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"?Authorities moved too quickly to solve the 2008 financial crisis.’
That’s a statement you don’t hear very often, but it’s an idea that comes courtesy of an innocuous-enough sounding BIS working paper* by Claudio Borio, Bent Vale and Goetz von Peter.
It’s a comparison of policy responses to today’s financial crisis with the Nordic banking crisis of the early 1990s. The so-called Swedish model, when governments forced asset writedowns, recapitalised and even nationalised some ailing banks, is one that’s often held up as an exemplary way of solving systemic banking crises. But in doing their comparison, the authors offer up an interesting critique of what might be missing from the more recent responses to financial crises.
Here’s the thrust of their thesis:
That said, the factor we would like to stress, as it has received less attention, relates to accounting conventions and, specifically, the coexistence of large credit portfolios that are valued on a fair value basis (marked to market where possible) with traditional loan books valued on a amortised cost basis. The current crisis was triggered by losses on mark to market portfolios; those in the Nordic crises by losses on traditional loan books. Mark to market accounting recognises losses much earlier than amortised cost accounting does. Paradoxically, this prompter recognition, and the earlier intervention it triggered, has actually complicated resolution in some crucial respects. For one, it has made it harder for authorities to exert the degree of control necessary to clean up balance sheets. For the most part, mark to market losses have wounded institutions but have not been large enough to make them technically insolvent, given the size of the loan books. This has inhibited the application of strict conditions or the enforcement of writedowns, given the higher risk of infringing the property rights of shareholders when the residual value of equity remains positive. In addition, the funding disruptions caused by mark to market losses may have clouded the interpretation of the underlying problems. For some time, what was fundamentally an incipient solvency crisis was treated more as a pure liquidity crisis. It was widely believed that the sharp asset price declines would be temporary and that central bank liquidity support would restore market functioning and effective intermediation. The looming losses on loan books did not receive equal attention. Partly as a result, the authorities stressed the need to sustain credit supply and aggregate demand rather than that of enforcing adjustment.
If this analysis is correct, there is a risk that existing policies may delay the restoration of conditions for a self-sustaining recovery in which the financial system can operate profitably and efficiently without public support. And contrary to received wisdom, it may be possible for the authorities to intervene too early. They may be caught in no man's land. The analysis puts a premium on the intensification of current efforts to repair balance sheets and remove excess capacity. It also suggests that, in future crises, policymakers should be alert to the possibility of intervening too early, and adapt their crisis management and resolution practices accordingly.
In a (BIS) nutshell then, what happened in late 2008 was that at the first sign of mark-to-market losses on bank assets, and the "?systemic event’ of Lehman collapsing, governments moved quickly to alleviate the issue, mainly with liquidity provision and sometimes recapitalisation via Tarp etc.
In contrast, when the Nordics were in trouble, it was much later in the financial cycle. They didn’t have as many assets held at fair value, so intervention took place when their held-to-maturity loan books were in trouble — when the banks themselves were on the cusp of insolvency.
That meant it was much easier for Nordic regulators to go in, write down assets and recapitalise accordingly. In contrast, in the current crisis, authorities were slightly more hamstrung. Either investors didn’t think their banks were insolvent, or regulators didn’t think they needed to intervene.
It was, they said, a liquidity problem.
Asset prices had vastly undershot their real value, and would eventually recover. What they didn’t imagine was a looming insolvency crisis as the slow-drip of losses on banks’ (much bigger) loan books came through. You can see the relative timing of the two crises in the below charts:
So say the BIS academics.
And it’s certainly something to think about as Europe debates the methodology of its bank stress tests, and others debate whether the stress tests will actually result in any bank recapitalisation.
* The link to the paper, which was published on the BIS website on Friday has mysteriously gone missing. Hence, us uploading our own copy.
Related links: The Fed’s last QE experiment… - FT Alphaville Recapitalise, or resisting the lure of liquidity – FT Alphaville Accounting is semi-officially exonerated from causing crisis - FT Alphaville Stress tests and sovereign solvency… – Bronte Capital
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