N E A E F The Cause and the Cure of the Current U.S. Financial - PowerPoint PPT Presentation

N E A E F The Cause and the Cure of the Current U.S. Financial Crisis O c t o b e r 2 0 , 2 0 0 8 N a n k a i U n i v e s i t y Prof. Yoshinori Shimizu, Ph.D. Hitotsubashi University Tokyo, Japan

Two Largest Economies of the World (Japan & the U.S.) both experienced Bursts of Real Estate Bubbles International Spread of the Financial Crisis What’s Wrong? What to Change? The Cause: BIS International Banking Regulation The Cure: Use the Free Market Mechanism

→ 1988: The Bank of International Settlement (BIS) introduced a Regulation for international banks to keep their own capital ratio more than 8% of the total assets. (2004: introduced revised version, Basel II) → Assets (loans, securities, etc.) are limited to less than 12.5 times of its own capital. → Limits the profit size. Bank Loan, Capital Markets, Real Estate Markets ・ A Single, Unified, & un-separable Market ・ Only Banks are regulated ・ Technical Progress in the Financial Markets → Bank’s natural reaction → Regulatory arbitrage → Securitization, new financial commodities, etc.

BIS Capital Regulation → Changed the Global Financial Markets BIS Regulation ＝ Focuses only on the soundness of banks in a single consolidate financial and capital markets Financial Unbundling Bank’s Reaction Securitization → Regulatory Arbitrage Off balancing Assets Establish unconsolidated SIVs Growth of Investment Funds Benefited banks in countries with large capital markets → Created International Competitive Inequality → Bank’s risks spread to the whole financial system → True Risks have been covered up

Theoretical Expectation Securitization → Isolating Risks from Banks Enhanced Raise the BIS Ratio Bank Soundness Specialize High Return Business Reality Risk Isolation Impossible ← Un-separable & Complex Relationship between Banking and Capital Markets ・ Banks gave large loans to buyers of Securitized loans ・ Banks established SIVs that hold Securitized loans ・ Vague SIV Consolidation Standard → Cover up the Deteriorated Own Capital Ratio ・ Accurate Valuation of Securitized loans Impossible → Un-transferable Risk Information → Poor Traceability to Original Assets

Defects of the BIS Regulation: → Regulates only banks in a consolidated single & larger financial market → No Theoretical Rationale for enhancing bank soundness → No Evidence for enhancing bank soundness → Actual Implementation diverts from the theoretical concept Bank Management = To find the best mix of ・ Rate of return ・ Bad loan ratio ・ Own capital ratio ← Only this index is regulated ・ Many other management indices → Pro-cyclicality (enlarges business fluctuations) ← an unchanged & unique risk level of the financial market → Aggravates an economy at a time of macro-shock

Reality of the BIS Regulation Tier I (Globally uniform basic items) BIS Capital = Tier II (Each country can define arbitrarily up to the amount less than Tier I) ・ Measures taken to keep the 8% capital ratio: → Definition of Tier II has been kept enlarged ・ 1988: 45% of unrealized profit from held equities, ・ 1990: Subordinate debts ・ 1998: 45% of revaluation of real estate properties ・ 1999: Deferred tax assets (effective tax rate times the future expected taxable income for over 5 years) → 1998-1999: Public money Injection → This effort deserves credit. ・ Otherwise, Japanese economy must have been Much Worse! → Same with the successive bailouts in the U.S. now

･ BIS Capital ratio → • Impossible for outsiders to know → • Too complex → Use of own internal model are allowed for • large banks → • Does not reflect true bank soundness Hard for regulators to assess the correct value

F i g . 1 R a t i o o f T i e r I a n d T i e r I I : M a j o r B a n k s A v e r a g e 第２ 図 T i e r 1 とT i e r 2 の推移 大手行平均 8 7 6 5 % 4 3 2 1 0 月 月 月 月 月 月 月 月 月 月 月 月 月 月 年3 1 9 9 0 年3 1 9 9 1 1 年3 9 9 2 年3 1 9 9 3 年3 1 9 9 4 1 年3 9 9 5 1 年3 9 9 6 年3 1 9 9 7 1 年3 9 9 8 年3 1 9 9 9 2 年3 0 0 0 年3 2 0 0 1 2 年3 0 0 2 2 年3 0 0 3 0 1 2 3 4 5 6 7 8 9 0 1 2 3 9 9 9 9 9 9 9 9 9 9 0 0 0 0 9 9 9 9 9 9 9 9 9 9 0 0 0 0 M a r c h 1 1 1 1 1 1 1 1 1 1 2 2 2 2 T i e r I R a t i o T i e r I I R a t i o T i e r 1 比率平均 T i e r 2 比率平均

F i g . 2 M a j o r C o m p o n e n t s o f T i e r I I : R a t i o s f r o m H i d d e n A s s e t s a n d f r o m D e b t s M a j o r B a n k s A v e r a g e 第３ 図 T i e r 2 の主要な構成要素 資産含み益と負債からの算入額の推移（ 大手行平均） 5 4 Ｄ ｅ ｂ ｔ ｓ 3 % 2 1 Ａ ｓ ｓ ｅ ｔ ｓ 0 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 月 月 月 月 月 月 月 月 月 月 月 月 月 年3 年3 年3 年3 年3 年3 年3 年3 年3 年3 年3 年3 年3 M a r c h 0 1 2 3 4 5 6 7 8 9 0 1 2 9 9 9 9 9 9 9 9 9 9 0 0 0 9 9 9 9 9 9 9 9 9 9 0 0 0 1 1 1 1 1 1 1 1 1 1 2 2 2 資産から の含み益比率平均 負債から の算入額比率平均

What is a Better Measure? ・ A Market-Valued Own Capital Ratio = (Total market value of the bank/Total asset) → A better & more transparent measure → Reflects true bank soundness → Markets see through true bank soundness → A bank fails when it drops to 2% → Negatively correlated with bad loan ratio Let’s take a look of the data →

F i g . 3 B I S R a t i o o f C i t y B a n k s

F i g . 4 M a r k e t V a l u a t i o n o f C a p i t a l R a t i o : C i t y B a n k s

F i g . 5 B I S R a t i o a n d M a r k e t V a l u a t i o n o f C a p i t a l R a t i o : A l l C i t y B a n k s A v e r a g e

M i z u h o F i g . 6

F i g . 7 M i t s u b i s h i U F J

M i t s u i S u m i t o m o F i g . 8

R i s o n a F i g . 9

F i g . 1 0 H o k k a i d o T a k u s h o k u B a n k B I S C a p i t a l R a t i o M a r k e t V a l u a t i o n o f C a p i t a l R a t i o

J a p a n L o n g - t e r m C r e d i t B a n k F i g . 1 1

J a p a n C r e d i t B a n k F i g . 1 2

A s h i k a g a B a n k F i g . 1 3

F i g . 1 4 B a d L o a n R a t i o : C i t y B a n k s

F i g . 1 5 B I S R a t i o , M a r k e t V a l u a t i o n o f C a p i t a l R a t i o , a n d B a d L o a n R a t i o : A l l C i t y B a n k s A v e r a g e

Conclusion The BIS capital regulation → has been obsolete through technical progress in the last 20 years → has facilitated number of financial innovations that led to international consolidation of financial markets (Bank loan markets, Capital markets,Real estate markets, etc…..) → has introduced a greater volatility to the global economy due to its pro-cyclicality. → has facilitated international spread of financial risks → has obscured the real risks The Market-valued own capital ratio → is a more accurate & more transparent measure of bank soundness → Let banks free to choose their own capital ratio → Once regulates, governments are captured → Let markets free to evaluate & control bank’s behavior → Moral Hazard is ubiquitous! → Need to create global financial system free from moral hazard