The global financial crisis is “a crisis of credit markets”, says Malcolm Edey, Assistant Governor (Economic) of the Reserve Bank of Australia.
In an address to the Foundation for Aged Care Business Breakfast in Sydney, Edey traced the origins of the financial crisis, discussed its effects and looked at responses to the crisis.
Text of Reserve Bank Assistant Governor Malcolm Edey’s speech:
I’ve been asked to talk this morning about the current financial crisis: where it came from, and the effects that it’s having on the economy.
What we refer to as the global financial crisis is, at its core, a crisis of credit markets, centred particularly in the United States, the UK and Europe, but with significant spill-over effects to the rest of the world.
Over the last year or so, financial institutions in the major economies have reported losses on a large scale. Some of these institutions have become insolvent, or have had to be taken over or rescued by their governments. Associated with all of that has been a massive swing in the appetite of world financial markets for risk, and in their capacity to accept risk. The result has been a shift from easily available credit to tight credit.
This type of financial cycle, while very severe in the current case, is not new. In the course of my studies a number of years ago, I came across the following description of the kind of thing that can sometimes go wrong in credit markets. The author writes, in language that might now seem a bit quaint:
‘At periods of this kind [that is, of general optimism] a great extension of credit takes place. […] A generally reckless and adventurous feeling prevails, which disposes people to give as well as to take credit more largely than at other times, and give it to persons not entitled to it.’
The author goes on to say that such an episode is typically followed by a reaction which may include ‘in extreme cases, a panic as unreasoning as the previous over-confidence.’ The overall result is ‘an unusually extended employment of credit during the earlier period, followed by a great diminution, never amounting however to an entire cessation of it, in the later’.1
Those words were written by the philosopher and early political economist John Stuart Mill. He was describing a bout of credit excess, associated with speculation in the cotton market, that took place in 1825. But with a few adjustments, Mill’s observations could serve as a description of events in our own time. These events are still unfolding, and I’m not in a position to predict how they might develop from here. What I want to do this morning is to focus briefly on three questions:
- how did the current crisis come about?
- how is it affecting the world economy? and
- how are governments and central banks responding to it?
1. How did the crisis come about?
One way of getting at that question is to describe the sequence of events through which these credit market strains became apparent.
The immediate background to the crisis was the emergence of problems in the US market for sub-prime housing loans in the first half of 2007. Sub-prime loans, in US terminology, are essentially loans that don’t meet standard criteria for good credit quality, such as a sound credit history on the part of the borrower, good income documentation or a conservative loan-to-valuation ratio. Their nearest equivalent in Australia is what we call ‘non-conforming loans’.
But, whereas non-conforming loans have never been more than a tiny part of the Australian market, sub-prime lending became very significant in the US in the middle part of this decade. By 2006, these loans were about a fifth of new housing lending in the US, and they amounted to an estimated 15 per cent of the stock of housing loans outstanding. And they were vulnerable to rising default rates as lending standards slipped and as the overheated housing market turned down, from late 2006 onward.2
A feature of this period was that the loans were increasingly being securitised by the original lenders to be sold off to other investors. This occurred partly through conventional mortgage-backed securities but also, increasingly, through more complex products called collateralised debt obligations (or CDOs), that came to play an important part in the spreading of the crisis.
CDOs work by layering the claims on a pool of mortgages into tranches that give the senior claims a buffer against losses. That structure enabled some of these securities to gain high credit ratings even when the average quality of the underlying loans was poor. In combination with their relatively high yields, these features made them seem highly attractive to investors. What wasn’t well-understood, though, was that the layering structure could result in substantial losses, even to the senior tranches, in the event of a generalised downturn in the market, which is what subsequently occurred.
When these problems first became apparent, in the first half of 2007, the effects seemed to be confined largely to the US. The first significant impacts on global markets began in August 2007. It was at that time that the major French bank BNP?Paribas announced the suspension of three of its funds that were investing in US mortgage securities.
That announcement drew attention to the fact that a number of European banks, or off-balance-sheet vehicles associated with them, had invested heavily in these securities and could therefore be exposed to significant losses. But uncertainty about the size and location of these exposures meant that financial institutions in general suffered a serious loss of investor confidence. The result was that risk spreads in credit markets widened markedly, and banks found it more difficult, and more expensive, to obtain funding through financial markets. These developments placed already strained institutions under further pressure.
I should stress, by the way, that Australian banks have been much more prudent than their overseas counterparts, and they have remained in sound condition throughout the crisis period.
In the months that followed on from August 2007, market sentiment fluctuated, but the crisis widened as more information about the scale of losses was revealed.
Some of the big developments were:
- the run on the British bank Northern Rock in September 2007, which led to the bank being nationalised;
- a string of large-scale losses announced by major banks and investment banks in the US and Europe, beginning in late 2007; and
- the rescue of the US investment bank Bear Stearns.
The Bear Stearns rescue, which took place in March 2008, appeared for a while to mark a turning point. For a few months after that, market conditions settled down and credit spreads started to narrow, though they remained well above pre-crisis levels.
But the crisis intensified sharply with some events that occurred in September 2008, and particularly the failure of the US investment bank Lehman Brothers.
The Lehman failure was significant because it was the first time in the crisis that losses were incurred by creditors of a major financial institution. It sparked a severe loss of confidence not just in the financial sector, but across households and businesses more widely. In the weeks that followed, world equity markets experienced a period of extreme volatility, and equity prices fell in net terms to eventually reach levels around 50 per cent below their most recent peaks. It was during this period that governments around the world moved to guarantee deposits in their banking systems. They also took a series of other measures to support their financial systems, which I’ll come to shortly.
In the period since September last year, there have been no further major failures of financial institutions. But markets have remained under strain, and it has been in the post-Lehman period that the most severe effects of the crisis on global economic performance have been observed.
The chronology that I’ve just outlined gives us an idea of how the crisis happened in a mechanical sense. But it doesn’t get to the deeper question of the underlying causes. This is something that has been much debated over the past year of so, and it’s fair to say that explanations have centred on two sets of factors.
The first of these revolves around the low interest rate structure that prevailed in the major economies for much of the early part of this decade. The US, the Euro area and Japan all ran unusually low interest rates during that period. The reasons that they did so are themselves subject to debate. They were partly related to cyclical economic conditions in those economies and partly related, at a deeper level, to global savings imbalances.
But whatever we take to have been the ultimate driving factor behind the low interest rates of that period, it encouraged what’s widely referred to as a ‘search for yield’ in financial markets, in which investors sought to increase their returns by taking on more risk. This was an environment that was conducive to the kind of financial cycle that JS Mill was talking about in the passage I quoted earlier. It doesn’t mean that a financial bubble was inevitable in these circumstances. But we know that these events do occur from time to time, and they are more likely to occur in times when credit is cheap.
So this first line of explanation stresses the factors that are common to all financial bubbles – in particular the combination of cheap credit and a general increase in the appetite for risk.
The other set of explanations focuses on those features of the financial system that encouraged the particular types of risk-taking that were prevalent on this occasion, and that made this financial cycle different. Included in that category were the growing use of off-balance-sheet vehicles and structured securities, weaknesses in risk controls on those activities, and the unhelpful role played by credit rating agencies.
I’ve commented on another occasion that the unintended consequences of financial regulation can help to shape the types of risk that end up being taken in this kind of environment. The most obvious example of that is bank capital regulation. Banks in the US and the other major economies responded to the incentive to economise on capital by shifting more and more of their activities into off-balance-sheet vehicles. In this way, a set of regulations intended to contain a certain type of risk actually had the effect of shifting risk into the unregulated sector.
I might add that a similar point can be made with respect to private-sector practices – that is, the informal network of market conventions, investment mandates and rules of thumb that govern investor behaviour. All of these things contribute to shaping the direction of financial innovation and the nature of risk-taking. I suspect, for example, that much of the demand for CDOs came from rule-based investors whose mandates required them to invest in securities with a minimum credit rating. Or from naïve investors, like local governments, who were using rules of thumb roughly along the lines of ‘invest in the AAA-rated securities with the highest yield’.
Just as regulators are now in the process of reviewing their structures and practices in response to the lessons learned from the crisis, investors and other market participants are likely to be doing the same.
No doubt, the debate on lessons from the crisis will go on for some time, and I’ve been able to do no more than give you a brief overview of some of the issues today.
Let me go on, even more briefly, to my remaining two questions.
2. How is the world economy being affected by the crisis?
There’s no doubt that conditions in the major economies took a sharp turn for the worse in the period following the Lehman collapse in September last year. Business and consumer confidence deteriorated markedly, as did financial sentiment.
In the general climate of uncertainty, households around the world responded by cutting their discretionary spending. This seems to have had a particularly pronounced effect on demand for manufactured goods. The result was a sharp fall in global industrial production late last year, and significant contractions in GDP in most of the major economies. The Chinese and Indian economies continued to expand, but at much reduced rates. Indications are that world economic conditions have remained very weak in the early part of 2009.
A useful way of summarising these developments is to look at the evolution of official forecasts by bodies such as the IMF. As recently as July last year, the IMF forecast for world growth in 2009 was 3.9 per cent, or close to average. Revised forecasts released in January were cut back to growth of ½ per cent, and it now looks likely that the next revision will show a contraction in world GDP this year.
A shift in the forecast of this magnitude within such a short period of time is, to my knowledge, unprecedented. I don’t say that as a criticism of the forecasters, but as an indication of how quickly the situation has been changing, especially over the last six months. On the latest forecasts, growth of the world economy is expected to resume in 2010, as the various policy measures that are being put in place gradually take hold.
3. How are authorities around the world responding to the crisis?
It’s important to recognise that substantial actions are being taken on a number of fronts to restore growth and to improve the functioning of financial systems.
On monetary policy, central banks around the work have cut their policy interest rates to very low levels. They’ve supplemented that with a range of actions to provide additional liquidity to financial markets.
In addition to that, governments in the major economies have provided direct support to their financial institutions. They’ve done that through a variety of mechanisms including direct capital injections, asset purchases and the provision of various forms of guarantees. More still needs to be done, but one encouraging sign is that banks have been able to make good use of their capacity to issue guaranteed bonds, and this is helping to alleviate uncertainty about the availability of longer-term funding.
Another area of substantial response has been in fiscal policy. Many of the large countries including the US, the UK, Germany and China have announced major packages to support demand in 2009 and in 2010. In total, discretionary fiscal measures announced since late last year will provide a stimulus of close to 2 per cent of world GDP in 2009. This is in addition to the effects of the automatic fiscal stabilisers, which are themselves quite substantial.
Finally, I should note that considerable work is underway on reforming financial regulatory policies. Without going into details, the overarching issue here is the need to better contain financial risk taking, and to do so in a way that remains effective as the financial system evolves. As I said earlier, experience suggests that regulations aimed at containing risk-taking can result in risk being pushed out to the unregulated part of the system. It’s in the nature of markets that they will tend to innovate around regulations, and in any case the nature of risk-taking is going to keep changing as financial systems get more sophisticated. All of that highlights the need for regulatory frameworks to be adaptable to changing circumstances.
Because of the interdependency among financial systems, these issues necessarily have to be tackled cooperatively at an international level. Considerable work is being done on this front by the major international bodies, including the Financial Stability Forum and the G-20, and Australia is playing an active part in that.
To conclude, financial cycles like the one we’re having now are not new, but this one has been very severe, and it entered a particularly intense phase with the collapse of Lehman Brothers in September last year. These events have driven a sharp downturn in global demand and activity. In this environment, it’s not going to be possible for Australia to avoid some further weakness in 2009.
Nonetheless, it’s important to recognise that some very substantial actions are being taken around the world to alleviate financial strains, and to restore growth over time. Australia is fortunate to have come into this period in better shape than most, with sound financial institutions, and with more scope than most for macro-economic policies to respond as needed.
Once again, I want to thank the Foundation for the invitation to speak today, and I wish them success in their very important work.
- The quotations are from JS Mill, Principles of Political Economy, Book III, Chapter 12, ‘Of the influence of credit on prices’. (back to text)
- The chronology summarised here is drawn from the G-20 Study Group on Global Credit Market Disruptions, October 2008 (http://www.g20.org/Documents/sg_report_on_global_credit_market_disruptions_071108.pdf).