Still, even if FSF members didn’t fully appreciate in September 2007 how bad the situation might get, they accepted with alacrity a request from the G7 that would put the FSF at the centre of the official response. Paradoxically, this idea had come from the United States. After years of restraining the FSF from acting decisively, the US Treasury decided that the body ought to assume the task of drafting a plan to deal with the various fragilities and structural problems that the nascent crisis was exposing. The Americans’ change of heart was partly attributable to the belief that “this was more than just a US problem, so we needed to deal with it in a global way,” recalled Clay Lowery, who was then assistant Treasury secretary for international affairs, in an interview. But another important reason was that the Bush administration hoped to deflect the heated denunciations coming from Europe, where blame was being heaped on the US financial system. “We didn’t want to be on the back foot, and the best way to not be on the back foot is to be on the front foot by proposing an action-oriented agenda,” Lowery said. Accordingly, two Treasury undersecretaries, David McCormick and Robert Steel, co-authored an op-ed that was published on September 12 in the Financial Times, declaring that despite calls for immediate regulatory action, “US economic decision makers are committed to work multilaterally to put these events in perspective, examine the root causes and respond in a thoughtful and timely fashion.” The G7, they announced, would assign this job to the FSF.1
1 David McCormick and Robert Steel (2007), “A Framework to End the Market Volatility,” Financial Times, September 12.
This was, in a sense, a moment Mario Draghi had been preparing for all his life, although he could hardly have imagined how many more moments like it were coming. He proposed, to general agreement, the establishment of a “small, agile, senior group” — in effect, one super-elite club within another — to prepare the broad outline of a response to the crisis that the G7 wanted. (The FSF publicly announced the formation of the body, which was dubbed the Working Group on Market and Institutional Resilience.) Finance ministry officials were deliberately kept out in favour of central bankers, regulators and chiefs of international standard-setting bodies and committees, who were deemed more likely to have the necessary expertise. Finance ministry officials, most agreed, would be prone to engaging in political bickering with their counterparts, which could wreck the chances of producing a consensus document; moreover, if a finance ministry representative from one country was included, those from other countries would all insist on joining.
Creating one small multinational group for the purpose of working closely together on a crisis response was a sound idea. Coordination among major countries’ policy makers would, however, come very close to complete and catastrophic breakdown as the crisis reached its most acute stages in the fall of 2008. The FSF should not be condemned for this problem; it had not been envisioned as a crisis coordinating body. Even so, the coordination snafus that arose highlight deeply worrisome flaws in the international economic governance system.
“No Idea, Bluntly”
The Working Group’s report was issued publicly in the form of a 70-page document submitted by the FSF to the G7 in April 2008. By all accounts, the meetings that had produced these conclusions were far more stimulating and productive than those of the full FSF had been; the Working Group’s high-powered members2 recall spirited discussions about what had caused the crisis and what ought to be done about it.
2 In addition to Draghi, Sanio, Geithner, Knight, Papademos, Gieve, Prada, McCarthy and Wellink, who have been mentioned previously, members included Julie Dickson, Canada’s superintendent of financial institutions; Donald Kohn, vice chairman of the US Federal Reserve; John Dugan, US comptroller of the currency; Jaime Caruana, director of the IMF’s Monetary and Capital Markets Department; Jean-Pierre Landau, deputy governor of the Bank of France; Hermann Remsperger, member of the Bundesbank executive board; Takafumi Sato, commissioner of Japan’s Financial Services Agency; Philipp Hildebrand, vice chairman of the Swiss National Bank; Christopher Cox, chairman of the US Securities and Exchange Commission; and John Smith, board member of the International Accounting Standards Board.
At the time, the report was widely perceived as offering a searing indictment of the financial system’s flaws as well as fairly ambitious proposals for how to correct them.3 It excoriated banks and other financial institutions for inaccurately assessing or even properly understanding the risks they were taking; it accused the US subprime sector of “unsound...and in some cases fraudulent” practices; it blasted credit-rating agencies for “weaknesses in rating models, inadequate due diligence...and insufficient attention to conflicts of interest.” And although it aimed most of its blame at the private sector, it also offered a mea culpa of sorts: “Public authorities recognized some of the underlying vulnerabilities but failed to take effective countervailing action, partly because they may have overestimated the strength and resilience of the financial system.”4
3 See Larry Elliott (2008), “Policymakers Join Forces to Repair Battered Markets,” The Guardian, April 14; Tara Perkins and Kevin Carmichael (2008), “More Rules? No Thanks, Banks Say,” The Globe and Mail, April 10; and Chris Giles and Krishna Guha (2008), “Banks’ Self-regulation Plan Shunned,” Financial Times, April 13.
4 FSF (2008). “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,” April, available at: www.financialstabilityboard.org/publications/r_0804.pdf.
The report’s 67 recommendations spanned a host of areas, ranging from strengthening the capital and liquidity of big financial firms to changing the rules for credit-rating agencies to preparing supervisors for a big bankruptcy. Most involved tasks that various international bodies, central banks, supervisors and private firms were expected to achieve, in many cases by specific deadlines. Especially remarkable were proposals that issued directions to standard setters in ways they had never been directed before. Shocked at how the Triple-A ratings on many CDOs had grossly misrepresented the actual risks, for example, the report’s authors urged that such products be rated using a different system than that used on corporate bonds.
The Basel Committee was given some direction, too. Up to that point, the Basel Committee had fiercely guarded its independence; the idea that it would accept guidance from a body like the FSF’s Working Group was all but unthinkable. But flaws in Basel II were becoming increasingly glaring, putting the committee on the defensive. The paradoxical fact that Basel II hadn’t even been implemented yet in the United States left the new rules even more open to ridicule. (A joke told by the late Michael Mussa, the wisecracking former chief economist of the IMF, was illustrative: “What is the difference between Basel II and the Titanic? Basel II sank before its maiden voyage.”)
The run by depositors at Northern Rock had made it apparent that Basel II was missing a key element — a standard ensuring that banks held a sufficient amount of liquidity. Although Basel II’s focus on bank capital was well placed — capital, after all, is essentially resources that banks need to ensure that losses will not wipe out their capacity to pay obligations — protecting against inadequate capital is only one of the things a bank must do. Lack of ready cash can be just as threatening to survival, and Northern Rock was a clear illustration of how, in today’s global financial system, liquidity shortages can be transmitted internationally. The lender had not assumed exposure to US subprime assets, but had nevertheless found itself unable to obtain the funds needed to continue operating. The Northern Rock case also showed how misguided Basel II had been in treating mortgages as safer than ordinary loans. Roughly three-quarters of the British bank’s assets were in the form of mortgages.
Even more damning were some of the other weaknesses of Basel II that had come to the fore — in particular, the way in which banks had been able to manipulate the new rules. By letting banks’ own models determine how risky their portfolios were, Basel II gave banks an incentive to load up on assets that, while seeming sa
fe enough to require little capital, actually involved enough risk to provide juicy earnings — a canonical case being US subprime mortgages that had been bundled together, sold to investors and insured. The banks’ models, which predicted that such assets would never produce losses, or that the risk of such an outcome was minuscule, had proven stunningly wrong.
Accordingly, the FSF’s Working Group decreed that the Basel Committee would issue proposals in 2008 to raise the amount of capital banks would be required to maintain if they invested in “certain complex structured credit products such as CDOs of asset-based securities.” Beyond that, the Working Group’s report offered a somewhat vague recommendation: the Basel Committee “will continue to update the risk parameters and other provisions of the Basel II framework.”
Better late than never, the Working Group’s report also incorporated Bank of England Deputy Governor John Gieve’s idea about strengthening cross-border cooperation to prepare for the wind-down of a multinational bank or other financial conglomerate. (This was no coincidence; Gieve was on the Working Group and headed the subcommittee responsible for the matter.) “For the largest cross-border financial firms, the most directly involved supervisors and central banks should establish a small group to address specific cross-border crisis management planning issues,” the report said. “It should hold its first meeting before end-2008” — a deadline obviously set in blissful ignorance of how much cross-border cooperation would be needed in the autumn of that year, when various disparities in legal systems and failures to coordinate exacerbated the Lehman debacle in particular.
The deeper the financial system sank in the months after the spring 2008 release of the FSF Working Group’s report, the less cutting edge the report looked. “It was a good document in April this year; does it look adequate given the scale of what has occurred?” Adair Turner, the UK’s new FSA chairman, said in a Financial Times interview published in mid-October 2008, a month after the bankruptcy of Lehman Brothers. “In April of this year everybody knew that something pretty big had happened to the world’s financial system. What we had no idea, bluntly, was how extreme it was going to be.”5
5 “FT Interview: Lord Turner, Chairman of the FSA” (2008), Financial Times, October 15.
The extremity of what might happen was, however, evidently starting to dawn on the FSF when it formally approved the Working Group report at a meeting in Rome on March 28-29, 2008. At that meeting, the FSF was already contemplating the need for much more radical options than those contained in the report. The reasons should be obvious to anyone who can recall the major milestones in the evolution of the “too big to fail” syndrome: earlier that month, another, even more cataclysmic version of a bank run had occurred, this time bringing one of Wall Street’s five biggest securities firms to its knees. Bear Stearns, which had been one of the Street’s most aggressive buyers of mortgage-backed assets and borrowers of short-term funding, found itself bereft of willing creditors the week of March 10, and on the night of March 16, a Sunday, the Bush administration — fearing a financial apocalypse if Bear’s fate remained uncertain when Asian markets opened on Monday — approved government backing for a bailout, enabling the firm to be purchased by J.P. Morgan & Co.
What a Difference Six Months Makes
“The process of adjustment to the financial turbulence that started last summer is proving to be far more protracted, and more damaging to the real economy, than had been expected six months ago,” admitted the Secretariat’s note on vulnerabilities that was circulated ahead of the FSF’s March 28-29, 2008 meeting.
No longer was the direst scenario “a core financial institution encounter[ing] severe financial distress,” as it had been at the September 2007 meeting. According to the March 2008 note, “heightened gridlock in primary and secondary financial market activity” was one of the distinctly plausible paths that the world might take. “In a worst-case scenario, credit flows could decelerate rapidly and asset values fall sharply throughout the financial system, spurring a self-reinforcing flight to safety,” the note said. “Illiquidity, and the threat of insolvency, would spread to a widening circle of financial institutions.” Also conceivable were “institutional failures,” the note continued. “A worst-case scenario would be the distress or insolvency of one or more large and complex financial institutions. The sharp and speedy decline in Bear Stearns’s liquid assets, which fell from $18 billion to $2 billion in a matter of days, illustrates the precariousness of balance sheet liquidity, especially for institutions that rely on overnight wholesale funding markets.”
Despite the extensive measures that governments had already taken — monetary and fiscal stimulus, steps by central banks to promote market liquidity, actions to prop up individual institutions and initiatives to bolster the US housing sector — “financial systems remain extremely fragile,” the note concluded. “There is a strong risk that conditions will not improve by themselves, and may indeed get substantially worse before they get better.”
This was where the radical policy ideas came in — some of which were later adopted in one form or another. “Authorities may need to consider whether to take a more proactive approach,” the note warned. “It is important to consider options that will lay the groundwork for responses ahead of time rather than under the pressure of fast-moving events.” As befits a multilateral body, the note argued: “coordinated international initiatives may enjoy a greater public profile and garner more political support than measures taken on a piecemeal basis by different countries,” and it enumerated several for the FSF’s consideration:
Coordinated lending to systemically important institutions: This might be desirable because providing liquidity support to individual firms would only raise questions about others; therefore, lending could “encompass a broad range of institutions, regardless of their liquidity or capital status.”
Coordinated recapitalization of systemically important institutions: This alternative might be preferable because, “with solvency having started to replace liquidity as the primary perceived risk to systemic stability, the effectiveness of further moves to provide official-sector credit to financial institutions would not be clear.” Although public funds might help recapitalize individual firms, “[i]n a worst-case scenario of more widespread doubts about solvency in the financial system, one option could be to consider a broader effort to bolster capital simultaneously in a number of institutions,” perhaps involving “cross-border cooperation.”
Further efforts to move illiquid assets off balance sheets: Ideally, governments would mobilize “consortia of private buyers” for such assets, but authorities might have to use guarantees to “facilitate” the purchases. “A more radical approach might be a government-sponsored or publicly funded facility to buy the assets, and then sell them off slowly as markets recover.”
The public got an unprecedented glimpse into the FSF’s deliberations, thanks to a Financial Times scoop based on a leaked copy of an “options paper” showing many of the various policy actions listed in the Secretariat’s note. The newspaper’s headline: “Stability Forum Begins to Think the Unthinkable.”6
6 Chris Giles (2008), “Stability Forum Begins to Think the Unthinkable,” Financial Times, April 2.
It was about time. The unthinkable was just months away.
Global in Life, National in Death
At the Rothschild villa in Saint-Jean-Cap-Ferrat, one of the French Riviera’s most elegant settings, John Gieve was attending a dinner for European finance ministers and central bankers on Friday, September 12, 2008, after a long day of meetings in Nice. The highlight of the evening, which was hosted by Christine Lagarde, then France’s finance minister, was a tenor’s performance of an aria mentioning central bankers, much to the audience’s delight. But for Gieve, who was representing the Bank of England, and for UK Chancellor of the Exchequer Alastair Darling, the mood was broken when Darling received a call on his mobile phone from US Treasury Secretary Hank Paulson. Lehman Brothers was the
reason for Paulson’s call — the United States urgently wanted the British government’s help.
Now it would become clear why Gieve had been right to press, at FSF meetings and elsewhere, for advance planning and mutual understandings among officials of major financial centres in the event that a large cross-border institution went under.
The story has been told often, and needn’t be repeated here in detail. Lehman got into trouble by assuming large exposures, as Bear Stearns had, to both mortgage bonds and commercial real estate, and by funding its speculative positions with very short-term borrowings. Also familiar to anyone who has read much about the crisis is the tale of how Paulson and Geithner summoned the heads of major banks and securities companies to the New York Fed on the weekend of September 13-14 in the hope that the bankers could organize a rescue of Lehman — a rescue that would have to take place without government assistance, because Paulson was adamantly opposed to providing any taxpayer funds whatsoever.
The most promising idea, readers of accounts about that dramatic weekend will recall, was to sell Lehman to a firm of sufficient size and stability; at first, the most likely candidate for such a deal was Bank of America. But Bank of America’s top management opted instead to purchase Merrill Lynch, which was also in rocky shape. With Bank of America no longer available as a saviour, the only remaining hope for rescuing Lehman was a sale to Barclays, the British banking giant, whose CEO was keen to do a deal. But that option was thwarted by the UK financial authorities’ refusal to approve the transaction. In his book On the Brink, Paulson recounts his angry outburst at a meeting with the bankers on Sunday, September 14 — “the British screwed us!” — as it became clear that Lehman would go into bankruptcy the next day.
Off Balance Page 18