PrefBlog

I will admit that I’m very unfamiliar with the Australian bank market, but the Reserve Bank of Australia has released its September 2009 Financial Stability Review:

A number of interrelated factors have contributed to the relatively strong performance of the Australian banking system in the face of the challenges of the past couple of years. One is that Australian banks typically entered the financial turmoil with only limited direct exposures to the types of securities – such as CDOs and US sub-prime RMBS – that led to losses for many banks abroad. Moreover, they have typically not relied on the income streams most affected by recent market conditions: trading income only accounted for around 5 per cent of the major banks’ total income prior to the turmoil. Banks’ wealth management operations have been affected by market developments, but the major banks still reported net income of around $2.3 billion from these activities in the latest half year.
One reason why Australian banks garnered a relatively low share of their income from trading and securities holdings is that they did not have as much incentive as many banks around the world to seek out higher-yielding, but higher-risk, offshore assets. In turn, this was partly because they were earning solid profits from lending to domestic borrowers, and already required offshore funding for these activities. As a result, Australian banks’ balance sheets are heavily weighted towards domestic loans, particularly to the historically low-risk household sector.

As discussed in detail in the previous Review, there are several factors that have contributed to the relatively strong outcome in Australia, including:

• • Lending standards were not eased to the same extent as elsewhere. For example, riskier types of mortgages, such as non-conforming and negative amortisation loans, that became common in the United States, were not features of Australian banks’ lending.
• • The level of interest rates in Australia did not reach the very low levels that had made it temporarily possible for many borrowers with limited repayment ability to obtain loans, as in some other countries.
• • All Australian mortgages are ‘full recourse’ following a court repossession action, and households generally understand that they cannot just hand in the keys to the lender to extinguish the debt.
• • The legal environment in Australia places a stronger obligation on lenders to make responsible lending decisions than is the case in the United States.
• • The Australian Prudential Regulation Authority (APRA) has been relatively proactive in its approach to prudential supervision, conducting several stress tests of ADIs’ housing loan portfolios and strengthening the capital requirements for higher-risk housing loans.

The Australian housing stress-tests of 2003 have been discussed on PrefBlog.

Capitalization is also good:

The Australian banking system remains soundly capitalised.The sector’s Tier 1 capital ratio rose by 1.3 percentage points over the 12 months to June 2009 to 8.6 per cent, its highest level in over a decade (Graph 37). In contrast, the Tier 2 capital ratio has fallen by around 0.7 percentage points over the same period, mainly because term subordinated debt declined. As a result of these developments, the banking system’s total capital ratio has risen by almost 0.7 percentage points over the past year, to stand at 11.3 per cent as at June 2009. A similar pattern has been evident in a simpler measure of leverage – the ratio of ordinary shares to (unweighted) assets – which has risen by around half a percentage point over the past six months. The credit union and building society sectors are also well capitalised, with aggregate total capital ratios of 16.4 per cent and 15 per cent.

In response to falling profits, many banks have cut their dividends (Graph 39). Despite these lower dividends, the major banks’ dividend payout ratio increased to around 80 per cent over the past year.

Most banks are endeavouring to increase their share of funding from deposits, in response to markets’ increased focus on funding liquidity risk. For some of the smaller banks, it is also because of a lack of alternative funding options, given the difficulties in the securitisation market. These factors have led to strong competition for deposits, especially for term deposits, and deposit spreads have widened. For instance, the average rate paid by the major banks on their term deposit ‘specials’ is currentlyaround 175 basis points above the 90-day bank bill rate, compared to about 75 basis points as at end December 2008.

I’m not sure just what a “special” might be … can any Australians elucidate the matter? I assume that a “bank bill” is essentially a bearer deposit note, but confirmation would be appreciated.

After the review of the current environment, there is a discussion of The International Regulatory Agenda and Australia:

As noted in The Australian Financial System chapter, following the capital raisings by the Australian banks this year, the Tier 1 capital ratio for the banking system is at its highest level in over a decade. In addition, APRA’s existing prudential standard requires that the highest form of capital (such as ordinary shares and retained earnings) must account for at least 75 per cent of Tier 1 capital (net of deductions); other components, such as non-cumulative preference shares, are limited to a maximum of 25 per cent. In some other countries this split has been closer to 50:50.

The old Canadian standard was 75%; after relaxing to 70% in January 2008, OSFI debased capital quality requirements in November 2008 to 60%.

The Boston Fed – a rich source of high quality research – has released a paper by Ryan Bubb and Alex Kaufman titled Securitization and Moral Hazard: Evidence from a Lender Cutoff Rule:

Credit score cutoff rules result in very similar potential borrowers being treated differently by mortgage lenders. Recent research has used variation induced by these rules to investigate the connection between securitization and lender moral hazard in the recent financial crisis. However, the conclusions of such research depend crucially on understanding the origin of these cutoff rules. We offer an equilibrium model in which cutoff rules are a rational response of lenders to perapplicant fixed costs in screening. We then demonstrate that our theory fits the data better than the main alternative theory already in the literature, which supposes cutoff rules are exogenously used by securitizers. Furthermore, we use our theory to interpret the cutoff rule evidence and conclude that mortgage securitizers were in fact aware of and attempted to mitigate the moral hazard problem posed by securitization.

I am astounded that cut-off rules exist, but they do and they are step functions:

One promising research strategy for addressing this question is to use variation in the behavior of market participants induced by credit score cutoff rules. Credit scores are used by lenders as a summary measure of default risk, with higher credit scores indicating lower default risk. Examination of histograms of mortgage loan borrower credit scores, such as Figure 1, reveal that they are step-wise functions.

Using step functions to evaluate differences in complex systems is suspicious at the very least. Any time you hear a portfolio manager talk about a “screen” for instance, you should ensure that the screen is very coarse, throwing out only the most ridiculous of potential investments. For proper, verifiable, assessments of single entitites in a complex universe – whether it is a universe of government bonds, preferred shares, common equity, or mortgage applicants – you need a coherent system of continuous smooth functions.

The only rationale I can think of for using step functions at all is suggested by the authors: lenders must make a decision regarding whether or not to incur costs to collect additional data to feed into (a presumably rational) evaluation system and incurring such a cost – whether it’s a single charge, or a member of a sequence of possible charges – is a binary decision, implying a stepwise preliminary evaluation. But anyway, back to the paper:

It appears that borrowers with credit scores above certain thresholds are treated differently than borrowers just below, even though potential borrowers on either side of the threshold are very similar. These histograms suggest using a regression discontinuity design to learn about the effects of the change in behavior of market participants at these thresholds. But how and why does lender behavior change at these thresholds? In this paper we attempt to distinguish between two explanations for credit score cutoff rules, each with divergent implications for what they tell us about the relationship between securitization and lender moral hazard.

We refer to the explanation currently most accepted in the literature as the securitizer-first theory. First put forth by Keys, Mukherjee, Seru, and Vig (2008) (hereafter, KMSV), it posits that secondary-market mortgage purchasers employ rules of thumb whereby they are exogenously more willing to purchase loans made to borrowers with credit scores just above some cutoff. This difference in the ease of securitization induces mortgage lenders to adopt weaker screening standards for loan applicants above this cutoff, since lenders know they will be less likely to keep these loans on their books. In industry parlance, they will have less “skin in the game.” Because lenders screen applicants more intensely below the cutoff than above, loans below the cutoff are fewer but of higher quality (that is, lower default rate) than loans above the cutoff. We call this the “securitizer-first” theory because securitizers are thought to exogenously adopt a purchase cutoff rule, which causes lenders to adopt a screening cutoff rule in response. Under the securitizer-first theory, finding discontinuities in the default rate and securitization rate at the same credit score cutoff is evidence that securitization led to moral hazard in lender screening.

We offer an alternative rational theory for credit score cutoff rules and refer to our theory as the lender-first theory. When lenders face a fixed per-applicant cost to acquire additional information about each prospective borrower, cutoff rules in screening arise endogenously. Under the natural assumption that the benefit to lenders of collecting additional information is greater for higher default risk applicants, lenders will only collect additional information about applicants whose credit scores are below some cutoff (and hence the benefit of investigating outweighs the fixed cost). This additional information allows lenders to screen out more high-risk loan applicants. The lender-first theory thus predicts that the number of loans made and their default rate will be discontinuously lower for borrowers with credit scores just below the endogenous cutoff.

Such a cutoff rule in screening also results in a discontinuity in the amount of private information lenders have about loans.

We investigate these two theories of credit score cutoff rules using loan-level data and find that the lender-first theory of cutoff rules is substantially more consistent with the evidence than is the securitizer-first theory. We focus our investigation on the cutoff rule at the FICO score of 620. We do this for two reasons: of all the apparent credit score cutoff thresholds, the discontinuity in frequency at 620 is the largest in log point terms; also, 620 is the focus of inquiry in previous research. After reviewing institutional evidence that lenders adopted a cutoff rule in screening at 620 for reasons unrelated to the probability of securitization, we use a loan-level dataset to show that in several key mortgage subsamples there are discontinuities in the lending rate and the default rate at 620, but no discontinuity in the securitization rate. Without a securitization rate discontinuity at the cutoff, the securitizer-first theory is difficult to reconcile with the data.

Having established that the lender-first theory is the more likely explanation for the cutoff rules, we then interpret the evidence in light of the theory. We find that in the jumbo market of large loans, in which only private securitizers participate, the securitization rate is lower just below the screening threshold of 620. This suggests that private securitizers were aware of the moral hazard problem posed by loan purchases and sought to mitigate it.

However, in the conforming (non-jumbo) market dominated by Fannie Mae and Freddie Mac (the government sponsored enterprises, or GSEs), there is a substantial jump in the default rate but no jump in the securitization rate at the 620 threshold. One explanation for this is that the GSEs were unaware of the threat of moral hazard. An arguably more plausible explanation is that, as large repeat players in the industry, the GSEs had alternative incentive instruments to police lender moral hazard.

The authors conclude:

Interpreting the cutoff rule evidence in light of the lender-first theory, our evidence suggests that private mortgage securitizers adjusted their loan purchases around the lender screening threshold in order to maintain lender incentives to screen. Though our findings suggest that securitizers were more rational with regards to moral hazard than previous research has judged, the extent to which securitization contributed to the subprime mortgage crisis is still an open and pressing research question.

Assiduous Readers will remember that I have long complained about the dearth of research on the ill-effects of Canada’s bank capitalization requirements. Various OSFI puff-pieces (e.g., a speech by Mark White; an essay by Carol Ann Northcott & Graydon Paulin of the Bank of Canada and Mark White; a speech by Jule Dickson later clarified for the sub-moronic) have given unreserved praise to the high capitalization required by OSFI. I have long wondered what the through-the-cycle costs of having all this excess (by world standards) capital tied up in banks might be – ain’t NUTHIN’ free! The high levels of bank capitalization certainly helped through the crisis (although not, probably, as much as secure retail funding) but what did that cost us and is it worth that cost?

I don’t know the answer – I’m just annoyed that Canadians are not asking the question.

Into the breach steps the UK Financial Stability Authority, which has just published a paper by their staff members William Francis and Matthew Osborne titled Bank regulation, capital and credit supply: Measuring the impact of Prudential Standards:

The existence of a “bank capital channel”, where shocks to a bank’s capital affect the level and composition of its assets, implies that changes in bank capital regulation have implications for macroeconomic outcomes, since profit-maximising banks may respond by altering credit supply or making other changes to their asset mix. The existence of such a channel requires (i) that banks do not have excess capital with which to insulate credit supply from regulatory changes, (ii) raising capital is costly for banks, and (iii) firms and consumers in the economy are to some extent dependent on banks for credit. This study investigates evidence on the existence of a bank capital channel in the UK lending market. We estimate a long-run internal target risk-weighted capital ratio for each bank in the UK which is found to be a function of the capital requirements set for individual banks by the FSA and the Bank of England as the previous supervisor (Although within the FSA’s regulatory capital framework the FSA’s view of the capital that an individual bank should hold is given to the firm through individual capital guidance, for reasons of simplicity/consistency this paper refers throughout to “capital requirements”). We further find that in the period 1996-2007, banks with surpluses (deficits) of capital relative to this target tend to have higher (lower) growth in credit and other on- and off-balance sheet asset measures, and lower (higher) growth in regulatory capital and tier 1 capital. These findings have important implications for the assessment of changes to the design and calibration of capital requirements, since while tighter standards may produce significant benefits such as greater financial stability and a lower probability of crisis events, our results suggest that they may also have costs in terms of reduced loan supply. We find that a single percentage point increase in 2002 would have reduced lending by 1.2% and total risk weighted assets by 2.4% after four years. We also simulate the impact of a countercyclical capital requirement imposing three one-point rises in capital requirements in 1997, 2001 and 2003. By the end of 2007, these might have reduced the stock of lending by 5.2% and total risk-weighted assets by 10.2%.

Unfortunately for the direct translation of this paper’s conclusions to the Canadian experience, the paper focusses on shocks to bank capital requirements, which may be different from the steady-state effects of a constantly high requirement. For all that, however, the reasoning seems applicable in general terms:

Moreover, a large body of theoretical and empirical literature suggests that, contrary to the predictions of the Modigliani-Miller theorems (Modigliani and Miller (1958)), maintaining a higher capital ratio is costly for a bank and, consequently, a shortfall relative to the desired capital ratio may result in a downward shift in loan supply (Van den Heuvel (2004); Gambacorta and Mistrulli (2004)).
…
A secondary aim of our paper is to use evidence of systematic association between changes in banks’ balance sheets and banks’ surplus or deficit relative to desired capital levels during economic upturns to develop measures that may assist policymakers in calibrating capital requirements, including proposals for counter-cyclical capital requirements, which are explicitly designed to address the build-up of risk during a credit boom.

Not surprisingly, there is an effect:

Our results show that regulatory capital requirements are positively associated with banks’ targeted capital ratios. We further show that the gap between actual and targeted capital ratios is positively associated with banks’ loan supply (suggesting that loan supply falls as actual capital falls below targeted levels), suggesting that banks amend their supply schedule (for example by raising the cost of borrowing or rationing credit supply at a given price) or take action to raise capital levels (for example, restricting dividends in order to retain profits or raising new equity or debt capital). Taken together, these results indicate that capital requirements affect credit supply, confirming the linkage found by previous researchers and demonstrating a ‘credit view’ channel through which prudential regulation affects economic output. We also find significant and positive relationships with growth in the size of banks’ balance sheets and total risk-weighted assets, and significant and negative relationships with growth in capital.

The effect of increasing regulatory requirements on Italian banks has been examined:

One notable study that addresses the problem of a lack of heterogeneity of capital requirements and assesses the impact on bank lending is Gambacorta and Mistrulli (2004). The authors explicitly examine the effects of the introduction of capital requirements higher than the Basel 8% solvency standard on lending volumes of Italian banks. They find that the imposition of higher requirements reduced lending by around 20% after two years. The results are consistent with the idea that, in the face of rising capital requirements, banks may find it less costly to adjust loans than capital as the risk-based capital requirement becomes increasingly more binding. Frictions in the market for bank capital make adjusting (raising) capital in response to higher regulatory requirements, in this case, expensive, so the result of the trade-off may be a reduction in lending. This result is consistent with the idea of a ‘bank capital channel’.

As noted, the paper’s emphasis is on the effect of shocks, not upon the constant effects of higher capital requirements, and the author’s conclusions reflect this bias:

Our simple theoretical model clarifies the link between capital requirements and lending and shows how, in the presence of capital adjustment costs, the “bank capital channel” implies that higher capital requirements lower a bank’s optimal loan growth. That effect, however, depends on the level of excess capitalization, with better capitalized banks (i.e., those with more capital above regulatory thresholds) experiencing less pronounced impacts on their lending. These predictions depend on departures from the Modigliani-Miller propositions and, in particular, increasing marginal costs of capital adjustment.

A full examination of the Canadian experience would include an accounting for the effects on loans of steady-state capital ratios and – perhaps equally importantly – some accounting of the crowding-out effects on risk-capital of other firms of requiring so much equity in banks. Don’t look for any pearls of wisdom from OSFI, though; perhaps the Bank of Canada might do it.

The Bank of England has announced the release of the 2009 Q3 issue of the Bank of England Quarterly Bulletin with the usual top-notch research. This quarter’s articles are:

• Foreword
• Markets and operations
• Global imbalances and the financial crisis
• Household saving
• Interpreting recent movements in sterling
• What can be said about the rise and fall in oil prices?
• Bank of England Systemic Risk Survey
• Monetary Policy Roundtable

The article on Global imbalances seeks to challenge Taylor’s assertion that there was no global saving glut by focussing on gross, not net numbers:

An important factor was the adoption of managed exchange rate policies by some EAEs [East Asian Economies],(2) whereby a particular level of their currency was targeted, usually against the US dollar. This policy was prompted, in part, by the aim of spurring economic development through exports, thereby addressing extensive rural underemployment.(3)(4) The desire to accumulate foreign exchange reserves as insurance against a repeat of the 1997–98 Asian currency crises was an additional motivation.(5) Another factor may have been the slow pace of financial development in many EAEs which meant that there was a dearth of domestic investment opportunities (see Caballero et al (2008)). This may have necessitated savings being channelled to the deeper and more liquid financial markets in western economies.
…
Bernanke (2005) has argued that the low and falling savings rates in deficit countries which accompanied the credit boom, were principally the outcome of an endogenous process by which the excess savings of the surplus countries — the ‘global
savings glut’ — were recycled.

Meanwhile, banks were exposing themselves to liquidity risk:

An associated innovation was that banks changed their funding models. In particular, banks sold the new types of securities to
end-investors via the so-called ‘shadow banking system’, encompassing structured investment vehicles (SIVs) and conduits, which provided a framework for lending and borrowing without accepting deposits. This was termed the ‘originate to distribute’ model: aiming to spread the risks associated with securitised assets off their balance sheets, banks sold them to SIVs, which then aimed to sell them on to end-investors.(1) At the same time, banks increasingly relied on wholesale funding markets, including in selling the securitised assets, see the October 2008 Financial Stability Report. The magenta bars in Chart 8 show that the share of funding by UK banks derived from securitisations increased between 2000 and 2008.(2)

The authors repeatedly emphasize this point:

The funding structure of financial institutions, with its reliance on wholesale markets and the use of securitised assets (Chart 8), was a related vulnerability. In particular, this funding model relied on the continued functioning of those markets. This funding often came from foreign investors and this, together with banks’ increased lending overseas and the growth of the shadow banking system, generated the further vulnerability of increased and complex cross-border linkages between both financial institutions and between countries more generally. Such complex international linkages potentially give rise to unappreciated, but potent, interconnections between firms in the global financial system.

The article on oil prices makes a claim of regulatory significance:

The price of oil rose steadily between the middle of 2003 and the end of 2007, rose further and more rapidly until mid-2008 and fell sharply until the end of that year. Commentators agree that a significant part of the increase in the oil price over that period was due to rapid demand growth from emerging markets, but there are substantial differences of view about the relative importance of other factors, and limited work thus far in explaining the large fall in oil prices in the second half of 2008. The purpose of this article is to analyse the main explanations for the rise and fall in oil prices in the five years until the end of 2008. It argues that shocks to oil demand and supply, coupled with the institutional factors of the oil market, are qualitatively consistent with the direction of price movements, although the magnitude of the rise and subsequent fall during 2008 is more difficult to justify. The available empirical evidence suggests that financial flows into oil markets have not been an important factor over the period as a whole. Nonetheless, one cannot rule out the possibility that some part of the sharp rise and fall in the oil price in 2008 might have had some of the characteristics of an asset price bubble.

I recently highlighted a paper by Alistair Murdoch of the University of Manitoba in which he showed that, in terms of the effect on the CAPM Beta of the common stock, preferred shares that were not convertible at a fixed rate into common were perceived by the market as being debt-like.

This paper was used as evidence to support the accounting reclassification of retractible preferred shares as debt for audited balance sheet purposes.

He then wrote a follow-up paper examining the effects of this change, titled Management Reaction to Mandatory Accounting Changes: The Canadian Preferred Shares Case:

The new Canadian accounting standards for financial instruments require that retractable preferred shares be classified as debt, thus negatively affecting the debt/equity ratio. Previous research, most of which has examined the impact of a change in American accounting standards affecting the determination of earnings, indicates that firms with such shares will act to mitigate the negative impact of the accounting change on their financial statements. Specifically, firms are likely to: a) reduce the amount of retractable preferred shares outstanding, and/or b) reduce the amount of other liabilities, and/or c) increase the amount of equity outstanding.

I test these predictions using data on firms required to file information on their preferred shares with Canadian securities commissions. Evidence based on a sample of 34 such firms indicates that they did indeed reduce the amounts of both retractable preferred shares and the amounts of other liabilities and issued additional common shares. Surprisingly, smaller firms did not make greater reductions (as a proportion of total assets) than larger firms.

He makes one statement about market efficiency that I consider worthy of comment:

The economic consequences of the replacement of retractable preferred shares by other sources of financing, primarily common shares, is not clear. If retractable preferred shares became a popular financial instrument during the 1970s and 1980s because they allowed firms to issue debt in the guise of equity, then their disappearance due to the standard change having stripped this disguise from them is desirable because it promotes informational efficiency.

This is of interest because it may be flipped upside down and used as an attack on the Efficient Market Hypothesis. The mandated change in classification is cosmetic only; no information is supplied to the marketplace by an auditor’s opinion as to whether a particular instrument is best placed in the shareholders’ equity section of the balance sheet or not. The prospectus contains all the necessary information for investors to judge the nature of the instrument for themselves and is not changed by this opinion.

Thus, any change in management or market behaviour due to such a change is evidence that the market’s efficiency has changed; and if the market’s efficiency can change, then the EMH does not hold.

In this particular case, I take the view that the change increased the efficiency of the market, by allowing bozos (who equate the term “research” with “looking stuff up in Compustat”) to more closely match the judgement of those who have actually examined the data and thus reduces the rewards for market professionals to think about what they are doing.

This supports the hypothesis that informtion has a value – it ain’t free!

Of interest in the paper was Table 1 “Number of publicly listed Canadian companies with outstanding retractable preferred shares”, which documents a nearly monotonic decline from 1988 (114 companies) to 1997 (32 companies). With the benefit of over a decade’s worth of additional data, we can now see that retractibles from Operating Companies (the HIMIPref™ subindex “OpRet”) has dwindled to virtual insignificance.

This is an old paper (1997) but interesting none-the-less.

Alistair Murdoch of the Deparment of Accounting and Finance, University of Manitoba wrote a paper Are Preferred Shares Debt or Equity?: Some Canadian Evidence with the abstract:

I test the appropriateness of new accounting standards that would treat some types of preferred shares as debt rather than equity. I develop a new model to examine whether capital markets view the (systematic) risk of preferred shares to be more like the risk of debt or more like the risk of common equity. The proposed model is compared to a traditional model tested on 1986 to 1994 data of thirty-nine companies that trade on the Toronto Stock Exchange and issued preferred shares during that period. Debt, retractable preferred shares and p lain vanilla preferred shares appear to be substantially less risky than common shares. Other types of preferred shares are more risky than debt; some appear to be more risky than common shares. These results support the view that some types of preferred shares should be classified as liabilities.

He reasons that:

A firm that increases its debt/(common) equity ratio increases the risk of the (common) equity and may increase the risk of the debt. If preferred shares are viewed as debt, then issuing preferred shares should have the same effect as increasing the debt/(common) equity ratio. If they are viewed as equity, then their issue should have the same effect as decreasing the debt/(common) equity ratio. Finally, if they are some intermediate form of financing, they may have no effect on the risk of the (common) equity.
…
… I confirm that debt is less risky than common equity. I find that retractable preferred shares and plain vanilla shares are also less risky than common equity and that in most of my tests their level of risk is not statistically significantly different from that of debt. Other kinds of preferred shares are more risky than debt. Convertible preferred shares are as risky as common shares, while preferred shares that are convertible at market or that are both retractible and convertible appear more risky than common shares

Risk is defined as Beta in the Capital Asset Pricing Model. The “Asset Beta” of each company is decomposed into the equity beta and terms representing the contributions of debt and the various flavours of preferred share, where:

A firm’s asset beta is a measure of the relation between the firm’s return on assets and the market return. Beta is usually estimated by regressing the firm’s return on the market return over some period during which beta is assumed to be constant.

After performing the regressions, the author concludes:

This paper has attempted to determine empirically whether during the past decade the Canadian market has viewed preferred shares as being more like debt or more like equity. It reports that retractable preferred shares have been viewed much like debt which supports the recent change in the accounting classification of these securities

An interesting paper in that it attempts to classify preferred shares according to the effect of their issuance on the Beta of the common, rather than considering the market price of the preferred shares themselves.

OSFI has published a speech by Assistant Superintendent Mark White of OSFI to the RBC Capital Markets Central Bank Conference.

The most delicious part is:

Looking forward, effective prudential regimes will be characterized by regulators with focus, effective tools and accountability.

Successful regulators will not relax rules to win business from other jurisdictions – or to promote the business objectives of their domestic institutions if they are not consistent with prudential regulatory objectives.

Successful regimes will not expect prudential regulators to forego prudential objectives to achieve non-prudential goals.

Instead, banks and investors will seek regulation that is focused, transparent, consistent and fair – as these factors will be hallmarks of a strong and reliable financial system.

OSFI’s lack of transparency has aroused my ire in the past: in that paper I made particular note of the totally inconsistent, completely opaque nature of the change in the rules when MFC got into trouble.

One reason why the Canadian financial sector has been relatively untroubled is because whenever an institution got into trouble, the rules were changed to let them off the hook. The change with MFC was not isolated: when it became apparent that OSFI’s incompetent testing of the effect of Basel 2 had created unexpected effects in the Assets-to-Capital Multiple they changed the rules.

Mr. White also predicted increased international use of capital ratios, presumably without knowledge of the BIS Press Release making that promise a few weeks ago.

As has become normal, Mr. White praised the high capital levels of Canadian banks without making the slightest effort whatsoever to perform a through-the-cycle (including this cycle!) cost/benefit analysis. Maybe the higher capital ratios are, all in all, good; maybe the higher capital ratios are, all in all, bad; I don’t know and neither, it would seem, does Mr. White.

Update, 2009-9-19: For an outsider’s view of the recent past, see Why Have Canadian Banks Been More Resilient?. It is claimed that the critical element is funding; Canadian banks get a huge amount of their funding from low-cost, very stable deposits.

The Bank of Canada has released the proceedins of its “Festschrift in Honour of David Dodge’s Contributions to Canadian Public Policy”.

Sessions reported are:

• The Financial Crisis and the Policy Responses : An Empirical Analysis of What Went Wrong
• Whither Financial Regulation?
• Inflation Targeting
• Fiscal Priorities for Canada: Building on the Legacy of David Dodge
• The Paradox of Market-Oriented Public Policy and Poor Productivity Growth in Canada
• Canada’s Aging Workforce: Participation, Productivity, and Living Standards
• Economic Change and Worker Displacement in Canada: Consequences and Policy Responses

The first session, by John Taylor of Taylor Rule fame, discusses the causes of the crisis. He repeats his thesis, mentioned on PrefBlog on Feb. 6, 2008 and discussed on Econbrowser in its post The Taylor Rule and the Housing Boom:

The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses—frequently monetary excesses—which lead to a boom and an inevitable bust. In the recent crisis, we had a housing boom and bust, which in turn led to financial turmoil in the United States and other countries. I begin by showing that monetary excesses were the main cause of that boom and the resulting bust.

What? It wasn’t simply greedy, stupid, over-bonused bankers who caused the crisis? Prof. Taylor is actually suggesting that regulators might have something to do with it? Such heresy!

Taylor is dismissive of the ‘global savings glut’ theory:

This alternative explanation focuses on global savings. It argues that there was an excess of world savings—a global savings glut—which pushed interest rates down in the United States and other countries.
…
The main problem with this explanation is that there is no evidence for a global savings glut. On the contrary, as Chart 3 shows in very simple terms, there seems to be a savings shortage.

But don’t blame it all on Greenspan, he had lots of helpers:

Nevertheless, there are possible global connections to keep track of when assessing the root cause of the crisis. Most important is the evidence that interest rates at several other central banks also deviated from what historical regularities, as described by a Taylor rule, would predict. Even more striking is that housing booms were largest where the deviations from the rule were largest.

Naturally, there are complicating factors:

A sharp boom and bust in the housing markets would be expected to have had impacts on the financial markets as falling house prices led to delinquencies and foreclosures. These effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjustable-rate variety, which led to excessive risk taking. In the United States, this was encouraged by government programs designed to promote home
ownership—a worthwhile goal but, in retrospect, overdone.

It is important to note, however, that the excessive risk taking and the low-interest monetary
policy decisions are connected.

Sub-prime, in and of itself, is merely an amplifying factor:

A significant amplification of these problems occurred because the adjustable-rate subprime and other mortgages were packed into mortgage-backed securities of great complexity. The risk was underestimated by the rating agencies either because of a lack of competition, poor accountability or, most likely, an inherent difficulty in assessing risk owing to the complexity.
…
In the United States, other government actions were at play. The government-sponsored agencies Fannie Mae and Freddie Mac were encouraged to expand and buy mortgagebacked securities, including those formed with the risky subprime mortgages. While legislation such as the Federal Housing Enterprise Regulatory Reform Act of 2005 was proposed to control these excesses, it was not passed into law. The actions of these agencies should be added to the list of government interventions that were part of the problem.

The crisis was prolonged due to counterparty risk:

In autumn 2007, John Williams and I embarked on what we thought would be an interesting and possibly policy-relevant research project [3] to examine the issue. We interviewed traders who deal in the interbank market and we looked for measures of counterparty risk. The idea that counterparty risk was the reason for the increased spreads made sense, because it corresponded to the queen of spades theory and other reasons for uncertainty about banks’ balance sheets. At the time, however, many traders and monetary officials thought it was mainly a liquidity problem.
…
The results are illustrated in Chart 8, which shows the high correlation between the unsecured/secured spread and the LIBOR-OIS spread. There seemed to be little role for liquidity. These results suggested, therefore, that the market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather, it was inherently an issue of counterparty risk, which linked back to the underlying cause of the financial crisis. This was not a situation like the Great Depression, where simply printing money or providing liquidity was the solution; rather, it was due to fundamental problems in the financial sector relating to risk.

And then, he claims, regulatory actions either did not help or made things worse:

As evidence, I provide three specific examples of the interventions that prolonged the
crisis, either because they did not address the problem or because they had unintended
consequences.
…
Term Auction Facility
…
Temporary cash infusions
…
The initial cuts in interest rates through April 2008

… and he claims that the increase in severity in fall 2008 was more complicated than “Lehman”:

The main message of Chart 13 is that identifying the decisions over the weekend of 13 and 14 September as the cause of the increased severity of the crisis is questionable. It was not until more than a week later that conditions deteriorated. Moreover, it is plausible that events around 23 September actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe. At a minimum, a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed and thereby added to business and investment decisions at that time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere.

Dr. Taylor concludes:

In this paper, I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not for others in an ad hoc fashion without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.