Archive for September 7th, 2007

Banking Crises

September 7, 2007

I think you need to be a superman to keep up to the huge research literature being shared across. On top of that, you have number of conferences being hosted where number of ideas are shared and are important to read.

I am still struggling with comments given in Jackson Hole Symposium and we have another conference being hosted by San Francisco Fed. The topic is Asian Financial Crisis Revisited. (This is also one of the hot topics in conferences these days; as it has been 10 years since the crisis took place)However, the saving grace is that most papers are still not on the website. So atleast for sometime dont have to bother with new ideas on the subject.

However, Randall Krozner’s (Governor, Federal Reserve)  opening speech in the conference is available. And it is a wow.  A primer on banking sector and its impact on real economy.

He mainly discusses the findings of his recent paper ‘Banking Crises, Financial Dependence, and Growth’. I could not find the recent paperbut the earlier version is here.

As the conference is on Financial Crises, he discusses the same but focuses on banking sector – If Banking system collapses what happens? It makes sense as Banks are the major component in a financial system and more so in Asian countries.

What is Banking Crisis?

The definition of banking crisis I will use today, consistent with the definition in our recent paper, is an episode during which the capital of the banking sector has been depleted due to loan losses, resulting in a negative net worth of the banking sector.

What does the paper aim to find?

In particular, we investigate whether the impact of a banking crisis on sectors dependent on external sources of financing varies with the level of development of the financial system.  If the banking system is the key element allowing firms that depend heavily upon external funding sources to finance their growth, then an impairment of these intermediaries–in a system where such intermediaries are important–should have a disproportionate contractionary impact on precisely those sectors that flourished in “normal” times, due to their reliance on banks.  Thus, an important element of our analysis is the level of development of a country’s financial system, that is, whether it is “deep” (more developed) or “shallow” (less developed).

What are the findings:

More specifically, we find that in well-developed and deep financial systems, sectors highly dependent on external sources of funding tend to experience a greater contraction during a banking crisis than do externally dependent sectors in countries with shallower financial systems. In other words, sectors of the real economy that rely heavily on external finance (that is, do not fund capital expenditures through cash flow) tend to experience a substantially slower growth of value added during a banking crisis than those sectors that do not rely so heavily on external funding.  This effect is more pronounced in countries with more developed financial systems.  Our results hold for a wide group of countries and over a long time span, but as I note below, have particular relevance to emerging market countries. 

He then discusses the results in a bit more detail (and don’t worry no numbers are there) and suggests that good health of banking system is very important.

Read the entire thing. It is an excellent summary of many ideas.

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Solutions for fixing subprime mess

September 7, 2007

I am trying to read through the speeches given in the just held Jackson Hole Symposium as reading papers take a lot of time. So far I have covered Bernanke and Feldstein. Both have interesting observations to make.

I just finished speeches by Stefan Ingves, Governor, Sveriges Riksbank and another by Ed Gramlich. Gramlich could not make it to the conference as e was ill. His comments were stated by David Wilcox, deputy director of research at the Fed. And then he passed away on Sep 5, 2007.

Ingves gives a perspective on the view on housing markets from a central bank that practices inflation targeting. As I have mentioned earlier, inflation targeters just look at inflation and ignore the rest. However, if asset prices are a threat to inflation, then they need to look at the problem.

He explains, Riksbank follows the same approach and is criticised both ways for their approach. Some say they put  much emphasis on asset prices some say they put little emphasis. But again like most he says there is not a very clearcut framework on how asset prices lead to building inflationary pressures in the economy and the need for central banker to focus on asset prices as well.

He believes it is better if we could reduce the probability of any negative event beforehand rather than fixing it after it happens.

The comments from Gramlich enlightened me further on the subject. When everyone is talking about solutions like cut in fed funds rate, effectiveness of discount rates, Bailouts from the government etc, we have some different ideas from Gramlich. It is a must read.

He says subprime has led to large number of people having their homes. America’s homeownership increased from 64% to 69% making US having one of the highest homeownership rates.  Subprime originations grew from 0 to $625 bliion a 26% annual increase.

Why the growth? Apart from Bernanke’s reasons Gramlich adds that decline of usury laws allowed lenders to make higher priced mortgages. This along with Bernanke’s reason of financial innovation and information technology led to the huge growth.

Now his ideas on the cource of problems. He had written a book on subprime earlier so he has more ideas than most:

1) He says there is more regulation for prime lenders than subprime lenders and it should be the other way round. Prime lending is done by commercial banks which are supervised where as most subprime by entities that are not federally supervised. Hence we have a problem.

2) This is a corollary of first.  We have more exotic products in subprime tha in prime. Prime has mostly fixed rate mortgages where as latter has all kinds of stuff. So we sell risky loans to least sophisticated borrowers. Nice idea this:-)

3) He says subprime markets losses could be minimised if some distressed properties could be bought and rented out.

His solutions for fixing the mess are changes in supervision and regulation and not lowering the fed funds rate. Between his ideas he suggests how changes can be made in current regulations to address this problem.

A nice, different perspective. However, changing regulations is not that easy. 

And then, he does not address the bigger problem. The subprime problem has two sides to it. One is the subprime loans itself which he addresses and two the financial innovation (securitization etc) which he does not really address.This is understood as he was an expert in matters pertaing to the former as this statement shows.

But, latter is a bigger problem as no one knows how big the problem is. The Banks etc have fuzzier balance sheets and it is difficult to understand how much exposure each one has. Hence, the problem remains unaddressed and only time will tell what will happen.

Keep posted for developments.

Assorted Links

September 7, 2007

1. Rodrik points to French view on Globalisation.

2. James Hamilton of Econbrowser on Fin Markets.

3. Jaspal Singh in ET has a nice article on Formula One.

4. ET reportsMinistry of Corporate Affairs has declared Sep 2007 as Month of Increased Investor Awareness. Why just one month? The website makes no mention of the same.

5. Madhukar Sabnavis has a nice article in BS on the way advertisements have evolved.

6. TCA points to a new paper in his Friday Column. This one is on Healthcare in India.


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