GLOBAL FINANCIAL CRISIS

ISHRAT HUSAIN
July 12, 2012
 AGENDA

 CONTEXT AND BACKGROUND

 BRIEF CHRONOLOGY OF KEY EVENTS
 CONTRIBUTORY FACTORS
 WHAT WENT WRONG
 RESPONSE TO THE CRISIS
 IMPACT OF CRISIS IN PAKISTAN
 SALIENT FEATURES AND LESSONS LEARNT
 LESSONS ON CORPORATE GOVERNANCE OECD FINDINGS
 LESSONS FOR SHAREHOLDERS KEY QUESTIONS TO ASK –
BOARD ASS...
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 Context and Background

 World economy has recorded fastest growth in the last 50

years ushering in an unprecedented era of prosperity for
the majority of the population. Even in this decade of slow
growth the global economy will grow to 10 to 20 percent
faster than it did a decade ago, 60 percent faster than it did
two decades ago, and five times as fast as it did three
decades ago.

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 Context and Background
(Continued)

 Developing and emerging economies which were

impoverished and faced with poverty, hunger, illiteracy have
been able to make a remarkable turn around and increased
their share of world GDP from almost negligible proportion
to almost 50 percent. In 1980, the number of countries that
were growing at 4 percent a year was around 60. by 2007, it
had doubled to 120. even now, after the financial crisis and
recession the number is more than 80. Then annual average
growth rate in the last decade was an impressive 6.4 percent.

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 Context and Background
(Continued)

 Poverty has been reduced more in the past 50 years than in

the previous 500 years. About one billion people have been
lifted out of poverty since 1980. The proportion of people
living below the poverty line has dramatically fallen from 52
percent to about 20 percent in this period.

 Between 2005 and 2010 both the poverty rate and the
number of people living in extreme poverty have fallen in all
the six developing countries, the first time that has
happened.

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 Context and Background
(Continued)

 The World Bank projections show that the global

target of the Millennium Development Goals (MDG) of
halving World poverty has been achieved five years
early.

 Rising agriculture production has kept ahead of

population growth. World Food Production Index rose
by 75% in the last 20 years while population grew by 50
percent in the same period.

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 Context and Background
(Continued)

 Mobility of people, capital, ideas, goods and services

across country border has never been as high as in the
last two decades.

 Technological revolution inform of Internet, mobile

phones, cable and satellite TV, networking, have made
communication and connectivity easy and physical
distances shrink. Cell phones today have more
computing power the Apollo Space Capsule.

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 Context and Background
(Continued)

 World Trade growth has consistently outpaced world

output growth; Capital flows in form of portfolio
investment, loans equity investment, remittances,
official aid have risen sharply.

 This increased mobility of factors and integration of

markets would therefore have consequences – both
positive as well as negative.

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 Context and Background
(Continued)

 Financial markets have peculiar characteristics and

the spillovers and contagion effect are more
pronounced and highly destabilizing if triggered by a
negative shock.

 The correlation between distant markets and

different types of assets has increased.

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 Context and Background
(Continued)

 Financial innovation and financial engineering based

on complex models gave rise to new products that
has transformed the basic landscape of Derivatives,
credit default swaps, collateralized debt obligations,
securitization were developed as instruments to
manage and mitigate risks.

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Trigger Point Sub-Prime lending
Defining it

A loan made to someone with weak credit

Little or no down payment

Teaser rates and adjustable rates

“Liars’ loans”

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Brief chronology of key events

March 2008
Bear Stearns is sold to J.P. Morgan for $ 240 million with Fed backing.

A year ago it was valued at $ 35 billion.

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 Brief chronology of key events
(Continued)

 October 2008
 UK government announces a $ 88 billion rescue plan for the
financial system.
 Takes major stake in UK banks.
 US government approves a $ 700 billion plan.
 European and Asian governments follow suit.
 Iceland takes over a third bank and obtains IMF assistance to
cope with the financial crisis.
 Contagion, spillovers, linkages and herd instincts proved to be fairly
strong and the EDEs also suffered output and export losses.
However, they recovered much quickly than the AEs.

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 Contributory factors
(Continued)

Other factors were:

 Excess global liquidity and globalization of investment flows
 Federal reserve policy response of monetary easing
 Asset inflation (housing and commodities bubbles)
 Poor and incomplete supervision and oversight of shadow banking system
 Pressure to grow revenues by taking more risk
 Excessive leverage
 Pervasive reliance on mathematical models
 External credit ratings substitute for banks own due diligence
 Deficiencies in the “Originate to distribute” model vs. previous “Originate
to Hold” model
 Over-extended borrowers
 Vulnerable to unscrupulous lending practices

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 What went wrong?
Banking System

 Poor governance practices

 Short term focus of remuneration packages
 Use of ROE based indicators led to excessive leverage
 Risk and business units operating in “silos”; Risk given back seat
 External ratings replaced internal risk assessment
 Over dependence on short-term funding sources - Widening
maturity gaps
 Securitization and innovation; “Originate to Distribute” slice and
dice model had flaws
 Unethical mortgage brokers and lending practices

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 What went wrong?
Shadow Banking

 In the absence of regulatory oversight and supervision excessive risk taking on

leveraged funds.

 Rapid sale of assets in a crisis caused liquidity spirals

 Moral hazard created by “asymmetric fee structure” of hedge funds

 Contributing to greater systemic risk

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 What went wrong?
Credit rating agencies

 Significant underestimation of the risks of structured products

 Conflict of interest
 Relationship conflicts: Long, established relationships with CDO and MBS issuers
 Issuer-paid model: “… paid by the very people whose products they rate”
 Advisory business: CRAs advised banks on structuring MBSs leading to good rating

 Exacerbating the asset price spirals

 Mass downgrades during late 2007 triggered the limits of many institutional investors,
leading to forced selling
 Pro-cyclical nature of credit ratings

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 What went wrong?
Flawed Theoretical Assumption

 Efficient Market Hypothesis (EMH) has been the predominant theory

governing financial markets. The assumption that market prices are
based on rationality has proved wrong in practice. Individual rationality
does not ensure collective rationality.

 Individual does not always behave rationally but in network economy his/
her behavior depends on what others are doing. Herd instinct is a
common observable trait.

 Securitization was believed to improve financial stability. In actual fact,

trading in these marketable instruments made them vulnerable to
market sentiment.
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 What went wrong?
Flawed Theoretical Assumption
(Continued)

 Mathematical models and algorithms would allow financial innovation,

ease in manufacturing and trading in complex derivatives such as
credit default swaps (CDSs) and collateralized Debt Obligations
(CDOs). The models made the assessment of credit quality of
underlying loans quite difficult and complicated. There were serious
omissions in the specifications of models such as complete exclusion
of high risk events, systemic risks and non-linearity.

 Information asymmetry and Moral hazard have been studied

extensively in economics literature but their application in designing
new financial products was far from satisfactory.
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 What went wrong?
Regulators

 Missing macro-prudential supervision

 Pro-cyclical capital requirements
 Built-in reliance on rating agency opinions
 Little attention to liquidity risk and the risk of trading book of banks
 During the crisis, many weak banks were allowed to merge with
other banks. This in turn created many “too big to fail” institutions
 Creation of deposit insurances has exacerbated the moral hazard
problem
 Weak regulatory framework for market infrastructure – Payment
and settlement systems

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 Response to the crisis
A summary of responses
Regulators‘ response
» Supervisors are challenging:
 Underwriting standards
 Rating process
 Securitization markets
Business » Central bank funding replaces
interbank market
activities and » Better operational infrastructure
ownership » New deposit protection schemes
» Significant state involvement in
the banking sector
» Greater oversight
 Avoid undue risk-taking
» Guidelines on compensation
Compensation practices
Response by the industry
» Rethink business model
» Aggressively reduce balance
sheet
» Increased cost of doing business
» Shifting focus to domestic
markets
» Reduced risk appetite
» Shift towards earning greater fee
based income
» Overhaul remuneration approach
» Greater symmetry between risk
horizons and compensation
» Claw-backs
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 Response to the crisis
A summary of responses

Regulators‘ response Response by the industry

» Supervisors are demanding: » Rethink reliance on sophisticated

 Greater Board/management
oversight
 Better understanding of risks
 Stronger risk aggregation
» Strengthening guidance relating
to risk management
modeling
» Capture ‘tail-risks’
» Intensify direct dialogue of Board
members with supervisors
» Improve risk reporting:
 Content

Risk » Supervisors are challenging:  Frequency

 Historical risk measures in an  Addressees
management &
‘originate-to-distribute’ model
control  VaR models and stress testing
scenarios
 Assumptions of new product
risks
» Supervisors are hiring more
specialists in risk management
and control
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 Response to the crisis
A summary of responses

Regulators‘ response Response by the industry

 Additional capital buffers » Rapid deleveraging and
 Backstop leverage ratios divestitures
 Changing treatment of » Greater capital buffers
securitization and trading book » Reconsider capital allocation
Capital and  Greater scrutiny of models
leverage capital/balance sheet planning » Long-term funding
» Capital with government support

 Improved management, » Enhance models, stress testing

oversight and governance of and contingency planning
liquidity risk » Identify alternate funding
 Contingency planning mechanisms
Liquidity  Additional reporting » Develop stringent internal
 Link capital with liquidity controls on liquidity risk
 Better liquidity risk
management
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 Response to the crisis
A summary of responses

Regulators‘ response Response by the industry

 Strengthened risk disclosures » Benchmark risk disclosures and
 Rigorous valuation processes valuation practices against other
 Robust valuation disclosures financial institutions
Valuation, » Reassessment of the contribution
Accounting and of MTM to pro-cyclicality
» Use of measures like Mark-to-
Disclosures
funding

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 Impact of the crisis on Pakistan

 Financial sector reforms in the pre-crisis period had strengthened

the Financial soundness Indicators of the banking system.
 Private sector ownership and management brought about
efficiency but a strong regulatory regime did reform its watchdog
function in continuing exercise risk taking.
 Plain Vanilla Derivatives were introduced gradually on a case-by-
case basis.
 Cautious liberalization particularly on capital account convertibility
insulated the banking system from contagion shock.
 Non-banking system was a minor player in the game and could not
cause any ripples.
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 Impact of the crisis on Pakistan
(Continued)

 Banking sector had little lending exposure in troubled

countries
 Trading book almost non-existent
 Exposure to securitized products was limited
 However, an indirect (and in some cases the direct) impact is
felt
 There is a lag effect
 Liquidity dried up (or cost of funding increased)
 Concentration in portfolios
 Name lending portfolio quality is uncertain
 FDI flows are not certain - Linked to economic growth
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Salient Features and Lessons Learnt

 The question therefore arises as to what were the salient

features that distinguished the US and European systems from
those in Canada, Australia and New Zealand and the EDEs and
what are the lessons learnt?

 First, Bank lending forms the bulk of financial sector lending in

EDEs and Capital markets are not so well developed unlike the
US and Europe. The contagion risk and transmission effect of an
interconnected world capital markets in the EDEs remained
muted.

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Salient Features and Lessons Learnt
(Continued)

 Second, Asian countries had learnt the hard way from the crisis
they face in 1997-98. Prudent macroeconomic management,
credibility of policy makers, open trading and investment
regimes, accumulation of sufficient foreign exchange reserves
combined together to maintain an enabling environment for
growth and stability.

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Salient Features and Lessons Learnt
(Continued)

 Third, the banks in EDEs relied upon low cost and stable deposits
for financing their assets rather than wholesale funding that was
volatile and expensive. This permitted maturity transformation,
ample liquidity to the system and preserved confidence among
investors. In the US and Europe, abrupt withdrawal of wholesale
funds led to a vicious cycle of distressed sales of assets, falling
asset values, shortages in capital adequacy and difficulties in
raising fresh capital from the private sources.

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Salient Features and Lessons Learnt
(Continued)

 Fourth, the Central banks in EDEs had developed the capacity to

draw the rules of the game and enforce them in a way that was
orderly and least disruptive. The quality of banks’ portfolio had
improved as a result of the Central banks vigilance and
continuous watchdog monitoring. Mark-to-Market accounting,
loan-loss provisioning and capital infusion helped the
strengthening of the banks.

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 Salient Features and Lessons Learnt
(Continued)

 Fifth, the bank lending in EFEs avoided exotic products such as

derivatives, loans to hedge funds, private equity, credit default swaps.
Capital infusion from time to time helped strengthen the balance sheets.

 Sixth, partial capital controls and lack of full capital convertibility in

China, India, Pakistan, did not allow large exposure to foreign currency
denominated assets. The market share of the large financial
conglomerates was kept limited by design and therefore direct
exposure of the significantly important financial institutions was quite
low.

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Salient Features and Lessons Learnt
(Continued)

 Seventh, as the markets in EDEs are generally considered

imperfect or incomplete and market failures loom large on the
horizon the intellectual foundation of contemporary financial
theory – efficient market hypothesis – did not assume a pivotal
role as in the developed markets and therefore, did not lead to
the widespread belief and practice in Market is self correcting
and therefore, a hands-off approach by the regulators.

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 Lessons on Corporate governance
OECD Findings

1. Independence of Boards is a necessary, but not a sufficient

condition for good governance
2. Shareholders nominate Board members; involved in their
appointment and evaluation
3. Separation of the Chairman/CEO position
4. Board member liability; no consensus on existing practices
5. Identifying skills-sets of Directors best suited for the Bank’s Board
6. ‘Fit and proper’ should include general governance and risk
management skills
7. Independence can be affected by the time board members have
served under the same CEO or Chair
8. Adopt voluntary practices to improve Corporate Governance
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 Lessons for Shareholders
Key questions to ask – Board assessment
Risk oversight
» Is risk management a key
component in the company’s
overall strategy?
» Has the Board articulated its risk
strategy?
» What mechanisms does the
Board have in place to evaluate
risk?
» What is the role of the CRO and
the reporting structure?
Disclosure practices
» What steps has the Board taken
to improve transparency of the
bank’s risk-taking initiatives?
» Are risky instruments fully
disclosed to shareholders?
» Does the Bank have an updated
Disclosure policy?
» Does the Bank disclose Board
meeting minutes, attendance
etc.?
Board composition
» What changes has the Board
made to its structure as a
response to the crisis?
» How effective are the committees
or the Board in overseeing risk?
» Has the Board appointed
sufficient independent Directors?
» Are long-tenured directors
serving on the Board?
Compensation practices
» What percentage of pay is
skewed toward short-term
individual performance?
» Do pay practices include “claw-
back” provisions?
» Does the Bank have an updated
Remuneration policy?
Director qualifications
» Is the Board equipped with
adequate risk expertise?
» Is the Board considering director
qualifications in the nominating
process ?
» What process does the Board
have to train NEDs on risk
management?
» Do the Directors adhere to a
minimum time commitment?
Conflicts of interest
» Does the Board have a Conflict of
Interest policy which mitigates
potential conflicts that could
distort the Board and
management’s understanding of
potential risks?
» Are all related party transactions,
conflicts of interest disclosed?