Alan Bollard: Learnings from the Global Financial Crisis
Paper by Dr Alan Bollard, Governor of the Reserve Bank of New Zealand, and Mr Tim Ng,
for the Sir Leslie Melville Lecture at the Australian National University, Canberra, 9 August.
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1. Introduction
The global financial system went through major convulsions in 2008, putting great pressure
on an already weakening global economy. A massive global economic recession followed,
contributing to the emergence of a sovereign debt crisis in the euro area. European
sovereign debt problems remain a dark cloud overhanging the world economy.
These extreme events have provoked us to re-think what is known and where economic
research should focus, in some cases fundamentally. We had long known that banks that
appear individually sound can be vulnerable to problems affecting the whole banking system,
and that such problems can amplify economic shocks. But the crisis sharply accelerated the
study of financial fragility, contagion and instability nonetheless.
The crisis has also challenged us as financial regulators and monetary and fiscal
policymakers. We are all working to understand, contain and repair the damage to financial
systems, to economies and to governments' financial capacity. The policy choices in many
areas involve difficult and uncertain tradeoffs.
This paper discusses some lessons from the crisis experience to date, and some analytical
and policy challenges. Australia and New Zealand escaped the worst of the financial crisis,
but not without extraordinary policy actions of our own at various times, and not without a
certain legacy of issues to deal with in our own neighbourhood.
We find it useful to structure the discussion in three parts: the episode of near-seizure in
many advanced-country financial systems in 2007-08; the global recession of 2008-09; and
the current situation of extreme fiscal weakness in many parts of Europe. (Of course, real
events have not been as simple and linear as that structure might suggest - expectations
and feedback loops have played a substantial role.) We conclude with some reflections
about research and policy strategy in this new world.
2. Financial system disruption, 2007-08
Global financial markets sharply became unsettled in July and August 2007, when a number
of large US and European financial institutions suspended redemptions in investment
vehicles linked to US mortgage debt and their derivatives. Through the following year,
concerns mounted about the extent and complexity of global bank exposures and
vulnerabilities to growing economic weakness. These concerns soon embraced a very wide
sweep of financial products in the US and elsewhere. Bear Stearns was effectively bailed out
by the US taxpayer on the basis that it was too interconnected to be allowed to fail. But the
shock bankruptcy of Lehman Brothers in September 2008 saw investors panic, as
perceptions about the safety of financial institutions in general took a sudden turn for the
worse. Each of these events saw funding spreads in interbank markets worldwide spike
(Figure 1).
Firms, investors and regulators generally failed to anticipate quite how financial system
fragilities could interact. Prior to the crisis, they had viewed hedging markets and financial
engineering as powerful means of detaching credit and liquidity risk from a wide range and
large volume of circulating private-sector securities. The rapid growth and use of apparently
low risk private-sector securities in funding markets was itself due to a number of interacting
factors. These included a strong global demand for low-risk assets (mis-sold or mis-used on
the basis of inaccurately high credit ratings), loose monetary policy, and credit-fuelled
housing booms in a number of advanced economies, which encouraged financial innovation
to meet the demand for low-risk assets.
Figure 1
LIBOR-OIS spreads
Source: Bloomberg.
In many large advanced countries, an overall result leading up to the crisis was increased
leverage and funding fragility in both the financial system and the "real" economy. Many
could see that these growing imbalances were unsustainable and would need to correct, and
that the correction might be very disruptive. But to anticipate fully the magnitude of the
subsequent event would have required connecting many apparently disparate pressures and
signals. Among the most important of these were two factors: first, the funding fragilities
created by the shadow banking system; and second, the catastrophic collapse of liquidity
caused by investors' sudden doubts about the credit risk and marketability of previously
"safe" assets, and about the standing of counterparties.
The dumping of risky financial assets and indiscriminate cutting of funding caused asset
return correlations to jump. The shock rapidly spread between global banks, partly reflecting
high-frequency marking-to-market. The cost of credit default insurance for the large financials
shot up (Figure 2). Bottlenecks in market or institutional hubs impeded or prevented risk
shedding. The fire sales and chain reactions proved very difficult to halt.
Faced with disappearing private-sector funding markets, central banks stepped in to supply
funds in large quantity to solvent banks. To limit their own (and hence their governments')
financial exposure, the idea was to take good collateral at interest rates and haircuts high
enough to recognise the lending risks. However, lending terms could not be so punitive as to
discourage use of the facilities, which would defeat their purpose. This was easier said than
done given the shrinking supply of good collateral.
Figure 2
CDS spreads, selected global banks
Source: Bloomberg.
Banks that became insolvent despite central bank funding assistance presented their
governments with tough choices about rescue. Financial support in the form of direct
injections of equity or debt blew out government balance sheets in many cases (Figure 3),
and guarantees of bank debt added sizeable contingent liabilities.
Figure 3
Gross government outlays to support financial sector since crisis
In New Zealand and Australia, problems in the core banking system during the crisis were
comparatively mild, reflecting our more vanilla-flavoured banking sector and relatively sound
bank capital structures. There was little exposure to complex instruments and opaque
interconnections in our markets. Nevertheless, during the period of extreme market nerves,
like other authorities we had to act rapidly to support system liquidity and banks' ability to
fund themselves, including by issuing government guarantees of bank liabilities.
Regulatory responses
Regulators worldwide have responded to the financial crisis experience with a large and
ongoing programme of reforms. Among the most important include strengthening
requirements on banks' capital and liquidity structures, and bolstering domestic and
international financial supervision.
Basel III is a key international process to facilitate the parts of these reforms focused on bank
balance sheets. We do note, however, that not all the proposed reforms relate to problems in
the Australasian banking system. Neither is it clear that all countries that experienced
banking system problems will adopt all the reforms.
In our simpler banking systems it is generally easier to recalibrate regulatory standards.
Capital levels have not been heavily eroded by the crisis, so capital and liquidity standards
can be strengthened quickly compared to those advanced economies struggling with weak or
complex financial systems. In some economies there is a risk that banks will meet higher
capital or liquidity ratio requirements by contracting lending, rather than by increasing capital.
This has slowed the strengthening of bank balance sheets and crimped the availability of
credit to firms for investment. With the current risk that global funding conditions could turn
adverse very suddenly and our banking system's dependence on offshore wholesale
funding, in New Zealand we have placed priority on strengthening liquidity standards even
before increasing capital ratios.
3. Global recession, 2009-10
The rapid deterioration in financial and economic conditions in late 2008 and early 2009
quickly caused a collapse in business and consumer confidence, exacerbating the
interruption of economic activity across the world. Cross-border spillovers through regional
supply chain structures and global customer markets were accelerated by short-term funding
disruptions, such as in trade finance. Now economies without large direct financial exposures
to "toxic" assets, such as Asian export-oriented economies, were sucked into the downdraft.
The abrupt marking-down of the outlook for Western growth and consumption of high-value
goods saw inventories pile up, especially in those countries positioned as manufacturing
hubs or producers of capital goods. In six months or less, industrial production in Japan,
Singapore and Korea, for example, fell 30, 25 and 19 percent respectively.
The damage to bank balance sheets from suspect loans and marked-down asset valuations,
as well as the sudden exit from the scene of many financial intermediaries, showed up in
restricted lending capacity and greatly expanded funding spreads. Accordingly, those
non-financial firms and households that still wanted or needed credit either had to pay
elevated rates or to deleverage, further depressing activity.
When central banks recognised the magnitude of the recessionary forces in train, they cut
policy interest rates very quickly (Figure 4). In some Northern Hemisphere markets, the
dysfunction in the financial system had loosened the link between official policy rates and
lending rates to firms and households. As well as cutting official interest rates, the US
Federal Reserve and the Bank of England stepped in directly to key credit markets to lower
interest rates in those markets.
Policy interest rates
Source: Bloomberg.
The relatively high level of interest rates before the recession meant that deep cuts were
possible. The New Zealand and Australian Reserve Banks, for example, cut policy rates by
575 and 425 basis points respectively between July 2008 and April 2009.
Crisis then brought opportunities. Monetary policy researchers had always wondered what
might happen if price inflation and interest rates approached zero in several major countries,
or even went negative. Now we would find out. The case of Japan no longer seemed so
unique. As monetary policy interest rates approached zero in a number of advanced
countries, some central banks began to try to influence general financial conditions through
"unconventional" tools, meaning tools other than the official short term interest rate (the "cash
rate" in this part of the world).
One such tool is purchases of long-maturity financial securities in large volume on the open
market, called "quantitative easing" or QE. These purchases have been most prominently
carried out by the US Fed and the Bank of England, causing roughly a tripling and
quadrupling, respectively, of their balance sheet sizes to date (Figure 5). One channel by
which QE is believed to work is by increasing demand for the targeted securities, raising their
prices and hence reducing interest rates on them, which should then flow through to
longerterm interest rates in general. Other possible channels include exchange rate impacts and
signalling of a central bank's expectations to keep policy rates low.
Unconventional policies can have unconventional side effects. We are currently observing
spillovers from large economy QE impacting capital flows and exchange rate pressures in
small open economies. Continuing exchange rate pressure is problematic for a country like
New Zealand.
Central bank asset holdings
Source: Bloomberg.
In the face of plummeting demand, many countries hurriedly enlisted discretionary fiscal
policy also. With a fiscal and credit stimulus package of 4 trillion yuan (about 600 billion
US dollars, or 14% of Chinese GDP), China carried out the biggest fiscal stimulus in post-war
history. Fiscal stimulus packages were typically worth several percent of GDP, with the
cumulative expansionary shift of the fiscal stance over the three years from 2007 to 2009
amounting to four percent of GDP in both advanced and emerging economies. These
expansions are now being wound back (Figure 6).
Figure 6
Shifts in fiscal stance
4. Sovereign credit challenges, 2010-
In many advanced countries, the recession-induced reductions of tax revenue and increased
social spending were compounded by governments taking on debt to support the banking
sector. These actions brought forward sovereign debt sustainability problems in some
countries, particularly in Europe. By the second quarter of 2010, sharply rising concerns
about the fiscal position of first Greece, and then other non-competitive indebted euro area
countries, were quickly reflected in the interest rates they had to pay in sovereign funding
markets. Markets made and continue to make sharply differentiated judgements about
sovereign creditworthiness across the euro-area countries, placing considerable strain on
euro-area political and economic institutions.
The crisis also refocused public and market attention on the fiscal cost of aging populations.
The projected sharply increasing cost of state-funded health care and income support for
retirees, at the same time as a reducing working population, had been recognised for some
time. But now, the problem has come forward in time, with the potential national incomes
available to support future fiscal expenditure looking much lower. Some severe implications
for wealth and transfers between generations are starkly apparent, and these will be
politically and socially difficult to manage.
While market fiscal sustainability concerns are especially focused on the euro area currently,
governments elsewhere are also drawing lessons for the re-alignment of fiscal settings with
reduced growth prospects. In some ways these are difficult lessons to accept, as well as to
debate publicly. Where countries are under strain, fiscal austerity measures may be needed
to signal the political commitment to achieving consolidation, even though this can also
reduce growth, at least in the short term. The cost and availability of funding for many euro
area countries remains very sensitive to fiscal sustainability projections, probably
exacerbated by the inability of these countries to issue the currency of their debt.
Figure 7
Government debt ratios and bond rates
Governments needing to finance deficits have had to pay considerable attention to market
conditions and perceptions. In general, where discretionary fiscal measures were quickly
implemented, and were seen to be extraordinary, targeted and sunsetted, markets have
been more forgiving. To date, the US, Germany, Japan and the UK have retained the
confidence of investors and their status as safe havens - despite government debt ratios that
are high even by the standards of the troubled euro area countries. Australia and New
Zealand have continued to benefit from relatively low public debt ratios (Figure 7).
5. A new world
Five years after the first tremors in 2007, the world looks rather different. Interest rates are
much lower. Risk pricing is much more sharply differentiated. The threat of deflation is now
real for several countries, and inflation is very low for others. In most advanced countries
since the crisis, real per capita GDP growth has been insipid at best.
Although weak banks appear to be much less of a problem in Australasia, impaired bank
balance sheets in the Northern Hemisphere are casting a long economic shadow. Some
banking systems remain weighed down by non-performing loans, while markets for
securitised loans are still largely moribund. Financial institutions and their funders appear to
have recognised the importance of robust funding, loss-absorption capacity and clarity about
bank balance sheet exposures.
The risk aversion in global credit markets is still reaching our shores via bank funding
markets, in the form of elevated funding spreads and a heightened demand for local
deposits. Although these developments at least partly reflect a transition to "new normal"
balance sheet structures, it is also possibly a sign that the pre-crisis model of highly
leveraged and interconnected banking may no longer attract investors. That of course could
be a helpful thing for macro-financial stability and for the rebalancing of non-bank balance
sheets - provided it persists when good times return.
The new environment creates some structural and strategic challenges for the global
financial industry. Much-reduced financial engineering and weaker financial institutions are
likely to see some retrenchment of certain banking activities. Also, with very low yields,
financial institutions subject to obligations or strong expectations to pay fixed returns (such
as pension funds) face pressure to increase holdings of risky assets, so they can support
these returns. A renewed search for yield for these reasons raises the risk of excessive
investment or bubbles in such lower quality assets.
Global spending and investment appear very cautious, and seem likely to remain so for
some time, given the overhang of debt from before the crisis. In advanced economies,
deleveraging in the private sector appears to have started, but will take a long time - perhaps
a generation. Very cautious households are a large part of the story of a slow and fragile
recovery. They have been hit hard by sustained labour market weakness, and in the US and
some other advanced economies this has been compounded by loss of housing wealth and
balance sheet weakness.
The apparently lower appetite for debt among New Zealand and Australian households is an
interesting departure from the recent past, or perhaps a return to the more restrained
standards of post-war years. In New Zealand, this continues, despite an emerging pickup in
housing market activity (albeit off a very low base). For example, New Zealand household
credit growth has traditionally tracked the value of house sales, but this relationship has
loosened since the crisis.
Household caution is understandable given the restrained growth outlook, and the continued
need for external rebalancing. But it is also consistent with cyclically weak labour and
housing markets. We have yet to see whether deleveraging will continue as the gradual
recovery proceeds, or if households instead revert to pre-crisis behaviours.
Currently, business sector balance sheets after the crisis are generally in better shape than
following previous recessions. The labour market weakness probably means some shift in
the share of national income in favour of capital. Furthermore, a reluctance to invest in the
current environment of uncertainty (the Australian mining sector being a notable exception)
means that many firms are actually quite cash-rich.
Asia-Pacific impacts
Increased saving and reduced investment in advanced economies, and the beginnings of a
shift towards domestic expenditure and away from exports in emerging economies, are
starting to reduce the global imbalances that had grown markedly pre-crisis. However, in the
meantime, the reduced investment is also holding back global productivity and potential
growth. This probably adds to the pressure for re-balancing of external and domestic growth
drivers in emerging economies.
While world growth has fallen overall, the share accounted for by emerging markets,
particularly in Asia, has continued to grow. This shift, combined with the strong rebalancing
forces, has produced an unusual constellation of economic conditions in Australia and New
Zealand.
The high exposure of Australia and New Zealand to emerging Asian demand for industrial
raw materials and protein has sent the relative prices of those products, and hence our real
exchange rates, to high levels. While that shift has encouraged labour and capital to move to
those sectors, high real exchange rates are also promoting expenditure switching towards
foreign goods and away from domestic ones. Non-resources sectors and regions are
squeezed as a result.
At the same time, in New Zealand we have our own post-crisis debt, resulting from pre-crisis
debt-fuelled household expenditure, which is now proving to be a restraint on demand. And
although our fiscal positions are favourable relative to many other advanced economies, the
debt overhangs, dependence on offshore funding and its sensitivity to sustainability concerns
suggest that the current tilt of fiscal policy towards consolidation may persist for a while.
Moreover, the pressure of the high nominal exchange rate is not the only relevant "headwind"
for our economies. Sectors other than those directly exposed to resources are seeing their
relative productivity and cost-competitiveness decline. This reflects the ongoing and rapid
industrialisation of Asia, and perhaps globalisation more generally. In New Zealand, the most
obvious relative decline is in import-substituting sectors.
Research and analysis
The crisis has re-oriented the economic research agenda. Beliefs that self-stabilising
processes in the economy and financial system generally dominate destabilising herd
behaviour have been shaken up. The potential and proper roles of financial, fiscal and
monetary policy, have also been seriously challenged by experience.
The management of tail risks is the supposed province of regulators, financial experts and
insurance contracts. Yet the industry's extensive risk-management apparatus failed to
anticipate and struggled to cope with the financial crisis. Some markets that locked up
involved recent financial instruments such as complex mortgage derivatives, whose
behaviour under stress had never really been tested.
When markets struggle to clear at any price, and when cross-border exposures grossly
multiply the number of relevant variables, formal modelling to support risk management
becomes difficult. By definition, tail risk analysis is about extrapolation of observed behaviour
to speculate about scenarios never before seen. We should be humble about our
frameworks' ability to capture these scenarios.
Economists have yet to get fully to grips with the complex roles of the financial system,
financial frictions, asset prices and credit flows in international macroeconomic dynamics.
The research and policy communities are now busy introducing richer financial behaviour in
models. Some promising avenues include study of how financial margin behaviour can
propel economic booms, financial incapacity can exacerbate busts, and diffusion of bad
news can generate panics. Experimental economics is using lab settings to study human
reactions to imperfect information and discontinuous events.
But uncovering enduring and reliable inferences about behaviour from discontinuous and
perhaps unique real-life observations is daunting. Non-linearities, contagion and large-scale
failures are a far cry from familiar linear models with diversified exposures and rational
expectations. The jury is still out on whether extreme behaviour is forecastable in a useful
way at all, even if it can be modelled in the abstract. A good example is the sudden change
of perceptions about current monetary and fiscal arrangements for euro area. From barely
perceptible differences between euro area government bond rates since the euro began
trading in 1999 until 2008, we now face divergences many times greater than those seen
even during the convergence period before the euro's creation (Figure 8).
Figure 8
Euro area government bond rates
Source: Bloomberg.
Policymakers' models are usually built around a well-defined economic equilibrium. In the
current environment, knowing exactly where equilibrium is and whether it is unique seem like
especially big asks. More than usual, the financial industry and policymakers alike appear to
be groping to understand how things will look in the next decade.
Modelling approaches based on chaotic dynamics and multiple equilibria are not new to the
profession. But their utility has been limited due to their extreme sensitivity to assumptions,
and the difficulty of extracting a simple story on which to base decisions. Yet at least they
remind us of the limits to predictability and certainty.
Policy strategy
What does all this mean for macroeconomic and financial policy strategy in the years ahead?
As a first goal, and one that is unchanged by the crisis, macroeconomic and financial policy
should seek to provide a stable backdrop for economic activity. The familiar guideposts of
price and financial stability remain relevant. As a second goal, policy might try to buffer and
insulate the economy to some extent from disturbances. Third, while buffering to the degree
possible given limited knowledge, policy should allow resource allocation signals to come
through as undistorted as possible.
Within this high-level policy framework, the stresses on fiscal and monetary policy in many
economies have led to new policy challenges. Policy interest rates are very low and fiscal
deficits very large in many countries. In New Zealand and Australia, policymakers must
manage ongoing exposures to offshore financial disruptions as well as generalised
deleveraging pressures at home and abroad. Finally, exchange rates and relative prices and
wages are shifting due to commodity market developments.
Financial regulation and supervision
The crisis confirmed that the financial system's central economic role, and sudden escalation
of systemic problems, make it politically very difficult to ensure that a bank's shareholders
and creditors bear the full costs of the bank's failure when the entire system is under threat.
Weak banks, effectively holding the economy to ransom, readily pass their liabilities and risks
on to governments. Authorities' priority in the midst of a financial crisis tends to be focused
on ensuring that the liquidity crunch conditions sparked by bad banks do not drag good
banks under.
All the various forms of official support involve unpalatable market distortions and incentives
for further bad behaviour (moral hazard). While equity stakes capture some upside from the
rescue for the government, they also involve difficult governance problems. Junior debt
leaves the government with credit risk but no influence over risk-taking. Senior bank debt
limits the government's credit risk, but can make the bank's fragility worse by scaring off
private investors. Government guarantees of deposits and other liabilities might limit the
upfront cashflow implications of financial support, but cast the shadow of moral hazard very
broadly.
Moral hazard can probably never be eliminated, only reduced, especially after the
widespread bailouts and government guarantees seen in the crisis. Some level of regulation
and supervision to constrain the extremes of risk-taking behaviour will therefore always be
necessary.
With reduced credit demand, costly funding and stricter regulations, the banking sector is
going to have to get used to more restrained returns. The financial system's basic function is
to make credit judgements across uncertain investment propositions, to monitor borrowers'
performance and creditworthiness, and to price credit accordingly. Restoring that function is
the ultimate goal of financial reform. In doing so, we need to ensure that regulation does not
overly increase the costs of banking, especially in more vanilla systems such as Australia's
and New Zealand's. Our systems are already focussed on utility banking, rather than on the
riskier types of investment banking.
The sobering experience of the crisis underlines the difficulty of getting the right balance of
light-handed versus heavy-handed supervision. Supervisors, financial institutions, credit
rating agencies and everyone else inevitably see financial and economic developments
imperfectly, both ex ante and ex post. It is therefore unrealistic to expect to be able to reduce
the probability of a systemic crisis to zero. Part of the strengthening of the financial system
overall must therefore include practical preparation for further crises. This includes regulation
and supervision with an eye to ensuring that a crisis can be dealt with effectively, should it
eventuate.
In our integrated Australasian banking system we have learned the value of strong
homehost cooperation in regulating trans-Tasman entities. We have also learned the value of
having the capacity in each jurisdiction to deal with failed institutions expeditiously, whatever
their size or parentage. In New Zealand, we have emphasised having mechanisms to
allocate losses appropriately to creditors and shareholders and to release residual claims on
the bank quickly, in the event of trouble at the banks.
Macro-financial policy
We learned in the crisis that a "micro-prudential" focus on the soundness of individual
institutions does not ensure that the whole system will continue functioning under adverse
conditions. Part of the international response is macro-financial policy, a new focus of policy
development concerned with the stability of the financial system as a whole, and on financial
behaviour and its interactions with the economy.
Macro-financial policy acts on the structure of financial institution balance sheets and
behaviours across the whole system. Such controls add to micro-prudential controls to
ensure the soundness of individual institutions considered in isolation. Macro-financial policy
settings are intended to deliver automatic stabilisation akin to that of fiscal (tax and benefit)
systems, as well as larger buffers against system-wide shocks and some degree of leaning
against strong credit upswings. The settings would be reviewed from time to time to suit
changing financial and economic circumstances. Macro-financial settings would be expected
to change much less frequently than monetary policy.
Like most policy interventions, macro-financial measures (such as capital and liquidity buffers
or restraints on certain kinds of risky lending) involve costs in the form of potential distortions
to financial activity. Such interventions are likely to complement monetary policy, but this
cannot be guaranteed. Indeed, we have very limited practical experience of macro-financial
policy.
These concerns suggest that macro-financial policy should not seek to be too activist.
Distortions will be most likely to occur where a policy intervention creates an opportunity for
regulatory arbitrage between the regulated and unregulated sectors, or between regulated
and unregulated activities. And the incentives for arbitrage will be greater under strong credit
demand conditions, suggesting the likelihood that any restraining effect of macro-financial
tightenings on business cycle upswings is likely to be small.
Under such conditions, the appropriate response to a future credit-fuelled upswing could well
be a combination of measures. Macro-financial tightening would counter banks relaxing
credit standards and undermining the stability of the overall system, while monetary policy
tightening would address rising inflationary pressures associated with the strong credit
demand. But in comparison with other policy areas, macro-financial policy knowledge is still
immature, and we have a lot to learn.
Fiscal policy
The experience of sovereigns in less favourable fiscal positions demonstrates how quickly
and catastrophically a sovereign can lose credibility for ongoing prudent fiscal and economic
management, especially if the exchange rate is not available as an adjustment mechanism
and internal cost structures are not flexible. That credibility is a vital resource.
Although we have our own versions of the aging population problem, we went into the crisis
from a fairly healthy government financial position. Australia's position now appears still to be
relatively favourable, while New Zealand is more in the middle of the pack of advanced
countries.
Yet, other features of our national balance sheets give some cause for concern should
another global funding pressure event occur. It will take a long time for the structural causes
of financial fragility in Europe to be addressed, and for the process of public and private
balance sheet repair to run its course. In the meantime, crises may reoccur and cause either
funding disruption to Australia and New Zealand, or even worse, a renewed global economic
downturn.
Local issues include the relatively heavy dependence of our economies on bank lending, the
relatively heavy dependence of the banks on foreign funding, and the high degree of
conce