Investment Imbalance

So for the world as a whole, despite widespread strong productivitygrowth, investment has remained relatively weak, while desired savings isstrong Call this a “savings glut” as did Chairman Bernanke or “invest-ment restraint” as did the International Monetary Fund (IMF), the neteffect is an imbalance between desired savings and realized investment.Consequently, real long-term interest rates have been low for some time.Interestingly, even as the Federal Reserve has raised policy rates, long-term interest rates have fallen further — in slowing domestic demand inthe United States, markets may believe the Fed is aggravating the world-wide excess of desired savings over realized investment further

Current conditions are unlikely to be permanent, though a quick look

at history [see Catao and Mackenzie (2005),2for example] would suggestthat the low real interest rates of the present period are more representa-tive than the high interest rates of the previous three decades Given agingpopulations in developed countries though, one would presume that therebalancing of worldwide investment to desired savings will have to takeplace primarily in nonindustrial countries Investment will increase partlythrough foreign direct investment, but partly mediated by the financialsystems in emerging markets, which will have to develop further Increases

in consumption, as safety nets improve and retail finance becomes widely

2 Catao, Luis and G A Mackenzie, 2006, “Perspectives on Low Global Interest Rates”, IMF, working paper, March, No 06/76.

available, will also help reduce desired savings Certainly, the seeminglyperverse pattern of net capital flows, from poor to rich countries, will have

to change, if for no other reason than to accommodate demographics

I now want to turn to my second issue — the increasing ization of, and competition within, advanced financial markets The linkbetween the issues will soon be clear The break-up of oligopolistic bank-ing systems and the rise of financial markets has expanded individualfinancial investment choices tremendously While individuals don’t deposit

institutional-a significinstitutional-ant portion of their sinstitutional-avings directly in binstitutional-anks institutional-anymore, they don’tinvest directly in the market either They invest indirectly via mutualfunds, insurance companies, pension funds, venture capital funds, hedgefunds, and other forms of private equity The managers of these financialinstitutions, whom I shall call “investment managers”, have largely dis-placed banks and “reintermediated” themselves between individuals andmarkets

As competition among these various institutional forms for the lic’s investment dollar increases, each one attempts to assure the publicthat they will offer superior performance But what does superior perfor-mance mean?

pub-3 Performance Management

The typical manager of financial assets generates returns based on the tematic risk he takes — the so-called beta risk — and the value his abilitiescontribute to the investment process — his so-called alpha Shareholders

sys-in any asset management firm are unlikely to pay the manager much forreturns from beta risk — for example, if the shareholder wants exposure

to large traded US stocks, she can get the returns associated with that risksimply by investing in the Vanguard S&P 500 index fund, for which shepays a fraction of a percent in fees What the shareholder will really payfor is the manager beating the S&P 500 index regularly, that is, generatingexcess returns while not taking more risk Indeed, hedge fund managersoften claim to produce returns that are uncorrelated with the traditionalmarket (the so-called market neutral strategies) so that all the returns theygenerate are excess returns or alpha, which deserve to be well compensated

In reality, there are only a few sources of alpha for investment agers One comes from having truly special abilities in identifying under-valued financial assets — Warren Buffet certainly has these, but study

man-after academic study shows that very few investment managers do, andcertainly not in a way that can be predicted before the fact by ordinaryinvestors

A second source of alpha is from what one might call activism Thismeans using financial resources to create, or obtain control over, realassets and to use that control to change the payout obtained on the finan-cial investment A venture capitalist, who transforms an inventor, a garageand an idea into a full-fledged profitable and professionally managed cor-poration, is creating alpha A private equity fund that undertakes a hostilecorporate takeover, cuts inefficiency and improves profits is also creatingalpha So is a vulture investor who buys up defaulted emerging marketdebt and presses authorities through various legal devices to press thecountry to pay more

A third source of alpha is financial entrepreneurship or engineering —investing in exotic financial securities that are not easily available to theordinary investor, or creating securities or cash flow streams that appeal

to particular investors or tastes Of course, if enough of these securities orstreams are created, they cease to have scarcity or diversification valueand are valued like everything else Thus, this source of alpha depends onthe manager constantly innovating and staying ahead of the competition.Finally, alpha can also stem from liquidity provision For instance,investment managers, having relatively easy access to finance, can holdilliquid or arbitrage positions to maturity: If a closed end fund is trading

at a significant premium to the underlying market, the manager can shortthe fund, buy the underlying market and hold the position till the premiumeventually dissipates What is important here is that the investmentmanagers have the liquidity to hold till the arbitrage closes

4 Illiquidity Seeking

This discussion should suggest that alpha is quite hard to generate sincemost ways of doing so depend on the investment manager possessingunique abilities — to pick stock, to identify weaknesses in managementand to remedy them, or undertake financial innovation Unique ability israre How then do the masses of investment managers justify the faithreposed in them by masses of ordinary investors? The answer is probablyliquidity provision, which is the activity that depends least on special man-agerial ability and could be termed the poor manager’s source of alpha

The problem when the world has excess desired savings relative toinvestment, and when central banks are accommodative, is that it is awash

in liquidity Many investment managers can enter the business of ity provision, and even as they take ever more illiquid positions, theycompete away the returns from doing so The point is that current benignconditions engender “illiquidity seeking” behavior But they could haveworse effects

liquid-5 Tail Risk and Herding

What is the manager with relatively limited ability to do when central banksflood the market with liquidity and the rents from liquidity provision arecompeted away? He could hide risk — that is, pass off returns generatedthrough taking on beta risk as alpha by hiding the extent of beta risk Sinceadditional risks will generally imply higher returns, managers may takerisks that are typically not in their comparison benchmark (and hidden frominvestors) so as to generate the higher returns to distinguish themselves For example, a number of hedge funds, insurance companies and pen-sion funds have entered the credit derivative market to sell guaranteesagainst a company defaulting Essentially, these investment managers col-lect premia in ordinary times from people buying the guarantees With verysmall probability, however, the company will default, forcing the guarantor

to pay out a large amount The investment managers are thus selling ter insurance or, equivalently, taking on “peso” or “tail” risks, which pro-duce a positive return most of the time as compensation for a rare verynegative return.3 These strategies have the appearance of producing veryhigh alphas (high returns for low risk) so managers have an incentive to load

disas-up on them, especially when times are good and disaster looks remote.4Every once in a while, however, they will blow up Since true performance

3 Peso risk is named after the strategy of investing in Mexican pesos while shorting the US dollar This produces a steady return amounting to the interest differential between the two countries, although shadowed by the constant catastrophic risk of a devaluation Another example of a strategy producing such a pattern of returns is to short deep out-of-the money S&P 500 put options See Chan, Nicholas, M Getmansky, S Haas and A Lo, 2005,

“Systemic Risk and Hedge Funds”, MIT, working paper, August.

4 Certainly, the pattern of returns of hedge funds following fixed income arbitrage gies suggested they were selling disaster insurance The worst average monthly return between 1990 and 1997 was a loss of 2.58 percent, but losses were 6.45 percent in September 1998 and 6.09 percent in October 1998.

strate-can only be estimated over a long period, far exceeding the horizon set bythe average manager’s incentives, managers will take these risks if they can One example of this behavior was observed in 1994, when a number

of money market mutual funds in the United States came close to ing the buck” (going below a net asset value of $1 per share, which is vir-tually unthinkable for an ostensibly riskless fund) Some money marketfunds had to be bailed out by their parent companies The reason they came

“break-so close to disaster was because they had been employing risky derivativesstrategies in order to goose up returns, and these strategies came unstuck inthe tail event caused by the Federal Reserve’s abrupt rate hike

While some managers may load up on hidden “tail risk” to look as ifthey are generating alpha, others know that for the more observableinvestments or strategies for their portfolio, there is safety in mimickingthe investment strategies of competitors — after all, who can be firedwhen everybody underperforms? In other words, even if they suspectfinancial assets are overvalued, they know their likely underperformancewill be excused if they herd with everyone else

Both the phenomenon of taking on tail risk and that of herding canreinforce each other during an asset price boom, when investment man-agers are willing to bear the low probability tail risk that asset prices willrevert to fundamentals abruptly, and the knowledge that many of theirpeers are herding on this risk gives them comfort that they will not under-perform significantly if boom turns to bust

6 Risk Seeking

Times of plentiful liquidity not only induce investment managers to seekilliquidity and tail risk, as well as to herd, since they are also times of lowinterest rates that may induce more familiar risk-seeking behavior Forexample, when an insurance company has promised premium holdersreturns of 6 percent, while the typical matching long-term bond rate is 4percent, it has no option if it thinks low interest rates are likely to persist,

or if it worries about quarterly earnings, but to take on risk, either directly

or indirectly through investments in alternative assets such as hedgefunds Similarly, a pension fund that has well defined long dated obliga-tions will have a greater incentive to boost returns through extra risk whenrisk-free returns are low All manner of risk premia are driven down bythis search for yield and thus risk

So, let me summarize We are experiencing a widespread phenomenon

of high productivity growth but low investment relative to desired ings, which has pushed down interest rates and pushed up asset prices.With plentiful liquidity, investment managers have reduced the premia forrisk as they search for yield In an attempt to generate alpha, many man-agers may be taking on beta risk, and even underpricing it Of course, lowinterest rates and plentiful access to credit will, for a time, result in lowdefault rates, which will appear to justify the low risk premia The searchfor yield and for illiquidity knows no borders as oceans of capital spreadacross the globe, and asset prices across the globe are being pumped up

sav-As one says in French, “Pourvu que ça dure! (Provided that that lasts!)”

7 Consequences

What could go wrong? Our hope is of a “soft” landing in the real sectorwhere the factors that led to the current real sector imbalances reversegently — for instance, domestic demand picks up in the nonindustrialworld, and growth recovers in Europe and Japan, even while tighter finan-cial conditions slow consumption in the United States As a better balancebetween desired savings and investment is achieved, interest rates move

up slowly, credit becomes less easy (aided by central bank tightening),and illiquidity seeking and risk-seeking reverse gently without majorblow-ups

Of course, if any of this happens more abruptly, the consequencescould be uglier Since many of you are banking experts, I will not belaborthe possible risks to the banking system, about which you are well aware.Indeed, I do think the greater concern has to be about the rest of the finan-cial system, the 80 percent of value added by the financial sector that isoutside the banking system The nonbank sector is increasingly central toeconomic activity and is not just a passive holder of assets Moreover,some nonbanks, such as insurance companies, and some hedge funds aresubject to runs But most important, risks to financial stability are invari-ably compounded by political risk

Let me explain this last concern As you know, there has always been

a constituency in American politics that has viewed Wall Street as preying

on Main Street In Jacksonian times, this expressed itself as the concernthat the East Coast bankers were holding back the frontier, in the time ofWilliam Jennings Bryan, it was the worry that the bankers’ adherence to

the Gold Standard was crucifying the indebted farmer During the sion, it was the view that universal banks had exploited the ordinary firmand investor This anti-finance constituency typically gains power in theaftermath of a financial crisis, and while some of the constraints it imposes

depres-on finance may be warranted, some like the Glass–Steagall Act are neitherjustified by the evidence nor, by most counts, welfare enhancing

It may well be that today’s financial sector comes out of a future ical investigation smelling like roses But as you will guess from this talk,

polit-I see some ingredients that have me more concerned

First, the general public’s money is being invested in some of themore risky ventures, a fact highlighted by the revelation that a number ofstate pension funds were invested in a risky hedge fund like Amaranth.Diversification into such alternative investments can be a valuable com-ponent of an overall investment strategy if it is carefully thought out Theproblem is that, all too often, it takes place as a form of herding and late

in the game — after lagging pension managers see the wonderful returns

in energy or from writing credit derivatives made by their more tent or lucky competitors, so there is pressure on them to enter the field.They do so late, when the good hedge or commodity funds are closed toinvestment and when the cycle is nearer peak than trough Myriad newunseasoned hedge or commodity funds are started precisely to exploit thedistorted incentives of the pension or insurance fund managers who queuelike lemmings to dutifully place the public’s money Thus far, losses fromisolated failures have been washed away in diversified portfolios and thepublic has not noticed Will this always continue?

compe-Second, the fees charged by investment managers like hedge fundsand private equity cannot but arouse envy It is surprising that despite thefuror over chief executive officer (CEO) pay, very little angst has beenexpressed over investment manager pay, even though Kaplan and Rauh(2006) suggest that investment manager pay growth has probablyexceeded CEO pay growth.5My sense is that there is a belief amongst thepublic that many investment managers are following sophisticated invest-ment strategies — in other words, that the managers are generating alphasand earning returns for their talents — hence their pay is not questioned Yet, investigations of collapsed funds such as LTCM don’t seem toindicate terribly sophisticated strategies — indeed more beta than alpha

5 Steve Kaplan and J Rauh, 2006, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?”, working paper, University of Chicago.