Comments onFranklin Allen and Elena Carletti,“Financial Regulation Going Forward”
Takatoshi Ito
University of Tokyo
May 27, 20102010/6/3

Takatoshi Ito1Outline• (1) Origin of Global Financial Crisis of 2007‐09• (2) Bubble in general• (3) Global Imbalances• I agree with most of the views and assertionsof Allen‐Carletti, but a few quibbles• I add a few points that would elaborate theirpoints
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(1) Origin of GFC: three views• (1‐1) Sup & Reg failure• (1‐2) Loose monetary policy• (1‐3) Global Imbalances and Asian central
bank purchases of Treasuries• Allen‐Carletti emphasize (1‐2) and (1‐3)• I think (1‐1) is very important
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Sup & Reg failure• Overlooked—– Originate to distribute model– CDOs (false assumptions)– Conflict of interest, Credit rating companies (AAA negotiated)– Off‐balance sheet conduits• Intra‐firm management and accounting problem• Regulatory failure of examination– Investors’ complacency (just trust AAA)

• Too big to fail– Investment banks, as opposed to deposit‐taking institutions,were not supposed to be bailed out– No mechanism of orderly resolution (temporary nationalization)– Reg reform should have been done after Bear Stearns (March2008)• Question. Was there a political will? –see Ito (2009)2010/6/3

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Loose Monetary Policy• Interest rate was too low (to prevent possibledeflation) in 2004‐2006– “Off Track” –John Taylor• The low interest rate encouraged risky
investment, risky loans, etc• Questions.
– Low “teaser rates” are possible even at the higherinterest rate
– How much interest hike would have been needed tostop a bubble, already in process? Could cause arecession to stop a bubble—desirable?
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5Global Imbalances and the role of
Asian central banks• High demands for US Treasuries from Asianinvestors, esp. central banks; which depressed
the interest rate
• Question– Even if Asians had not bought US treasuries,
someone else might have—very deep market.
How much differences would the change mighthave?
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6What ifs—search for a crucial factor• What if regulators did their jobs? Tightening
rules on securitization/CDO businesses andlegislators introduced orderly resolution
mechanism in time (without change inmonetary policy and Asian central banks)?
– Was excessive securitization stopped, so that
subprime crisis prevented?
– Were investment banks nationalized instead ofbailed out?

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What ifs—search for a crucial factor• What if monetary policy was tightened?
Interest rate hike by 425bp in a few steps in
2004,instead of 17x0.25bp over two years(without changes in sup&reg and Asiancentral banks)?
– Could a housing bubble (subprime, vintage 2004‐06) have been prevented?
– Could it not have produced a recession anddeflation?

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What ifs—search for a crucial factor• What if China appreciated 20% in 2004‐2006(instead of 2005‐2008) and all Asian central
banks intervened much less in 2004‐2006(without changes in Sup&Reg)?
– Did less capital inflows trigger higher interest ratein the US, which prevented the housing bubble?
– Did the Federal Reserve not have lowered theinterest rate anyway to make sure preventing
deflation?

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(2) Allen‐Carletti: Bubble in the source• “The basic problem that caused the crisis wasthat there was bubble in real estate in the U.S.
and also in a number of other countries such as
Spain and Ireland.”• Causes– Too loose monetary policy, 2003‐04• Question. Earlier than Taylor criticizing the rate in 2004‐06.

– “Lowering interest rates significantly below thecurrent rate of house price appreciation thus createda profitable opportunity to buy property.”• Question. The interest rate above 10% !?

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Takatoshi Ito10Comparison
US vs. Japan• Let me add Japanese experiences:• Japan– bubble, 1985‐90– and burst, 1990‐2003– Banking crisis climax, November 1997

• US– Bubble, 2000‐2006– And burst, 2006‐ ??
– Banking crisis climax, September 2008

• Japan went through similar regrets and reform inthe late 1990s.
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Japanese Land price (16 yrs earlier) vs. Case‐Shiller

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Resolution mechanism• I think that the resolution mechanism is the key, asAllen‐Carletti also mentions it• One aspect Japan did better than US– Japan introduced a resolution mechanism (FinancialReconstruction Law of 1998) within one year of the climax,and dealt with the subsequent failures in 1998
– The was abolished but the related law was– Revised resolution mechanism remains on the book now• Deposit Insurance Law, Article 102– Article 102‐1. Capital injection– Article 102‐2. Liquidation– Article 102‐3. Temporary nationalization• One problem. How to resolve investment banks and“securities run” (as opposed to a bank run)
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Bubble and burst, and financial system• View (1):– Difficult to detect when a bubble starts as opposed tofundamentals. Bubble and burst is of capitalism nature– Important is to keep banks robust to a shock from bubble burst(increase core capital)– Resolution mechanism. Prevent moral hazard, while financial
stability is maintained– Question. How much capital is enough; how to overcome too
big to fail• View (2):– Bubble itself should be prevented (no sure way to make banksrobust)– Asset price stability should be in central banks’ objective– Question. Three objectives (π(CPI), π(asset), y) and one
instrument?
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(3) Global Imbalances• Origin of Global imbalances (Allen‐Carlettiview)– Asian crisis Æ self‐insurance (fat reserves) Ædemand for US treasuries Æ low interest rate
– Self‐insurance is due to Asian countries’ distrustof IMF. Allen‐Carletti thinks IMF made mistakes
and Asia has good reasons to be unhappy– Allen‐Carletti’s solution. Promote Asians in IMF
and other IFIs.
– No prospect to change
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Prospects of Change• I agree with their analysis, See Ito (2007)• Comments:– IMF has NOT officially admitted that it had made mistakes– IMF has changed in practice• FCL is very much like lender‐of‐last‐resort without conditionality– Difficult to differentiate “solvency crisis” that should comewith conditionality and “liquidity crisis” that should behelped by FCL• Do you want to led to Greece without conditionality?

– Asia now has Chiang Mai Initiative Multilateralized (CMI‐M), which is like AMF and which is like European
Stabilization Fund (recently proposed 750 billion Eurofacility)
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Asia is vindicated—many ideas andproposals denied in 1997‐98• Ban on short‐selling• Criticize credit rating agencies• Criticize hedge funds• Asian Monetary Fund
• Low interest rate and fiscal stimulus during the crisis• Suspend mark‐to‐market• Support the currency stability with massiveintervention (large swap or LOLR)• No premature foreclosure or a bulk sales of distressedassets
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Concluding Remarks:
Yes, I agree most of Allen’s points• [Crisis prevention]– Detect early (model and common sense judgment)– Employ all measures, incl. macro prudential (LTV ratio; tax) as
well as the interest rate (lean against), since the interest rate
alone cannot do a job• [Crisis management]– Legislate a resolution mechanism is the key– International coordination is important but difficult• [Global Imbalances]– No chance of preventing it– Asian voice in international institutions should be
strengthened—but the utilization of human capital is poor inJapan and most of Asia
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References• Ito, Takatoshi, “Asian Currency Crisis and the IMF,Ten Years Later: Overview” Asian Economic
Policy Review, vol. 2, no. 1, June 2007: 16‐49.
http://www3.interscience.wiley.com/journal/118501087/
issue• Takatoshi Ito, “Fire, Flood, and Lifeboats: Policy
Responses to the Global Crisis of 2007‐09” inFederal Reserve Bank of San Francisco, “Asia andthe Global Crisis” October 19‐20, 2009http://www.frbsf.org/economics/conferences/aepc/2009/agenda.php

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