Memorandum from Professor Willem H Buiter,
London School of Economics and Political Science
According to a report in the Financial Times,
"European nations are to draw up radical proposals to improve
transparency in financial markets and to change the way credit
rating agencies operate in an attempt to prevent any recurrence
of the financial turmoil arising from the credit squeeze".
Are transparency in financial markets and better
rating agencies indeed key to preventing the recurrence of the
kind of mess we have been experiencing in the world's most developed
financial systems for these past three months? I intend to take
a romp through the crisis to see what lessons it holds for policymakers
and market participants.
The problems we have recently seen across the
industrialised world (but not, as yet, in the emerging markets),
was by a "perfect storm" bringing together a number
of microeconomic and macroeconomic pathologies. Among the microeconomic
systemic failures were: wanton securitisation, fundamental flaws
in the rating agencies business model, privately rational but
socially inefficient disintermediation, and competitive international
de-regulation. Proximate drivers of the specific way in which
these problems manifested themselves were regulatory and supervisory
failure in the US home loan market and excessive global liquidity
creation by key central banks.
In the UK, the problems were aggravated by:
1. a flawed Tripartite arrangement between
the Treasury, the Bank of England and the Financial Services Authority
(FSA) for dealing with financial crises;
2. supervisory failure by the FSA;
3. flaws in the Bank of England's liquidity-oriented
open market policies (too restrictive a definition of eligible
collateral and an unwillingness to try to influence market rates
at maturities longer than overnight, even during periods of serious
lack of market liquidity; and
4. flaws in the Bank of England's discount
window operations (too restrictive a definition of eligible collateral;
only overnight lending; too restrictive a definition of eligible
discount window counterparties).
Both shortcomings in the Bank of England's operating
arrangements and procedures were due to a flawed understanding
of the nature and determinants of market (ill)liquidity, of the
Bank of England's unique role in the provision of market liquidity
because of its ability to create unquestioned liquidity instantaneously
and costlessly, of the conditions under which there is a trade-off
between moral hazard (bad incentives for future bank behaviour)
and the ex-post provision of liquidity to (a) markets and (b)
specific individual institutions, to prevent collateral damage
to the financial system and the real economy.
Among the macroeconomic pathologies were the
(1) An ex-ante global saving glut,
brought about by the entry of a number of high-saving countries
(notably China) into the global economy and a global redistribution
of wealth and income towards commodity exporters that also had,
at least in the short run, high propensities to save.
(2) Excessive liquidity creation by the world's
leading central banks and by the desire of many new industrialising
and oil and gas exporting countries to limit the appreciation
of their currencies. The behaviour of the central banks may be
in part explained as a response to the Keynesian effective demand
weaknesses that resulted from (1).
Traditionally, banks borrowed short and liquid
and lent long and illiquid. On the liability side of the banks'
balance sheet, deposits withdrawable on demand and subject to
a sequential service (first come, first served) constraint figured
prominently. On the asset side, loans, secured or unsecured to
businesses and households were the major entry. These loans were
typically held to maturity by the banks (the "originate and
hold" model). Banks therefore transformed maturity and created
liquidity. Such a combination of assets and liabilities is inherently
vulnerable to bank runs by deposit holders.
Banks were deemed to be systemically important,
because their deposits were a key part of the payment mechanism
for households and non-financial corporations, because they played
a central role in the clearing and settlement of large-scale transactions
and of securities. To avoid systemically costly failures by banks
that were solvent but had become illiquid, the authorities implemented
a number of measures to protect and assist banks. Deposit insurance
was commonly introduced, paid for either by the banking industry
collectively or by the state. In addition, central banks provided
lender of last resort (LoLR) facilities to individual deposit-taking
institutions that had trouble financing themselves.
In return for this assistance and protection,
banks accepted regulation and supervision. This took the form
of minimum capital requirements, minimum liquidity requirements
and other restrictions on what the banks could hold on both sides
of their balance sheets.
In the 1970s, Fannie Mae (Federal National Mortgage
Association), Ginnie Mae (Government National Mortgage Association)
and Freddie Mac (Federal Home Loan Mortgage Corporation) began
the process of securitisation of residential mortgages. Asset
securitisation involves the sale of income generating financial
assets (such as mortgages, car loans, trade receivables (including
credit card receivables) and leases) by a company (the originator
of the financial assets) to a special purpose vehicle (SPV). The
SPV, which might be a trust or a company, finances the purchase
of these assets by the issue of bonds, which are secured by those
assets. The SPV is supposed to be bankruptcy-remote from the originator,
that is, it has to be an off-balance sheet entity vis-a"-vis
the originator. Cash-flow securitisation works in a similar way,
as when the UK government agreed to create the International Finance
Facility which was supposed to securitise future development aid
Private institutions, especially banks, immediately
took advantage of these securitisation techniques to liquefy their
illiquid loans. The resulting "originate and distribute"
model had major attractions for the banks and also permitted a
potential improvement in the efficiency of the economy-wide mechanisms
for intermediation and risk sharing. It made marketable the non-marketable;
it made liquid the illiquid. There was greater scope for trading
risk, for diversification and for hedging risk.
There are three problems associated with securitisation
(and the generally associated creation of off-balance sheet vehicles).
1. The greater opportunities for risk trading
created by securitisation not only made it possible to hedge risk
better (that is, to cover open positions); it also permitted investors
to seek out and take on additional risk, to "unhedge"
risk and to create open positions not achievable before. When
risk-trading opportunities are enhanced through the creation of
new instruments or new institutions, and when new populations
of potential investors enter the risk-trading markets, we can
only be sure that the risk will end up with those most willing
to bear it. There can be no guarantee that risk will end up being
borne by those most able to bear it.
2. The "originate and distribute"
model destroys information compared to the "originate and
hold" model. The information destruction occurs at the level
of the originator of the assets to be securities. Under the "originate
and distribute" model the loan officer collecting the information
on the creditworthiness of the would-be borrower is working for
the Principal in the investing relationship (the originating bank).
Under the "originate and distribute" model, the loan
officer of the originating banks works for an institution (the
originating bank) that is an Agent for the new Principal in the
investing relationship (the SPV that purchases the loans from
the bank and issues securities against them). With asymmetric
information and costly monitoring, the agency relationship dilutes
the incentive for information gathering at the origination stage.
Reputation considerations will mitigate this problem, but will
not eliminate it.
3. Securitisation also puts information in
the wrong place. Whatever information is collected by the loan
originator about the underlying assets remains with the originator
and is not effectively transmitted to the SPV, let alone to the
subsequent buyers of the securities issued by the SPV that are
backed by these assets. By the time a hedge fund owned by a French
commercial bank sells ABS (asset backed securities) backed by
US subprime residential mortgages to a conduit owned by a small
German Bank specialising in lending to small and medium-sized
German firms, neither the buyer nor the seller of the ABS has
any idea as to what is really backing the securities that are
The problems created by securitisation can be
mitigated in a number of ways.
1. Simpler structures. The financial
engineering that went into some of the complex securitised structures
that were issued in the last few years before the ABS markets
blew up on August 9, 2007 at times became ludicrously complex.
Simple securitisation involved the pooling of reasonably homogeneous
assets, say residential mortgages issued during a given period
with a given risk profile (subprime, alt-A or prime, say). These
were pooled and securities issued against them were tranched,
with the higher tranche having priority (seniority) over the lower
tranches. This permitted the highest tranche secured against a
pool of high-risk mortgages, say, to achieve a much better credit
rating than the average of the assets backing all the tranches
together (the lower tranches, of course, had a correspondingly
lower credit rating).
However, second-tier and higher-tier-securitisation
then took place, with tranches of securitised mortgages being
pooled with securitised credit-card receivables, car loan receivables
etc. and tranched securities being issued against this new, heterogeneous
pool of securitised assets. Myriad credit enhancements were added.
In the end, it is doubtful that even the designers and sellers
of these compounded, multi-tiered securitised assets knew what
they were selling, knew its risk properties or knew how to price
them. Certainly the sellers did not.
There is a simple solution: simpler structures.
This will in part be market-driven, but regulators too may put
bounds on the complexity of instruments that can be issued or
held by various entities.
2. "Unpicking" securitisation.
This "solution" is the ultimate admission of defeat
in the securitisation process. A number of American banks with
(residential mortgage-backed securities on their balance sheet
have been scouring the entrails of the asset pools backing these
securities and have sending staff to specific addresses to assess
and value the individual residential properties. This inversion
of the securitisation matrix is, of course, very costly and means
that the benefits from risk pooling will tend to be ignored. It
is an ignominious end for the securitisations involved. RMBS
3. Retention of equity tranche by originator.
When the originator of the loans is far removed from the ultimate
investor in the securities backed by these loans, the incentive
for careful origination is weakened. One way to mitigate this
problem is for the originator to retain the "equity tranche"
of securitised and tranched issues. The equity tranche or "first-loss
tranche" is the highest-risk tranchethe first port
of call when the servicing of the loans is impaired. It could
be made a regulatory requirement for the originator of residential
mortgages, car loans etc. to retain the equity tranche of the
securitised loans. Alternatively, the ownership of the equity
tranche could be required to be made public information, permitting
the market to draw its own conclusions.
4. External ratings. The information
gap could be closed or at least reduced by using external rating
agencies to provide an assessment of the creditworthiness of the
securitised assets. This has been used widely in the area of RMBS
and of ABS. This "solution" to the information problem,
however, brought with it a whole slew of new problems.
2. RATING AGENCIES
A small number of internationally recognised
rating agencies (really no more than three: Standard & Poor's,
Moody's and Fitch) account for most of the rating of complex financial
instruments, including ABS. They got into this business after
for many years focusing mainly on the rating of sovereign debt
instruments and of large private corporates. They have been given
a formal regulatory role, (which will be greatly enhanced under
the about-to-be-introduced Basel 2 Capital Adequacy regime) because
their ratings determine the risk weighting of a whole range of
assets bank hold on their balance sheets.
Their role raises a number of important issues
because it creates a number of problems.
1. What do they know? This is a basic
but important question. One can imagine that, after many years,
perhaps decades, of experience, a rating agency would become expert
at rating a limited number of sovereign debtors and large private
corporates. How would the rating agency familiarise itself with
information available only to the originators of the underlying
loans or other assets and to the ultimate borrowers? How would
the rating agency, even if they knew as much about the underlying
assets as the originators/ultimate borrowers, rate the complex
structures created by pooling heterogeneous underlying asset classes,
slicing and dicing the pool, tranching and enhancing the payment
streams and making the ultimate pay-offs complex, non-linear functions
of the underlying income streams? These ratings were overwhelmingly
model-based. The models used tended to be the models of the designers
and sellers of the complex structures, who work for the issuers
of the instruments. Models tend to be useless during periods of
disorderly markets, because we have too few observations on disorderly
markets to construct reasonable empirical estimates of the risks
2. They only rate default risk. Rating
agencies provide estimates of default risk (the probability of
default and the expected loss conditional on a default occurring).
Even if default risk is absent, market risk or price risk can
be abundant. Liquidity risk is one source of price risk. As long
as the liquidity risk does not mutate into insolvency risk, the
liquidity risk is not reflected in the ratings provided by the
rating agencies. The fact that many "consumers" of credit
ratings misunderstood the narrow scope of theses ratings is not
the fault of the rating agencies, but it does point to a problem
that needs to be addressed. First, there has to be an education
campaign to make investors aware of what the ratings mean and
don't mean. Second, the merits of offering (and requiring) a separate
rating for, say, liquidity risk should be evaluated.
3. They are conflicted. Rating agencies
are subject to multiple potential conflicts of interest.
(a) They are the only example of an industry
where the appraiser is paid by the seller rather than the buyer.
(b) They are multi-product firms that sell
advisory and consulting services to the same clients to whom they
sell ratings. This can include selling advice to a client on how
to structure a security so as to obtain the best rating and subsequently
rating the security designed according to these specifications.
(c) The complexity of some of the structured
finance products they are asked to evaluate makes it inevitable
that the rating agencies will have to work closely with the designers
of the structured products. The models used to evaluate default
risk will tend to be the models designed by the clients. It's
not just the problem that marking to model can become marking
to myth. There is the further problem that the myth will tend
to be slanted towards the interest of the seller of the securities
to be rated.
There is no obvious solution other than "try
harder and don't pretend to know more than you know" for
the first problem. The second problem requires better education
of the investing public. The third problem can be mitigated in
a number of ways.
1. Reputational concerns. Reputation
is a key asset of rating agencies. That, plus the fear of law
suits will mitigate the conflict of interest problem. The fundamental
agency problem cannot be eliminated this way, however. Even if
the rating agencies expect to be around for a long time (a necessary
condition for reputation to act as a constraint on opportunistic
and inappropriate behaviour), individual employees of rating agencies
can be here today, gone tomorrow. A person's reputation follows
him/her but imperfectly. Reputational considerations are therefore
not a fully effective shield against conflict of interest materialising.
2. Remove the quasi-regulatory role of
the rating agencies in Basel 2 and elsewhere. Just as the
public provision of private goods tends to be bad news, so the
private provision of public goods leaves much to be desired ("the
best judges money can buy etc"). The official regulatory
function of private credit risk ratings in Basel I and II should
be de-emphasized and preferably ended altogether.
I may get my wish here, because Basel II appears
fatally holed below the waterline. It was long recognised to have
unfavourable macroeconomic stabilisation features, because the
capital adequacy requirements are likely to be pro-cyclical (see
Borio, Furfine and Lowe (2001), Gordy and Howells (2004) and Kashyap
and Stein (2004)). On top of this, the recent financial turmoil
should that the two key inputs into Pillar 1, the ratings provided
by the rating agencies and the internal risk models of the banks
are deeply flawed.
As regards internal risk models, there are two
problems. The first is the unavoidable "garbage ingarbage
out" problem that makes any quantitative model using parameters
estimated or calibrated using past observations useless during
times of crisis, when every crisis is different. We have really
only had one instance of a global freeze-up of ABS markets, impairment
of wholesale markets and seizure of leading interbank markets
simultaneously in the US, the Eurozone and the UK. Estimates based
on a size 1 sample are unlikely to be useful. Second, the use
of internal models is inherently conflicted. The builders, maintainers
and users of these models are perceived by the operational departments
of the bank as a constraint on doing profitable business. They
will be under relentless pressure to massage the model to produce
the results desired by the bank's profit centres. They cannot
be shielded effectively from such pressures. Chinese walls inside
financial corporations are about as effective in preventing the
movement of purposeful messages across them, as the original Great
Wall of China was in keeping the barbarians out and the Han Chinese
inthat is, utterly ineffective.
3. Make rating agencies one-product firms.
The potential for conflict of interest when a rating agency sells
consultancy and advisory services is inescapable and unacceptable.
Even the sale of other products and services that are not inherently
conflicted with the rating process is undesirable, because there
is an incentive to bias ratings in exchange for more business
in functionally unrelated areas. The obvious solution is to require
any firm offering rating services to provide just that. Having
single-product rating agencies should also lower the barriers
4. End payment by the issuer. Payment
by the buyer (the investors) is desirable but subject to a "collective
action" or "free rider" problem. One solution would
be to have the ratings paid for by a representative body for the
(corporate) investor side of the market. This could be financed
through a levy on the individual firms in the industry. Paying
the levy could be made mandatory for all firms in a regulated
industry. Conceivably, the security issuers could also be asked
to contribute. Conflict of interest is avoided as long as no individual
issuer pays for his own ratings. This would leave some free rider
problems, but should get the rating process off the ground. I
don't think it would be necessary (or even make sense) to socialise
the rating process, say by creating a state-financed (or even
industry-financed) body with official powers to provide the ratings.
5. Increase competition in the rating
industry. Competition in the rating process is desirable.
The current triopoly is unlikely to be optimal. Entry should be
easier when rating agencies become single-product firms, although
establishing a reputation will inevitably take time.
There are no doubt solid economic efficiency
reasons for taking certain financial activities out of commercial
banks and out of investment banks, and putting them in special
purpose vehicles (SPVs), Structured Investment Vehicles (SIVs,
that is, SPVs investing in long-term, often illiquid complex securitised
financial instruments and funding themselves in the short-term
wholesale markets, including the ABCP markets), Conduits (SIVs
closely tied to a particular bank) and a host of other off-balance-sheet
and off-budget vehicles. Incentives for efficient performance,
including appropriate risk management can, in principle, be aligned
better in a suitably designed SPV than in a general-purpose bank.
The problem is that it is very difficult to come up with any real-world
examples of off-balance sheet vehicles that actually appear to
make sense on efficiency grounds.
Most of the off-balance sheet vehicles (OBSVs)
I am familiar with are motivated by regulatory arbitrage, that
is, by the desire to avoid the regulatory requirements imposed
on banks and other deposit-taking institutions. These include
minimal capital requirements, liquidity requirements, other constraints
on permissible liabilities and assets, reporting requirements
and governance requirements. Others are created for tax efficiency
(ie tax avoidance) reasons or to address the needs of governments
and other public authorities for off-budget and off-balance sheet
finance, generally to get around public deficit or debt limits.
OBSVs tend to have little or no capital, little
or no transparency and opaque governance. When opaque institutions
then invest in opaque financial instruments like the ABS discussed
earlier, systemic risk is increased. This is reinforced by the
fact that much de-jure or de-facto exposure remains
of the sponsoring banks to these off-balance-sheet vehicles. The
de jure exposure exists when the bank is a shareholder
or creditor of the OBSV, when the OBSV has an undrawn credit line
with the bank or when the bank guarantees some of the OBSV's liabilities.
De-facto exposure exists when, for reputational reasons,
it is problematic for the bank to let an OBSV that is closely
identified with the bank go under.
Banks in many cases appear not to have been
fully aware of the nature and extent of their continued exposure
to the OBSVs and the ABS they carried on their balance sheets.
Indeed the explosion of new instruments and new financial institutions
so expanded the populations of issuers, investors and securities
that many market participants believed that risk could not only
be traded and shared more widely and in new ways, but that risk
had actually been eliminated from the system altogether. Unfortunately,
the world of risk is not a doughnut: it does not have a hole in
it. All risk sold by someone is bought by someone. If the system
works well, the risk ends up being born by those both willing
and most able to bear it. Regrettably, it often ends up with those
most willing but not most able to bear it.
Mitigation of the problems created by excessive
disintermediation will be part market-driven and partly regulatory.
1. Re-intermediation. Either Conduits,
SIVS and other OBSVs are taken back on balance sheet by their
sponsoring banks, or the ABS and other illiquid securities on
their balance sheets are sold to the banks. The OBSVs then either
wither away or vegetate at a low level of activity.
2. Regulation. We can anticipate a
regulatory response to the problem of opaque instruments held
by opaque OBSVs in the form of reporting requirements, and consolidation
of accounts requirements that are driven by broad principles (`duck
tests') with constant adaptation of specific rules addressing
particular institutions and instruments. For instance, if the
Single Master Liquidity Enhancement Conduit (M-LEC) proposed by
JPMorgan Chase, Bank of America and Citigroup ever gets off the
ground, it is questionable whether the US regulators will permit
the participating banks to keep it off-balance-sheet for reporting
purposes, including earnings reports.
Regulators of financial markets and institutions
are organised on a national basis and are, in part, cheerleaders
and representatives of the interests of their national financial
sectors. While regulation is national, finance is global. The
location of financial enterprises and markets is endogenous. A
thriving financial sector creates jobs and wealth, and is generally
environmentally friendly. So regulators try to retain and attract
business for their jurisdictions in part by offering more liberal,
less onerous regulations. This competition through regulatory
standards has led to less stringent regulation.
There have been occasional reversals in this
process. The Sarbanes-Oxley Act of 2002 was a response to the
corporate governance, accounting and reporting scandals associated
with Enron, Tyco International, Peregrine Systems and WorldCom.
It undoubtedly contributed to a loss of business for New York
City as a global financial centre. Because Sarbanes-Oxley compliance
is mainly a matter of box-ticking (like most real-world compliance,
especially compliance originating in the USA), it has not materially
improved the informational value of accounting or the protection
offered to investors.
Is this global competitive deregulation process
a welcome antidote to a tendency to excessive and heavy-handed
regulation or a race to the bottom in which everyone loses in
the end? I believe the jury is still out on this one, although
I am inclined, if pushed, to suggest that the following are likely
to be true:
Principles-based regulation (allegedly
what we have in the UK) vs. rules-based regulation is an unhelpful
distinction. You need both. You need principles that spell out
the fundamental "duck test": (a) Does the institution
lend long and borrow short? (b) Does it lend in illiquid form
and borrow in markets that are liquid in normal times although
they may turn illiquid during period of market turbulence? Do
banks have substantial exposure to it? If so, it should be either
consolidated for reporting purposes with the bank or treated as
a bank it its own right. Then you need rules that are constantly
adapted to keep up with developments in instruments and institutions.
Self-regulation is no regulation
unless backed up credibly with the threat that, unless effective
self-regulation is implemented, external regulation will be imposed.
Voluntary codes of conduct are without
significance unless they can be and are used by the regulator
(through "comply or explain" rules) to impose and enforce
standards. That means that if the explanation is not to the regulator's
satisfaction, compulsion can be used.
The UK's "light-touch"
regulation has become "soft-touch" regulation and needs
to be tightened up in a large number of areas.
1. Greater international cooperation between
regulators. This is a no-brainer, but very hard to achieve.
2. A single EU-wide regulatory regime
for banks, other financial institutions and financial markets.
National financial regulators in the EU should go the way of the
dodo. An EU-level FSA would be a good idea, although the central
banks (the ECB and for the time being still 14 national central
banks) should collect more information about individual banks
than the Bank of England has done since it lost banking supervision
and regulation in 1997 when the Bank became operationally independent
for monetary policy.
3. A crackdown on "regulators of
convenience". This requires tough measures towards "regulation
havens", some found in the Caribbean, others closer to the
UK. One effective approach would be the non-recognition and non-enforceability
of contracts, court judgements and other legal and administrative
rules from non-compliant jurisdictions.
5. THE GLOBAL
The macroeconomic background to the crisis is
the "Great Moderation"low and stable global inflation,
high and stable global real GDP growth of the past decade. Actually,
this moderation is more apparent from the inflation figures than
from the GDP figures. Figure 1 shows the spectacular decline and
recent stability of global inflation.
Figure 2 demonstrates two points.
First, the stability of global GDP growth does
not appear to have increased since the early 1980s. Second, the
common belief that global growth over the past four years has
averaged over 5% is based on the wrong statisticsthat is,
on data that weight national GDPs at purchasing power parity (PPP)
exchange rates rather than market exchange rates. PPP exchange
rates are the best conversion factors if comparisons between national
standards of living are made. To get the best estimate of developments
in global economic activity, market exchange rates should be used.
GDP growth at market exchange rates has averaged around 3.5% per
annum over the past few years. The difference between the two
measures is due to the fact that PPP exchange rate give a much
greater weight to developing countries and emerging markets than
do market exchange rates. Since emerging markets (China, India,
Vietnam, South Africa) have been the fastest growers by far over
the past decade, global growth measured at market exchange rates
has been well below global growth measured at PPP exchange rates.
This is confirmed by the observation that by 2006, the global
share of investment in GDP was only slightly above its previous
peak value achieved in 1994 (see Figure 3).
Another striking feature of the global macroeconomic
environment has been the declining level of real interest rates
since 1001, and specifically the marked decline since the bursting
of the tech bubble at the end of 2000. This is shown clearly by
Figure 4, which is taken from Desroches and Francis (2007).
The proximate determinant of the trend decline
in global real interest rates is an ex-ante saving glut, caused
by the rapid growth of new emerging markets like China, which
have extraordinarily low propensities to save, and, in more recent
years, the global redistribution of global wealth and income towards
a limited number of producers of primary energy sources (especially
oil and natural gas) and raw materials. For a number of years,
the absorptive capacity of the beneficiaries could not keep up
with their new-found wealth, and vast amounts of savings had to
be recycled. The extreme financial conservatism of many of the
big savers (in China, Japan, India, Russia, and most South East
Asian and Latin American countries and in the Gulf states, these
often were the central banks) meant that much of the increased
demand for financial assets was directed towards default-risk-free
financial instruments, especially US Treasury bonds. With no response
of supply, risk-free real rates fell very low indeed (see Caballero
In addition, the response of the US monetary
authorities to the bursting of the tech bubble, the continued
liquidity trap in Japan and, for a while also the rather relaxed
monetary policy in the Euro area resulted in massive and excessive
global liquidity growth, especially from 2003 till the end of
2006. Many rapidly growing and high-saving emerging markets and
a number of key oil producers (including the six members of the
Gulf Cooperation Council) pursued policies of undervalued nominal
exchange rates and sterilized intervention, which although only
partially effective, resulted in an unprecedented accumulation
of foreign exchange reserves and, until recently, growing demand
for high-grade sovereign debt instruments.
As a result of this, not only were long-term
risk-free nominal and real interest rates extraordinarily low
since 2003, but unprecedentedly low credit risk spreads (that
is, default risk spreads) prevailed across the board. There was
also an explosion of leverage, although interestingly enough not
in the non-financial corporate sector. Households leveraged up
and so did the financial sector. Prima facie, commercial banks
did not increase their leverage very much. The increased leverage
in the financial sector took place outside the commercial banks
in investment banks, hedge funds, private equity funds and a whole
range of new financial institutions (SIVs, conduits etc), often
using the new securitisation-based financial instruments discussed
earlier. It was insufficiently appreciated, by regulators, by
the banks and by the new financial institutions themselves, that
being off-balance-sheet for certain regulatory, auditing and reporting
purposes, does not mean that there is no substantive (and potentially
substantial) financial, commercial and economic exposure.
Low global risk-free real interest rates have
been rising since the end of 2006, as the absorptive capacity
of the oil and gas exporters has risen and as central banks at
last lost control of the management of the external assets acquired
in the high-saving emerging markets. The transfer of these resources
to sovereign wealth funds with a much greater willingness to take
risk and a thirst for returns, means that at first the incremental
flows, but increasingly also the existing stocks of external assets
are being shifted away from high-grade sovereign obligations and
into such things as equity, infrastructure and other riskier but
As regards excessive liquidity creation, it
looks as though both Japan and the US may be repeating (or be
about to repeat) the policies of the beginning of the decade.
Japan appears to be sliding back into recession, with renewed
deflationary pressures and no prospects for an early normalisation
of nominal interest rates. The Bernanke Fed has turned out to
be more like the Greenspan Fed than I would have expected or hoped,
and has, since the crisis started in August 2007, cut the Federal
Funds target rate by 75 bps and the primary discount rate by 100bps,
despite the presence of serious inflationary pressures. While
the exchange rates of many oil and gas producers have appreciated
somewhat against the dollar, there has been considerable intervention
to keep down the rate of appreciation. The same has been true
in China and India. It looks as though the foundations for the
next global liquidity glut are being laid while the world is still
struggling with the (market) liquidity crunch that started this
6. THE ONSET
Facts can be ignored for a long time, but not
forever. The realisation that risk may have been underpriced dawned
first in the USA to holders of securities backed by sub-prime
mortgages. During the second half of 2005, the delinquency rate
on these mortgages began to creep up from a low of 10% at an annual
rate (see Figure 5).
During 2006, the delinquency rate rose further
and by early 2007 it had reached 15%. It became clear that, because
many of the mortgages granted in 2005 and 2006 had up-front "teaser
rates", which during 2007 and 2008 would reset at much higher
levels, there was only one direction delinquencies were going
to go: up.
The prices of sub-prime mortgage credit default
swaps began to fall late in 2006 (see Figure 6) and dropped like
a stone by the middle of the year, indicating higher perceived
default risk for the underlying assets.
The widening of credit risk spreads that followed
was not confined to sub-prime related instruments and institutions.
As is clear from Figure 7, which shows the behaviour of Sterling
corporate bond spreads by rating, the global underpricing of risk
had affected virtually every private financial instrument, and
the sovereign instruments issued by all but a small number of
highly creditworthy sovereigns.
The US sub-prime mortgage crisis was just the
trigger of the global crisis. To illustrate, early in 2007, a
large amount of unsecured household debt (consumer credit) had
to be written down/off by UK banks.
In August 2007, we say something we had never
seen before. The simultaneous global freezing up of virtually
all wholesale capital markets, including the interbank markets,
CDO markets, markets for asset-backed-commercial paper (ABCP)
(where the crisis hit Canada first) and markets for all but the
very best asset-backed securities. Global new CDO issuance dropped
precipitously (see Figure 8) and it became impossible to roll
over outstanding stocks of commercial paper, especially asset-backed
commercial paper, which as a result declined sharply (see Figure
7. HOW DID
None of the world's leading central banks exactly
covered themselves with glory, although some did better than others,
and the Bank of England probably did the worst job.
The Federal Reserve
After the crisis erupted on 9 August, the Federal
Reserve decided to reduce its (primary) discount rate by 50 basis
points from 6.25% to 5.75% on 16 August. This was at best a meaningless
gesture. There were no US financial institutions for whom the
difference between able to borrow at the discount rate at 5.75%
rather than at 6.25% represented the difference between survival
and insolvency; neither would it make a material difference to
banks considering retrenchment in their lending activity to the
real economy or to other financial institutions. It was a reduction
in the discount window penalty margin (previously 100 basis points)
of interest only to institutions already willing and able to borrow
there (because they had the kind of collateral normally expected
at the discount window). It was small subsidy to such banksa
small treat for their shareholders.
A possible rationalisation of this actionthat
it was a way for the Fed to say "we feel your pain; we know
and we care", without doing anything substantive, like a
cut in the Federal Funds target ratereally makes little
sense, as from a substantive viewpoint, the Fed's action on 16
August was cheap talk.
Subsequently, on 18 September, the Fed cut the
Federal Funds Rate by 50 basis points, with a further reduction
of 25 basis points following on 31 October. In both cases, the
Discount rate was reduced by the same amount.
The Fed also extended the maturity of loans
at the discount window from overnight to up to one month. It also
injected liquidity into the markets at maturities from overnight
to three-month. The amounts injected were somewhere between those
of the Bank of England (allowing for differences in the size of
the US and UK economies) and those of the ECB.
Throughout the three months of the crisis, it
is difficult to avoid the impression that the Fed is too close
to the financial markets and to leading financial institutions.
This was definitely the case for the Greenspan Fed, but came as
a surprise to me as regards the Bernanke Fed. There is an always-present
danger of a regulator getting too close to the industry it is
supposed to be regulating in the public interest. Even if conscious
regulatory capture is avoided, the regulator is at risk of internalising
the objectives, fears and worldview of the regulated industry
to such an extent that it interferes with the regulator's ability
to make an impartial judgement about what actions are most likely
to serve its official mandate.
There can be no doubt in my view that the Fed
under Greenspan treated the stability, well-being and profitability
of the financial sector as an objective in its own right, regardless
of whether this contributed to their legal triple mandate of maximum
employment, stable prices and moderate long-term interest rates.
While the Bernanke Fed has but a short track record, its rather
panicky reaction and actions in August and September suggest that
it too may have a distorted and exaggerated view of the importance
of the financial sector for macroeconomic stability. "Time
The European Central Bank injected liquidity
both overnight and at longer maturities on an very large scale
indeed, but with limited success (see Figure 10 below). It did
not cut the policy rate or its discount rate, but it refrained
from raising rates as it had planned to do, and had effectively
pre-announced following its last pre-crisis Governing Council
rate-setting meeting on 2 August. Since then there have been three
more meetings where rates have been kept on hold, but where the
rhetoric strongly hints at a bias towards further rate increases.
The longer talk without action persists along these lines, the
lower the credibility of the forward-looking statements of President
The Bank of Japan
The Bank of Japan did nothing in particular,
but did it very well. This is justified if the absence of evidence
(of significant exposure of Japanese banks to sub-prime-backed
securities or to other devalued financial instruments) is indeed
evidence of absence (of such exposure). There is, unfortunately,
a long history of Japanese banks not owning up to asset impairments,
and refusing to write down underperforming assets. Japanese banks
continue to be opaque, even by the modest standards of the rest
of the banking sectors of the advanced industrial countries.
The Bank of England
The Bank of England cut neither its discount
rate nor its policy rate. It injected liquidity on a modest scale,
at first only in the overnight interbank market. Rather late in
the day, it reversed this policy and offered to repo at three-month
maturity, but subject to an interest rate floor, that is, effectively
at a penalty rate. No one came forward to take advantage of this
The Bank now manages the Liquidity Support Facility
for Northern Rock, although the Treasury is on the hook for any
losses the Bank may suffer through its exposure to the mortgages
that it is taking from Northern Rock as collateral for its use
of the Facility.
Just before the Northern Rock crisis blew up,
on 12 September 2007 (in a Paper submitted to the Treasury Committee
by Mervyn King, Governor of the Bank of England) the Bank told
the world the following:
" . . . the moral hazard inherent in the
provision of ex post insurance to institutions that have engaged
in risky or reckless lending is no abstract concept".
On 13 September 2007, the announcement came
that the Bank of England, as part of a joint action by HM Treasury,
the Bank of England and the Financial Services Authority (according
to the Memorandum of Understanding between these three parties),
had bailed out Northern Rock, a specialist mortgage lender, by
providing it with a credit line (the purpose-designed Liquidity
Support Facility). Without this, Northern Rock, which funds itself
mainly in the wholesale markets, would not have been able to meet
its financial obligations.
Even today we don't know how any of the details
of how this reported credit line is secured, or how any draw-downs
of this credit line are collateralised. If Northern Rock had sufficient
collateral eligible for rediscounting at the Bank of England's
Standing (collateralised) Lending Facility, it presumably would
have done so, rather than invoking this emergency procedure involving
the Bank, the FSA and the Treasury. Collateral eligible for rediscounting
at the Standing Lending Facility consists of sterling and euro-denominated
instruments issued by UK and other European Economic Area central
governments, central banks and major international institutions
rated at least Aa3 (and, exceptionally, US Treasury bonds). Such
assets are said to be scarce on the balance sheet of Northern
Rock. The severity of the penalty rate (relative to the policy
rate of 5.75%) charged Northern Rock will also be important in
determining the long-term moral hazard damage caused by this operation.
The Bank's 12 September Paper recognises conditions
when this kind of bail out is justified:
" . . . central banks, in their traditional
lender of last resort (LOLR) role, can lend `Against good collateral
at a penalty rate' to any individual bank facing temporary liquidity
problems, but that is otherwise regarded as solvent. The rationale
would be that the failure of such a bank would lead to serious
economic damage, including to the customers of the bank. The moral
hazard of an increase in risk-taking resulting from the provision
of LOLR lending is reduced by making liquidity available only
at a penalty rate. Such operations in this country are covered
by the tripartite arrangements set out in the MOU between the
Treasury, Financial Services Authority and the Bank of England.
Because they are made to individual institutions, they are flexible
with respect to type of collateral and term of the facility".
The MOU states in paragraph 14:
"14. In exceptional circumstances, there
may be a need for an operation which goes beyond the Bank's published
framework for operations in the money market. Such a support operation
is expected to happen very rarely and would normally only be undertaken
in the case of a genuine threat to the stability of the financial
system to avoid a serious disturbance to the UK economy".
It is clear that the conditions for a justifiable
bail out, as specified in the MOU and reiterated in the Bank's
12 September Paper, were not satisfied.
First, no evidence has been offered to support
the frequently-heard assertion (from Northern Rock, the Treasury,
the Bank of England and the FSA) that Northern Rock (total assets
£113 billionn as of 30 June 2007) suffered just from illiquidity
rather than from the threat of insolvency. Delinquencies on its
mortgages are said to be below the average of the UK mortgage
lending industry, and that indeed is good news.
However, the organisation has followed an extremely
aggressive and high-risk strategy of expansion and increasing
market share, funding itself in the expensive wholesale markets
for 75% of its total funding needs, and making mortgage loans
at low and ultra-competitive effective rates of interest. In the
first half of 2007, Northern Rock accounted for over 40% of the
gross mortgage lending in the UK, and for 20% of the net. It is
hard to see how with such a breakneck rate of expansion, it is
possible to maintain adequate quality control over the lending
process. Creditworthiness vetting must have slippedthere
are limits to the speed of organic growth. In addition, the bank
reputedly offered mortgages up to six times annual income, and
packages of mortgage and personal loans adding up to 125% of the
value of the collateral for the mortgage. That seems reckless
and an strategy designed to end up with non-performing loans.
There is some information surely in the fact that Northern Rock's
share price had been in steep decline since February of this year,
well before the financial market turmoil hit.
In my view, the solvency if Northern Rock is
a matter still to be determined. As usual, there is no hard information
to go by.
Second, it is hard to argue that the survival
of Northern Rock is necessary to avoid a genuine threat to the
stability of the UK financial system, or to avoid a serious disturbance
to the economy. The bank is not "too large to fail".
As the fifth largest mortgage lender in the UK, it is not systemically
significant. When all else fails, the "threat of contagion"
argument can be invoked to justify bailing out even intrinsically
rather small fish, but irrational contagion, that is, contagion
not justified by objective balance sheet and off-balance sheet
realities, is extremely rare in practice, and could have been
addressed directly had it, against the odds, occurred, following
the insolvency Northern Rock. In a well-designed financial system,
Northern Rock would have been taken into public ownership, with
the deposits ring-fenced and distributed swiftly to the depositors,
and with the bank remaining open to manage existing exposures
and commitments. This would give everyone involved time to discover
the best longer-term destination for Northern Rock, its assets
The combination of talking tough but then providing
the liquidity support to Northern Rock and of describing liquidity
support to the markets at longer maturities as creating moral
hazard (an erroneous view, in my opinion) but subsequently offering
to provide such support after all, has undermined the credibility
of the Bank. I believe the Bank recognises this and is taking
steps to avoid a recurrence of such mishaps.
One of the ironies (and surprises) of this set
of events is that despite the contrast between the low-key and
small-scale interventions of the Bank of England, the massive
liquidity injections at all maturities, including three months,
of the ECB, and the rate cuts and continued moderate liquidity
injections of the Fed, the effect of these policies on one key
measure of money market distress, the spread between -3 month
Libor (the interbank rate) and the three-month OIS rate or Overnight
Indexed Swaps, is now about the same for sterling, the euro and
the US dollar. Figure 10 makes that clear. The spread of Libor
over the Overnight Indexed Swap rate is a better indicator of
the market's view of default risk plus liquidity risk than the
spread of Libor over the policy rate, because over a three-month
horizon, the policy rate can be expected to change.
This has obviously been the case for the Federal Funds target
rate since the beginning of the crisis.
8. LESSONS TO
The way the crisis unfolded damaged the prestige
and international standing of the City of Londonthe financial
capital of the worldmore than the other leading financial
The damage is manageable and remediable, but only if effective
steps are taken to correct the many manifest weaknesses of the
UK financial system that were brought to light by the crisis.
I believe there are 13 lessons for the UK authorities.
(1) The Tripartite arrangement between the
Treasury, the Financial Services Authority and the Bank of England,
for dealing with financial instability is flawed. Responsibility
for this design flaw must be laid at the door of the man who created
the arrangementthe former Chancellor and current Prime
Minister, Gordon Brown. The Treasury, as the dominant partner
in the arrangement, also bears primary responsibility for the
way in which the Tripartite arrangement performed operationally.
The main problem with the arrangement is that
it puts the information about individual banks in a different
agency (the FSA) from the agency with the liquid financial resources
to provide short-term assistance to a troubled bank (the Bank
of England). This happened when the Bank lost banking sector supervision
and regulatory responsibility on being made operationally independent
for monetary policy by Gordon Brown in 1997. It's clear this separation
of information and resources does not work.
There are two solutions. Either banking supervision
and regulation are returned to the Bank of England, or the FSA
is given an uncapped and open-ended credit line with the Bank
of England, guaranteed by the Treasury, so the FSA can perform
the Lender of Last Resort function vis-a"-vis individual
troubled institutions. The Bank would of course retain the Market
Maker of Last Resort Function of providing liquidity to markets
and supporting systemically important financial instruments.
If the Bank were to regain banking supervision
and regulation, two deeply political activities, its independence
would be jeopardised, especially its operational independence
for monetary policy. One solution to this problem could be to
take the Monetary Policy Committee out of the Bank of England.
The Governor of the Bank of England would no longer be the Chairman
of the MPC, although I suppose he (or she) could still be an external
member. The MPC would just set the target rate for the overnight
interbank market. The Bank would act as agent for the MPC in keeping
the overnight rate as closely to the official target as possible.
Anything else (including liquidity-oriented interventions at maturities
longer than overnight, and foreign exchange market intervention)
would be the province of the Bank of England, not of the MPC.
(2) Two months after the creation of the
Liquidity Support Facility and the granting of deposit insurance
cover to Northern Rock (and to any other bank that might fight
itself in similar circumstances), Northern Rock is still on life
support, having drawn over £20 billion from the LSFjust
under 20% of its assets. This is a shambles. First, it never should
have been necessary to provide both liquidity support and a deposit
guarantee for Northern Rock. By effectively guaranteeing access
to funds for Northern Rock and insuring virtually all unsecured
creditors to Northern Rock (and all other UK banks who might find
themselves in similar straights), the UK has socialised all risk
to both sides of the banking sector balance sheet.
Several courses of action would have been preferable.
They include the following:
(a) Let Northern Rock sink or swim (ie no
Liquidity Support Facility), but guarantee all deposits. This
would probably have resulted in the insolvency of Northern Rock.
(b) Let Northern Rock sink or swim, but guarantee
all deposits up to £50,000. This would probably have resulted
in the insolvency of Northern Rock and a much smaller run on the
bank by depositors than actually took place.
(c) Take Northern Rock into public ownership.
(3) The UK deposit insurance arrangements
(which have been in place since 1982) are flawed. The amount covered
(£2,000 outright and 90% of the next £33,000) was too
low; the deductible for deposits over £2,000 was an invitation
to run, and the time (allegedly up to six months) it could take
for depositors to get their money back was far too long. Responsibility
lies with the Chancellor, although the Bank and FSA could have
been better advisors and counsellors to the government in these
matters. The necessary reforms are obvious.
(4) The FSA did not properly supervise Northern
Rock. It failed to recognise the risk attached to Northern Rock's
funding model. Stress testing was inadequate. The "war-games"
organised by the three parties to the Tripartite arrangement also
seem to have suffered from a lack of imagination.
(5) The much-vaunted "light touch"
UK model of regulation (based on principles) turned out to be
instead of model of "soft touch" regulation. It is clear
that the principles vs rules debate is vacuous. You need both.
The principles should state a clear "duck test". Eg
if it borrows short and lends long, if it borrows liquid (during
normal times, but with the risk of occasional illiquidity in its
usual funding channels) and lends illiquid and if banks are substantially
exposed to it, then it will be regulated like a bank, even if
it says "Hedge Fund" on the letterhead. The rules should
aggressively chase the unceasing attempts to avoid regulation
by institutional and instrument innovation.
(6) Bank insolvency law in the UK is flawed.
A bank that goes into administration has its deposits frozen.
The UK needs a US-style arrangement, where the regulator can take
a threatened bank promptly into public ownership, ring-fence its
deposits so they can be transferred immediately to the depositors,
and reopen the bank immediately to manage its existing activities
and commitments while a longer-term plan for is worked out.
Provided a troubled and potentially failing bank
can be taken into public ownership, I don't believe there is any
need to give banks a dispensation from the laws governing its
take-over by, sale to or merger with another institution. Despite
the assertions to the contrary by the Governor of the Bank of
England, the EU Market Abuse Directive was never an obstacle to
an undercover rescue or support operation for Northern Rock.
(7) Following the announcement of the Liquidity
Support Facility, there should have been a joint appearance by
the Prime Minister, the Chancellor of the Exchequer, the Governor
of the Bank of England, the Chairman of the FSA and the CEO of
the FSA, looking solemn and reliable, and intoning jointly: "your
money is safe". It might not have prevented the banana-republic-style
bank run that started on the 14th, but it was worth a try.
(8) In case even the joint appearance of
the Talking Heads would not do the job, the Treasury should have
guaranteed the deposits of Northern Rock at the same time the
LSF was announced.
(9) The Bank of England has a flawed liquidity
policy, both in the money markets and at the discount window.
It accepts as collateral, both at the Standing Lending Facility
(discount window), and in liquidity-oriented open market operations
(repurchase agreements) only instruments that are already liquid
(UK and European Economic Area government bonds, bonds issued
by a few highly-rated international organisations and, under exceptional
circumstances, US Treasury securities. It should emulate the ECB
and the Fed and accept as collateral also private instruments,
including illiquid and non-traded instruments such as mortgages
and asset-backed securities. Provided this collateral is priced
severely or even punitively, and has a further "haircut"
or discount applied to it, there will be no moral hazard and the
Bank can expect not to lose money.
The Bank does not need to have superior information
to the private sector in order to ensure that the prices it pays
for illiquid and nontraded securities are not excessive. Many
auctions, including the reverse Dutch auction, are (reservation)
price discovery mechanisms. With the Bank acting as a monopolistic
buyer at these auctions, it could (provided there is no collusion
among the sellers) cream off most of the surplus over and above
the reservation prices of the sellers.
The Bank would not have to form a view on the
true value of these securities following the auction either. It
could simply hold them on its books until maturity. That's the
advantage provided by being the one institution that is never
(10) The Bank should recognise that the spread
between, say, three month Libor and the expected policy rate over
the three month period (as measured, for instance, by the spread
of three-month Libor over the three-month Overnight Index Swap
rate) can reflect liquidity risk premia as well as default risk
premia. In its memo to the Treasury Committee of 12 September,
it got close to arguing that this spread reflected just anticipated
default risk. That makes no sense.
Liquidity can vanish today, because market participants
with surplus liquidity fear that both they themselves and their
potential counterparties, will be illiquid in the future (say,
three months from now), when the loans would have to be repaid.
A credible commitment by the Central Bank to provide liquidity
in the future (three months from now) would solve the problem,
but it is apparent that the required credibility simply does not
exist. Therefore, the only time-consistent solution, in the absence
of a credible commitment mechanism, is to intervene today at a
three month maturity.
The Bank of England should aim, through repos
at these longer maturities, to eliminate as much of the "term
structure of liquidity risk premia" as possible. This corrects
a market failure. It does not create moral hazard.
Points (9) and (10) assign to the Bank the responsibility
to be the Market Maker of Last Resort, to provide the public good
of liquidity when disorderly markets disrupt financial intermediation
and threaten fundamentally viable institutions.
(11) The Bank should lend at the discount
window at longer maturities than overnight. Loans of up to one
month should be available (properly priced and with a short back
and sides, and at a punitive rate). Given points (9) and (10),
the discount window would become, for all banks and on demand,
what the Liquidity Support Facility purpose-built for Northern
Rock is now.
(12) Northern Rock should have known about
the Bank of England's repo and discount window policy. Given these
policies, its funding policies were reckless.
No party involved in this debacle comes out smelling
of roses. At least the Bank of England appears to be willing to
learn, and even to admit that it made some errors. We are still
waiting for the Treasury to admit to anything less than perfection.
(13) My last observation concerns the failure
of effective Parliamentary scrutiny of and oversight over the
laws, rules, regulations and institutions that brought us this
debacle. Parliament has done little more than sniping ex-post
at the other principals in this drama. Finger-pointing and blame
allocation are not, however, substitutes for effective ex-ante
Parliamentary scrutiny of the laws, rules and regulations and
institutions, at the point that they can still be moulded and
shaped. Where was Parliament when it could have done some good?
When all the relevant lessons have been learnt
and all appropriate recommendations implemented, we still will
not have a system in which banks cannot fail or in which systemic
instability cannot take hold.
Capitalism, based on greed, private property
rights and decentralised decision making, is both cyclical and
subject to bouts of financial manic-depressive illness. There
is no economy-wide auctioneer, no enforcer of systemic "transversality
conditions" to rule out periodic explosive behaviour of asset
prices in speculative markets. It's unfortunate, but we have to
live with it. The last time humanity tried to do away with these
excesses of capitalism, we got central planning, and we all know
now how well that worked. Hayek and Keynes were both right.
Regulation should try to curb some of the more
egregious excesses of a decentralised capitalist market economy,
but without killing the goose that lays the golden eggs. In the
UK, the pendulum towards de-regulation and self-regulation has
probably swung too far. It will, however, be difficult to tighten
up unilaterally, as business would no doubt be lost to other jurisdictions
with more relaxed standards. Regulation of financial markets and
institutions at the EU level would be a major step forward. After
that, intergovernmentalism, that is, cooperation between national
(or supranational) regulators and tax authorities, will have to
take over, to stop the regulatory race to the bottom from discrediting
financial globalisation altogether.
Borio, C, C Furfine and P Lowe (2001): "Procyclicality
of the financial system and financial stability: issues and policy
options", in Marrying the macro- and micro-prudential
dimensions of financial stability, BIS Papers, no 1, March,
Caballero, Ricardo J (2006), "On the Macroeconomics
of Asset Shortages", November 2006. Forthcoming: The
Fourth European Central Banking Conference 2006 Volume.
Desroches, Brigitte and Michael Francis (2007), "World
Real Interest Rates: A Global Savings and Investment Perspective",
Bank of Canada Working Paper 2007-16, March 2007.
Gordy, Michael B and Bradley Howells (2004), "Procyclicality
in Basel II: Can We Treat the Disease Without Killing the Patient?",
Board of Governors of the Federal Reserve System; First draft:
April 25, 2004. This draft: 12 May 2004.
Kashyap, A K and J C Stein (2004): "Cyclical
implications of the Basel II capital standards", Economic
Perspectives, Federal Reserve Bank of Chicago, First Quarter,
33 Financial Times, 8 October 2007, EU plans
market reforms to avert crisis, Back
Nothing much can be concluded from eyeballing the ex-post saving
and investment rates in Figure 4. They are supposed to be identically
equal, and any difference represents just measurement error. Back
An Overnight Indexed Swap is a fixed/floating interest rate swap
with the floating leg tied to a published index of a daily overnight
rate reference. The overnight rate is close to the policy rate,
so the fixed leg of an OIS swap can be interpreted as the market's
expectation of the policy rate over a three-month horizon. Back
The damage done by weaknesses in the design of the framework for
financial stability and the implementation of policy by the three
key players, the Treasury, the FSA and the Bank of England should
not be exaggerated. The position of London as the world's primary
financial centre is threatened more by its grossly inadequate
transportation infrastructure, its excessive cost of living (especially
housing) and sub-standard and/or wildly expensive primary and
secondary education facilities than by anything connected with
the recent financial crisis. Back