23 October 2009 Bledisloe Address – Reflections on the financial crisis
Bruce Ross, born in Dunedin and now living in Lower Hutt, is Emeritus Professor of Agricultural Economics at Lincoln University, the institution he headed for 11 years, and of which he is a graduate. He was the last Principal of Lincoln College and the first Vice-Chancellor of Lincoln University, and played a seminal role in advocacy by the College for autonomous university status. Lincoln achieved this in 1990. Before his appointment as College Principal, Bruce occupied the Chair of Agricultural Economics. With his appointment to that post in 1970 he was, at 31, the youngest professor on campus.
Bruce Ross had a distinguished period of secondment to the OECD in Paris in the mid-1980s. From Vice-Chancellor of Lincoln University he was appointed Director-General of Agriculture in 1996. He retired from that position in 2001.
In 2002 he was appointed a Companion of New Zealand Order of Merit. In 2007 he was made a Distinguished Fellow of the New Zealand Association of Economists and in 2009 he was awarded Lincoln University’s Bledisloe Medal.
Below is Brue Ross's Bledisloe Address:
"When thinking of what I should speak about today, I decided that as many of my friends and acquaintances were asking me various questions about the financial crisis, this could be both a timely and possibly useful topic. I hasten to add that I am no expert, and I am speaking as an interested outside observer with no inside information. Nevertheless, I hope I can contribute enough to help people look at the still developing situation with greater clarity.
One final disclaimer; it is a very complex situation, I don’t fully understand it and I have simplified what I do understand, so whatever you take out of my comments, I would like to appropriate and recommend to you the slogan on the tee-shirts sold by a science correspondent of The Guardian: “I think you will find it is more complicated than that.”
In modern parlance, I think the events of 2008 represented a perfect storm of events which, taken together, gave us the frightening events we witnessed last year, but where did it all begin?
Firstly, a lot of the blame can probably be attributed to the innovation and increasing lack of transparency of the United States financial system in the 1980s and ‘90s.
Secondly, many commentators have suggested that the seeds of the crisis are to be found in the Asian financial crisis of 1998, and the Dot Com hiccup of the early years of this decade. On both occasions, Alan Greenspan and the US Federal Reserve acted quickly and decisively, lowering interest rates to stimulate the US economy and fend off any major recession.
These actions were met with general acclaim at the time, and were seen as highly successful, but looking back it may be that they gave the American financial sector the idea that if trouble threatened the Fed would come to the rescue.
This gives rise to a problem known as moral hazard, which describes the situation under which people are encouraged to take greater risks than they would otherwise, because they feel that some other party will protect them from the full consequences of any mishaps which they may suffer. It is considered that this attitude explains some of the apparently reckless behaviour which came to characterise the American financial sector later in the decade.
Another outcome of the Asian crisis was that several of the countries that were badly affected felt that they would have got through the crisis with less pain if they had had larger foreign exchange reserves. They therefore encouraged the generation of trade surpluses in order to build their reserves.
Stimulated by the Bush tax cuts, and protected from significant recession by the Federal Reserve, the US economy underwent a period of consumer led growth, which led to great economic imbalances between countries.
The high US levels of demand sucked in large volumes of imports, the US deficit ballooned, and large surpluses were generated, particularly in Asia and most spectacularly in China, where reserves grew to over two trillion dollars. These surpluses, together with those of the oil-rich Gulf states, were largely invested in the United States, in government bonds, direct investment (buying companies or property) and deposited in banks.
The huge US deficits stimulated the world economy, just as had happened in the late ’sixties and early ’seventies with the Vietnam war induced deficits.
Within the US, the banks, flush with funds from the deposit of the other countries’ surpluses back into the US, were keen to invest and the mortgage market seemed a good outlet. Massive amounts were lent out on mortgages in the early 2000s, and as house prices rose as a consequence, this outlet for the funds seemed a secure bet for the banks, and a degree of circularity was established. More funds leading to higher house prices which seemed to provide security for lending more.
Many of the mortgages were arranged by mortgage agents working on commission, then passed on to banks or other financial institutions. The crucial point is that the agents dealing with retail customers and approving the loans, were not themselves taking on the risks associated with any loan.
The mortgages were traded between banks and institutions as income earning assets in packages of, say, one hundred at a time. This process of “securitisation” was seen to minimise risk, as one or two of the mortgages defaulting would be small in relation to the total package, just as an insurance policy represents a pooling of risk. As a result, the rating agencies classified these investments as safe.
Rapidly rising house prices made this process seem a one-way path to riches, especially for greedy mortgage agents who lent more and more on riskier and riskier investments. Stories abound of the lending that was undertaken towards the end of the boom;-
- 100% mortgages to people with no assets and no income
- 125% mortgages, to allow for the furnishing of a house as well as its purchase,
- and “come on” mortgages with extra low interest for the first two or three years.
These high risk mortgages were what became known as “sub-prime mortgages”.
As house prices rose, and the mortgage brokers and the banks took on bigger and bigger risks, the rating agencies failed to issue effective warnings. Either they were unaware of what was going on, or they too assumed that the rising house prices, and the securitisation of the loans, meant that a good rating for these investments was still justified. (Ironically, these are the same rating agencies we work so hard to please in order to maintain New Zealand’s international credit rating.) Many of the securitised mortgages were on-sold, (with a markup!) to superannuation funds and other investment institutions on the basis of their credit rating.
The regulation of US banks had been relaxed in the 1990s, and in their determination to show increasing profits each quarter, the banks, having already, perhaps unknowingly, taken on extra risk on the asset, or loans, side of their balance sheets, started taking greater risks on the liabilities or deposits side.
To allow themselves the opportunity to lend more they lowered their capital reserves ratio. That is, of every $100 deposited they kept back less and less as a capital reserve against the possibility that depositors would want to withdraw their funds. For example, instead of holding, say, 10% of deposits in reserve and lending out 90%, they held only 5% and lent out 95%, thus increasing their profits but at the expense of taking on extra risk. By the early years of this decade the US banks had become more or less self-regulating so there was almost a race to the bottom with respect to capital reserve ratios.
To describe the banks as self regulating might be seen as a bit of an exaggeration, as there are literally thousands of employees in the regulatory bodies, but the agencies are uncoordinated and they seem to have adopted a hands off approach.
The cavalier approach of the authorities is well illustrated by their gross negligence in the Bernard Madoff affair. They were warned several times that things seemed to be awry with his investment business, but after perfunctory investigations concluded each time that there was nothing wrong. After his eventual arrest for fraud, having lost his investors more than $50 billion, he confessed that on two or three occasions he had thought the authorities were on to him, but for years nothing happened.
The big investment banks have traditionally taken bigger risks with their loans – part of their reason for being, and their contribution to the economy, is, after all, the financing of new and possibly risky enterprises. Consequently they tend to set their capital reserve ratios with respect to their loans, rather than with respect to their sources of funds which they regard as more secure.
Different asset classes are treated differently, one ratio for shipping investment loans, another for car makers, another for the construction sector and so on. Since the crash it has emerged that some banks were double counting their reserves, on the grounds that history suggested that the asset values of different sectors would not all decline at the same time. That is, $100mn kept as a reserve against risks with shipping loans was also seen as a reserve against the risk of defaults on loans to manufacturers. As things transpired, of course, the banks’ sense of history was shown to be somewhat limited.
It has been calculated that collectively the American banks would have required twice the reserves they actually had, in order to be in a position to withstand the shocks that eventually came without help from the authorities.
As house prices continued to rise, the apparent wealth of home owning households was increased. As a group they borrowed against this extra wealth, re-fuelling the consumer boom, which, among other things, again sucked in more imports, increasing the US deficit and raising the surpluses of other countries which were largely invested back in the United States.
This situation could not continue, and as house prices got more and more out of line with income levels, an increasing number of observers started expressing concern, just as they did here. Long standing political support for the idea of people owning their own homes, however, made politicians reluctant to act. At the same time the flow of funds into the country restricted the Federal Reserve’s ability to raise interest rates.
As an aside, there has been a long running argument about whether central banks should worry about asset prices, particularly house prices, as well as the general level of economic activity and general inflation. With such strong evidence as to the way in which rising asset prices lead to borrowing against extra wealth, it now seems largely agreed that asset prices do matter, and presumably this will be reflected in future policy.
About the same time as the voices of those expressing concern at the state of the housing market were rising to a crescendo, the first significant numbers of the “come on” mortgages ran out of their low interest phase. As market rates started to bite many of the over-optimistic borrowers found they could not pay their interest. As they defaulted in increasing numbers the boom in mortgage sales began, and house prices started tumbling. The sub-prime crisis had begun.
By the end of the first quarter this year 27% of mortgage holders owed more than their houses were worth.
At first, whilst people recognised that there were some serious problems, no-one realised the extent and seriousness of the situation. Many institutions which had bought securitised financial instruments did not realise that they included a chunk of defaulting sub-prime mortgages, or if they did not know how big that chunk was.
Those banks and institutions that knew they had loans at risk, however, started hoarding cash, beginning the process of tightening the screws on the whole financial system. As the extent of the potential losses started to emerge, the whole tightening process intensified, and those institutions which had over-reached themselves soon found themselves in trouble. Northern Rock, the Icelandic banks, Bear Stearns, the Royal Bank of Scotland, Lehmann Brothers and others had all been expanding quickly with adventurous borrowing and/or lending and soon became high profile basket cases.
Several issues quickly arose. Were these banks too big to be allowed to fail? In other words, would their failure have such widespread effects on the financial sector and the whole economy that government intervention to prevent this happening was justified?
The near panic around the collapse of Lehmann Brothers suggested that the failure of another big American bank could have been catastrophic, which suggested that government was right to act. On the other hand, possibly looking to the future, Niall Ferguson, the author of The Ascent of Money, has said recently that, “Any institution too big to fail is too big”. It’s a good line, but I think it is a bit simplistic.
What is the difference between having one large bank fail, or having thousands of small banks fail, as happened in the United States during the depression with disastrous consequences? The issue is the maintenance of the free and efficient operation of the financial system whilst avoiding the problem of moral hazard.
As I see it, the need is, or was, for the banks to be saved as working institutions, thus preserving the financial system, but for all those associated with the mistakes that led to the need for a rescue to lose their total investment, thus dealing with the issue of moral hazard. If a bank would have collapsed without state aid, leaving its shareholders with nothing, and the management with no contractual bonuses, there seems to me to be no good reason why a rescue package should save the shareholders and management as well as those with dealings with the bank.
The creation of totally new legal entities, rather than propping up the existing ones with loans or by taking a shareholding, would have prevented government embarrassment when some of the rescued banks paid enormous bonuses and retirement packages to those, such as the former Chief Executive of the Royal Bank of Scotland, who were as least partly responsible for the problems faced by their institutions.
Just sticking with bonuses for a moment: they may seem a side issue in the whole scheme of things, but if there had been no rescue packages the ramifications of the crisis would have spread much more widely through the financial sector, and even banks which did not in the event have to accept government help, could have collapsed. In these circumstances, it does not seem totally unreasonable for governments to impose some restraints on the remuneration and bonuses of employees of all firms in sectors that have had financial assistance.
In response to the crisis, in which it seemed that the stability of the world’s integrated financial system was at risk, central banks around the globe lowered interest rates dramatically and injected funds into their banking systems, or indicated their willingness to do so if necessary. Banks have not responded with freer lending quite as quickly as had been hoped, but together with huge government stimulus packages something in excess of three trillion US dollars has been injected into the world economy, and the rescue packages seem to be working.
The situation has improved to the point where the Australian Reserve Bank has raised interest rates, the New Zealand Reserve Bank has announced that some of its emergency contingency measures will be withdrawn as no longer required, a number of governments, particularly in Europe, have announced that their stimulus packages will be reduced or withdrawn and stock markets around the world are recovering. Despite some talk of a false recovery, and the risk of another downturn, it does seem as though the worst is passed, and it has not been as bad as was feared 9 to 12 months ago.
So the steps taken by the authorities can be said to have worked, but not without a cost. Governments around the world have taken on huge debts that will haunt taxpayers for years, and recent a IMF study of over 80 banking crises found that, on average, seven years after a crash an economy’s level of output was almost 10% below where it would have been without the crash.
So where to from here? We can go back to the factors which constituted the perfect storm: moral hazard leading to excessive risk taking, huge imbalances between economies, the separation of risk from those making lending decisions, the disguising of risk by the securitisation of loans, the failure of the rating agencies and the failure of the regulatory agencies.
Dealing with these factors will take time but is not impossible. I have focussed my attention mostly on the United States situation, because that is where the excesses were greatest, the rating and regulatory failures were greatest, the international banks which got into greatest trouble were heavily involved in the US sub-prime market, and because, as by far the largest economy in the world, the impact of the crisis on the US economy has spread throughout the world.
We learned many lessons from the depression of the ‘thirties, and they have contributed to the great growth we have experienced internationally since 1945, and to the rate of recovery from the latest crisis. The need now is to refine some of those lessons, and perhaps recollect some that have been forgotten.
To me it seems clear that the financial sector, if not all individual institutions, is too big and important to be allowed to fail. If left unregulated, there will always be rogue institutions that push the boundaries to eventual breaking point.
There now seems to be general agreement that prudential, or prudent, capital reserve ratios need to be set substantially higher for US banks. Some US bankers have been asking for higher ratios to be imposed, in tacit acknowledgement of the fact that without reasonable ratios being set by compulsion, competitive forces will again drive some banks to operate with dangerously low ratios in future.
By setting conservative ratios, central authorities are not only protecting the bank’s customers, but also the system, and they are protecting themselves from the need for another expensive rescue package.
I think that it is with respect to reserve ratio policy that we could see some innovative developments in the short to medium term future. Ben Bernanke, the Chairman of the Federal Reserve Board, said recently that he had a wide range of policy instruments at his disposal, which, to my mind, signalled a possible change in the modus operandi of the Board.
The jury is still out on the issue of whether the huge injection of funds into the system was simply compensating for the enormous losses that had been suffered, or whether those funds will eventually cause an inflationary explosion. Inflation may be seen by some governments as a way of reducing the real cost of the debts they have incurred, but if does rear its head, and governments want to control it, funds could quickly be frozen by raising reserve ratios. This possible action has the added attraction that it could deal with the issue of the flow of funds into the US, which rendered the Federal Reserve’s interest rate policies increasingly ineffective in the middle of this decade.
A former chief economist of the World Bank has questioned the effectiveness of such an active reserve ratio policy, on the grounds that there are too many non-bank institutions accepting deposits, but I think he is being a bit pessimistic. I think the climate is right in most countries for an acceptance of an extension of regulatory controls to a wider range of financial institutions.
Bankers are as wily as tax lawyers in finding their way around new regulations, and it is generally accepted that any financial tool tends to diminish in effectiveness over time, but I think the US could benefit, at least for a time, from a more active reserve ratio policy.
I think there is an even stronger case to be made for an active reserve ratio policy in New Zealand. Such a policy was in fact at the heart of the Reserve Bank’s operations up until the mid nineteen eighties. Changing the compulsory ratios of funds that had to be held by the banks affected the economy chiefly through changes in interest rates, as a result of changes in the supply of money. They were seen to be slow acting, however, and it was decided to act directly on interest rates by setting the Official Cash Rate, or OCR.
In 2000 the Reserve Bank published a paper that examined the policy tools available to the Reserve Bank, which concluded that the OCR was still more effective than quantitative tools such as reserve ratios, but I suspect they might be less certain today. Reporting to a Select Committee in May of this year, the Reserve Bank noted that 40% of New Zealand banks’ funding requirement now comes from overseas, and that longer term mortgage rates are influenced more by overseas term rates than by the OCR.
The Governor has been complaining that banks have been unresponsive to changes in the OCR, and perhaps we have got to the point where it is time for a change in policy tools.
Just to show that I am not too old to be at least a little radical, I will conclude with the following suggestions for New Zealand financial policy. First, we could revert to using capital reserve ratios as the prime policy tool, but on the deposits side of the banks’ balance sheets we should require higher reserves as a proportion of overseas deposits, or borrowing, than we require for domestic deposits. This would make domestic deposits more valuable to the banks, giving them an incentive to pay higher interest rates to domestic depositors, thus encouraging higher savings.
For a given market lending rate in New Zealand, the banks could pay higher rates to domestic savers and lower rates to overseas depositors. This would affect, most of all, the volatile money of investors like the iconic Belgian dentist and the Japanese housewife who are chasing the best rates around the world.
Any move which reduces the dependence on the most volatile overseas funds should reduce the fluctuations in our exchange rate, which make life so difficult for people operating in the tradeables sector of the economy. Currently, with our dependence on the OCR, the New Zealand dollar is the eleventh most traded currency in the world, which is ridiculous for the size of our economy and trade.
Next, we could revert to a practice of years ago by affecting the spread of banks’ loans. By requiring the banks to take account of the ratio of reserves to specific types of loans, as the US investment banks do, we can discriminate against lending on assets such as houses and land, which are seen as becoming overpriced to an extent that has undesirable flow-on consequences for the economy. Special arrangements could be made for first homebuyers, but if we believe that asset prices do matter then something needs to be done in this area.
I could go on, but I have already exceeded my allotted time, and I am keeping you from your lunch. Thank you for listening; I hope you have found something of interest."