Off Balance

by Paul Blustein

  Small wonder, though, that the outgoing governor of the Reserve Bank of Australia — who was attending his last FSF meeting before his retirement — expressed dissatisfaction with his experience on the body.

  “At the end of the meeting, Ian Macfarlane noted that the Secretariat’s background notes and members’ discussions about vulnerabilities have identified a number of different areas of concern over the years,” the meeting summary states, “but it was not always clear how useful those discussions had proved to be.”

  Coming Up Short

  Even though the FSF didn’t see the crisis coming, it could still have taken action to prepare for unexpected catastrophes in markets or at major financial institutions. But on this score, too, the body delivered too little, too late. One of the most salient examples of the FSF coming up short is the issue of strengthening the capacity of authorities in different countries to coordinate in the event of a collapse at a financial institution with operations around the globe.

  As early as 2000, participants in FSF meetings were raising concerns about the need for rules and systems regarding the cross-border resolution of financial institutions that were on the verge of failure. “Would it be wise to be better prepared by thinking in advance?” Crockett asked at the September 7, 2000 meeting. “Most of those who would be drawn in are around this table and they could usefully exchange views here.” His suggestion drew a hearty endorsement from Germany’s chief regulator, Jochen Sanio, who said, “We need a ‘script’ for dealing with the bankruptcy of a large and complex international bank.”

  The problem is one of the thorniest in global regulation. The world’s 30 largest financial institutions — including Deutsche Bank, JPMorgan Chase, HSBC, Citigroup, BNP Paribas, Barclays, Goldman Sachs and Santander — have more than half of their assets abroad, and close to 1,000 subsidiaries, on average.17 Wide disparities exist among major countries in their bankruptcy codes and procedures for handling failing financial institutions. Some require intervention only when a bank’s net worth has declined to zero, while others envision that supervisors will step in much earlier. The entity that initiates intervention may be supervisory authorities in some countries, but in others it may be the courts or creditors. Countries also maintain different rules regarding the treatment of a failing bank’s foreign operations. In sum, there are no detailed international agreements concerning how authority would be apportioned in a crisis at a big institution or who would bear responsibility for providing public funding should that prove necessary.

  17 See Stijn Claessens, Richard J. Herring and Dirk Schoenmaker (2010), “A Safer World Financial System: Improving the Resolution of Systemic Institutions,” Geneva Reports on the World Economy No. 12, International Center for Monetary and Banking Studies (Geneva) and Centre for Economic Policy Research (London), July.

  A confidential report drafted in 2001 at the behest of the FSF and a number of other international bodies outlined a long list of obstacles that would impede the orderly wind-down of a financial conglomerate with a variety of businesses in different jurisdictions. The report didn’t even try to offer a comprehensive set of rules; the best it could do was make recommendations for how supervisors should maintain up-to-date information about the far-flung activities of institutions under their purview, “develop regular contacts” and “effect ongoing dialogue” with their foreign counterparts, and prepare contingency plans for a crisis, in part by familiarizing themselves with the legal systems in other countries, especially those governing insolvency.18

  18 The report remained secret for many years, but was recently disclosed as the result of a lawsuit involving the Lehman Brothers bankruptcy, and is available on the web at: www.scribd.com/doc/42414020/Defendant-Federal-Reserve-Docum-Production-Lehman-Part-II-summer-2008-heavy-redactions-Lawsuit-3.

  FSF members remained worried enough about the issue to ask in 2005 for a follow-up appraisal, and the Secretariat responded with a brief report stating that “there has been progress in contingency planning,” including the formation of “colleges of supervisors” from around the globe who would meet to discuss issues concerning a few of the largest individual institutions. “However, work remains ongoing and most of the arrangements remain untested in practice,” the report said.

  One FSF member remained particularly anxious about the need for better preparation — John Gieve, deputy governor of the Bank of England. Given London’s role as a financial centre, Gieve and his British colleagues had a bias of sorts on this issue; they wanted to be more involved in supervising foreign banks operating in the City. Partly at Gieve’s urging, the FSF and the British authorities jointly held a workshop on the issue in London on November 13-14, 2006, and Gieve delivered a speech on the first day, in which he said:

  In its first seven years, much of the FSF’s focus has been on the identification and assessment of risks in a rapidly changing financial system; it has played a valuable role in building a common understanding among authorities and among market participants of what the risks are and how they can be reduced. However, that level of progress has been less apparent on putting in place arrangements for handling and resolving cross-border crises. Overall, I do not know anyone who believes we have established either the common approach to crises or the practical machinery which would enable us to handle a complex cross-border failure with confidence.19

  19 John Gieve (2006), “Practical Issues in Preparing for Cross-Border Financial Crises,” speech at the Financial Stability Forum Workshop: Planning and Communication for Financial Crises and Business Continuity Incidents, London, November 13, available at: www.bankofengland.co.uk/publications/Documents/speeches/2006/speech290.pdf.

  Gieve argued that the discussion needed to move from general principles — which might prove inapposite, or too inflexible, in a crisis — to specific case studies. His favoured approach was what he called “table-top exercises,” in which small groups of regulators and supervisors from various countries would get together to discuss how they would handle the failure of particular major institutions with operations in their jurisdictions — and thereby gain some insight into the concrete problems that would be most likely to arise. This idea was somewhat more focussed than the “college of supervisors” concept, since it wouldn’t include every supervisory authority in which a large bank or investment firm had operations, just the ones that would be confronting the most consequential decisions in the event that the firm was going belly-up.

  “What role could the FSF play in promoting these kinds of bilateral or small multilateral discussions?” Gieve asked. This was his answer:

  As we all know, it is not the role of the FSF to manage cross-border crises. But my view is that the FSF does have a role in this area. To me it seems the ideal group to draw out the common messages and lessons that may emerge from these interest group discussions, and to establish a common framework for handling crises which will be of use both to its members and more widely.

  Gieve’s proposal for active FSF involvement got a cool response, according to a report on the conference delivered by the Secretariat to the FSF at its next meeting:

  Reactions since the workshop from FSF members and workshop participants have suggested that in practice such discussions and exercises are best conducted by those with specific technical expertise and responsibility in this area rather than by the FSF itself.

  Regardless of the FSF’s reluctance to foster and encourage the exercises he envisioned, Gieve continued to press his case that they should take place. He reckoned that it would be most fruitful to start with such talks among US, British, Swiss and Dutch authorities, given the size of their financial sectors. But, as he recalled in an interview:

  There was no real appetite on the US side to get into discussing particular examples. We were offering to put HSBC or Barclays on the table, with real balance sheets, and maybe in return, they would do Citi or Lehman. But that never got off the ground.

  Later, the FSF would embrace Gieve’s approach �
� although only after the crisis was well underway. This was one of the steps the FSF took to raise its game once the crisis had begun. Before turning to the FSF’s performance during the crisis, however, a comparative analysis of its pre-crisis failings is in order.

  7

  Cluelessness: A Matter of Degree

  “We weren’t the only ones who didn’t see it coming.” A number of the FSF’s members offered this explanation for the body’s performance in the run-up to the crisis. This defence is both obviously true and well worth exploring. In critically assessing the performance of a body like the FSF, it is important to consider how other institutions fared by comparison. As chagrined as FSF members may be over their failure to anticipate and forestall the crisis, they can take some comfort from the fact that, for the most part, other bodies with similar remits did not do much better and, arguably, did worse. In this chapter, confidential documentary material of the sort used elsewhere in this book provides new evidence about what went on behind the scenes in these bodies, augmenting information that is already public.

  The Committee on the Global Financial System

  If a group of top economic policy makers in the pre-crisis period was awarded a booby prize for cluelessness, the meeting on November 6, 2006 of the Committee on the Global Financial System (CGFS) would be a strong contender. Here is an excerpt from a confidential summary of that meeting:

  Conditions in the financial sector...remained favourable despite some shocks. For instance, the weakening of mortgage markets in the United States and elsewhere did not have knock-on effects. Against this background, the main risks were not easily identified. Many members felt that a possible risk could be that financial markets were “priced to perfection” as a result of the benign economic environment, and that market participants might be too complacent about the possibility that the beneficial conditions would not remain in place...Another could be that banks did not fully appreciate the risks on their balance sheets. However, the committee did not identify any particular threat at this juncture.

  The CGFS was a group of central bank officials from around the world, including some at the deputy level — vice chairmen, deputy governors and the like — as well as senior staffers from central banks’ international departments. The committee’s history dated back to the late 1960s1 and it had always maintained a penchant for secrecy similar to that of the FSF, keeping its discussions strictly hidden from the public eye. It overlapped in a number of ways with the FSF, although with a narrower focus, because it didn’t include officials from finance ministries and regulatory agencies. The responsibilities of the CGFS to detect systemic vulnerabilities were very similar to those of the FSF, and some people served on both bodies. One important difference was that a wider group of countries was represented at CGFS meetings, with the People’s Bank of China and the Reserve Bank of India joining in March 2005. But the presence of these representatives from emerging economies didn’t help the committee much in discerning where the main threats to the system lay.

  1 The CGFS’s original name was the “Eurocurrency Standing Committee,” which was changed in 1999 to reflect the global scope of its responsibilities.

  In perusing notes of CGFS meetings and confidential summaries like the one cited above, it is remarkable to see how closely the discussions resembled those of the FSF. Members knew about many of the forces that would ultimately cause the crash, and some of them expressed concern. Problems in the US housing market were a frequent topic of conversation. One of the most farsighted comments was offered by Peter Praet, who represented Belgium’s central bank, at a CGFS meeting in December 2004. During a discussion about CDOs, notes of the meeting show, Praet warned: “CDOs have the capacity to transfer risk and transform risk. Some tranches could go from being high quality to worthless very fast.”

  But well into 2006, the CGFS maintained an overall assessment of global conditions that its internal documents referred to as “so far, so good.” As with the FSF, discussions ranged far and wide into areas that caused members to fret about that assessment, although many of the worries that were raised proved, in retrospect, to be not nearly as damaging as initially feared. These included the possibility that monetary tightening by central banks would generate an adverse market reaction, the danger of a collapse in the dollar stemming from the US current account deficit, the threat that China’s boom would come to an abrupt end, and a host of other issues including rising oil prices, shadowy hedge funds, inflationary overheating and “geopolitical events” such as a terrorist attack.

  The confidential summary of the September 11, 2005 meeting is illustrative in this regard:

  The majority view was that...benign conditions would remain, and that the likelihood of downside risks to the economic outlook would materialize was limited. Yet, the committee was reluctant to reconfirm its earlier “so far, so good” assessment — or to strengthen it, perhaps, to “as good as it gets” — as uncertainties around the near-to-medium term outlook had increased and a number of participants were uncomfortable with some aspects of the present situation. In particular, there was a palpable concern that...the longer some of the current imbalances and risks remained, the greater the likelihood that they could unwind in disruptive ways. This was noted with regard to several factors, including house price developments, current account imbalances and the very limited exchange rate flexibility seen so far in China.

  At times, interventions by CGFS members bordered on the Panglossian, at least with the benefit of hindsight. At a meeting in March 2006, for example, Karen Johnson, director of the US Federal Reserve’s division of international finance, dismissed fretful comments by some European officials with the following remarks: “The housing market is becoming more cautious — it is ‘plateauing’ — but there is no collapse,” she said, according to notes of the meeting. “Household mortgage debt is high, but there is no rise in defaults. As regulators, the Fed feels the banking system is in good shape. It is well capitalized, and credit quality remains high. Regarding the US current account deficit, if the market is happy then all is well.” Chiming in to support Johnson’s view was John Murray, a deputy governor of the Bank of Canada, who exclaimed, “We are struggling to find something to worry about!”

  The CGFS produced a couple of public reports that some members still regard with pride because they highlighted problems that, when the crisis erupted, proved to be major contributory factors. Most noteworthy was a 2005 report titled “The role of ratings in structured finance.” It asserted that both comfort and concern could be drawn from the burgeoning phenomenon in which banks and other financial institutions were pooling assets and selling them to investors using instruments such as asset-backed securities, CDOs and the like. Such activities can result “in more efficient pricing and an improved dispersion of credit risk. Consequently, structured finance may enhance financial stability,” the report said. “Yet, the properties of structured finance instruments may also lead to situations where certain market participants hold positions that are riskier than they or their counterparties appreciate, thereby generating or magnifying unintended exposures to credit events.”2 The bottom-line conclusion of the report was apt, although it hardly constituted a clarion call of alarm:

  2 CGFS (2005), “The Role of Ratings in Structured Finance: Issues and Implications,” January.

  Overall, if risk is inaccurately priced and exposures are concentrated in ways that are not fully appreciated by market participants, the occurrence of worst case scenarios could have systemic implications. Although the current scale of the more sophisticated structured finance activities is still quite small relative to other parts of the credit market, central banks may nevertheless want to be vigilant as markets continue to grow.

  Perhaps most revealing is the dumbstruck reaction of CGFS members at their meeting on September 9, 2007, after financial markets had suffered the first jolts of the crisis. Earlier in the summer, prominent investment banks had been forced to acknowledge severe t
rouble at hedge funds they sponsored, which had invested heavily in securities backed by US mortgages using money they had raised by issuing short-term commercial paper to investors. Two funds in particular, which were closely linked to Bear Stearns, were nearly bankrupt because of a combination of mortgages gone sour and a refusal by investors to continue providing short-term credit. The announcement in mid-July of similar woes at IKB, a mid-sized German lender, and the bankruptcy filing on August 6 of American Home Mortgage Investment Corp., helped send investors scurrying away from any paper issued to fund mortgages. Emergency moves starting on August 9 by the European Central Bank and US Federal Reserve to inject tens of billions of euros and dollars into the banking system failed to produce the calming effect needed to get money flowing normally. Unsure how far the rot in mortgages had spread, market participants were halting all credit to any counterparty that looked shaky, especially the special investment vehicles and “conduits” that banks had established off their balance sheets to buy pools of mortgages for sale to investors.

  This was the backdrop for the September 9 CGFS meeting, where the group listened to a scathing reproof by Terrence Checki, an executive vice president of the New York Federal Reserve Bank. Checki didn’t claim to have foreseen how markets would buckle, but as a veteran of many past crises he had long taken a dubious view of the boom, and he made clear he wished that the CGFS had been more proactive.