The global financial crisis and financial reform. René Stulz

Transcription

1 The global financial crisis and financial reform René Stulz

2 Outline Some facts about the crisis Banks and the crisis Are we safer now? What is the future of banks?

3 House prices Source: The Economist

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6 2010 Bank sample indices Year EW Sample Index VW Sample Index VW CRSP Index Index Value

7 Banks Stock Performance (as 1.00 investment in 2nd July of 2007) Bank of Ireland Allied Irish Bank

8 Bank performance across countries Sample of 164 large publicly traded banks in 31 countries. Banks in top quartile of performance in 2006: 38.71% average return in % during the crisis Banks in bottom quartile in 2006: 25.96% average return in % during the crisis AIB, 90%; Bank of Ireland, 93%; US valueweighted, 75%.

9 What failed and why did it matter? Blinder: Give smart people go for broke incentives and they will go broke. Duh. FCIC: dramatic failures of corporate governance and risk management at many systemically important institutions were a key cause of this crisis. Rajan: Financial firms were taking tail risk. Acharya, Schnabl, and Suarez: banks increasingly devised securitization methods that allowed them to concentrate risks on their balance sheets which eventually led to the largest banking crisis since the Great Depression. 9

10 Conventional wisdom Why did the relatively small subprime securitized market lead to such a crisis? Incentives led to excessive risk taking by banks. When securities collapsed in value, investors did not trust banks anymore and banks lost equity that forced them to sell assets, which started a vicious circle. Because banks were highly levered, a small loss could lead to large asset sales and large decreases in lending. The resulting credit crunch led to a massive recession. Policy lessons: Constrain leverage more, fix incentives, increase transparency to reduce concerns about counterparty risk. 10

11 How much of this conventional wisdom is right? Some facts should make us cautious. AAA MBS were viewed as safe before the crisis by regulators, not just by banks. The big banks became bigger, not smaller. Corporate lending did not fall in In this talk, I will review empirical evidence on the crisis that addresses some of the predictions of the conventional wisdom view. 11

12 Poor crisis performance: The role of risk culture Work with Fahlenbrach and Prilmeier, December 2012, Journal of Finance We looked at 347 U.S. financial institutions that existed in 1998 and

13 Key Results Banks that performed poorly during the 1998 crisis Performed poorly during the credit crisis Were more likely to fail during the credit crisis Bank return during 1998 crisis helps explain leverage and funding before the credit crisis Banks that did poorly in both crises had higher growth and more short term funding 13

14 Governance and incentives Governance experts argue that CEO incentives are better when CEOs own more shares Governance experts also argue that governance is better when board has more independent directors How did that work out? 14

15 Largest equity portfolios 1. James Cayne (Bear Stearns, $1,062 million) 2. Richard Fuld (Lehman Brothers, $911.5 million) 3. Stan O Neal (Merrill Lynch, $359 million) 4. Angelo Mozilo (Countrywide Financial, $285 million) 5. Robert J. Glickman (Corus Bankshares, million) 15

16 Stock returns ROE Bonus/Salary Ownership ($) 0.079** 0.073** Equity risk ($) Fahlenbrach and Stulz, 2011 JFE 16

17 How did bank performance differ across countries? Sample of 164 large publicly traded banks in 31 countries. Banks in top quartile of performance in 2006: 38.71% average return in % during the crisis Banks in bottom quartile in 2006: 25.96% average return in % during the crisis

18 Performance: Stock returns, July 2007 to December 2008 Increases with Tier 1 capital pre crisis Increases with deposits/assets, falls with more short term market funding Worse for banks that did better in 2006 Worse for banks with more shareholder friendly boards Worse for banks with greater exposure to U.S. real estate 18

19 Why did banks hold highly rated tranches of securitizations? Paper with Erel and Nadauld, RFS. We focus on publicly traded U.S. BHCs as of December 31, 2006 For the typical bank, holdings of highly rated tranches (AAA and AA) were economically trivial. Median holdings over assets of 0.15% in But, holdings are skewed as mean is 1.3% in Big differences across big three: Citi, 5.75%, BAC, 1.96%, JPM, 1.09%. Banks with the highest holdings were not riskier before the crisis but they had worse performance during the crisis! 19

20 Results Securitization active banks held more highly rated tranches Evidence consistent with skin in the game arguments and possibly with a sophisticated view of regulatory arbitrage Holdings increased with bank assets, but the largest banks did not have higher percentage holdings Inconsistent with a simple too big to fail incentives of banks as an explanation No support for bad incentives or bad risk management theories 20

21 Fire sales Hard to get data on fire sales by many market participants Paper with Nadauld, Merrill, and Sherlund Use trades by insurance companies Sample is AAA rated RMBS 21

22 A Key fact of the financial crisis is the dramatic drop in value of structured finance securities 22

23 What did we find? Accounting matters. P&C were mark to market for low ratings of bonds. Life was not until 2009 P&C capital constrained firms sell at lower prices than other firms Life capital constrained firms sell at lower price after 2009 The discount can be large A one standard deviation drop in operating cash flow results in a 82% drop in price, keeping fundamentals the same 23

24 Regulation follows crises National Bank Act of 1864 Depository Institutions Deregulation and Monetary Control Act of 1980 Depository Institutions Act of 1982 Garn-St Germain Economic Growth and Regulatory Paperwork Reduction Act of 1996 Gramm-Leach-Bliley Act of 1999 Federal Reserve Act of 1913 Financial Institutions Regulatory and Interest Rate Control Act of 1978 Competitive Equality Banking Act of 1987 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 International Money Laundering Abatement and Financial Anti- Terrorism Act of 2001 To Amend the National Banking Laws and the Federal Reserve Act International Banking Act of 1978 Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) Riegle Community Development and Regulatory Improvement Act of 1994 Sarbanes-Oxley Act of 2002 Banking Act of 1933 The Glass-Steagall Act. Bank Holding Company Act of 1956 Crime Control Act of 1990 RTC Completion Act Fair and Accurate Credit Transactions Act of 2003 Banking Act of 1935 FDIC Federal Deposit Insurance Act of 1950 Federal Deposit Insurance Corporation Improvement Act of 1991 (FDCIA) Housing and Community Development Act of 1992 Dodd Frank Wall Street Reform and Consumer Protection Act of 2010

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26 Capital Requirements Focus on macro-prudential goal of protecting the system from fire-sale and credit-crunch spillovers. Greater capital requirements for large banks and banks with less liquid assets Heavy use of short-term debt causes system fragility. Capital requirements should be higher with more shortterm debt financing Higher capital and liquidity requirements will create strong pressure for activity to migrate out of regulated banking sector.

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28 3 Product-specific RoEs show highest impact on structured products, especially credit and rates RoE (effect), Percent (Percentage points) Asset class Pre regulation B II.5 Mkt risk Basel III/Other 1 2 8a 8b 3 6/7 CCR RWA red. Rev. impact Cap. / Lev Lqd./ Fund. X Post regulation Delta, percent Most significant impact 1 FX a Rates Flow b Rates Strctrd a Credit Flow b Credit Strctrd Commodities Cash Equities a EQD Flow b EQD Strctrd Prime Svcs Prop Trading Total Borrowed from McKinsey/Toni Santomero 2 8

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31 Where are we on other issues? Derivatives Resolution Living wills Systemic regulator Volcker rule

32 Conclusions Many common features across countries. Many explanations for the problems are not supported. Regulatory reform has reduced some risks, but not as much as is claimed and may have increased some other risks as well. We had a spectacular world wide real estate bubble. Not clear what we have done to prevent resurgence.