Eric D Cruikshank, Eric D Cruikshank-Distressed Financial Markets - Navigating The Shoals of Liquidity Risk-Euromoney Institutional Investor (2008)

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Distressed Financial Markets:

Navigating the Shoals of Liquidity Risk
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Distressed Financial Markets:

Navigating the Shoals of Liquidity Risk
Eric D. Cruikshank
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To Cleo
for your encouragement to write this book
and your love and support throughout
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Contents
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Chapter title
Contents
Foreword xi
About the author xiii
Introduction xv
Part 1 – The framework
1 Financial crises and their origins 3

Early examples 3
Boom–bust dynamics 7
Who to blame – external or internal causes, crowds or
policy-makers? 11
The problem with statistics and probabilities 14
2 Evolving characteristics of financial markets 17

The institutional importance of a financial market perspective 17
The role of legal frameworks 18
Macroeconomic preconditions 21
Intermediation and disintermediation – how banks and securities
markets handle risk 22
The functions of financial markets and their trade-offs 24
Liquidity – what does it mean? What does it matter? 26
The convergence of markets and institutions 28
Factors affecting the stability of financial markets 37
3 Systemic liquidity and financial market distress 40

The distinction between individual and systemic liquidity 40
Identifying financial market distress 42
Early warning signs of systemic financial distress 51
Macroeconomic and financial sector assessment and surveillance 54
4 Financial risk management and liquidity risk 57

Evolution of the markets for hedging products 57
The securitisation explosion and its influence on global financial
markets 72
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Contents
The symbiosis between risk markets and securities markets

(strengths and weaknesses) 76
The difficulty of hedging against sudden illiquidity 83
Best practices in institutional liquidity risk management 84
Part 2 – Country cases and global trends
5 Country case histories of financial market distress 89

Spain (1977) 89
Chile (1982) 91
United States Savings & Loan (1985) 95
United States Black Monday (1987) 99
Norway (1987) 102
Finland and Sweden (1991) 104
Japan (1992) 105
Mexico (1994) 108
South Korea and East Asia (1997) 112
Russia (1998) 115
Brazil (1999) 117
United States dot-com (2000) 118
Argentina (2001) 121
Lebanon (2002) 124
United States sub-prime (2007) 126
A practical typology for the country case histories 141
6 Financial globalisation – global trends and the new functions,

institutions and markets and their importance for financial
market distress 146
The migration of liquidity – how sustainable are emerging
capital markets? 146
Basel II and its ramifications 147
Banks and the end of entitlement 148
Financial institutional form follows function 148
Global imbalances and its mirror image: the rise of sovereign
wealth 149
The new institutional realities 150
Current developments in financial markets 158
Part 3 – Lessons for policy-makers and portfolio managers
7 Lessons from financial crises for policy-makers 163

Thoughts on contagion 163
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Contents
Thoughts on orthodox and heterodox economic policies 170

Sequencing economic liberalisation 175
Prescriptions for individual countries 178
When financial crisis crystallises 182
Macroeconomic policy lessons 182
Financial supervision and regulation 183
Global considerations 190
8 Lessons from financial crises for portfolio managers 193

The limits to hedging 193
The use of financial leverage 199
Asset allocation 200
Are sovereign ratings sufficient or should portfolio managers
develop their own country scorecards? 202
Active versus passive management and separating alpha and beta 203
Developing the institutional capacity to monitor and manage
liquidity risk 206
9 Conclusion 209
Annex 1 Treynor’s models of market bubbles 215
Annex 2 Securitisation and the market for structured finance products 219
Bibliography 224
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Foreword
Foreword
The focus of this book is on financial markets, the ways they can become distressed, and
the actions that can be taken to at least mitigate the severity of the impact of distress.
However, the definition of ‘market’ will be applied quite broadly since the signs of distress
can originate in environments or ‘transaction spaces’ lacking many of the features of the
highly liquid and well-organised markets we recognise today.
For example, the US housing market has on at least two occasions – notably during the
S&L crisis of the 1980s and the sub-prime crisis in 2007 – been at the root of abundant financial
market distress. And although we use the term ‘market’ in connection with housing, clearly
transactions in this sector lack many of the features of homogeneity, continuity, liquidity, and
price discovery found, for example, in the bond market. In fact, even within the US bond market,
the extent to which these attributes vary across sub markets for different types of instrument is
sufficiently wide as to have some of them overlap with the products of banks and other financial
institutions for which the term ‘market’ is less rigorously applied.
Another example is the ‘market’ for banking services. To the extent that a bank-
dominated system involves competition among privately-owned banks (or combinations of
privately-owned and state-owned banks), market forces are at work even if the precise ser-
vices and corresponding assets themselves are not as readily transferable as capital market
instruments would be. Yet, in times of trouble, the phenomenon known as the ‘flight to
quality’, whereby depositors remove their savings from institutions perceived to be weaker
in order to shelter them in those seen as being stronger, is in its own way an example of
the market at work.
Finally, with most countries having opened their capital accounts so that financial capital
can move freely in or out, an understanding of the dynamics of a domestic bank run today
has broader applicability. This occurs because as bank deposits, whether denominated in the
domestic currency or held in local banks in foreign currency accounts, become increasingly
owned by foreigners and sophisticated local inhabitants who are free to invest in other
markets, the idea of a bank crisis being contained to just the banking sector has become
no more than a theoretical construct. In fact, while examples are provided in this book of
cases in which currency crises occurred without a banking crisis having happened (for
example, Brazil in 1999), the converse is much rarer. In recent decades, it is unusual to find
a serious banking crisis that did not also precipitate worrisome attacks on the domestic
currency if not cause an outright currency crisis. This is because with open external accounts,
a bank run quickly translates into capital flight as the tighter coupling is felt among today’s
stock, debt, currency, and even derivatives markets and the banking sector. Therefore, we
will try to avoid focusing excessively on banks or for that matter any one asset market in
particular – instead following the liquidity or lack thereof – in order to gain a better view
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Foreword
as to how distress can take place in any of these segments of a financial sector and quickly
spread to some or all of the other segments.
An enquiry into the nature of financial crises and financial market distress invites the
temptation to draw heavily from the theoretical developments of recent decades which are highly
quantitative in nature. This temptation has been resisted in this book on several counts:
• Quantitative methods have added much to finance. But they have been found especially
wanting in precisely those areas addressed by this book. For the majority of circum-
stances, statistical and probabilistic approaches are valuable. When it comes to extreme
events, however, quotidian relationships break down much the way in plasma physics
distinctions among (and properties of) the three phases (solids, liquids, and gases) as they
apply to matter became exceedingly blurred. This is not to say that pioneering efforts
have not been made in trying to quantify the causes and dynamics of financial distress.
But it is still very much work in progress.
• While the quantitative models and tools used in applied finance today come from tradi-
tional theory (the efficient market hypothesis, modern portfolio theory, the capital asset
pricing model, various option pricing models and so on), many of the phenomena observed
leading up to and during financial crises are best explained under the branch of academic
finance known as Behavioural Finance. When the notion of ubiquitous investor ration-
ality is no longer handed to us as a given but instead scrutinised under the microscope
of behavioural analysis (thus allowing for individual emotions and institutional agendas,
as well as the ways in which both tend to ‘frame’ the problems and the choices they
encounter), these explanations are usually that much richer if they are not reduced
completely to mathematical formulae.
• As the purpose of this book is to reach professional practitioners, we are less concerned
with tight expositional rigour based on assumptions which greatly simplify (yet ignore
the more mathematically-intractable yet at times crucial aspects of) reality, so as to achieve
mathematical consistency. Instead, we are more interested in how to detect and deal with
financial market distress in its various manifestations in a much more practical sense –
even if this is at the expense of some degree of rigour.
In conclusion, the focus of this book is primarily an attempt to synthesise how financial
markets can become distressed as a consequence of financial institutions, instruments and
markets interacting with government policies and regulatory approaches in allocating
resources and dealing with risk. In this regard, in-depth treatment of the specific design
features and working mechanics of most financial instruments has been avoided – the excep-
tion being with respect to some of the newer structured finance products. The idea, however,
is in no way to pretend to a comprehensive treatment of securitisation and structured finance
but merely to provide enough description to illuminate how certain features of these devel-
opments, while having introduced new markets and innovative financial products, have
nonetheless introduced new types of financial market risk, which at the time of writing have
indeed crystallised on a massive scale.
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About the author
Eric D. Cruikshank is an economist and finance specialist with over 35 years of professional
experience in more than 40 countries. He currently heads his own financial advisory firm
since retiring from the World Bank Group in 2005 following nearly three decades of service.
During his career in both the World Bank and its affiliate, the International Finance
Corporation (IFC), he was professionally involved in helping resolve several of the country-
specific systemic financial crises described in this book. As a former IFC manager, he had
operational oversight responsibilities for staff in connection with new investments, portfolio
supervision and asset resolution. He also served as IFC’s nominee on the boards of several
banking and financial institutions.
Before joining IFC, he served as a World Bank loan officer, senior economist and deputy
resident representative. He was a Canadian International Development Agency (CIDA) adviser
in several countries, including serving as the executive project director for an energy and
water resource policy and planning team in Nepal.
His earlier career included stints in management consulting and securities analysis. Mr.
Cruikshank holds a BA in economics from Mount Allison University and an MBA and MA
in economics from York University.
He is the author of Adding Value in Private Equity: Lessons from Mature and Emerging
Markets, a 2006 Euromoney Books publication.
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Introduction
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Introduction
Introduction
Even the ancients recognised that nature and life ebbed and flowed. Those who readily
grasped the idea of cycles and nonlinearities with turning points became shamans or high
priests. With the benefit of reasoned observation, they would take actions to forestall the
worst effects of recognisable cycles through anticipatory action. Of course, they didn’t always
get it right, which may explain why certain tribes passed into extinction. And many of them,
when certain that their calls were right, exploited those successes to maximum advantage
to preserve their reputations as clairvoyants well beyond that which they deserved. Members
of the other group, the bulk of the populace, who either lacked the capacity or the inclin-
ation to take a critical look at events or the willingness to heed those around them who did,
found themselves constantly at the mercy of the gods. The development of a group survival
imperative, thus no doubt helps explain historically the predilection many societies have
shown for governance systems based on authoritarianism, whether theocratic, despotic, or
based on a ruling elite.
Things today have not changed all that much. When modern-day financial crises break,
we find forecasters and their followers in one group and in the other we find those who
seem to have been oblivious to ‘the signs’ all along. Like the ancients, some of the former
group tend to pass into obscurity, if not oblivion, for having made more wrong calls than
right ones (with the most recent calls, of course, more heavily weighted). Those more
successful at prediction today, as in the past, tend to advertise their successes and down-
play their failures. Many of the second group, similar also to their counterparts of the past,
continue to find themselves economically in harm’s way.
Irrespective of the era in which widespread financial distress is examined, the existence
of cyclicality and oscillating tendencies and the factors which cause them is central to under-
standing the potential for distress. Neither the amplitude of oscillations nor the frequency
of their occurrence is synonymous with financial distress. Yet many crises have culminated
after periods exhibiting fluctuating and recurring behaviour. Distress arises when those
affected by change are caught unprepared and consequently cannot respond the way they
must or would like to because of sudden lack of flexibility. The confluence of factors which
frustrates this need or desire to act very often causes contractual undertakings and rela-
tionships to break down. Things that were promised cannot be delivered and significant
disruption, with the potential for more of the same, tends to mount. Because of the bilat-
eral (or even, in some cases, multilateral) nature of economic transactions, events or factors
giving rise to a sudden failure to comply with one side of a contractual undertaking imme-
diately convey direct hardship to the counterparties to the transaction. Moreover, this hardship
occurs irrespective of any behavioural aspects.
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Introduction
To the extent that those affected by financial distress develop coping responses, these
responses often result in excessive loss. This happens through a combination of them having
both the need (whether real or perceived) to act and the propensity to panic and overreact
to the evolving situation. Such action based on panic tends to trigger similar behavioural
responses in others and thus can become highly contagious in environments where partici-
pants are able to see each other’s actions.
When pervasive crises in financial markets occur, the causes of such occurrences may
vary, the transmission mechanisms may vary, but one feature is common to all – it is the
materialisation of liquidity risk. In simplest terms, liquidity may be defined as the capacity
to meet one’s needs and obligations on a timely basis without having to expend undue effort
or incur significant losses in doing so. And the concept of liquidity risk addresses those
factors which can (or threaten to) impair this ability, irrespective of the solvency or other-
wise of the person or entity involved.
At the level of an individual person or company, the financial distress suffered, as
impaired liquidity crystallises, is usually regarded by others in society as either due to bad
luck (such as from uncontrollable externally-imposed developments – natural catastrophe,
illness, sudden loss of employment, manmade accidents involving persons or property and
the rest) or poor financial management (failure to insure, to control spending, to control
indebtedness and so on). At some point, however, when financial distress is shared by a
multitude, the problem is seen to pass from being framed as representing a number of
personal or individual problems to becoming a social problem. The point at which this
occurs, although difficult to predict, is marked by a sudden impairment of systemic liquidity
whether of a banking system, a currency market, or organised financial markets. When this
occurs, the gravity of the situation transcends the fate of a collective of individuals – no
matter how large the collective. The most serious aspect of systemic distress is the threat
it poses, if left unattended, to a country’s system of financial institutions and infrastructure
– especially, its payments system.
While easy to understand from an ex post perspective, liquidity risk is perhaps the most
elusive of all types of financial risk from the viewpoint of measuring it and drawing reli-
able early warnings. Liquidity risk is a phenomenon that has been very familiar to bankers
throughout the ages, even in countries where securities markets were non-existent or nascent.
A banker’s greatest fear in any country or financial system has always been the spectre of
arriving at the bank one morning to face a queue of frightened depositors all with one aim
in mind – that of withdrawing their deposits from the bank. But under circumstances causing
widespread financial distress, the bank run has its counterpart in either a massive stock
market sell off or mutual fund redemptions. Although the structural aspects of fractional
reserve banking are more susceptible to severe liquidity problems than in those types of
financial institution which do not employ financial leverage, nonetheless any number of
events which erode public confidence can provoke similar stampedes in the capital markets
and at other types of financial institution. It may, however, just take a more severe event to
do so.
Economic boom and bust cycles go as far back as written history. For centuries, the
technologies and institutions involved did not change appreciably. In recent years, however,
new forces have been shaping the dynamics of financial interaction and asset valuation in
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Introduction
ways that were perhaps inconceivable only a few decades ago. Factors which have changed
the financial landscape internationally include: economic liberalisation, globalisation,
telecommunications and computer technology, and the proliferation of new financial prod-
ucts and related institutions. Many of these developments were designed to improve certain
aspects of economic life and have done so. In many instances, they have introduced risk-
mitigating features themselves. But they carry with them sources of new risk and vulnerability
to liquidity problems which require new understanding, vigilance and safeguards.
An examination of distress in financial markets will start from how financial distress
can originate and affect an individual person or institution. In large measure, the scope for
action and reaction is demarcated by contractual undertakings between economic agents.
When events transpire, however, which adversely impact many agents simultaneously, the
problem shifts, as mentioned above, from one best viewed within the context of a series of
bilateral contracts to one characterised by myriad transactions and their underlying contrac-
tual arrangements entering the social and even the political sphere. The tipping point at
which these shifts take place varies geographically and in time. Up until this point is reached,
those in net debtor positions will apply one set of coping actions and net creditors will
apply another. Behavioural responses change dramatically, however, as payment problems
transition from bilateral undertakings to widespread conditions with many in society calling
for a social or political resolution. The aim of this book will be to examine the many factors
which underpin both the causes of and responses to distress in financial markets. It will
also provide recommendations to national economic managers and portfolio managers
regarding both prudential norms to avoid excessive exposure to the risk of distressed finan-
cial markets as well as loss-mitigating actions if caught unawares.
This book is divided into three parts. The first part sets forth the framework for under-
standing the causes and dynamics of financial market distress.
• Chapter 1 begins with a brief overview of financial crises and their origins, providing a
few early examples of booms, busts, manias and crashes. It addresses some of the formal
explanations of boom and bust dynamics spanning macroeconomics, financial theories
explaining the formation of asset price bubbles, behavioural finance and herding theory.
It further examines the roles that national economic policy plays on the one hand and
the mass behaviour of markets and crowds plays on the other. It concludes with a crit-
ical assessment of the problem formal explanations encounter when relying too much on
the assumptions inherent in statistical and probabilistic approaches.
• Chapter 2 explores the evolving characteristics of financial markets as they affect finan-
cial market stability and the constantly changing challenges to risk management. It
addresses such topics as the role of the legal framework, macroeconomic preconditions
for achieving a diverse financial market with ample breadth and depth, the ways in which
the once sharp dichotomy between financial intermediation and disintermediation has
morphed into a hybrid in which large financial intermediaries now play key roles in the
issuance and trading of securities and what this means for risk management. It examines
the role and significance of liquidity, the convergence of some aspects of large financial
institutions and certain segments of the securities markets. It concludes with an assess-
ment of the determinants of financial market stability.
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Introduction
• Chapter 3 tackles the pivotal role that systemic or overall market liquidity plays in
producing financial market distress. From a distinction between the liquidity associated
with being able to transact quickly and efficiently in a specific homogeneous financial
asset and that which pertains to the overall market for the asset in question or indeed a
broader swathe of the financial market, the chapter goes on to examine those conditions
leading up to and defining a broader state of financial market distress, including some
of the more important early warning signs within the context of macroeconomic and
financial sector surveillance.
• Chapter 4 provides an overview of how the advent of quantitative financial risk manage-
ment spawned markets for new types of financial products aimed at insuring or hedging
different types of financial risk. These products also supported both the explosive growth
as well as the transmutation of markets for structured finance products, particularly the
collateralised debt obligation. Despite the progress made in the development of risk
management tools, the ability to hedge against sudden illiquidity continues to pose a
major challenge. The chapter concludes with a summary of best practices in the manage-
ment of the liquidity risk facing financial institutions.
The second part provides a chronology of the main stylised facts and apparent causes of
a series of country-specific financial crises.
• Chapter 5 briefly examines some of the main similarities and differences among a selected
group of the countries experiencing financial crises in the latter half of the 20th and first
decade of the 21st centuries. These are:
• Spain (1977)
• Chile (1982)
• United States Savings & Loan (1985)
• United States Black Monday (1987)
• Norway (1987)
• Finland and Sweden (1991)
• Japan (1992)
• Mexico (1994)
• South Korea and East Asia (1997)
• Russia (1998)
• Brazil (1999)
• United States dot-com (2000)
• Argentina (2001)
• Lebanon (2002)
• United States sub-prime (2007)
• Chapter 6 examines some of the main ways in which the world began to change signifi-
cantly, even during many of the crises described in the previous chapter, as to tighten
the couplings defining economic relationships across national boundaries and indeed
among financial institutions, products and markets.
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Introduction
The third part presents some of the key lessons to be drawn from historical crises for
policy-makers as well as for those who manage portfolios of financial assets.
• Chapter 7, while not in any way intended to be comprehensive in terms of treatment or

prescriptions, attempts to draw some of the main lessons from financial crises and finan-
cial market distress which may be of use to economic policy-makers.
• Chapter 8, on the other hand, also draws selectively on a few lessons from the perspec-
tive of those responsible for managing investment portfolios whether at the institutional
or individual level.
• Chapter 9 concludes the book with several observations in the way of synthesis. It also
provides a look at the future. A caveat, however, is in order. Those expecting either
specific forecasts or predictions will be disappointed. Instead, the book concludes with
an examination of those key principles which will need to be embraced and those key
actions which will need to be taken to cushion and indeed to repair the damage done by
the massive blow to international trust and confidence afflicting financial markets, finan-
cial institutions and financial market participants even as this is written. At the end of
the day, finance, for all its sophistication, is only as good as its inherent ‘promise to pay’
is generally perceived to be. When the quality of that promise has been badly marred at
a systemic level, seeking solutions within the field of finance is likely to be frustrated.
Rather, the unequivocal focus must be on a matter which transcends finance and that is
how to restore trust.
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Part 1
The framework
Chapter 1
Financial crises and their origins
Early examples
Economic cycles can be traced as far back as written history. In the Bible, Noah’s warning
of the impending flood precipitated measures to mitigate what would have surely been the
ultimate distress scenario for mankind. It is interesting that accounts of a similar deluge
have been historically preserved and re-told by the descendants of other early societies in
various parts of the globe. Another economic cycle from the Old Testament was the Pharaoh’s
dream of seven fat cows being devoured by seven lean cows. This was interpreted by Joseph
as a portent of seven bountiful years to be followed by seven years of famine throughout
ancient Egypt. Arguably, it was the first historical account of a commodity cycle forecast.
Since we are more interested in financial markets than in the broader topics of natural
calamities and even economic cycles for that matter, we will fast forward to ages which
postdate the creation of money.
Tulip mania
Tulip mania, which was based on a phenomenon of speculative excess in 17th century
Holland, is one with which most are familiar. The speculative boom which ensued started
with rumours about the impending scarcity of certain types of prize tulip bulbs but soon
found its way into the open-air food markets of Amsterdam as even edible bulbs as well
were bid to stratospheric price levels. Like many subsequent price bubbles, the tulip bubble
burst and things returned to ‘normal’, although not without financial pain for many.
The South Sea bubble

Another early bubble occurred in England between 1711 and 1720. It began when the British
government granted exclusive trading rights to the South Sea Company (SSC) in connec-
tion with carrying goods and slaves to the Spanish colonies of South America.1 These trading
rights were predicated on the supposition that Britain would win the War of the Spanish
Succession in which it was engaged with Spain at the time. As it happened, the war ended
favourably for the British and the Treaty of Utrecht of 1713 provided the expected conces-
sion to the SSC although it was one that would not be as comprehensive as originally
anticipated.
The British government saw an opportunity to fund £10 million of government debt in
connection with the war by exchanging short-term notes for a new issue of stock in the
3
Part I: The framework
SSC with a generous annuity payment involved. Then in 1717 and again in 1719, the
Company bought significant portions of the country’s public debt (over half of the £50
million then outstanding) with further stock issues. By way of an aggressive stock promo-
tion campaign, the Company succeeded in ‘talking up’ the price of its stock from £128 per
share in January 1720 to £550 per share by May of that same year. Much of the stock thus
offered was placed with high-level government officials and notables without receiving
serious financial consideration in return and was done to curry political favour for the
Company. By publishing the names of these blue ribbon stockholders, the Company was
able to maintain an inflated share price and attract new investors at these higher price levels.
Successive rounds of buying drove the share price to £1,000 by August 1720 after which
it quickly plummeted to about £100 a share before the end of that year. Before SSC’s share
price reversed direction, it had created enormous interest not only in the Company’s shares
but in other companies as well. New companies with foreign schemes were formed, many
with entirely fraudulent claims. Some were even formed in Paris and in Amsterdam. Many
investors borrowed heavily to fund their stock purchases. Consequently, when the bubble
burst, SSC’s share price decline precipitated a fall in the share prices of other companies
as the panic spread. The rush for liquidity expanded quickly even as far as continental
Europe. Investors were furious. Thousands of individuals were financially ruined. And the
British government was forced to introduce palliative measures.
The panic of 1907

The speculative tactics of financial trusts in the United States met with strong resistance
from a number of New York bankers, one of whom was J. P. Morgan. When one of the
banks, the National Bank of Commerce, refused to honour cheques drawn on Knickerbocker
Trust, owned by F. Augustus Heinze, this action precipitated a run on the trust which trig-
gered similar runs on nearly every other trust in New York as well.
The financial panic that ensued led to a decline in the New York stock market of almost
50% from its peak in 1906. The panic eventually spread across the nation, leading to the
collapse of numerous banks and businesses. It was only with the actions of first the then
US Treasury Secretary, George B. Cortelyou, who set aside $35 million of federal money,
that the situation was stabilised. J. P. Morgan organised a team of bankers and financial
executives who redirected money between banks, secured international lines of credit, bought
up distressed corporate shares and succeeded in averting a national disaster. Confidence in
the financial sector was restored by February 1908.
However, banking reform became a major political priority. At the time, the United
States did not have a central bank. Monetary stability was achieved through the actions of
the nation’s lead bankers.
In May 1908, the Aldrich-Vreeland Act established the National Monetary Commission
to look into the causes of the 1907 panic and measures which could be taken to guard
against such occurrences in the future. The work of the Commission, particularly its
Chairman, Senator Nelson Aldrich, led to the famous Jekyll Island meeting of 1910 attended
by the country’s principal financiers. The discussions held at Jekyll Island focused on mone-
tary policy and the workings of the banking system. They paved the way for the creation
4
of the Federal Reserve System as an important institution to dampen the effects of future
financial panics. On the recommendation of the National Monetary Commission, the Federal
Reserve Act was adopted in 1913.
The Wall Street crash of 1929 and the Great Depression

An historical account of financial crises would be incomplete without reference to the Wall
Street market crash of 1929 and the Great Depression. Without a doubt, the precipitous drop
in share prices on the New York Stock Exchange (NYSE), which began on October 24 1929
(Black Thursday) and continued its catastrophic descent on October 28 and 29 (Black
Monday and Black Tuesday) was seen by the public as the start of a major economic down-
turn. The financial market dynamics, however, were only part of a much larger set of
economic problems which had been in play much earlier and which transcended inter-
national borders and the capital markets.
Many people blamed the US stock market crash as being the cause of the Great
Depression which followed. Many of these individuals used the crash and the Great
Depression to impugn capitalism (with no small measure of success at the time) and to
advance their own alternative solutions. These alternative solutions generally tended to run
along a spectrum of organisational arrangements marked by varying degrees of socialism
with a pervasive role for government in virtually all cases. What was not well appreciated
until much later was that the economic conditions following World War I evoked policy
responses in the US, the UK and the western European countries which were largely to
blame for a growing malaise. Much of the prevailing economic thinking which informed
government decision makers at that time was predicated on myths which would eventually
be de-bunked.
The year 1929 began in the United States with all the indications of a major economic
boom. The US capital markets were enjoying not only the influx of speculative capital from
domestic sources, largely aided by massive use of available credit, but from European capital
seeking higher returns than the European economies seemed to be able to offer in the after-
math of World War I. The Allies were able to pay back the war debts they owed to the
United States with reparations payments made by Germany. Germany was able to make the
reparations payments to the European Allies by borrowing from the United States. Despite
a major trade war, the United States was acquiring new customers for its commodity and
manufactured exports in Europe as well as in Latin America, financed in large measure by
US banks. Technological innovation (mainly the radio and wire services) were hailed as
opening new business frontiers. Credit was abundant. Signs of a major boom were respon-
sible for strong optimism which fanned both consumer and government spending. It was
being heralded as a ‘new era’ in economics with seemingly no upper limits to stock
valuations.
From about May 1929 and over the following months, the Federal Reserve began tight-
ening credit. Higher interest rates attracted more foreign capital but the flow of funds from
New York to Europe dropped significantly resulting in interest rate increases in Europe in
response to the credit crunch which was developing there. Meanwhile, stock speculation in
New York continued unabated with even greater use of margin credit (with financial leverage
5
ratios as high as 10 to 1). As stock prices reached successive new heights, the markets
started showing signs of nervousness with the arrival of news each day. Market dips began
occurring with regularity. Moreover, many speculators were beginning to margin those
portions of their holdings which had not been previously margined in order to support their
already-margined holdings which were under water. As railroad and pipeline stocks began
to soften in the first half of October, rounds of margin calls went out. Once selling activity
got under way, successive margin calls and the abrupt shift from optimism to panic unleashed
a downward spiral in share prices, culminating in the major declines of Monday October
28 and Tuesday October 29. By the end of the day on October 29, the Big Board had lost
over a third of its value from where it stood on October 19 (about $30 billion2). Over the
following two weeks, the market briefly rebounded then teetered between the opposing
forces of value hunters who tried to pick up bargains, and bankers and brokers who tried
to unload distressed holdings from their portfolios. On November 13 1929, the market
continued its descent to levels as low as where it had stood in July of 1927 (a decline of
almost 50%). A succession of bankruptcies – both corporate and personal – and suicides
followed.
It did not take long for the fear to spill into the real economy as businesses revised
their purchasing plans sharply downward. The Great Depression, which followed, both
expanded its impact to be felt globally and lasted the better part of a full decade. Numerous
books have been written on the causes of the Great Depression. Opposing schools of thought
have enumerated the causes of these events. Among the theories proffered are those which
focus on:
• the model of social organisation (Marxism versus capitalism);

• savings and income distribution;
• tight money;
• the gold standard;
• psychological explanations; and
• the financial losses realised during the 1929 crash.
While each of the aforementioned aspects no doubt was present and played some role
in prolonging or perhaps even exacerbating the magnitude of the Great Depression, many
economists and economic historians today attribute the underlying causes to a confluence
of structural weaknesses in the real sectors and to misguided government economic poli-
cies, particularly in the United States. In this regard, the trade war which the US fanned
with the passage of the Smoot-Hawley Tariff on June 17 1930, invited rounds of counter-
vailing protectionist measures by other countries. The combination of policies, however,
entailed both defensive measures such as quantitative restrictions, tariffs and other restraints
on imports as well as offensive measures such as subsidies, price and wage fixing, credit
allocation and special tax treatment. The main effects of the trade war and related economic
policies were to:
• Cripple the economies of Germany and other war-torn European countries indebted to
the United States thus impairing their ability to service their debts to the United States.
6
• Induce companies to invest in over capacity in protected industries and to run uneco-
nomic surpluses.
• Induce farmers enjoying price support to over-produce those crops and commodities bene-
fiting from the support.
• Unleash precipitous drops in commodity prices, mainly in agriculture but also in other
commodities and manufactured goods as the pinch was felt and subsidy support was
overwhelmed by the failure of export and domestic sales.
It is important to note that while the main weaknesses giving rise to the Great Depression
and which prolonged its duration were structural and policy-related, their combined influ-
ence was multifaceted, complex, mutually-reinforcing and cumulative.
As we examine financial crises which came after the Great Depression in Chapter 5, it
is particularly instructive to note that the Great Depression was in many respects unequalled
in terms of the full array of its causes and its dynamics. Some of the main features which
set it apart from later crises include the following.
• It was not preceded by commodity or industrial price inflation.

• There was no compelling evidence of merchandise inventory anomalies (neither massive
build-ups nor depletions) to serve as early warning signs.
• Interest rates moved upward for awhile but still remained below their earlier highs.
• Banks were relatively well capitalised and strong as first the crash and then the depres-
sion unfolded (smaller banks did eventually fail in numbers, dragging some larger ones
into their orbit, but not until well into the depression).
• Paradoxically, going into the depression, the United States was sitting on ample gold
reserves.
• Prices plummeted to pre-World War I levels but without being able to equilibrate.
Both the economics profession as well as national economic policy-makers learned much
from post-mortems of both the Crash of 1929 and the Great Depression. But while some
of the more obvious mistakes have been avoided since then, to this day, other aspects –
such as the financial overleveraging which led to the severity of market and personal distress
in 1929 – seem to have been dangerously replicated today, albeit in new ways. While the
use of leverage in 1929 was applied directly through ‘buying on margin’ to positions on
the Big Board, stock market regulations today prevent such exposure. But, ironically, the
advent of the new risk markets has encouraged and allowed even greater use of leverage in
recent years.
Boom–bust dynamics
Thoughts on the causes of bubbles, panics and crashes

An important phenomenon observed in connection with financial crises and distressed finan-
cial markets is that in the majority of cases, the correction or crash was preceded by a
significant run up in value. This understandably has led to ample generalisation of financial
7
crises being explained as the bursting or at least rapid and severe deflation of a correspond-
ing asset price bubble. This raises some fundamental questions.
• What is a bubble?
• Does the emergence of a financial market in distress always require the explanation of
a bursting or deflating bubble?
• Alternatively, if examples can be found in which the market in question did not convinc-
ingly show evidence of the formation of a price bubble, then what other causes can be
realistically invoked?
• What explains the formation and accretion of bubbles?
• When financial markets become distressed, what are the characteristic market modalities
by which distress is transmitted?
• Are there fairly reliable early warning signs which can be used to attenuate the severity
of imminent distress?
• From the perspective of investors and portfolio managers, can the transformative nature
of risk provide guidance regarding appropriate action?
• What are some of the nonlinearities and second-order effects that might counsel caution
for policy-makers who are inclined to use robust intervention to avert an impending finan-
cial crisis?
What is a bubble?
An asset market bubble can be defined as a mechanism or process which is:
• self-reinforcing and perpetuating;

• preventing changes in asset prices from exhibiting random behaviour; and
• involving changes in the market index which are larger than that explained by the intro-
duction of any new information in connection with market fundamentals.
Are distressed financial markets always caused by bubbles?

Although the collapse of asset markets is very often preceded by a price bubble, distress
can also be brought on by a sudden shift in that market’s fundamentals or by contagion.
This means that the compartmentalisation of asset markets of the past owing to geography,
national policies and regulations, physical and economic limitations to communications and
so on, allowed the effects of bubbles to be contained. The high degree of interdependency
in the world today can result in signs of financial stress (and even distress) appearing unex-
pectedly, even though the situation may have been precipitated by a bubble somewhere
else.
What other causes can be responsible?

Fundamental changes can occur at the macroeconomic level such as through currency move-
ments or because of the onset of recession in the economy of a major trading partner.
Alternatively, it can originate in world commodity markets to the extent that price devel-
opments adversely affect both real and financial prospects for the home market. Or it can
8
be triggered by adverse developments in sectors – domestically, internationally, or both –

which represent an important source of demand for the most prominent sectors or even
companies which heavily weight the reference market index.
Even those causes labelled as being the result of ‘contagion’ can involve either the inter-
national propagation (with transmission) of effects via market fundamentals or spill over
effects from other domestic markets. This can happen as in the case of international
commodity price shocks, devaluations which affect the terms of trade, or as a consequence
of structural factors affecting the amount and the terms of credit made available by inter-
national banks. While medical analogies (from which the term ‘contagion’ was borrowed)
are common and at times useful to convey in a few words the concept of a phenomenon
that affects many, they risk imprecision. This has consequences for any attempts at either
diagnosis or prognosis of how effects are transmitted.
First of all, even when talking about contagion in health matters, distinctions are import-
ant as between those effects whereby a single external influence may affect a population
similarly (such as carbon monoxide poisoning of many people in an enclosed space) and
those where one person or organism passes to another an infection or weakness (such as
the flu or other type of virus), which is subsequently passed from one to another and so
on.
In the case of financial contagion, similar distinctions are needed between say the impact
that a sudden rise in the price of a key input such as energy might have on nearly all
producers across international borders and, for example, the contagion-like effect that non-
performing assets may have where claims against those assets have been tiered several layers
deep through structured finance instruments, resulting in interlocking effects on the balance
sheets of several financial institutions crossing one or more borders.
However, herding behaviour among international investors, bankers and portfolio
managers may seem irrational and a form of ‘pure’ contagion. Although if there has been
a ‘wake-up call’ effect which causes them to perceive risk and to discount expected returns
differently from the way they did previously, such behaviour may well possess its own
rationality. For example, highly leveraged institutions required by either charter or bond
indentures to maintain positions in nothing lower than investment-grade paper will, once
crisis strikes obligors adversely in a particular country, attempt pre-emptive selling in coun-
tries where obligors share similar characteristics to avoid being caught later when liquidity
in those issues might completely dry up. Examples of such behaviour during the Asia (1997)
and Russia (1998) financial crises are noteworthy.
What explains the formation and accretion of bubbles?

The assumption of the rationality of people (or ‘economic agents’, as many economists
would say), and by extension the financial markets as well, is the cornerstone of traditional
financial theory. What this means is that people act quickly and efficiently in incorporating
new information into their belief framework as it becomes available, assimilating it into
their decisions and that these decisions in the aggregate as reflected in the market are ‘good’
or ‘acceptable’ in some normative sense.3
It took years of agnosticism (supported by abundant empirical research that simply
failed to provide the solid support for the simplistic view of rational behaviour assumed in
9
traditional financial theory) that gave birth to behavioural finance. This offshoot from
mainstream finance posits that finance is better understood if some people are treated as not
acting in ways the traditional theory considers to be fully rational. It was a view that was
not readily accepted for some time as anything more serious than a niche area of finance
which looked into a few interesting puzzles and paradoxes.
Although it is beyond the scope of this book to provide either a comprehensive history
or catalogue of behavioural finance topics, from time to time we will draw on important
concepts developed in this field of enquiry as they help develop our analysis of contributing
determinants of financial crisis and distressed financial markets.
A major contribution of behavioural finance to the analysis of the dynamic behav-
iour of financial markets was to include wealth in addition to income as a major
determinant of consumption. Traditional financial theory, on the other hand, posited that
savings, investment and consumption decisions are predicated on the utility of suitably-
discounted future consumption. The expected future consumption was considered to be
determined primarily by the trajectory of income – largely from wages – an individual
could expect to earn over his lifetime. All of this, of course, was adjusted for anticipated
inflation. Savings figured into the picture but its growth was predicated on the propen-
sity to save and a natural rate of return (interest) which could be earned on the savings.
The earlier models did not explicitly take into account the effect of the vicissitudes of
fortune which might require the person to draw from savings unexpectedly. In fairness,
the alternative ways, the timings and the magnitudes of how this could happen are virtu-
ally infinite and involve uncertainties to such an extent that they would be virtually
impossible to predict in any event. Nor did the traditional framework take into account
sudden or unanticipated windfalls, irrespective of their source, which similarly can happen
in a variety of ways, amounts and moments in time and thus would have defied cred-
ible prediction. Thus with personal income representing the most tractable quantity to
forecast, it is not surprising that real consumption came to be seen as being determined
preponderantly, if not exclusively, by real income. In reality, however, sudden windfalls
do change people’s consumption patterns whether the windfall is the result of winning
a lottery, unexpectedly receiving a large inheritance or seeing one’s store of wealth – in
real or financial assets or both – suddenly multiply in value due to an asset price bubble.
The importance of understanding how wealth effects enter into the determination of
consumption patterns is that when asset price bubbles inflate, consumption rises with
increasing ‘paper profits’. This provides significant economic stimulus which contributes to
even stronger inflation of the bubble. Then, as the bubble bursts and the inflated asset market
collapses, the sudden extinguishing of wealth impacts consumption brutally in the opposite
direction. This in turn causes financial distress to spill over into the real economy with
enduring trauma. The spiral of reduced spending, the contraction of economic output, the
associated unemployment of factor inputs (land, labour and capital) and the subsequent
rounds of further compression of consumption and contraction of output and factor utilisa-
tion become widespread and protracted. One only needs to look to the Great Depression as
a reminder of the potential for financial market distress to translate into broader economic
malaise.
10
Box 1.1
Trends versus mean reversion
When markets are trending, it is commonplace to see professional traders loading up on winning
positions and cutting back on losing ones. Trend following after all is predicated on momentum and
even if the more astute are vigilant regarding turning points, at least in the trend regions prior to
evidence suggesting imminent trend reversal, markets are characterised by positive feedback loops.
Relative value trading on the other hand is predicated on notions of fundamental values and tempo-
rary misalignments. The entire premise is that relationships that should hold are somehow temporarily
off-kilter but with time should undergo convergence. If the convergence ultimately occurs during the
life of the trade, the trade is considered successful. If not, then the losses involved will determine
the extent of ‘failure’. Astute traders, however, betting on convergence, will tend to lay on succes-
sive trades in the direction of the anticipated convergence. If they are large institutional players (and
here the notion of what is large is relative to the size of the market in which they are transacting),
then the directionality of their successive bets is not without its own influence on the way the market
subsequently moves. Therefore, market dynamics at any given moment, although affected by poten-
tially many things, can be viewed as a set of tensions between the forces of positive feedback
inherent in the prevalence of momentum trading on the one hand and the countervailing negative
feedback which characterises relative value and market neutral trades on the other.
Who to blame – external or internal causes, crowds or

policy-makers?
The role of macroeconomic policies as a cause of financial

market distress
When countries maintained closed capital accounts with the foreign exchange operations of
their central banks acting as a buffer between the rest of the world and their national
economies, the majority of financial crises first unfolded in the form of attacks on their
currencies. If a country with an overvalued currency came under speculative attack, it gener-
ally was because the exchange-rate regime it followed was not one of full flexibility which
would allow automatic equilibration via a new depreciated exchange rate. Therefore, the
success such a country would have in defending the currency would generally depend on
the adequacy of foreign exchange reserves relative to the combined needs of external trade,
investment and speculative activity. If it had enough reserves to meet these combined needs,
it could maintain its exchange rate. If not, it might wind up either changing to a floating
exchange rate following a massive devaluation, or it might try a series of orderly devalua-
tions until the foreign exchange market showed signs of stabilising.
With liberalisation of the financial sector as well as the external capital account in many
countries, the transmission path for external shocks became much more direct and often
showed up almost immediately in the host country’s financial sector (and even in its busi-
ness sector). In particularly severe cases nonetheless, financial crisis would take the form
of twin currency and banking crises occurring virtually simultaneously.
A key issue then is whether or not there are particular economic policy lessons to be
drawn from the multitude of financial crises over the past several decades.
11
In large measure, the conventional economic wisdom for at least several decades during
the post-war period recommended that for small emerging market open economies, a fixed-
rate exchange rate regime was preferable to a floating rate regime. As we will see in greater
depth in Part 2 and Part 3 of this book, a key underlying assumption was of course that
most countries of this type would be net debtor countries and that using the exchange rate
as a nominal anchor would curtail runaway inflationary build-up if fiscal policy were not
as conservative as desirable or alternatively it would prevent the country being ravaged by
a burgeoning external debt repayable in ever more expensive foreign currency beyond the
point of its macroeconomic solvency. Further on, we will examine the spate of financial
crises which were unleashed during the 1990s (in Mexico, then the rest of Latin America,
then in Asia, moving on to Russia and Brazil) and then post 2000 in Argentina, and several
others. We will also examine other global developments resulting in the US shifting from
being a surplus economy to one running twin deficits. These events conspired to allow
many of the previously deficit countries to begin accumulating excess reserves. This embar-
rassment of riches also carries with it a responsibility for prudent management of the
newfound wealth which in some cases may be of longer-term duration while in others it
may prove to be short-lived. In any event, as we will consider in Chapter 7, although
macroeconomic policies may not always precipitate distress in financial markets, early
detection (with remedial action) to mitigate such distress requires an assessment of the
nature of prevailing macroeconomic and sector policies and their potential contribution to
financial draw downs.
In Chapter 5, we will see in the descriptions of individual country episodes that economic
policies have relevance at the level of individual countries to the extent that they may help
explain conditions leading up to the formation of national stock market bubbles, credit
bubbles or other asset bubbles. In this connection, policies can be highly instrumental in
shaping these conditions so as to not only raise the prices of financial assets but also increase
functionally what Sornette calls the ‘crash hazard rate’.4 On a grander scale, however, macro-
economic policies internationally, taken as an ensemble, produced and have sustained certain
pronounced global imbalances. In Chapter 6, we will consider that the US economy for the
better part of the past decade has maintained twin deficits – an external deficit and a budget-
ary one. At the same time, developing Asian countries have enjoyed a series of surpluses
on external account which have allowed them to accumulate significant excess reserves. The
resurgence of commodity prices led by oil and natural gas has also allowed oil-producing
countries to accrete oil-related revenues at an unprecedented rate.
Countries which undertook trade liberalisation soon followed it with financial liberal-
isation. The combined effect was to heighten financial fragility in most cases but at the
same time to permit significant economic growth. Moreover, financial liberalisation has
usually resulted in financial deepening but with greater volatility which consequently has
exacerbated their boom-bust dynamics.5
While economic theory would suggest that a country relentlessly amassing excess
reserves would find it prudent to manage its exchange rate to equilibrate international prices
and to mop up the excess liquidity with its attendant inflationary pressures which such
reserves tend to produce, this has not been happening. Or at least, it has not been happening
fast enough. So in a sense, to the extent that the mounting global imbalances are risking
12
the stability of the global financial system, on this level too the issue of relevant economic
policies is one worthy of addressing.
It is in this context that the role of the US dollar as the world’s reserve currency needs
to be viewed. In recent years, countries running large external surpluses, particularly, China,
Japan, Russia, and Saudi Arabia, have together held over a trillion6 dollars of US Treasury
bills, notes and bonds. As the dollar started its downward descent in value over the last
several years, some of these key holders have toyed with the idea of shifting their inter-
national reserves at least partly out of dollars and into, for example, the Euro. What is
involved in such decisions needs to be viewed within the context of global currency symmetry
and asymmetry vis-à-vis the world’s reserve currency. In short, the rules for managing macro-
economic balances via certain key macroeconomic targets apply to all countries alike under
a symmetric international monetary system. An asymmetric international monetary system,
on the other hand, accommodates greater tolerance for deviations on the part of the reserve
currency country. This is largely because the demand for the reserve currency has a rationale
beyond that which is merely needed for trade. For many countries and even certain inter-
national commodities, the reserve currency not only serves as the means of payment to
balance the external accounts but acts as a numeraire with all invoicing conducted in that
currency as well (for example, international oil prices are quoted in dollars irrespective of
geographic location or the fact that contracting parties often do not even involve the United
States either on the buy side or the sell side).
The Euro has been showing sustained robustness and at least preliminary signs that
some surplus countries want to diversify their international reserves into Euro-denominated
instruments. A key issue then is whether it is possible to identify the point at which any
extra policy latitude enjoyed by the US economy and the dollar, currently afforded by inter-
national currency asymmetry, will become sharply constrained by a shift to a more symmetric
set of game rules for the entire global community.
In a world in which international money no longer has intrinsic backing, the elements
of monetary policy conducted primarily with the end in mind of maintaining economic
stability of the domestic economy and controlling domestic price inflation cannot be divorced
from management of the external accounts. This includes but is not necessarily limited to
the design and management of the exchange rate regime. The spectrum of domestic interest
rates, which is influenced, if not totally shaped, by central bank general instruments of
monetary policy is key to determining domestic financial asset values. However, in an open
economy with a relatively liberal capital account, it is the interplay between interest rates
and rational expectations as they apply to the rate of change (depreciation or appreciation)
in the price of foreign exchange which equilibrates both stocks and flows, including macro-
economic balances, the domestic inflation rate, and the price trajectory of traded financial
assets.
The human element in financial markets

Financial theory, as a specialised branch of economics, has been subjected to many of the
same tools and assumptions as have been applied to economics. These tools with their
inherent assumptions run the gamut from a predilection to view all decision making in terms
13
of its rationality, treating humans as economic agents without regard for other passions and
motivations which might explain their behaviour, to mechanistic treatment of a market
drawing from the physical sciences.
Without necessarily abandoning entirely these depictions of operative forces at work,
greater allowance for human behaviour seems essential to a better understanding of financial
market behaviour with its attendant risks. Central to a more humanistic behavioural view is
the phenomenon of imitation or herding. A description of this type of behaviour emphasises
that decision makers may or may not have in their possession the information required to
make rational decisions on the fundamental merits or demerits of investments. What drives
their decision making, however, is a de-emphasis of the information of this nature (which
either they already have or could acquire) and instead a need to conform to what others are
doing. There is both an economically rational and irrational element to this behaviour.
The rational element is recognition of the fact that in liquid markets when buying at a
certain price, it matters little what you should be paid but rather what the market is prepared
to pay when you exit. Consequently, an observation of what others are doing and therefore
seem to think is not such an intellectually shallow type of behaviour as fundamentalists
would like to suggest. The shorter the time horizon for investing and trading activity, the
more cogent this argument actually becomes. The irrational aspect can involve a host of
reasons which have little to do with the intrinsic nature of the investment decision at hand.
It may have to do with such things as fear of a loss of reputation for ‘going out on a limb’
or even fear of job loss (as in the old saying in business ‘no one has ever been fired for
buying IBM’).
While to the extent such reasoning behind decision making can be described as emotional
or non-pecuniary when framed in terms of a ‘buy’, ‘sell’, or ‘hold’ decision in connection
with a particular investment or financial asset, this is not to say it is not economic. After
all, for a well-known analyst or financial adviser to make a contrarian recommendation and
have it not pan out, the outcome could be to have such a decision adversely affect their
professional reputation with a concomitant loss of income. Whether that is fact or percep-
tion is not the issue. The motivation is still an economic one and thus rational in a broader
sense even if it is not considered to be rational when framed strictly within the context of
the immediate investment decision. However, other reasons can play a role in decision
making which have no apparent economic basis such as hubris or entertainment value.
The problem with statistics and probabilities
Random walk and misleading probabilities

Bachelier7 introduced the idea that stock market returns follow a random walk, an idea that
has stuck since its advent in 1900. The resulting assumption of the statistical independence
of stock market returns has been widely adopted and is underpinned by the efficient market
hypothesis (EMH). In fact, much of modern portfolio theory (MPT) is predicated on the
assumption that stock market returns adhere to a Gaussian or normal distribution. Exceptions
to the widespread acceptance of this assumption are found in the adherence of chartists and
technical analysts to the predictive power of market patterns through time, as well as in the
14
work undertaken by Fama and French8 in the 1990s which revealed that stock market returns
are likely not Gaussian at all but more appropriately fall into the category of stable paretian
distributions – a possibility raised at the conjectural level by the pioneers of MPT back in
the 1970s.
In many cases, that is so long as the market remains within certain bounds, the assumption
of a random walk conforms to observable data. Therefore, it is not uncommon for quantitative
practitioners to compute probabilities for market fluctuations. The problem with this approach
is that fluctuations of different magnitudes in percentage (or logarithmic) terms are assigned
probabilities of occurrence based on the frequency with which they have occurred historically.
But even that last statement is misleading. What has happened historically and what the analyst
observes to have occurred historically can be vastly different. The former would require
collecting data for all occurrences back to the point at which pre-history and history meet. The
latter in many cases would be lucky if it went back much more than one or two decades’ worth
of data collection and thus would only represent a subset of historical occurrence.
Reliance on frequency distributions in which events are assumed to represent random
occurrences, however, leads to overstatement of the length of time that we would be required
to wait to observe a run of repeating percentages. This is because when independence of
occurrence is assumed, a daily occurrence that has a probability of happening of, for example,
1% (representing 1 chance in 100) means that we would on average have to wait 100 days
to witness such an event. For it to happen in a run of three successive days, it would take
the value of 0.01 × 0.01 × 0.01 = 0.000001 or one occurrence in a million days (or once
in about 4,000 years, if we assume roughly 250 trading days a year on average). If we
expand a run to only five sequential days, the probabilities become totally absurd – we
would have to wait about 40 million years on average to witness such a run.
Clearly, the formation of bubbles (runs of sequential positive returns) and draw downs
(runs of sequential negative returns) occur in real life with much greater frequency. This
strongly suggests that even if periodic returns exhibit seeming independence when an indi-
vidual stock or the market as a whole is in a trading range, the formation of a trend represents
a correlation which temporarily emerges. Such correlation may even be characterised by
non-linearities. The fact that (linear) serial correlation very close to zero may be evidenced
over a range of time periods may be more the result of an arbitrariness of the choice of
time period combined with the inherent assumption that the presence of any correlation
must be linear in nature. When a trend begins to gather strength, what we may be witnessing
is the sudden emergence of temporary dependence and, within the limits of the length of
the trend, an emerging degree of predictability. So much for the parametric treatment of
correlation coefficients based on all historical occurrences!
In recent years (especially during 2007 and 2008), the crystallisation of financial crises
involving global financial institutions which used state-of-the-art quantitative methods and
models for managing risk raises important questions regarding what went wrong. The models
were enormous advances in rigour over the kind of thinking which informed banking and
portfolio decisions in past decades (since the advent of MPT in the mid-1960s). So what
went wrong?
The main problem, as explained by Rebonato, was that quantification was based almost
exclusively and to a large degree mechanistically on historical probabilities.9 In the attempt
15
to ensure confidence in the results large quantities of data were employed. But achieving
larger sample sizes from which to estimate key parameters with supposedly greater confi-
dence by shortening the time spans ignores the importance of capturing outlier risk. Certain
historical events with very low frequencies of occurrence but with enormous impact need
to be taken into account for a quantitative risk calculation to have meaning. To the extent
that such events did not take place during the time periods for which the historical data
were collected results in serious understatement of the real risks involved. Although data
on certain types of financial variables such as government bonds, key interest rates and even
the share prices of some companies go back for over a century, most of the instruments
used as reference assets for many of the risk management analyses simply have not been
in existence for more than even a decade. Yet this did not stop risk managers from calcu-
lating confidence intervals for probabilities significantly greater than 99%. The fact that this
spurious accuracy provided the basis for over exposure to risky assets and excessive use of
financial leverage points to a major flaw in modern risk management practices. It was that
of defining the universe of risk in terms of the strictly measurable without paying due regard
to less-likely but higher-impact events and indeed to the unknown.
1
It is interesting to note that the term ‘South Sea’ in those times referred to the waters off South America.
2
Throughout this book, the term ‘billion’ refers to a quantity equal to one thousand million.
3
Thaler (2005, p. 1).
4
Sornette (2003, p. 149).
5
Tornell and Westermann (2005, p. 33).
6
Throughout this book, the term ‘trillion’ is used to refer to a quantity that is equal to one million million or the
numeral one followed by twelve zeros.
7
Bachelier (1900).
8
Fama and French (1992).
9
Rebonato (2007).
16
Chapter 2
Evolving characteristics of
financial markets
The institutional importance of a financial market perspective

Traditionally, financial systems have been neatly characterised as being either bank-
dominated or capital-markets-dominated. Restrictive laws and regulations have played a role
in this regard. The relative simplicity of earlier financial products offered did as well – a
company, for example, could choose between seeking a bank loan and issuing an obliga-
tion on the stock exchange. Direct recourse to organised securities markets, such as selling
bonds or issuing stock on the stock exchange, came to be referred to as financial disinter-
mediation. The choice between this form of financing and bank loans was for years cast as
a mutually exclusive one. However, as the business and technology of securitisation of asset-
backed securities became widespread, the distinction between banking and capital markets
financing became blurred. Today the large bulge-bracket commercial banks play an import-
ant role in securities markets, not only in terms of the primary issuance of securities but
also in trading them in the secondary market as well. Moreover, when smaller banks ori-
ginate and then immediately sell mortgage loans to the government sponsored entities (GSEs)
such as Fannie Mae and Freddy Mac, they too are playing a symbiotic role in the financial
markets.
The investing and portfolio management activities of large mutual fund companies,
although rightly described as a form of financial intermediation, also play a symbiotic role
with the capital markets as well. This is further complicated by the rise of internal markets
within large mutual fund companies which enable cross trades, as well as by the emergence
and operation of dark pools of capital. ‘Dark pools of liquidity’, as they are also called, are
networks, some of which are independently operated. Others are operated by financial insti-
tutions already otherwise engaged as market participants. They provide liquidity by permitting
crossing of trades that are not shown in the order books of licenced broker-dealers trans-
acting on the major exchanges. In fact, in addition to the independents, a number of dark
pools are owned and operated by broker-dealers and even by exchanges. Not only do these
pools offer additional liquidity but they provide additional value to those traders who do
not want to reveal their identities nor signal their intentions through normal market trans-
parency. Consequently, they also do not reveal crossing prices, thus denying the market the
additional function of ‘price discovery’ which would otherwise be gained from transactions
conducted on the exchanges.
17
The role of legal frameworks

Two essential preconditions for a market economy to thrive are: (1) a system of clearly
defined property rights and mechanisms for their enforcement; and (2) operability of the
principle of exclusion (and the related concept of ‘the ability to appropriate’).
Regarding the former, in those societies guided by the rule of law, clear title allows
property to pass from one holder to another and so forth with minimal doubt or ambiguity
as to rightful ownership, which reduces the costly friction of having to resort constantly to
the court system to resolve contested claims.
In the case of the second precondition, the principle of exclusion and its conjugate
concept of the ability to appropriate, the act of possession allows the property holder to
‘exclude’ others from its use or to deny them access to it. Carried further, in the event that
others encroach on the property, it is physically within the power of the property holder
(assuming he has the means of enforcement) to ‘appropriate’ the property and in so doing
return it to his own exclusive possession and use.
A person may have uncontested legal title to property but for certain reasons is power-
less to exclude others from access to and use of the property in question. And conversely,
examples are common in which a property holder or claimant may be successful in excluding
others from the property’s use without the claimant necessarily having uncontested legal title
– hence the importance of both preconditions being satisfied for market economy to thrive.
Exchange can take place in certain circumstances if only one or the other of these two
preconditions is in place. However, the mutual reinforcement of both preconditions is neces-
sary for market economy to flourish, particularly one in which the method of payment
transcends the use of cash alone with ample recourse to the instruments of modern finance.
The preconditions above apply to all types of market. Promoting sound financial markets,
however, involves additional legal requirements. These include laws pertaining to the following.
• Property:
• land tenure;
• tenancy;
• transfer; and
• mortgage creation and secured transactions.
• Financial insolvency and creditor rights:
• collateral and security interests;
• secured and unsecured lending;
• seizure and sale of movable and immovable goods; and
• bankruptcy and claims resolution.
• Companies:
• types of companies and rules for their creation;
• registration and access to information;
• minimal capital;
• issue and transfer of shares; and
• shareholder rights, responsibilities, and governance.
• Financial sector consumer protection:
• rights to protection of information and privacy;
18
Evolving characteristics of financial markets
• undertakings regarding information security standards and safeguards;

• fair lending and service practices; and
• grievances and dispute resolution.
• Central bank:
• role;
• relationship to government; and
• limits on and conditions of lending to government.
• Banking:
• sponsor eligibility criteria;
• minimum capital requirements;
• criteria for principals (shareholders, managers, officers and so on);
• powers to accept deposits and conduct business;
• termination of licences;
• regulatory and supervisory responsibilities, powers and procedures (reference to sepa-
rate legislation as appropriate);
• distressed banks and remedial measures (intervention, restructuring, liquidation, revo-
cation of licences and so on);
• bank secrecy and confidentiality; and
• measures to curb money laundering and financing illegal activities (reference to sepa-
rate legislation as appropriate).
• Financial safety nets:
• emergency lending or support arrangements for banks;
• deposit insurance schemes for banks, credit unions, other financial institutions (FIs); and
• crisis stabilisation management framework and inter-agency relationships and respon-
sibilities.
• Payment systems:
• cash-based systems;
• cheque encashment;
• electronic systems (debit cards and credit cards);
• clearance systems, gross settlement arrangements, netting arrangements, real time and
swift-based terminal systems;
• confidentiality, supervision, and rules for netting; and
• ‘zero-hour’ rule provisions.
• Government debt:
• primary and secondary government securities markets;
• rights and obligations of dealers and agent banks;
• rules for conducting public auctions;
• maturities offered;
• registration and transfer of ownership; and
• physical and ‘dematerialised’ securities.
• Insurance:
• powers and responsibilities of the regulatory body;
• eligibility criteria and conditions for forming insurance and re-insurance companies and
registering them;
19
• disclosure requirements;
• prudential supervision;
• managing distressed insurers;
• reserves; and
• dispute resolution mechanisms.
• Capital markets:
• regulation of brokers, dealers, advisers, market-makers, specialists, and others forming
part of the securities industry;
• issuance of securities to the public;
• registration and trading of securities (including any rules applying to 3rd and 4th
markets);
• operation of stock exchanges; and
• rules pertaining to regulation of structured finance securities and entities.
The foregoing is a fairly comprehensive list of the key issues for which legislation is needed
to foster a modern and efficient market-based financial sector. To the extent that all of
these aspects are covered under existing legislation within a country, their efficacy would
then depend on the machinery of enforcement or execution, at the top of which lies the
judiciary system. Even partial coverage may be enough to launch a vibrant financial sector
as long as steady progress is made in addressing successively more of the items on the list.
Legal systems can also be usefully grouped in terms of whether they represent common-
law-based systems, such as those found in the UK and its former colonies and those European
and Latin American countries for example which inherited codified legal systems whether
from the influence of Napoleonic Code or from earlier Roman law. The main difference
between these two systems is the constraints imposed by codification under the latter, whereby
if lawmakers have not specifically foreseen a particular situation, then the law generally errs
on the side of conservatism thereby prohibiting (or at least not explicitly allowing) the action
or activity until new code is introduced which specifically permits it and which also spells
out the specific conditions under which it may take place.
For example, securitisation has been attempted under both types of legal system. Whereas
it has generally fared better under common-law based systems, this may not be so much the
result of the type of law rather than the fact that the supporting securities markets and ancil-
lary services to the securities industry have given those systems a head start. Some measure
of success has been achieved under countries with codified legal systems but these have
generally tended to take time and are not without occasional bottlenecks and frictions arising
out of the relative rigidities encountered under this type of system. A case in point was in
connection with the first mortgage securitisation schemes being considered in Mexico in the
early 1990s. For these transactions to work at that time, many of the required conditions and
supporting apparatus were in place. A major problem, however, turned out to be the require-
ment that for a mortgage loan as an asset on the books of a mortgage lender to change
ownership to another financial institution or to a trust, it was necessary to have both the
borrower and the lender be physically present before a notary public before the transfer could
be notarised and the transaction consummated. This requirement virtually dried up any liquidity
associated with secondary-market trading of mortgage-backed securities, thus greatly limiting
20
their attractiveness to investors. Furthermore, pending essential legal and regulatory changes,
it put in doubt the viability of the business model for securitised transactions which a number
of specialised financial companies were considering. Various examples of situations in which
codified law placed excessive and highly detailed restrictions on new types of financial activity
were encountered in many other emerging markets countries as well. In fairness, once a crit-
ical mass of interest in some of these newer types of activity reached a point where new
legislation was introduced, the results improved markedly.
Macroeconomic preconditions
In addition to a legal framework that supports and is conducive to the efficacious func-
tioning of domestic financial markets, a stable macroeconomic environment represents another
essential feature. Without investor confidence in the overall macroeconomic stability of the
domestic economy as well as in the country’s prospects for maintaining future price stability,
markets for financial obligations with tenors of one year or longer will not develop. In the
absence of economic stability, the bets that investors would place on high interest-bearing
paper would entail too much uncertainty. To the extent the financial markets develop within
such an environment, it would be heavily concentrated in financial obligations with very
short maturities, for example, defined in months if not days.
Brazil’s economy prior to July 1994, offers an extremely interesting example of the
importance of economic stability to the maturity structure and risk-taking environment to
be found in domestic financial markets. Since the monetary reform of 1964, the country
had developed an elaborate system of inflation indexing which served to preserve and link
valuations over decades of high and chronic inflation. At first blush, the country’s financial
markets offered an abundance of bonds and notes with maturities extending out in some
cases for decades. The telling feature, however, was that from three-month maturities onward,
interest rates were defined as a spread over a suitable inflation index. This meant that the
demarcation between the ‘short-term’ and the ‘long-term’ was crisp and discernible at 28
to 31 days as determined in the ‘Overnight Market’ for short-term (that is, of maturities less
than one month) financial instruments. Although during that period many Brazilian finan-
cial institutions actually had a category of 60-day paper, it did not trade. A long bond that
is indexed to inflation is not a ‘long bond’ in the same sense as the term is applied in coun-
tries with price stability. This is because in the case of the indexed bond, inflation risk has
been passed from the issuer to the bond-holder, which means that the instrument, even if
principal is payable over a number of years, is really a short-term bet with respect to infla-
tion that is reset every so often (in a number of cases, semi-annual or quarterly adjustments
were made).
From the perspective of a financial system possessing the characteristic of stability, the
importance of having a market for longer maturities, starting with government issues as bench-
marks and extending to corporate and municipal issues, in which the issuer assumes inflation
risk is the fundamental role that such instruments play throughout the maturity spectrum in
establishing a yield curve. In fact, without a well-defined yield curve, the guidance many
investors seek in order to give them the confidence to assume other types of risk associated
with instruments with different tenors is simply not available. This significantly reduces market
21
liquidity for such issues. When the financial institutions in a country are trying to establish
a market for securitisation and structured finance products as but one example, the market-
making aspects of existing bonds with referential value as benchmark issues assume
considerable importance.
A further observation on establishing a yield curve warrants consideration. Mathematical
techniques exist for making yield curve calculations as well as to interpolate or even extend
the relationships between yields and tenors beyond what is actually available in the market.
However, as important as the associated bond arithmetic is, a yield curve must be validated.
This is done by the willingness of buyers and sellers to actually transact in the relevant debt
instruments with various tenors throughout the prospective yield curve’s length. In the absence
of such transactions, the ‘calculation’ of a yield curve is reduced to no more than a theor-
etical exercise.
Intermediation and disintermediation – how banks and securities

markets handle risk
Traditionally, banks pooled risk and managed it on their balance sheets. Financial markets,
on the other hand, separated different types of risk and priced them via transactions. Over
centuries, societal preferences within countries for predominantly one or the other of the
two main types of financing evolved and diverged for cultural and historical reasons. For
example, Germany has long had a dominant banking-led financial system in which banks
not only lend money but play a key role as shareholder and even interlocutor for the com-
panies they finance on important social and political issues such as with environmental groups
and trade unions. In the UK and even more so in the US, the preference for the issuance
of securities has seen financial systems in those countries develop very differently with
investment banks, mutual funds and contractual savings institutions – all dealing in secur-
ities – dwarf the commercial banking activities of what are now financial conglomerates.
The reasons for which countries differ in how their financial systems have evolved are
numerous. Prominent among them, however, is the extent to which local conditions affect,
and how effectively policy-makers are able to deal with, the following issues.
• Stakeholder incentives and their determinants, specifically how these differ among share-
holders, creditors, managers, employees, bankers and customers.
• Pronounced differences in information that is available (what economists call ‘asymme-
tries of information’) to sellers and buyers of financial claims whether these be
intermediaries or market participants.
• The magnitude of transaction costs.
• The opportunities and scope for moral hazard.
• The predominance and pervasiveness of obstacles to competition.
• The key weak points in the economy which may give rise to financial instability and in
the extreme to ‘market failure’ in the provision of financial services and the anticipated
severity, incidence and consequences of excessive volatility and failures.
Cogent arguments have been made for the efficacy of market-based financial systems. They
are all predicated, however, on the assumption that countries adopting such systems will do
22
well as opposed to doing worse with regard to how they resolve the aforementioned issues.
For example, a leveraged financial institution which accepts the practice of mark-to-market
valuation of its assets (that is, because it classifies them as ‘traded assets’ rather than as
assets ‘held to maturity’) may quickly become insolvent if the nascent markets which deter-
mine its portfolio values are simply too thin and therefore become easily and rapidly distressed
or alternatively become too susceptible to manipulation.
Efficient markets require large numbers of participants capable of communicating with
one another in the market (whether that market is physical or virtual) in a cost-effective
way. Geography and infrastructure play important roles in this connection. It should not be
surprising then that even in large countries, before the conditions could be put in place to
facilitate easy and cost-effective communication among the many prospective participants
for stable and efficient financial markets to evolve, commercial banking (as well as other
types of financial intermediaries) dominated.
Commercial bank handling of risk through pooling does not simply refer to the lumping
together of numerous loans and investments. It also refers to the transformation of poten-
tially highly-liquid, short-term liabilities in the form of demand (and savings) deposits into
longer term loans and investments. The business model on which this transformation process
rests is the spread between the rates charged by the bank on the loan or investment it creates
as an asset and the rate it must pay depositors to attract funds.
Demand deposits for many years paid no interest but instead offered the convenience
of safety, liquidity and cheque account privileges with a reputable institution. Consequently,
spreads have often been significant and pure commercial banking (that is, absent the income
from other banking services) was at one time a profitable business. This profitability, however,
has always carried with it a risk that has not been traditionally easy to hedge or offset. That
risk arises through the maturity mismatches it can involve between the assets and liabilities
sides of the bank’s balance sheet. For this reason, nearly every country has minimal eligi-
bility criteria for starting a bank. This is necessary to protect depositors.
Beyond this, experience in managing a stochastic source of funding (involving balancing
profitability with safety through the use of statistical means) is a key skill that is essential
to any bank. Some do it systematically (quantitatively) while others do it somewhat more
intuitively, albeit, based on experience. More conservative banks will maintain higher percent-
ages of liquid assets such as cash and short-term Treasury bills and will also ensure that
the credit portfolio mix contains a significant proportion of loans that are shorter term in
nature such as working capital loans to businesses as well as short-maturity consumer loans
to individuals. This will, of course, tend to reduce their profitability and possibly their
competitiveness, depending on the structure of the market for banking services. However,
even among the more conservatively-managed banks, some amount of risk due to maturity
mismatch can arise from time to time. When the domestic economy, government economic
policies and the business cycle are all supportive, the effective replenishment (‘roll over’)
of short-term demand (and savings) deposits is readily achieved. The risk is during those
times when either general conditions (such as those precipitated by broad political and
economic events) or specific ones (such as those related to reputation or rumours associ-
ated with the bank itself) make the replenishment of depositary funding difficult. When this
happens, commercial banks still have a few options open to them. They can borrow from
23
other banks (through the inter-bank lending market), they can borrow from large institutions
(often called ‘managed liabilities’), or they can borrow from the central bank through the
window open to commercial banks and in those countries in which the central bank is
permitted by law or by charter to have a ‘lender of last resort’ role. If such conditions
continue and intensify, the changing composition of the bank’s liability portfolio may be an
early warning sign of impending financial distress for that institution. All of these sources
of funding involve what is termed ‘funding liquidity’. That is, they involve the confidence
and willingness of depositors or other institutions to transform readily and at reasonable
terms one type of financial asset, money, into another form of asset, a bank obligation.
Beyond the traditional predilections for one or the other of the main types of financing
(bank intermediation versus financial market disintermediation), however, two developments,
which we will explore in more detail are: (1) the involvement of commercial banks in the
issuance of public securities through asset securitisation (see Chapter 3) both at the short-
term maturities end of the spectrum (asset-backed commercial paper programmes) as well
as the long (collateralised mortgage obligations (CMOs), collateralised loan obligations
(CLOs), collateralised debt obligations (CDOs) and other forms of asset-backed securities);
and (2) the influence of Basel II on the size of banks internationally (see Chapter 6), as
they adjust to capture economies of scale and scope.
The functions of financial markets and their trade-offs

The functions of organised financial markets
From the perspective of market microstructure, organised financial markets have the following
functions:
• Price discovery – the desires of the broader market to hold units of a particular security
are reflected in the process of price discovery. The process entails certain tensions between
those who are seeking price guidance from the market as soon as possible and large partic-
ipants such as institutional investors who are reluctant to show their hand too readily.
• Consolidation of the order flow – consolidation is generally considered to be desirable
with respect to order flow and the pooling of information. It concentrates liquidity and
sharpens the focus and precision of price discovery. It is achievable if market design
features avoid excessive spatial and temporal fragmentation of order. This feature is
enhanced to the extent that information from all relevant trading books is widely and
easily available, access to trading facilities and related support functions is widely avail-
able, and arbitrageurs have easy access to the market.
• Efficiency (lower transaction costs) – minimising transaction costs is an objective which
must be seen in the context of the trade-offs facing the institutional investor: (1) the
certainty of being able to enter into a transaction at a particular price; (2) the risk of not
being able to complete the trade (failure of order execution) arising from an attempt to
improve on the price of the trade; (3) the choice between paying brokerage fees or incur-
ring slippage when buying from a dealer; and (4) the ability to preserve anonymity (in
the case of large or influential traders) and its associated cost compared with the market
impact costs associated with transparency.
24
• Fairness – fairness pertains to both market access and market operation. Fair access
means that traders are treated equally without any group having undue special privilege.
Fair operation means that trading rules are followed precisely and without exception.
Automated trading has removed most if not all of the uncertainty in this connection.
Those exchanges where auctions and trading floors still operate achieve fairness by having
close supervision of activities during trading hours. This extends to ensuring that records
are kept properly and provide suitable audit trails which provide information regarding
the details of how each and every order has been handled.
• Liquidity/immediacy – the broader concept of the two is liquidity which refers not only
to the speed with which a transaction can be entered into and completed but also the
ease with which this can be done without unduly moving the price. Immediacy, on the
other hand, relates to the rapidity of execution and is highly valued by traders and investors
who anticipate sudden movements in the security in which they wish to transact and who
want to avoid the risks of a protracted transaction.
• Transparency – markets have varying degrees of transparency. An important distinction
is made between ex ante transparency, which refers to markets which quickly dissemi-
nate information on quotes and orders, and ex post transparency, which refers to markets
which do not post quote and order information but only report trades once they are made.
Moreover, the market comprises traders and investors who as a group (and even at different
times as individuals) are ambivalent, if not schizophrenic with regard to transparency.
They want it when it works in their favour. But they prefer less transparency to the point
of avoiding it when they think it will confer an advantage to other participants that will
work to their own detriment.
• Volatility smoothing – an important distinction is made between fundamental volatility,
which is the change in price due to unanticipated changes in the main drivers of the
underlying instruments (for example, a change in a price-earnings (PE) ratio in the case
of a stock or a change in a relevant interest rate in the case of a bond or an option) and
transitory volatility which is a change in price due to trading activity on the part of unin-
formed traders, causing price to diverge from its fundamental value. Total volatility is
the sum of these two types of volatility. Regulators are concerned more with high tran-
sitory volatility than with fundamental volatility because the transitory variety can be an
indication that markets are becoming illiquid.
While mature markets can be described as having a high degree of informational efficiency,
there is no such thing as a perfectly efficient market.1 That is because if perfectly accurate
information were available and capable of being disseminated without the friction of signifi-
cant transaction costs, then there would be virtually no incentive for most market participants
to trade. The exception would be those, sometimes called ‘noise traders’, whose motives
for transacting would be other than price. One such example would be those seeking to
liquidate holdings due to unexpected needs, irrespective of the price they can obtain in the
market. Another example would be speculators who do not necessarily share in the ‘true’
information incorporated by the market but on some other perception akin to ‘noise’ but
which they treat as though it were reliable market information. To the extent that the latter
group is inconsequential with the vast majority of informed participants on the sidelines, this
25
would undermine the economics of keeping a market or exchange open for business.
Presumably it would reduce the ex ante returns of collecting financial information and trading
and hence the rationale associated with many jobs of those currently providing financial
services.
Liquidity – what does it mean? What does it matter?
The demand for and supply of financial liquidity

History has been marked by financial booms and busts. As humans strive, the interplay of
the conjugate emotions of fear and greed with external shocks has determined the collect-
ive bouts of optimism and pessimism which have buoyed or depressed asset values and
roiled financial markets.
Throughout this book, we will rely frequently on the concept of financial liquidity
(which we will abbreviate to just ‘liquidity’ for short) as a litmus test for the degree to
which financial markets experience distress. When the markets in which financial assets are
traded are perceived to be liquid, this is generally considered a healthy situation. When they
experience a diminution of liquidity, this usually is a sign of current or impending finan-
cial distress. Among the determinants of financial market liquidity, undeniably fundamental
factors are at work. However, liquidity cannot be disentangled from the notion of the degree
to which investors have confidence in the stability and orderliness of financial markets as
well as in financial asset valuations.
Although much of finance over a long historical span has been conducted without the
benefit of formal organised markets, the notion of liquidity or the ability either to reverse
or to enter into and to exit from financial positions unexpectedly and even prematurely has
been considered a useful one even where organised markets are not at work. But while the
term ‘liquidity’ as it is used in finance entered the lexicon long ago, it is instructive to keep
in mind that it is an abstraction drawn from the physical world. Just as bodies of water can
and often do ebb and flow, so does financial liquidity.
At the level of a single financial institution, an assessment of liquidity risk involves:
(1) comparing the structure of assets to the structure of liabilities on the institution’s balance
sheet in terms of the extent to which each category of asset is liquid or illiquid and each
category of liability is stable or volatile; (2) applying an analysis of the gap between the
realisable value of free (unencumbered) assets and the volume of short-term funding sources
and non-core deposits;2 and (3) undertaking an analysis of maturity mismatches between
assets and liabilities. Regarding maturity mismatches, it is important to recognise that cash
flow amount and cash flow timing can each be either deterministic (that is, pre-determined
contractually) or stochastic (event-driven), whereby: (1) both amount and timing are deter-
ministic: (2) amount and timing are stochastic; (3) amount is deterministic but timing is
stochastic; or (4) amount is stochastic and timing is deterministic. Funding ratios for different
time horizons compare the sum of available funding with tenors greater than the particular
horizon in question (measured in months or years) to the sum of assets maturing beyond
the particular horizon. Gap analyses are generally conducted for a variety of scenarios to
test the institution’s resilience to a variety of conditions.
26
Exhibit 2.1
Sources of financial institution liquidity risk
Internal External
Bank
• Credit risk increases • Market turmoil

• Problems with reputation • Payment system problems
• Operational risk events • Sovereign risk events
Source: Author’s own
One often finds that even experienced practitioners in finance sometimes equate volume
of transactions in a given period of time with some normative sense of the adequacy or
inadequacy of financial liquidity. While volume undeniably is an important consideration,
it fails as a proxy for financial liquidity. One only needs to think back to market crashes
which, at least in their initial days, experienced large transaction volumes but because the
impetus for the activity was all one-sided (panic selling), this activity was accompanied by
significant drops in asset prices. It is not uncommon to find that when markets are charac-
terised by pervasive fear culminating in panic, even previously illiquid assets will be offered
for sale, giving rise to higher transaction volumes in a period of time. It is for this reason
that unqualified measures of transaction volume can mislead us in gauging, or alerting us
to, impending financial market distress.
To anchor the concept of financial liquidity in solid ground for purposes of helping us
understand the forces and conditions which give rise to financial market distress, we should
envisage it as a property of a market with (at least) three dimensions. The first dimension
is the speed with which a market clearing price can be found. The second is the sensitivity
of market price to the transaction volume being attempted. And the third is the spread with
which those initiating transactions (buyers and sellers) and their intermediaries must contend.
Ideally, a highly liquid market, such as that for US Treasury bills, is one in which:
• buyers and sellers can transact quickly (speed) – that is, the faster a sale can be trans-
acted without moving the price, the greater the asset’s liquidity;
• large quantities of the financial asset either sought or offered in the market do not appre-
ciably move price (sensitivity) because of market depth, reflecting the number of buyers
27
and sellers who are in effect ‘stacked’ in queue for specific prices – in this case, the less
sensitive the asset’s price to transaction volume, the greater its liquidity; and
• bid-ask bands are narrow, which in turn indicates transaction efficiency (spreads) because
of market breadth, reflecting the cost of a unit of liquidity of being able to execute a
trade – or, the narrower the bid-ask spread, the greater the asset’s liquidity.
Additionally, many economists include the notion of market resilience, which reflects the
speed with which prices are restored to previous levels following a market disturbance.
By thinking in terms of these dimensions, we can see how public or market percep-
tions change in the light of external events or shocks. To the extent that the emotions of
market participants which are evoked by the external events or shocks cause changes in
these dimensions, with liquidity receding and price discovery left ambiguous or indetermin-
ate, then this provides us with a useful tool for assessing the extent to which financial market
distress is likely to be imminent.
Economists tend to equate liquidity with the availability of money or near-money in an
economy. While this focus is useful at a macroeconomic level, it does not provide us with
a fuller understanding of how liquidity is created and consumed in asset markets.3 In fact,
liquidity is usefully thought of as the ease with which one type of financial asset can be
transformed into another without a loss in value. Of course, money (measured by econo-
mists as M0 or base money, M1 or cash in circulation plus demand deposits and so on) is
no doubt the most ubiquitous type of financial asset as well as serving as the numeraire.
However, in connection with financial markets, the broader notion of liquidity encompasses
notions of credit availability, fund flows, asset prices and financial leverage. For an appre-
ciation of this process, we need to look at some of the features of market microstructure.
The convergence of markets and institutions

Technology has allowed asset markets to evolve in terms of their structural characteristics.
We will first examine the main types of markets, which are brokered markets, order-driven
markets and quote-driven dealer markets. We will then examine hybrid markets, which
combine features of the other three and which are very important, given that the NYSE and
the National Association of Securities Dealers Automated Quotation System (Nasdaq) stock
market fall in this category.
Brokered markets – a broker is someone who puts buyers and sellers together without
interposing himself directly in the transaction chain, no matter how brief the time interval.
In other words, brokers do not buy or sell on their own account. They always act as an
‘agent’ and not as a ‘principal’ in transactions.4 This also means they do not maintain inven-
tories of assets which they broker. Their main task is to seek out prospective buyers and
sellers for clients who wish to sell and buy respectively.
Brokered markets are quite common and generally found where the item being traded
has unique characteristics and when no dealers can be found willing to hold inventories in
the item. Some of the most prominent brokered markets include:
28
• real estate;
• entire companies and business franchises; and
• securities (stocks, bonds, and hybrid securities) when the sale amount exceeds a certain
size.
Order-driven markets – trading in these markets takes place between buyers and sellers
without dealer intermediation. Instead transactions are rule-based. A point of clarification is
warranted. The fact that buyers and sellers transact without dealer intermediation does not
mean that dealers cannot participate. In fact, in many order-driven markets, dealers account
for much of the trading and even supply much if not most of the market liquidity. However,
in pure order-driven markets (as opposed to either pure quotation-driven or hybrid market)
the dealers trade for their own account just like any other trader and are required by the
rules to trade with anyone who accepts their offers.
Before we examine trading rules and how they are applied within the structure of this
type of market, it will be useful to examine the nature of orders themselves and how they
affect liquidity.
Orders are instructions which traders specify to their brokers and to the exchange
regarding the manner in which the trade they wish to have executed is to be arranged. Some
of the specific details an order may provide include the following.
• Exact identity of the instrument (or instruments) to be traded; this is particularly impor-
tant, for example, where an issuer may have issued shares in several classes in order to
specify clearly in connection with which class the trader wishes to transact.
• Size or quantity (number of units, number of shares and so on).
• Whether the transaction represents a ‘buy order’ or a ‘sell order’ and further, whether
buy or sell orders represent ‘covered’ or ‘uncovered’ positions in the security in ques-
tion.
• Any specific conditions which the trade must be able to satisfy (the most common of
these is the ‘limit price’).
• How long the order is in force.
• Any special restrictions on timing of execution.
• Whether a partial fill is desired or alternatively if it is to be a ‘fill or kill’ order.
• The exchange on which the order is to be presented.
While orders can be written up in any type of market, in those markets where the trader
can arrange his or her own trade directly with one or more other traders, an order with a
high degree of specificity is not required. This is because the trader can monitor develop-
ments and react to the market immediately on the basis of what he or she observes. In
markets in which traders on the other side of the transaction will only be found by others
(such as by a dealer or by first a broker and then a dealer) with a lapse of time, then the
order will need to provide more guidance in terms of specificity in case the market changes
in the interval between the time when the order is placed and when it is executed or filled.
This additional specificity increases the chances of the order being filled rather than having
to be cancelled and re-submitted.
29
The trading rules governing how business is conducted in such a market comprise:
• those rules determining the precedence in which orders are executed which affects which
buyers and sellers wind up consummating a transaction; and
• rules regarding pricing.
Generally, the mechanism used in an order-driven market is an auction format with rules
that allow buyers to get the lowest price and sellers to get the highest price consistent with
the rules in what is called a price discovery process. Moreover, the structure of order-driven
markets can take a variety of forms. One form involves having occasional market calls
throughout the trading day with all orders accumulated up to that point cleared via a single-
price auction. Another form involves conducting two-sided auctions on a continuous basis
throughout the trading day. Crossing networks, in which buy and sell orders are matched
based on prices obtained from other markets, comprise yet another form.
All matching up of buyers and sellers is accomplished through the trading rules. This
means that buyers and sellers are not free to pick and chose with whom they transact. The
exact nature of the rules is very important as the rules influence market liquidity. Traders
can offer liquidity by stating the terms at which they stand ready to buy or sell while traders
who receive liquidity do so by accepting the terms of the available offers from liquidity
suppliers. The nature of liquidity supply is such that when a trader offers to sell a security
on certain terms, he or she is in essence providing prospective buyers who demand liquidity
with a call option.5 In other words, in accordance with the trading rules, they have the right
but not the obligation to call on the terms of the offering liquidity supplier. Similarly, those
traders offering to buy a security on certain terms are offering those who demand liquidity
on the sell side the equivalent of a put option.
Examples of actual order-driven markets, which include all markets conducting open-
outcry auctions or electronic auctions are:
• the larger futures exchanges;

• most stock exchanges;
• most options exchanges;
• many brokerage trading systems; and
• electronic communications networks (ECNs) organised for stocks, bonds, currencies and
certain financial derivatives like swaps.
Quote-driven dealer markets – in the pure form of this type of market, all trades are trans-
acted through dealers whether this is done directly between the trader and the dealer or
between the trader’s broker and the dealer. Since brokers tend to be dealers themselves, this
does not rule out the broker and the dealer being the same person. However, whether or
not this occurs will depend on if the broker has inventory of the security in question that
he is willing to supply in the size and at the price his client is seeking. Even if one trader
who wants to buy knows another trader who wants to sell, in a quote-driven market a direct
transaction between these two persons cannot take place but rather must occur through a
dealer. This is because price discovery is entirely based on quotes provided by dealers, hence
30
dealer intermediation is indispensable. In quote-driven markets, dealers provide all the

liquidity.
A characteristic feature of quote-driven markets is the freedom of choice among dealers
in picking their customers and those with whom they are willing to trade.
Examples of actual quote-driven markets include:
• nearly all bond markets;

• major currency markets; and
• a number of stock markets.
Hybrid markets – the two largest and most active stock markets in the US, the NYSE and
the Nasdaq Stock Market, are both examples of hybrid markets which combine features of
the three types of market described above. Although the NYSE has long been an order-driven
market, the role it assigns to specialist dealers whose primary function is to supply the market
with liquidity in one or more securities on a last-resort basis, makes it similar in this connec-
tion to quote-driven dealer markets. In the Nasdaq stock market, despite its essentially
quote-driven character, the requirement that its dealers circulate and under certain conditions
execute public limit orders makes it similar in this respect to order-driven markets.6
Market organisation and liquidity – the NYSE and the Nasdaq stock exchange both
attempt to increase liquidity through the intervention of specialised participants.
In the case of the NYSE, seven specialised firms which are securities dealers, with close
to 500 individuals covering several stocks each, are given the responsibility to ensure a fair
and orderly market for these specific stocks. They do this by ensuring that the reporting of
all incoming bids and asks is done in a fair, accurate and timely way and that order is main-
tained with regard to trading. Consistent with the auction-based organisation structure of
the NYSE, the specialist serves as an auctioneer for each stock that is its ‘specialty’, using
the method of open outcry. It is also the duty of the specialist to set the opening price for
the stock each morning, taking into account any incoming news between the previous day’s
close and the current day’s market opening. Specialists most frequently act as agents in that
they execute orders on behalf of others. In this capacity they are obligated to ensure that
each transaction is executed with the same fiduciary care as applied by the brokers from
whom they receive orders. At times, however, specialists are required to act as principals
in order to even out demand-supply imbalances. When such imbalances threaten continuity
in the price discovery role of the market, the specialist will either buy or sell quantities of
the stock to add or supply from their own inventory until appropriate price stabilisation in
the particular stock is achieved. Specialists also play a catalytic role. Because of their daily
close proximity on the floor of the exchange to traders and investors, they will often seek
out counterparties to transactions for which either buyers or sellers on the other side of the
transaction do not seem to be readily forthcoming.
The specialist system is not without controversy. Specialists enjoy certain privileges
not available to other traders. They also are restricted from certain activities. For example,
they are discouraged from holding limit orders on their books so as not to reduce the
supply of liquidity that is available to public traders. However, despite the offsetting nature
31
of restrictions and special privileges, those public traders who benefit from the services
the specialists provide and those who have incurred costs or losses are not usually the
same. Regulators need to decide with respect to the specialist system whether the benefits
outweigh the costs.
In the case of the Nasdaq stock market close to 300 market-makers, which are broker-
dealer firms, maintain inventories in the stocks they have been assigned and it is their
responsibility to provide regular firm bid and ask quotations on a stock. In this way they
are suppliers of liquidity.
Market-makers perform their role of liquidity provider as a business. It is not pro bono
work. Consequently, they will avoid posting firm bid and ask quotations which will unduly
place their capital at risk when market conditions become highly unstable and when they
correspondingly perceive the risk of being a liquidity provider during such conditions as
outweighing the expected benefit. When volatilities and uncertainties increase markedly,
liquidity in those securities can decrease sharply irrespective of the existence of market-
makers. Of course, the total liquidity that market-makers are able to supply is limited by
the capital they have to dedicate to these activities. Proposals to raise capital requirements
for brokers and dealers, however, are sometimes misunderstood. Greater capital can increase
the potential for increased supply of liquidity but it does not guarantee that the liquidity
will be forthcoming if the perceptions of market risk become too great.
From the perspective of which type of stock market is the most resilient in the face of
market distress, each has had its advantages and disadvantages. When volume spikes during
a generalised stock market panic, the capacity for an auction-based system to process orders
is threatened by the limits on humans to transact faster without losing accuracy or being
overcome by the temptation to take short cuts (such as failure to post all the information
on transactions and to complete the administrative tasks required of each trade). An auto-
mated communications network, however, has not been without its risks when for example,
at least in the past, the higher transaction volumes during market panics had the potential
to exceed available bandwidth and thus cause severe slowdowns (if not massive denial of
service) for traders and investors submitting their trades online. Advances in bandwidth,
storage, processing speed and reliability, and online security measures have mitigated such
risks considerably and no doubt will continue to do so in future.
Recent years have also seen a blurring of some of the sharp distinctions among types of
markets. At one point the future of the NYSE’s unswerving commitment to its trading floor
was seen by some as being anachronistic and thus a major risk, given the international trend
toward markets such as the Nasdaq and major European stock markets which comprise elec-
tronic networks with no distinct physical marketplace identified. However, even though the
Big Board still operates its trading floor, a combination of the multiple locations out of which
it now operates since the tragic terrorist attack on the World Trade Center towers of September
11 2001, when the NYSE was closed for four days, and the acquisition and operation of other
electronic and traditional exchanges (such as Instinet and the American Stock Exchange), are
indicative of the increased resilience it has acquired through strategic modernisation.
The bond market – sometimes called the fixed-income market, the credit market, or the
debt market, the bond market is a financial market which allows its participants to transact
32
in debt securities. Like the equity market, it comprises a primary market which involves the
public placement of new debt securities and a secondary market in which participants buy
and sell outstanding debt issues. A major difference between debt and equity markets is that
whereas common stock has no expiration date and no predetermined residual value, debt
instruments (with very few exceptions such as the British consol) have finite maturities and
contractually-determined payment schedules for interest and principal. This attribute has
important ramifications for the behaviour of the pricing of debt securities. Specifically, the
inherent ‘promise to pay’ embedded in a debt instrument acts as a valuation channel which
guides the market price for the security toward convergence with its payoff value at final
maturity. Another key difference is that governments (national, state and municipal) are
prominent participants in the bond markets in terms of new issuance (as well as on the port-
folio investor side) whereas a similar role of issuer in the equities markets has become
increasingly rare as a consequence of numerous countries undertaking privatisation
programmes.
At December 2007, the global bond market for domestic debt securities was estimated
to be about $57 trillion, of which the United States bond market represented a little over
$24 trillion; Japan, $8.9 trillion; Italy, $3.1 trillion; France, $2.8 trillion; Germany, $2.6 tril-
lion; Spain, $1.6 trillion; China, $1.7 trillion; and the UK, $1.4 trillion.7 Moreover, the
average daily trading in the US bond market of almost $1 trillion, which takes place in the
over-the-counter (OTC) market between registered bond broker-dealers and institutional
investors, contributes a large portion of the enormous liquidity in the US financial markets
which has allowed many new financial products not commercially feasible in other coun-
tries (at least not at the outset) to be first launched.
The international bond market comprises three segments: foreign bonds, Eurobonds,
and global bonds. Foreign bonds are issued by a foreign borrower to investors in the capital
market of a country other than that of the issuer and are denominated in that country’s
currency. A Eurobond is denominated in a particular currency (very often in US Dollars but
can also be in Euros or Yen) but sold to investors in countries other than the country of the
denominating currency. Global bonds are bond issues which are very large and are conse-
quently offered by the issuer simultaneously in North America, Europe and Asia. They have
in large measure been encouraged by the Securities and Exchange Commission (SEC) Rule
144A, which allows for the private placement of securities with attendant streamlining of
registration and other regulatory requirements normally associated with securities issues
among sophisticated investors who meet certain eligibility criteria.
The main types of bonds are:
• Fixed-rate bonds which have a designated maturity date at which all of the outstanding
principal is to be repaid. Throughout the bond’s life, fixed coupon payments are made
expressed as some percentage rate of interest applied to the face value.
• Convertible bonds resemble straight fixed-rate bonds but with the added feature of
allowing the investor to exchange the bond for a number of shares in the issuer’s equity
at a predetermined conversion rate. Convertible bonds have a floor value which is equal
to their fixed-rate bond value and generally trade at a premium above the greater of their
fixed-rate value and their conversion value. The value of the conversion feature is usually
33
reflected in the willingness on the part of investors to accept a bond coupon rate which
is lower than they would be willing to accept on a straight fixed-rate bond.
• Zero coupon bonds are bonds which pay out neither principal nor interest throughout
their lives but instead pay all cumulative interest and principal upon maturation. Stripped
bonds are zero coupon bonds which have been created by stripping out the coupons and
principal payments of a bond which normally pays a coupon. The stripping applied to a
single coupon bond generally results in a series of zero coupon bonds, each comprised
of the individual principal and coupon payments.
• Dual currency bonds are fixed-rate coupon bonds which are issued in and pay coupons
in one currency but repay the entire principal upon maturity in a different currency.
Consequently, they carry exchange-rate risk.
• Multiple (or composite) currency bonds are generally fixed-rate coupon bonds which
have been issued in a basket of currencies, the effect of which is to lower the variability
of the value of the coupon stream as well as the market price as a consequence of diver-
sified currency movements.
• Floating-rate notes (FRNs) are generally bonds of medium-term maturity which instead
of paying a fixed coupon rate expressed as a percentage of face value make coupon payments
referenced to an international index such as Libor, Euribor, US Prime and so on.
The bond market is further partitioned into five sub-markets.
• Corporate.
• Government and agency.
• Municipal.
• Mortgage-backed, asset-backed, and collateralised debt obligation.
• Funding.
The structure of the bond markets in terms of the aforementioned sub-markets varies consid-
erably among countries. Despite the absolute importance of US government bonds, this
sub-market is not proportionally as important in the United States as it is, for example, in
most European countries. For some countries, such as Germany, this reflects the relative
importance of banks as the source of most financing for business.
A major issue in the design, monitoring and regulation of a bond market is the matter
of how the characteristics of transparency, liquidity, and efficiency tend to interact. In general
terms, in countries with a high degree of transparency – both pre- and post-trade – trade
sizes tend to be smaller. On the other hand, the greater the transparency, the stronger the
tendency for large institutional traders to hold back in signalling that they are either seeking
or are prepared to offer securities for sale. In this connection, they tend to seek ways to
disguise their intentions such as splitting orders into smaller lots among a number of agents
(broker-dealers). An important adjunct to a country’s bond market is the size of the market
for ‘repurchase agreements’ or repo-financing.
Because of the heterogeneity of bonds and other debt instruments, even for a single
issuer, bond trading tends to be decentralised in most countries. Electronic trading has under-
scored this aspect of the market. In the United States, with the migration of bond trading
34
from the Automated Bond System to the NYSE, the number of issues traded has increased
from about 1,000 to 6,000.
The US bond market has been enriched over the past few decades with the issuance
and trading of sizeable volumes of mortgage-backed, asset-backed and collateralised debt
securities. Similar developments have also occurred in Europe although with some notable
differences. The main feature of US structured finance securities has been the effort that
has gone into achieving bankruptcy remoteness of the issuer from the originating institu-
tion. In contrast, the German Pfandbrief and European ‘covered bond’ markets, notably
Société de Credit Foncier (SCF) issues in France and Cédulas Hipotecarias in Spain which
were both introduced in 1999, involve the issuance of mortgage backed bonds of high
quality. These issues involve bonds the face value of which is fully backed or ‘covered’
by mortgages on the balance sheet of the issuer bearing the same interest rate as paid out
on the Pfandbrief bond or European covered bond and with the mortgage conforming to
having no more than a 60% loan-to-value (LTV) ratio. As Graham Cross8 points out, the
main differences between covered bonds and ABS/MBS are:
• Covered bonds involve collateral that remains on the balance sheets of the issuers whereas
ABS/MBS involve true sale transfers of assets off-balance-sheet to special purpose enti-
ties (SPEs).9
• Covered bond interest and principal payments are made by the issuer whereas ABS/MBS
payments flow directly from the assets.
• Depending on the legal jurisdiction, covered bondholders may have recourse to some
assets beyond the mortgage pool covering the bond issue whereas ABS/MBS bondholders
have no recourse beyond the collateral pools established for the associated securitisa-
tions.
• Covered bond collateral comprises assets which are well defined by law and hence accom-
modate substitution beyond that which is permitted under ABS/MBS structures.
• The strength of a covered bond issue lies in the strength of the issuer whereas in the
case of the ABS/MBS structure it lies in the quality of the assets.
• In the event of a covered bond issuer becoming insolvent, payments of principal and
interest may still be made subject to cash availability, whereas specific legally-defined
credit events in the case of ABS/MBS issues trigger acceleration of payments once they
have occurred.
Additional comfort provided in connection with the European mortgage-backed bonds

includes:
• the fact that in Germany there has not been a mortgage-bank bankruptcy in over 100
years;
• in France partial bankruptcy-remoteness by which the SCF is excluded from any bank-
ruptcy proceedings initiated for its parent; and
• in the case of Spain, the over-collateralisation which is customary in connection with the
Cédulas.
35
Legislation in these countries has widened the permissible asset base for these instruments,
both in terms of types of collateral as well as its geographical coverage. The cumulative
effect of these developments has been to increase the integration of financial markets as
well as the extent of ‘tight coupling’ within the global financial system. The implication of
this latter phenomenon is that the circuits for transmitting the contagion effects of both the
euphoria which accompanies financial bubbles as well as the panic which attends market
crashes have become more numerous and conductive.
Effects of liquidity differences in multi-leg positions

An important systemic feature of any financial system derives from the interaction between
and among the markets for different financial products and instruments. Activity in the sub-
markets does not occur in silos. Portfolio management decisions, including speculative and
hedging decisions, involve not only taking positions in asset holdings across sub-markets
but indeed the creation of new financially-structured or hedged products by using the more
familiar instruments as building blocks. For example, whether a long equity position in a
traded stock is combined with an option such as a put contract or a loan on a bank’s
balance sheet is protected by a credit derivative, the combination of the expected returns
and their associated volatilities of each instrument creates entirely new risk and return
profiles. What at times receive lesser scrutiny are the differences in the liquidity charac-
teristics of the various legs of the hedged position. To the extent that these differences
further diverge, the potential for upsetting the initial risk-return-liquidity balance is consid-
erable, possibly leading to financial distress on the part of the institution holding such a
position.
For example, let us envisage an institution which considers its portfolio of long hold-
ings to be suitably hedged by a portfolio of short positions. Then any development (action
or event) which curtailed trading in the relevant sub-market pertaining to either one side or
the other of the hedged position could drastically alter the risk-return-liquidity profile of its
overall portfolio. If that institution were subject to prudential norms, whether imposed by
a banking regulator, its own charter or by the prospective impact on its own share price in
the market place, then it may find it needs to unwind quickly some of those positions in
order to achieve a more prudent overall risk profile. If this could only be undertaken through
distressed selling, then it could also have the potential to cause some amount of contagion
(through panic for example) in the relevant markets. The extent of such an effect, of course,
would depend upon several things, not the least of which would be the size and possibly
the importance of the institution, the size of its affected holdings in the relevant markets in
which it was attempting to transact, its decision horizon (affecting the speed and urgency
with which it must attempt to balance its portfolio) and other fundamental and technical
conditions prevailing at the time.
However, just as it was found in solid state physics that speeds in semiconductors could
be augmented by passing current through wafers comprising layers of varying impedance,
in an analogous way, sudden (if not forced) transactions in connection with different legs
of a hedged position have the potential to convey financial market distress through liquidity
differentials as well.
36
Factors affecting the stability of financial markets
Attributes of mature and stable financial markets

Countries with mature, efficient and relatively complete financial markets tend to have the
following attributes.
• Long histories of macroeconomic – particularly price – stability.

• Strong, well-capitalised banks operating in accordance with well-established prudential
norms and with adequate control and risk management frameworks.
• Securities markets with compulsory registration for brokers, dealers and financial advisers
and subject to well-developed regulatory oversight bodies and functions.
• A significant degree of financial market ‘completeness’ achieved through such features
as securities lending and short selling.
• Appropriate laws and related legislation, institutions and bodies pertaining to financial
contracts and entities, foreclosure, bankruptcy, liquidation, minority investor rights, and
corporate governance.
• Appropriate laws and related legislation allowing rapid and transparent transactions
pertaining to negotiable instruments.
• Securities markets characterised by most if not all securities in ‘de-materialised’ rather
than physical form.
• Well-developed institutions for the generation and dissemination of financial information,
including media, rating agencies, financial appraisals and so on.
• Well-developed national oversight functions comprising three pillars, addressing:
• Macroprudential surveillance and financial stability analysis;
• Financial system supervision and regulation; and
• Financial system infrastructure (as described above).
We are interested in systemic aspects of financial market distress on multiple counts. First,
to the extent that financial market distress poses the threat of systemic risk, any knowledge
that can be applied as an early warning system has widespread value. Systemic risk is the
likelihood that distress at the level of one or a few institutions will spread to many, in the
extreme possibly even causing a disruption in the functioning of markets or financial infra-
structure such as clearing, settlement and payments systems. An appreciation of how financial
contagion and induced effects are transmitted can shed light on myths regarding risk control.
For example, the globalisation of many aspects of finance today casts doubt on the assump-
tion that international diversification provides full protection from systemic crashes or draw
downs – at least as much as it was believed to offer before international markets became
highly interrelated. Similarly, many hedged positions for example through the application
of financial derivatives, which otherwise would provide adequate risk cover under normal
circumstances, have a tendency to fail just when they are most needed during major market
corrections. From the detection of possible early warning signs, ideas regarding prudential
norms and risk-mitigating action can then be discussed from the perspective of portfolio
management – whether at the personal or institutional level.
Second, policy-makers need to understand the changing nature, including the growing
37
complexity, of the global financial system in order to ascertain those things that may need
fixing and those things best left alone. A concrete example of the latter is the decision at
the time of writing to bail out a limited category of indebted homeowners as a consequence
of the sub-prime mortgage lending crisis in the US. Early versions of such relief packages,
which actually aimed at providing forbearance to many who had not yet defaulted on their
home mortgage loans while effectively abandoning those who already had defaulted, did
not pay due regard to the full ramifications such relief is likely to have on the financial
markets. In this latter connection, they did not address the intricate lattice work of finan-
cial hedge products and guarantees which were liberally used as credit enhancements in
securitisations.
And third, through better understanding of the nature of the full spectrum of risks,
including those associated with extreme financial market events, financial innovation can
focus on those new products and institutions, within the framework provided by lawmakers
and policy-makers, that will be most likely to, if not fully stabilise the international finan-
cial system, then at least help limit the severity and incidence of market crashes and financial
meltdowns.
Analytical techniques which work at the level of the individual person or company
break down when applied to the task of understanding and predicting systemic phenomena
under extreme conditions such as widespread market distress or, in the extreme, market
crashes. This is because financial markets fall under the category of ‘self-organising struc-
tures’. This does not deny the importance of the role played by the original decisions on
the part of lawmakers and policy-makers in shaping the organisational and regulatory aspects
of market design. However, once in play, the functioning of a market takes on a life of its
own as a result of myriad interactions among market participants – investors, traders, market-
makers, specialists, the media and regulatory bodies. Considerable debate remains ongoing
regarding the nature of crises. One school of thought contends that in the same way that
category five hurricanes are also breezes or winds that grew too large and strong with time,
so financial market crashes are draw downs with extended duration. Consequently, their
nucleation or formation does not differ from that of their smaller relatives. According to
this school, it is a matter of duration and hence virtually impossible to predict. This leaves
unanswered the question of what determines the duration of financial draw downs. Are there
layers of causative pattern at work below that which is discernible which help explain the
accretive force leading to these extreme events? It is important to note that there are others
who reject this view. In the opinion of this other group, ‘tail’ events fall into their own cate-
gory which makes them much more difficult to forecast in a probabilistic sense. Yet such
events should not be disregarded nor discounted simply because the frequency of occur-
rence observed in the historical data for smaller events provide a seemingly more robust
quantitative basis on which to take risk management decisions.
Research has shown that the more heterogeneous a market in terms of participants’ hori-
zons and needs, the better the properties of system stability of the market. In Chile, the
advent of that country’s private pension management system is an interesting example of
ways in which the rules of conduct for pension fund managers involved rewarding ‘herd’
behaviour and penalising divergences from the average. In so doing, some observers have
noted that this tended to augment the amplitudes of market fluctuations. Whether or not in
38
reality this has increased the propensity for the Chilean financial market to trend toward
extreme events (a crash) has not been borne out. On the other hand, because a high-impact
low-probability risk has not yet materialised does not deny its existence.
1
Grossman and Stiglitz, in Sornette (2003, p. 47).
2
The most familiar concept in this connection is the cash capital concept developed by Moody’s Investor Services.
As described by Matz and Neu (2007), ‘… cash capital is defined as the aggregate of long-term debt, core
deposits and equity (and contingency funding capacities) minus firm-wide haircuts, contingent outflows and
illiquid assets.’
3
In fact, one can envisage situations in which certain other assets may at times and under specific conditions
actually be more liquid than money.
4
In some markets, brokers can also be dealers. If one should be seen transacting as a ‘principal’ for his own
account, then it means he is wearing his ‘dealer’ hat.
5
However, this needs to be viewed as an option on the liquidity and not with respect to the security.
6
Harris (2003, pp. 94–6).
7
BIS Quarterly Review June 2008. Statistical Annex, page A-96.
8
Graham Cross. ‘The German Pfandbrief and European Covered Bonds Market’, in Fabozzi and Choudhry (2004,
pp. 211–12).
9
We will use the terms special purpose entity (SPE), or special purpose vehicle (SPV) interchangeably throughout.
39
Chapter 3
Systemic liquidity and financial market

distress
The distinction between individual and systemic liquidity

Liquidity risk is a consequential risk.1 From the perspective of the individual enterprise, it
arises out of or is a consequence of factors which result in the enterprise not being able to
transform assets into liquid resources in sufficient quantity and in time to meet payment
obligations falling due. Market liquidity risk, on the other hand, occurs when a significant
number of assets cannot be sold at their fair value. It may also result from impaired access
to markets. Traditionally, the most durable example of impaired access was due to prob-
lems of reputation, such as in the case of a bank that is known or suspected to be insolvent.
In today’s electronic markets, it can also include system overload resulting in ‘massive denial
of service’ for example when traders become panicked by breaking news events and all try
to access markets simultaneously.
In fact, as discussed in Chapter 5, the Black Monday market crash of October 1987 was
blamed by many on the closure of the financial derivatives markets in Chicago during hours
in which New York traders could no longer maintain position hedges. This added to the panic
and may have fuelled massive selling even more. Although there were many other factors
responsible for the crash, it is during times of massive distress that market access is crucial.
To the extent that an increasing percentage of public securities backed by pools of assets
rely on financial derivative products (whether stand-alone products such as swaps, options
or ‘swaptions’ or embedded options in the form of legal covenants within loan documenta-
tion) in the form of external enhancement or even as the basis for undertaking a synthetic
securitisation (for example, credit derivatives), liquidity risk – both at the level of the indi-
vidual financial asset and at the level of the relevant financial markets – becomes a matter
of paramount importance. The problem is that derivative products work as hedges so long
as markets behave within tolerable bounds. Once these bounds have been breached, the
values of financial derivatives (very much like their mathematical counterparts when a func-
tion becomes discontinuous) become indeterminate. In such circumstances, they can no
longer provide the risk-reducing comfort for which they were employed in the first place.
When they involve securities the values of which interlock within a payment cascade they
can quickly render the valuation of entire portfolios indeterminate as well.
Thoughts on the asymmetry of market liquidity during booms and busts

Although factors, which contributed to an economic boom in the first place, are often present
only working in reverse during the subsequent bust, an important asymmetry is at play. It
40
Systemic liquidity and financial market distress
is the role of market liquidity. During the boom phase of an economic cycle, market liquidity
is ample and often grows along with the asset prices reflected in the boom. This occurs
because late entrants wanting to capitalise on the boom are ready to buy and a number of
those already holding long positions either want to cash out or alternatively want to switch
horses mid-stream as they perceive ways to enhance their gains. The exuberance they share
is symbiotic to the point of being strongly mutually reinforcing.
In contrast, as the expectations of a market reversal become stronger, exuberance is
initially subjugated to and then replaced by fear. First, an initial few participants holding
long positions decide to sell (or have been applying the discipline of moving stop losses
automatically which triggers this decision on their behalf). But as the risk seems to increase
that the upward trend has not only stopped but may soon reverse, these early sellers do not
find as many willing buyers. Their intended sales transactions can only be realised at steeper
price discounts than expected. As this information is digested by the market, additional
waves of long-position holders, feeling a rising sense of panic, rush to sell. Their combined
actions are met with even less enthusiasm on the buy side, thus necessitating even larger
price discounts. Initially these dynamics apply to individual holdings.
However, as investors or wealth-holders see the overall value of their portfolios decline
sharply, the selling quickly spreads systemically. As suppliers of liquidity see market prices
successively slip away from the prices they specified in their limit orders, many of them
increasingly switch to placing market orders. This results in them merely adding to the
unsatisfied demand for liquidity in a turbulent market. Traders and investors will often try
to exit also those asset positions which have yet to exhibit a clear reversal in the hopes of
salvaging as much realisable value as possible. This fear-driven action is like applying a
bellows to a few burning embers in a pile of coal. It becomes a process of price contagion
which aligns an increasing number of assets (which may have even been experiencing random
or even upward price changes and thus weakly correlated at the height of the boom) with
downward sales-driven pressure.
After a few successive waves of cumulative selling, with larger and more discontinuous
price declines involved, other information and effects kick in either to signal a bottom to
the crash or alternatively, propel it to even greater depths. In traditional asset markets, that
information and effect has always been value driven. By this it is meant that an industry of
analysts generally have an idea of what constitutes fair value of stocks, bonds, real estate
or other traditional assets based on certain shared views of fundamental analysis. This is
not to say that this view is identical. But analysts’ estimates tend to cluster, albeit with rela-
tively few outliers.
When market corrections have started the process of discounting asset prices, an initial
group of investors with resources to commit decides at some point that the discount to fair
value of the assets in question is sufficiently attractive for them to enter the market with
buy orders. This slows the rate of price depreciation for those assets. If this action is not
robust enough to turn prices around, one or more waves of investors, deciding that the now
further divergence between current prices and fair market prices is sufficiently attractive to
them, enter the market with buy orders following on from the initial wave.
At some point, with the prices declining but decelerating, a wave of new buyers entering
the market will succeed in reversing the direction in price movement. Once this becomes
41
evident and the market absorbs this information, successive waves of new buyers will enter
the market. If the market’s perception of a trend reversal is strong enough, a new boom phase
of a boom-bust cycle may start. If it is not, then prices may oscillate in a trading range for
some time before they break out. Which way they go from the breakout depends on many
factors, including the strength of updated fundamentals as well as technical attributes. In either
a new boom phase or in a trading range, the flow of liquidity is back into the market.
Complicating the analysis above, although in no way invalidating it, is the role of secur-
ities lending and short sellers. In mature markets in which securities can be loaned and
short positions taken, this market feature serves to lend greater stability to market dynamics.
Not all securities, however, offer the same potential for taking short positions. Consequently,
while short selling adds to ‘market completeness’, it is never perfectly complete. Asymmetries
in the number, size and attributes of short sellers in comparison with long-position holders
will usually result in merely dampening the market’s boom-bust oscillations without actu-
ally hedging them outright.
So much for traditional or conventional asset markets. Two recent crises serve as excel-
lent counterpoints to the self-correcting aspects of boom-bust mechanics described above.
The first was the dot-com boom and its subsequent total flameout (see Chapter 5, under
United States dot-com (2000)). The second has been the financial markets distress (as distinct
from the related homeowner distress) of the sub-prime crisis (see Chapter 5, under United
States sub-prime (2007)).
Identifying financial market distress
Anatomy of a financial crisis

Widespread financial crisis is a phenomenon that has been around for centuries and comes
in different forms. It has affected the international value of currencies, bank credit, securi-
ties markets, commodities markets, and financial derivatives markets in varying combinations.
While descriptions abound regarding the dynamics of how bubbles form in financial asset
prices, debate continues as to the root causes of financial crises and the manifestation to
which they often give rise – distressed financial markets. Some favour explanations of poor
economic policies on the part of a country’s economic authorities. Others blame specula-
tors and the conjugate emotions of fear and greed which drive markets. Mainstream economics
has long depended on the concept of human rationality, as embodied in the theory of rational
expectations, as a guiding principle for markets.
When one combines the uniformity of market information with notions of perfect and
total rationality, the idea of trade in financial securities, for example, breaks down. If all
economic agents have the same information and therefore tend to make the same valuations
based on the same information available to all, then it is difficult to reconcile in many cases
the simultaneous co-existence of buyers and sellers. It is not that their coexistence cannot
be explained but the arguments invoked (different appetites for risk, different time horizons
and so on) must carry greater weight as a consequence. When emotions are taken into
account, the main ones being fear and greed, then new information can be assimilated by
the market in different ways, depending on which of these two emotions is dominant among
42
the majority of market participants at the time. The existence of yet two additional behav-
ioural characteristics interact with fear and greed and in so doing act as an accelerant in
connection with the formation of manias and asset bubbles. These are (1) a penchant to
deceive; and (2) a tendency to be gullible.
Swindles have been included as an important category of phenomenon leading to a
financial crash or meltdown. At first blush, this may seem misplaced. However, the descrip-
tion of Ponzi schemes first initiated by a perpetrator of that name down to the fraudulent
behaviour of many mortgage brokers contributing to the 2007–2008 sub-prime debacle have
important systemic similarities. In every one of these cases, the abandonment of prudence
and probity contributed greatly to a weakening in the financial structure to the point that
the inevitable cooling in the forces driving the bubble left the system exposed to virtually
any precipitous action which would set off a financial avalanche. This whole process is often
at variance with financial developments as presented by the media.
Not a business day closes that the media is incapable of ascribing the reasons for the
market’s gain or decline to a single or in some instances a very few key events. This leaves
the readership with the distinct impression that the events unequivocally ‘caused’ the market’s
performance for the day. The implication being that, had the named event or events not
occurred, then the market would have been perfectly fine the way it was. It is rare that the
author of a byline will cast the role of the day’s events as being catalytic rather than funda-
mentally causative.
An analogy would be attributing the collapse of a major building exclusively to the
evils of a hurricane, instead of recognising that accreting structural weakness could just as
easily have been the main cause of the collapse and which could have just as easily been
alternatively triggered by, say, a strong wind, the vibrations of traffic or the subtle shift of
plate tectonics. Upon scrutiny, if a single event such as from among those just listed can
be attributed with precipitating a financial collapse, then the medium facilitating this will
be a sudden decline in market liquidity. To the extent that the market’s structural weakness
has been perceived by the public for some time as an ‘overhang’ in the form of a funda-
mental overvaluation, then even the professional and customary suppliers of buy-side liquidity
will tend to sit things out on the sidelines for fear of the impending value erosion to follow
the early transactions. This of course, only tends to aggravate, even if it postpones some-
what, the inevitable deluge. For example, in connection with the 2007–2008 sub-prime crisis
(described in Chapter 5), massive injections of liquidity by the Federal Reserve have failed
to pump up real estate sales at the time of writing because lenders remain convinced that
housing prices still have a significant way to fall.
Relative to activities in the real sectors (such as manufacturing), financial markets and
institutions are highly liquid. This is not to say that all segments of the financial market or
associated institutions are equally liquid but the prospect of being able to obtain frequent
if not instantaneous price quotations and to liquidate fairly quickly the assets in which they
transact invites and facilitates leverage. It does this on a scale and with an ease not mirrored
in real sectors of the economy. As Bookstaber clarifies, ‘Liquidity allows for ready leverage,
but it also creates the means for crises.’2
When financial leverage reaches a tipping point, the dynamic path of the resulting equili-
bration is difficult to predict. Whether or not a new equilibrium lies reasonably close to
43
the tipping point or recedes steadily as asset prices enter freefall, depends on the strength
of the need for the reduction in leverage and the price elasticities of the leveraged assets.
As long as the capital returned from assets being liquidated is able to reduce the leverage
ratio, then a new equilibrium can be found which preserves a significant amount of port-
folio value. However, to the extent that asset sales precipitate a fall in prices and thus
portfolio valuations which cause leverage ratios to remain constant or even to increase, then
the very act of starting a liquidation process will trigger the need for successive rounds of
further liquidation with no credibly-predictable end in sight. From a systemic viewpoint, the
path to a new and lower equilibrium depends mathematically on the nature of the roots of
the equations defining the demand and supply interactions in a liquidation. Generally, roots
of modulus less than one should cause the system to dampen with those greater than one
forestalling convergence and possibly making the adjustment an explosive one. Real roots
facilitate a smooth path (again whether leading to convergence or not depending on root
moduli) whereas complex roots will give rise to oscillations.
A principal form of bubble formation is described by log-normal periodicity and the
power law.
Reflections on real and financial assets and their markets

Normally, one does not associate speculative or herding behaviour directly with real goods
or assets. Historically, a principal exception to this in the literature on crises and crashes is
perhaps the ‘tulip mania’ that overtook the Netherlands in the 17th Century (see Chapter 1,
under ‘Early Examples’). As speculation became more prevalent in connection with finan-
cial securities and bank credit, in time extending to financial derivatives, the majority of
cases of financial distress have been related to financial assets and their derivatives.
In recent years, however, with technological advances, markets for many real goods
have begun exhibiting characteristics previously associated with financial markets. Decision-
making in real time has become itself characteristic of either speculation or the pre-emptive
avoidance of prospective speculation. Thus real estate transactions, once considered to be
not the best examples of liquidity or price discovery, now enjoy many of the same organ-
isational features which even major stock markets lacked decades ago.
Furthermore, technologies ranging from real world awareness (including but not limited
to radio frequency identification or RFID technology), supply chain management and tech-
nological forecasting have all contributed to the agility of manufacturing executives to shift
their bets on technology both in sourcing as well as in distributing and selling their prod-
ucts. To the extent that many of these real goods and services figure prominently as underlying
values (either as essential inputs to business or as outputs) underpinning financial securities
and derivatives, the new dynamics of their price behaviour is relevant to the formation of
bubbles and indeed the nucleation of outlier events leading to financial crises and distress.
We encounter this in connection with the current situation with global imbalances and the
ongoing debate as to whether the current commodity price boom represents the formation
of yet another bubble or represents fundamental and enduring structural shifts in global
demand and supply relationships.
44
Secured financing and collateral markets

Secured financing is not a new concept. Up until the explosion of structured finance prod-
ucts, most of the collateral offered as security to back secured lending – whether in the
form of bank loans or secured debentures – was preponderantly in the form of real assets
or assets which were not similar to or at least were clearly distinguishable from the secured
lending instruments themselves. It was not just that they were distinguishable but also that
they derive their value independently of the fortunes of the enterprise which owns them.
Strong security, therefore, comprised an asset the value of which correlated weakly with
that of the financial asset it was securing. Many publicly-traded securities today which are
backed by other financial obligations (and often in multiple layers), entail a self-referential
complexity3 that was not encountered when most obligations were secured by gold or silver,
real estate, commodities, inventories, or other assets the valuations of which were not derived
from the financial markets themselves. From the perspective of undertaking dynamic valu-
ation as a basis for maintaining a liquid secondary market for the trading of asset-backed
securities which include loans and even other asset-backed securities as part of their collat-
eral backing, the complexity of such an undertaking becomes more critical the more that
financial assets move away from their price averages. This is the case both in terms of where
they are situated in time as well as in terms of broader indices.
Types of financial crises

Until the creation of the Bretton Woods framework, countries followed first the gold stan-
dard (up until World War I), replaced by the gold-exchange standard as the mechanism for
determining international values of their currencies after the war. Although both variants of
this system met with increasing criticism resulting in its ultimate abandonment in 1971, it
had the advantage of a clear and physical means for automatic adjustment. For centuries,
items on capital account (even before countries had capital accounts) were of insignificance
in determining the balance between countries’ currencies. Trade in goods and services was
the determining factor. To the extent that a country bought more from others than it was
able to sell them, it experienced a net outflow of gold reserves to cover the difference in
value. Consequently, the automaticity of the gold standard provided a natural adjustment
that was easy to monitor and implement. Of course, even as far back as the days of sailing
ships the defects of this system were recognised in that countries often had motives and
objectives other than external trade alone for maintaining their currencies within certain
value ranges.
With the advent of the Bretton Woods system immediately following World War II, a
regime of closely linked (if not completely fixed) exchange rates was made the basis for
international currency management with the International Monetary Fund playing the role of
umpire. Despite the new mechanism, gold did not lose its status as the backing of curren-
cies in most countries. For example, until 1971, when President Nixon took the United States
off the gold exchange standard, US citizens were forbidden to hold or transact in gold (with
the exception of artisans or other industries which were licenced to do so in amounts commen-
surate with their primary non-financial business activities). In 1971, when the US went off
the gold exchange standard, it paved the way for a succession of countries to adopt fiat
45
currencies. Whereas reserve management before then had been aimed at ensuring adequate
reserves, the management of fiat currencies introduced a diverse array of exchange rate
regimes, most of which also needed to be managed. While many countries adopted managed
or ‘dirty’ float exchange rate systems, an exception which was to play an important role in
some of the crises we will examine was the adoption of a currency board – Argentina being
a particularly noteworthy example (see Chapter 5, under Argentina (2001)). In the new envir-
onment, characterised by capital controls and exchange-rate rigidities, the path of least
resistance for the transmission of shocks was through the value of the currency.
Currency crises
Nominal exchange-rate pegs were adopted by quite a few Latin American countries in the
1980s and early 1990s as an important component of exchange-rate-based inflation stabil-
isation programmes. These arrangements gave rise to a sizeable ‘carry trade’ whereby domestic
investors in these countries availed themselves of cheaper funds by borrowing abroad in a
foreign currency at lower interest rates and lending them domestically at much higher
prevailing rates of domestic interest. With the fixed rate, they captured sizeable profits in
the carry-trade spreads. Because they were for the most part unhedged, this resulted in
mounting foreign exchange risk as the home countries’ currencies became threatened by
economic fundamentals which depleted their international reserve positions.
A number of so-called first generation theoretical models of financial crises (Krugman
and others)4 attribute them to weak or inconsistent government commitments to maintaining
economic policies commensurate with the needs dictated by the country’s economic funda-
mentals. An example is when a central bank monetises fiscal deficits, depleting its foreign
exchange reserves and thus weakening its ability to maintain the exchange-rate peg. A second
group of theories, called second generation models (Obstfeld)5 holds that the government
weighs the costs and benefits of defending the exchange rate and weakens its resolve in
this connection, particularly if it feels that multiple equilibrium exchange rates exist. In these
models, the government’s perceptions as to relative costs and benefits are influenced by
private sector expectations and responses. Consequently, if the government in question feels
that a shift in private sector expectations would be consistent with higher inflation leading
to higher unemployment and reduced economic activity, it might opt in favour of a deval-
uation in order to re-establish external-internal equilibrium but at a higher level of capacity
utilisation.
Irrespective of whether the abandonment of a fixed exchange rate is the result of manage-
ment flaws or weakened commitment on the part of the national economic authorities, the
build-up of pressure on the currency is characterised by positive feedback loops which give
rise to self-fulfilling behaviour. If enough players mount speculative attacks, the resulting
downward pressure on the value of the currency is likely to provoke devaluation which then
serves as validating the speculative expectations in the first place, thereafter possibly encour-
aging further waves of speculative attack.
Banking crises
The inherent transformative nature of commercial banking operations carries its own type
of systemic risk which makes banks susceptible to bank runs. The essence of commercial
46
banking for centuries has been to collect demand or sight deposits which are redeemable
at full face value upon ‘demand’ and to use these funds to finance the bank’s portfolio of
loans and investments. Loans and investments tend to have longer and fixed-term matur-
ities. Demand deposits are potentially ‘callable’ at any time. It is the collective behaviour of
demand deposits, however, that makes them a suitable source of financing. While on a daily
basis, deposits are being demanded and withdrawn from a bank, these are to some degree
offset by similar new deposits. In fact very often a payment made by one party to another
may involve nothing more than a withdrawal from the first party’s account with a counter-
balancing deposit to the other party’s account within the same bank. A good example of
this would be payday in an isolated mining community with a single bank branch serving
the community. In the morning the payroll would be in the mining company’s account with
employee accounts running very low balances. By afternoon, the company’s account balance
would have been significantly depleted with employee accounts enlarged by the size of their
monthly pay deposits. From the perspective of the individual parties involved in these trans-
actions, the differences from morning to afternoon would be quite significant. From the
bank’s perspective, however, overall deposit balances would have changed little.
The foregoing example can be expanded to large urban settings or even to the national
level by admitting not only the one bank branch but its entire branch network as well as
those of other banks and financial institutions. In an advanced economy where people have
confidence in the financial system, the majority of transactions are conducted through banks
or financial institutions. For this reason, the amount of cash required in the financial system
on a given day is only a fraction of the actual number of financial transactions transpiring
during the day. Where many banks are involved, the need for cash for reserves is minimised
further by the practice (and payment infrastructure) whereby banks which experience net
outflows for the day can borrow from other banks which have experienced net inflows and
thus have excess cash on hand. As a last resort, banks can borrow from the central bank as
well. In normal times, the ratio of cash to deposits can be a modest percentage that remains
fairly stable. This is the essence of fractional-reserve banking.
If something happens to shake public confidence in either individual banks or possibly
even the entire national banking system, this can precipitate a run on a bank or banks. What
makes such behaviour so pronounced is the magnitude of prospective losses to be realised.
It is the fractional nature of banking that results in a bank simply not being able to honour
the promise of full-valued redemption to everyone simultaneously in the event of a bank
run. This can happen even though in balance sheet terms the bank might have the capacity
to meet all such claims, given enough time. It is the aforementioned transformative nature
of essentially short-term liabilities into medium-to-longer-term assets in an effort for the
bank to balance safety, liquidity, and profitability that can result in massive liquidity risk
materialising in the event of a bank run.
What allows fractional reserve banking to succeed is the combination of: (1) deposi-
tors who are prepared to leave their liquid wealth in their demand deposit accounts (or
interest-bearing accounts with modest costs or penalties for early withdrawal); and (2) from
the perspective of bank customers, a smooth and reliable payments system.
Regarding the first of the ingredients described above, the ‘preparedness’ of depositors
to rely on banks for storing their liquid wealth should not be taken too easily for granted.
47
It was not that long ago that factors such as educational inadequacies, recollections of polit-
ical turmoil, the ravages of war, and distrust of banks and other financial institutions combined
to make many residents in some European countries favour gold coins under the mattress
or jewellery hidden within the household as more reliable stores of value than banks had
to offer in the event of unexpected emergencies. Countries can still be found today where,
at least in rural areas, similar hoarding practices are dying slowly.
In respect of the second ingredient above, a smooth and reliable payment system entails
the means of debiting and crediting myriad accounts without requiring the transfer of actual
cash. It also requires as a sine qua non, the establishment of laws and regulatory infra-
structure to support the payment system. For decades, cheque writing served this purpose
although one could encounter significant differences among even the industrialised coun-
tries regarding the universal acceptability of cheques. In some cases, the reluctance of
merchants or businesses to accept cheques was based on knowledge of the true risks of
cheques bouncing. In many others, however, it was more the product of innate conservatism
or even ignorance with regards to rights and remedies.
Brazil prior to July 1994, had mounted one of the most efficient inter-bank cheque
clearing systems in the world. In what had been a highly inflationary economy for over
three decades, virtually no one carried cash for other than the smallest transactions. Not
only did it lose value too quickly, it became extremely cumbersome from a physical perspec-
tive, necessitating the need to carry large quantities of bank notes because the largest
denominations offered were soon dwarfed relative to the amounts involved to settle normal
daily transactions. Virtually all significant transactions were conducted by writing cheques
drawn on accounts which protected capital through the payment of interest linked to prevailing
rates of inflation. Moreover, the legal regime maintained the integrity of the system because
the threat of being deprived of cheque-writing privileges for reasons of fraud or undiscip-
lined management of one’s bank account was much more onerous than it would be in
countries with easier payment options.
Today, electronic transactions have already reached much of the world and for many indi-
viduals, they have replaced the bulk of those transactions which hitherto had relied on other
forms of payment. From online banking, to online investing, to online payment of credit and
charge cards (linked or not linked to their banks), to payment of utility bills, taxes and government-
sanctioned penalties such as parking fines and moving violations, to online shopping generally,
the explosion in internet-based transactions is ubiquitous. It transcends international bound-
aries and is spreading to even frontier countries (the emerging market countries having made
the plunge years ago). Another important feature of electronic banking is the prevalence of
automated teller machines (ATMs). Their convenience at a growing number of locations has
had a collective influence in reducing the amount of cash that individuals feel they need to
withdraw to meet unexpected cash-based transactions. The knowledge that one can go to an
ATM after midnight or on weekends has reduced the perceived need for individuals to hold
discretionary cash balances at times when banks are not open for business.
But while the features of a modern payments system, some of which have been described
above, have greatly facilitated business in ways and in volumes that previously were incon-
ceivable, they also carry with them certain types of risk. For one thing, while the daily use
of cash has seen a noticeable decline, when confidence is shaken and individuals want to
48
withdraw their wealth from a financial institution, cash suddenly becomes the most likely
form of payment they will try to receive.
As long as banks and other types of financial institution are perceived by the general
public to be strong, the fractional reserve system works well. When it is put to the test is
when something happens to shake public confidence in the safety and soundness not only
of those institutions but indeed of the safety of their own monetary balances on deposit in
those institutions. One device which has done much to assuage public concerns regarding
the safety of their deposits is deposit insurance systems. Usually, however, this insurance
only applies on certain types of deposit and only up to certain ceilings. Nonetheless, it covers
a large number of deposits directly affecting a large number of individuals in a country.
To the extent that significant amounts of money within the banking system remain out
of the direct line of protection of such programmes as the national deposit insurance scheme,
the potential for bank runs still exists. In comparison with older bank runs predating deposit
insurance and when long lines of people awaited the opening of the bank to withdraw their
funds, larger institutional balances (in the form of ‘managed liabilities’) can also represent
potential liquidity risk since a decision taken on the part of one or more such institutions
not wanting to roll over their holdings with the bank in question involves larger quantities
of funding attempting to be withdrawn in a single transaction even if the numbers of parties
at risk of doing so are significantly smaller.
Runs on banks and debt crises are also forms of mass behaviour involving positive
feedback loops and self-fulfilling outcomes. In short, when numerous seemingly independent
individuals all take similar and simultaneous action based on a shared expectation or fear,
then the result of that collective action can bring about the very phenomenon which prompted
that action in the first place. To the extent that only relatively few acted in concert to produce
the liquidity crisis – that is, withdrawal demands were not made by all depositors nor did
all international creditors refuse to roll over their credits, yet the actions of the few were
enough to cause financial distress – the resulting information regarding this ‘collapse’ can
provoke subsequent waves of panic to aggravate the crisis even more.
The lending dynamics are characterised by a tension between the prudence of lending
institutions to place credit limits on borrowers to ensure repayment because of imperfec-
tions in the machinery of contract enforcement on the one hand and the institutions’
willingness to risk insolvency when governments are prepared to provide bailout guaran-
tees on the other.6 An important feature of this tension is that it is asymmetric. Whereas the
relevant credit risk for imposing borrower limits is at the level of the individual borrower
and is related to the borrower’s net worth, the relevant credit risk involved in the case of
bailout guarantees is systemic. In other words, the concept of bailout does not apply to indi-
vidual borrowers on a case by case basis but only to the collective at some critical point
once a crisis unfolds. Mexico provides such an example when during the early to mid-1990s
the Mexican Government extended a de facto guarantee of all senior liabilities of the banking
sector, including inter-bank lending.
Twin currency and banking crises

World financial markets have become increasingly integrated in recent years – certainly since the
introduction of the euro post-1999. This has been due to widespread financial liberalisation,
49
including the removal of capital account restrictions in many countries. It has served to heighten
country vulnerability to ‘hot money’, which takes the form of short-term creditors who are free
to remove funds on short notice or even without notice. When combined with a pegged exchange
rate, it presents a dilemma frequently known to central bankers. If the central bank tries to soften
a financial crisis in the domestic banking system by easing credit and lowering interest rates, its
intentions and efforts can be confounded if not only is foreign portfolio capital dissuaded as a
result of lower yields but as well recipients of domestic resources fail to use the resources as
intended and instead turn around and use them to purchase foreign exchange in the open market,
thereby placing pressure on the exchange rate. In such cases, it is difficult to say with certainty
whether the crisis originated as strictly a banking crisis or is a currency crisis. In fact, because
of the temporal overlap of actions in the banking and currency spheres, such crises have
commonly come to be known as ‘twin currency and banking crises’.7
Compounding these problems is the fact that sovereign countries as well as an increasing
number of banks and other financial institutions are rated by the global credit rating agen-
cies.8 If the early warning signs of impending financial problems are leading the rating
agencies to contemplate a downgrade in credit ratings for the sovereign or the banks, then
this will serve to add fuel to the fire. On top of this, many foreign financial institutions are
limited by their charters or prudential norms to invest only in investment grade paper. If
the downgrade results in the obligors crossing over this limit in terms of their rated credit-
worthiness, then countries, their domestic banks and even their corporate borrowers may
suddenly find that readily-available liquidity recedes abruptly as institutions previously willing
to extend them financing are suddenly constrained from doing so.
In the case of twin crises, the lending dynamics also involve a tension. It is between
borrowing limits applied by lending institutions on the one hand and currency mismatches
on the other. When domestic lending institutions lend to borrowers in the nontradeables
sector but the loans are denominated in a foreign currency (presumably because they were
funded from the exterior), then the interplay between borrowing limits and the resulting
currency mismatch produces a spiralling dynamic of its own. The attractiveness of the
foreign-currency-denominated loans in the first place is due to an interest rate differential
with the higher domestic rate reflecting expectations concerning the risk of the domestic
currency experiencing a real depreciation. Yet this higher domestic interest rate translates
into lower borrowing limits relative to borrower net worth for those nontradeables producers
without access to external financial markets.9 As fewer investments in nontradeables occur,
this dampens economic growth in this sector. To the extent that some producers of nontrade-
ables have their debt denominated in foreign currency but receive revenues in domestic
currency, this shrinks their profitability and may even become loss-producing.
The resulting loss in vitality of the nontradeables sector contributes to stronger expect-
ations of impending domestic currency devaluation which widens the interest rate differential
and thereby results in further real exchange rate depreciation. Successive rounds of this type
of behaviour can spiral downward to the point of widespread financial distress and the
formation of a full-blown debt crisis. To the extent that an economy has a significant external-
trade sector, the decline in GDP growth will be dampened by the insulation of the exporters
from this spiral. On the other hand, net credit within the country will generally show a more
pronounced contraction with a resulting fall in the net credit to GDP ratio. Recent studies
50
have shown10 that the dynamics described above can be found occurring in a variety of
exchange rate regimes both fixed and flexible.
When real sector borrowers experience collective distress, this spills into the banking
system as the number and amounts of loans in non-performing status swell. Prior to this,
banks which had sourced funds in, for example, dollars and had on-lent to corporations in
dollar-denominated loans appeared to have prudent loan portfolios without currency
mismatch. What was involved, however, was the swapping of foreign exchange risk for
credit risk. The lending institutions have in effect passed on the foreign exchange risk to
their borrowers along with the benefit of the lower interest rate (possibly augmented by a
spread, albeit much smaller than had they denominated the loans in domestic currency).
However, to the extent that government bailout guarantees are more likely to be forthcoming
in the case of crystallising systemic credit risk (but would not have been in the case of
adverse exchange rate movements), then this ‘swap’ may not prove to have been such a bad
deal for the domestic banks.
Tornell and Westermann11 contend that as long as the severity and incidence of finan-
cial crises (which result in drastic credit crunches and loss of GDP growth) is such that
risk-adjusted growth promises to be higher with financial liberalisation than without, then at
least from a developmental perspective, there would seem to be a strong case for financial
liberalisation. The systemic credit risks they cite for emerging market countries tend to reflect
material imperfections in the legal and administrative machinery dealing with the governance
of financial contracts. While the preferred course of action would be judicial and adminis-
trative reform to remove the impediments to contract enforcement, in their absence financial
liberalisation is worth undertaking so long as the statistical odds favour higher growth.12
The types of reform needed for improving the enforcement of financial contracts include:
• foreclosure laws;
• bankruptcy laws;
• company law as it pertains to issuance of financial obligations, share capital, minority
shareholder rights, and corporate governance;
• the law of negotiable instruments;
• laws pertaining to assignment and novation; and
• laws dealing with disclosure.
Early warning signs of systemic financial distress

Financial crises rarely unfold without having announced their impending arrival in various
ways. To the extent that people are caught unprepared, it has more to do with their having
ignored the signs completely or having simply bet that there would still be time to ‘cover
their positions’. The following are some of the more common macroeconomic signs that
very often are evident before a financial crisis crystallises.
• Growing public sector indebtedness, particularly in debt which is denominated in foreign

currencies; overall government indebtedness (domestic and external) carries an interest
burden which over time becomes too much of a challenge for the economic authorities
51
to cover through a tight fiscal stance and the portion denominated in foreign currencies
carries the risk that any sudden or sustained weakening in the domestic currency will
cause it to grow to unmanageable proportions.
• Deteriorating capacity for the country to service its public sector external debt; this sign
can be measured in terms of an increasing trend in the country’s public sector debt-to-
GDP ratio as well as in its ratio of debt service payments (both interest payments and
debt repayments) to receipts from exports of goods and services.
• Chronic and growing deficits in the public sector accounts, the external accounts or both;
a meaningful assessment of public sector deficits requires looking beyond the accounts
of the central government in order to take into account the health of state or provincial
finances as well as that of any public sector enterprises (PSEs) and their potential impact
on the overall financial health of the public sector; and regarding the external accounts,
it is essential to distinguish shortfalls which have been financed with more manageable
longer-term sources of financing from those which have been ‘plugged’ with shorter-term
and potentially ‘hot money’.
• Rapid and sustained depletion of foreign exchange reserves often is a clear indication of
structural problems; in this connection, it is important to determine if it has occurred
mainly because of a deteriorating external trade position or alternatively because of large
changes in the country’s capital account.
• In conjunction with the sign immediately above, sudden and pronounced changes in a
country’s terms of trade (the trade-weighted ratio of the prices it receives for its exports
over the similarly weighted prices it pays for its imports) are an important indication of
whether a country’s international competitiveness has changed.
• Sizeable foreign exchange and maturity mismatches on the balance sheets of the country’s
financial institutions, which can result in financial distress in the event of sudden and
pronounced changes in the exchange rate and interest rates respectively.
• Evidence of the formation of asset price bubbles; it is important to keep in mind that
the existence of a bubble is difficult to prove when asset prices are on the rise; the
problem is the lack of sufficiently current macroeconomic data to demonstrate unequiv-
ocally that the price increases are being caused exclusively by speculative fever, herding
effects, and the self-referential nature of price changes and are not due to strong funda-
mentals; while hindsight after a market crash has the advantage of conferring unanimous
wisdom, the call for prudent action during the formation of a bubble will often encounter
resistance whether at the national or the institutional level.
Systemic financial sector warning signs include:
• Evidence, both formal and anecdotal, of chronic and growing non-performing loan (NPL)
ratios in the country’s financial institutions; it is important to keep in mind that low or
negligible reported levels of NPLs does not confer on the institution a regulator’s auto-
matic ‘passing grade’ since either laxity in banking regulations which do not require loan
classification and attendant provisioning (as well as write-downs and write-offs) or bank’s
efforts to ‘evergreen’ potentially problem accounts can materially understate the magni-
tude of the problem.
52
• Significant deviations from Basel II guidelines.

• Relaxation of banking regulations on the part of the regulating authority.
• Crowding-out effect evident in reduced financial sector liquidity concurrent with
pronounced growth in borrowings from the banks on the part of government.13
• Sudden increases or upward-trending in the number of financially-insolvent banks and
other financial institutions as reflected in reports published by banking supervisors, rating
agencies or securities analysts.
Common elements of financial crises and financial market distress

Glick, Moreno and Spiegel14 found that ‘… recent financial crises in emerging markets share
several features: (1) they occurred after extensive liberalisation, particularly in financial
markets; (2) they were preceded by significant capital inflow surges that subsequently ceased
abruptly; (3) at the time of the crises, relatively rigid nominal exchange rate regimes tended
to be in place; (4) unhedged foreign currency and interest rate exposure was high; and (5)
the crises tended to be widespread, involving a number of countries simultaneously.’
A debate is still ongoing regarding the main causes and transmission mechanism of
recent financial crises. Are financial crises primarily the result of financial panic and the
herding instinct of crowds, an argument that is based on factors other than economic condi-
tions? Or are inadequate national policies which tend to exacerbate economies already
labouring under a variety of stresses primarily to blame? An ultimate choice from among
these two alternative views will have far-reaching ramifications for the process of national
economic management. If the root causes are mainly behavioural and the result of panic,
then this would appear to circumscribe the scope for action on the economic policy front.
If weak or inappropriate domestic economic policies are deemed to be the root cause, then
reform must take place. In fact, financial crises often possess signs of both sets of causes
being at play and are not necessarily inconsistent with one another.15
One of the most interesting aspects of financial crises in recent years has been the
rapidity with which distress has spread across entire countries and even from country to
country. Spreading distress can occur when major external events exert a similar impact on
many actors. For example, a series of sizeable interest rate increases can adversely affect
numerous borrowers, particularly if their obligations are based on floating rates. Alternatively,
it can be the result of conjugate effects when financial impairment suffered by one group
in society provokes similar reactions on their part which may result in their passing on the
burden to other groups who are dependent on them. For example, financial distress resulting
from a significant drop in demand causes lay-offs which may amplify subsequent rounds
of reduced demand. Alternatively, a dramatic change in the future outlook for some assets
or types of investment may cause investors to scrutinise similar assets or investments in
other sectors or countries. In such cases, a country where a large category of assets or invest-
ments are suddenly perceived to be much riskier than previously believed may lead investors
to scrutinise similar assets or investments in other countries. This has happened in real estate
when mortgage loan originations standards have been revealed as defective or of poor quality.
Finally, the idea of ‘pure contagion’ generally is the result of behaviour associated with
‘herd mentality’. It has been likened to the phenomenon with which cattle drivers had to
53
contend when even the smallest sudden noise could spook an entire herd of cattle to stam-
pede. Once in play, a stampede is highly unpredictable and often would even result in the
entire herd hurrying over a precipice to its demise. In such cases, investors following herd-
like instincts are more fixated on the actions of other investors and the most recent market
price than they are on the actual fundamentals or financial health of their investments.
Macroeconomic and financial sector assessment and

surveillance
Work on macroeconomic and financial sector assessment and surveillance has been under-
taken by numerous institutions. Notable among these are the Bretton Woods institutions and
some of the large global commercial banks. Approaches vary considerably. Some are highly
quantitative. Others combine quantification with qualitative and even anecdotal evidence. In
a 2000 publication, the IMF16 presents a useful framework combining macroeconomic indi-
cators, which tend to be leading indicators, and aggregated micro-prudential indicators, which
tend to be lagging or cotemporaneous indicators at best.
The main macroeconomic variables which specialists of this topic tend to find the
most useful include:
• Measures of economic growth:

• overall economic growth rates; and
• sectoral indications of troughs or slumps.
• Balance-of-payments indicators:
• current account balances (surplus or deficit);
• measures of adequacy of foreign exchange reserves;
• external debt statistics (including the maturity structure);
• terms of trade (prices of exports to prices of imports, weighted by trade volumes);
and
• capital flow data (portfolio investment and foreign direct investment (FDI)) by compo-
sition and maturity structure.
• Inflation:
• distinguishing among GDP deflators, consumer price indices, producer price indices;
and
• inflation volatility.
• Interest rates and exchange rates:
• measures of volatility in both key interest rates and exchange rates;
• domestic real interest rates; and
• measures of exchange-rate sustainability.
• Lending and asset booms:
• credit booms; and
• asset price booms (stocks, real estate).
• Contagion effects:
• trade spillovers; and
• financial market correlations.
54
• Other factors:
• directed lending and investment;
• crowding out effects (government recourse to bank credit); and
• arrears in the economy.
Micro-prudential indicators include the following:
• Capital adequacy:
• aggregate capital ratios; and
• frequency distribution of capital ratios.
• Asset quality:
• For lending institutions:
䡩 sectoral credit concentration;
䡩 foreign currency-denominated lending;
䡩 non-performing loans and provisions;
䡩 loans to loss-making public sector entities;
䡩 risk profile of assets;
䡩 connected lending; and
䡩 leverage ratios.
• For borrowing entities:
䡩 debt-equity ratios;
䡩 corporate profitability;
䡩 other indicators of corporate conditions; and
䡩 household indebtedness.
• Management soundness:
• expense ratios;
• earnings per employee; and
• growth in the number of financial institutions.
• Earnings and profitability:
• return on assets;
• return on equity;
• income and expense ratios; and
• structural profitability indicators.
• Liquidity:
• central bank credit to financial institutions;
• segmentation of interbank interest rates;
• deposits in relation to monetary aggregates;
• loans-to-deposits ratios;
• maturity structure of assets and liabilities (liquid asset ratios); and
• measures of secondary market liquidity.
• Sensitivity to market risk:
• foreign exchange risk;
• interest rate risk;
• equity price risk; and
55
• commodity price risk.

• Market-based indicators:
• market prices of financial instruments including equity;
• indicators of excess yields;
• credit ratings; and
• sovereign yield spreads.
For both the macroeconomic indicators and the aggregated micro-prudential indicators listed
above, an analysis of the changes in values over time will provide warning signs of impending
financial distress.
01
Matz and Neu (2007, p. 4).
02
Bookstaber (2007, p. 94).
03
This phenomenon is treated at some length by George Soros under the heading of ‘Reflexivity’. Soros (2008).
04
Krugman (1979).
05
Obstfeld (1996).
06
Tornell and Westermann (2005, pp. 14–15).
07
Glick, Moreno and Spiegel (2001, pp. 8–9).
08
The terms ‘credit rating agency’ and ‘rating agency’ will be used interchangeably throughout.
09
In the case of companies producing tradeables, they will usually have access to external credit markets because
of their export sales and the demand for their goods will tend to be independent of the domestic economic cycle.
Hence, their borrowing does not figure prominently into the lending dynamics being described here.
10
Tornell and Westermann (2005, pp. 17).
11
Tornell and Westermann (2005).
12
A similar phenomenon can be found in many large banks where in the past bankers were encouraged to be very
prudent and to make sure that credit only went to those who were almost assured to pay it back. With changes
in the competitive landscape brought about by globalisation, economic liberalisation, technology and so on, in
the leading institutions, bankers are encouraged to take on much more calculated risk. This is anecdotally reflected
in mass mailings of pre-approved credit cards. In short, the business model is driven by statistical considera-
tions very akin to the actuarial bases found in the insurance industry.
13
It is important to look beyond the finances of the central government since a chronic build-up in state or provin-
cial debt or alternatively in PSE debt can reflect mounting weaknesses in public sector finances as well.
14
Glick, Moreno and Spiegel (2001).
15
Glick, Moreno and Spiegel (2001, p. 7).
16
Owen, Leone, Gill and Hilbers, Occasional Paper 192 International Monetary Fund. Washington DC, 2000.
56
Chapter 4
Financial risk management and

liquidity risk
Evolution of the markets for hedging products
The rise of new markets

Securities markets have traditionally been grouped into short-term negotiable debt instru-
ments (T-bills, commercial paper, trade receipts and so on), bonds (sovereign, municipal,
and corporate), and equities. Co-existing with securities markets for some time have been
derivatives markets of which the futures (first commodities and later financial) and options
markets have offered participants two distinct groups of instruments designed to facilitate
the functions of hedging and speculating. Since the mid-1990s, both securities and deriva-
tives markets have been broadened with new categories of instrument being introduced.
Primary and secondary markets for a new class of securities in the form of structured
finance products have grown explosively since the year 2000. These securities vary consider-
ably in terms of equity-like features, debt-like features, as well as the types of cash flow, risk
attributes, determinants of value, and durations they possess. Structured investment securities
are created through the process of ‘securitisation’. While the market for these securities initially
was dominated by participations in or obligations backed by home mortgages, it has rapidly
spread to structures backed by an array of financial assets ranging from commercial mortgages,
corporate commercial paper, corporate bonds and bank loans, vehicle loans, insurance policies,
and revenue streams as diverse as from oil interests to the future earnings of rock stars. Whereas
the early offerings of securitised products had only one or relatively few classes of holding, as
the market developed, they came to represent highly complex and variegated tiered structures
involving interlocking risks and claims. A major breakthrough, moreover, was the advent of
the synthetic securitisation through the combination of an asset pool (securities on an entity’s
balance sheet) and a derivative product (credit derivatives) which allowed the transfer of risk
(and claims) without the need for a ‘true sale’ or physical transfer having taken place.
Primary and secondary markets for financial derivatives have seen the fastest expansion
and growth in those areas related to corporate debt obligations, comprising mainly swaps
and credit derivatives. Not only have these segments of the financial derivatives market
provided a rich array of opportunities for hedging and speculating on a stand-alone basis,
but applied in combination with many types of security, they have spawned an entirely new
global industry of financial product through the creation of structured investment vehicles
(SIVs) and related securities. SIVs are very large pools of investment assets (usually in the
$ billions) which earn more money on credit spreads; tend to be held off-balance-sheet, can
be highly leveraged and have open (evergreen) structures without a finite life.
57
An examination of the organisation of the market for structured finance is essential to

appreciate how the ‘repackaging’ and transfer of risk has impacted global financial markets
generally. Although many of the same institutional participants as can be found in the markets
for more traditional financial products are now engaged in originating and trading struc-
tured investment products, some important new specialised institutions, or at minimum
specialised functions (organised separately within larger institutions), have evolved producing
an associated division of labour. Whereas much can be said and written on the economics
of traditional financial products without necessarily going into how their production and
distribution is achieved organisationally, the sheer complexity of many new structured invest-
ment offerings means that their initial pricing and dynamic valuation are less easily separated
from organisational aspects. Such aspects as bankruptcy remoteness and servicing rights and
responsibilities are inextricably linked to organisational design – not only for the entity spon-
soring the new securities but also for the process of continual price discovery in liquid
secondary markets.
Credit derivatives and structured finance products

Debt instruments, such as loans and bonds, carry several types of risk. Changes in market
interest rates will involve interest rate risk to varying degree, the nature of which will be
affected significantly by whether the relevant interest rate on the loan is nominally fixed or
varies in relation to a market reference rate such as Libor or the US prime rate. Operational
risk can crystallise as a consequence of actions and inactions within lender and borrower
organisations related to the business and legal processing, execution and monitoring of the
various specific provisions of the loan agreement. If the loan is ‘tradeable’ either currently
or prospectively, it can involve market risk resulting from changes in the value at which
comparable instruments change hands in the financial markets. For lenders and borrowers
operating across borders, currency risk is also present. And an important category of risk
spans those things which may prevent the borrower from honouring its contractual payments
of interest and repayments of principal. This category is known as ‘credit risk’. Institutional
appetite for financial instruments to hedge credit risk has been voracious. This allowed new
markets for credit risk products to take off.
Innovation in this field has been rapid. Credit derivatives are of three broad types: (1)
single-instrument-level or single-name products such as total rate of return swaps and credit
default swaps; (2) portfolio-level or multi-name products, such as basket default swaps and
portfolio default swaps; and (3) structured finance products such as collateralised debt obli-
gations and synthetic collateralised debt obligations. While structured finance products tend
to involve underlying or reference securities in very large volumes, the importance of the
single-name and multi-name variants of credit derivatives derives also from their value as
building blocks for structured products.
Total rate of return swaps

After the first currency and interest rate swaps debuted in the 1970s, the initial success of
transforming a company’s risk profile by exchanging one type of risk for another gave rise
to a new breed of financial derivative. Initially, total return swaps (TRS) served as a means
58
Financial risk management and liquidity risk
for exchanging debt-related risk among counterparties. A TRS swap allows an investor (who
also is the ‘seller of credit protection’), in return for making periodic payments to a dealer
or issuer, to receive all of the cash flows from a particular debt instrument which serves as
a ‘reference instrument’. This means the investor can replicate the benefits of the cash flows
of the reference instrument without ever having bought or owned it. The risks assumed by
the investor, however, are all of the risks associated with the reference instrument – interest
rate risk, market risk, as well as credit risk. Yet the credit risk component is generally suffi-
ciently important for credit derivatives dealers to count TRS transactions as an important
part of their credit derivative business. We generally say that the ‘buyer’ (of credit protec-
tion) takes a ‘short’ position in the reference instrument while the ‘seller’ (of credit protection)
takes a ‘long’ position in the reference instrument.
Payments are made periodically or at the end of the transaction, depending on the tenor
of the TRS transaction. An added advantage of a TRS is that the tenor of the transaction
can be shorter than the remaining term of the reference asset, in which case the final payments
include a component which takes into account the difference between the value of the refer-
ence asset upon expiration of the TRS and its value at the outset.
Exhibit 4.1
Total rate of return swap – cash flows
Interest payments
Credit Depreciation on reference asset Credit
protection protection
buyer Coupon payments from reference asset seller
Appreciation on reference asset
Reference
asset
Some of the reasons why counterparties enter into these transactions include improving
access to securities, better flexibility in managing a bank’s regulatory capital, improving the
average cost of funding, and applying financial leverage through alternative and more effi-
cient ways.
59
Credit default swaps

A credit default swap (CDS) is a bilateral contract between a party seeking credit protec-
tion (the buyer) in connection with a reference debt obligation (loan or bond) and a party
providing the credit protection (the seller). In its most basic form, the buyer undertakes to
make payments to the seller at specified points in time in exchange for the seller under-
taking to make specified payment(s) to the buyer in the event that the reference credit
defaults – that is, it fails to make a contractual payment.
Exhibit 4.2
Credit default swap – cash flows
Periodic payments
Credit Credit
buyer seller
Yes Credit
default
Credit test
event
payment
No
Reference
credit
instrument
The exchange of payments in the case of a CDS is very similar to that of a traditional
insurance contract. The credit protection buyer pays the credit protection seller periodic
payments at a fixed rate (comparable to an insurance premium). The credit protection seller
pays the buyer an amount linked to the occurrence of a ‘credit event’ which is generally a
credit default. If a credit event does not occur, a payment from the seller to the buyer is
not required (nor made). Credit protection can be defined in connection with an entity or
one or more obligations (which are specified in the contract documentation).
Upon delivery of a ‘credit event notice’ from the buyer to an agent designated under
the terms of the transaction documentation, arrangements are put in place regarding the
60
specifics of a ‘credit event payment’ to be made by the credit protection seller to the credit
protection buyer. The types of event which can trigger such a payment include:
• failure to make payment;

• acceleration or default;
• cross acceleration or cross default; and
• restructuring of debt (either full or modified).
Additionally, in the case of trans-border credit derivative contracts, debt repudiation and the
declaration of a debt moratorium constitute actions which may be taken by sovereign issuers
also giving rise to ‘credit events’.
Credit default protection can be purchased in the form of a credit default option (CDO)
as well. The main difference when compared to the CDS is that the payment by the buyer
of the credit protection must pay an option premium up front rather than make periodic
payments as is more usual in the case of the CDS. Furthermore, many synthetic CDO trans-
actions now have the advantage of a CDS index, values of which are published daily, as a
reference pool against which credit events are determined. Several of these indices are avail-
able as proxies for credit market risk.
Basket default swap (first to default)

The First-to-Default Basket Default Swap (and related option form of credit derivative) is
very similar to the CDS. However, instead of having a single reference instrument, the test
for default is applied against a basket of reference instruments (usually anywhere from a
few such instruments to as high as ten) which are pre-agreed between the buyer and the
seller of credit protection. Moreover, the credit event which triggers a credit event payment
is whichever of the reference instruments in the basket is the first to default. It is against
this first default that the seller of credit insurance is required to pay, after which the swap
expires.
The advantage to the seller is that he can generally charge higher premium payments
for the added flexibility than that he can charge for any of the individual reference instru-
ments. The advantage to the buyer is that in taking out protection on several reference
instruments to which the buyer may be exposed (although not necessarily – it could include
one or more credits which are similar to but not identical with the buyer’s exposure), the
associated insurance provides flexible coverage to a credit event that is not as expensive as
if individual CDSs were transacted on each of the basket reference instruments.
The main determinants of a first-to-default basket default swap’s value are: (1) the
number of instruments/entities in the reference basket; (2) the credit quality and expected
recovery rate of each instrument in the reference basket; and (3) the default correlations
between and among the various instruments in the reference basket. The basket premium is
calculated as the summation of the probabilities that each of the reference instruments will
default minus the probability that most or all of them will default together (as determined
by their covariances). To the extent that joint probabilities of default are either zero or very
low, the premium a credit protection seller would want to charge is close to the sum of all
individual CDS premiums on each of the instruments in the reference basket. When the
61
default covariances (and by extension, the correlations) among the instruments in the refer-
ence basket are very high (relevant correlations approaching 1) because of a common risk
factor, then the premium the seller will want to charge will tend to be that of the instru-
ment in the reference basket that is the most vulnerable to the common risk factor. In such
a case, the premium will be considerably less than the total premiums that would result if
individual CDSs were used to hedge the same credit risk. While this is the way the premium
is determined, the basket default swap with its first-to-default feature leaves the credit protec-
tion buyer exposed in the event that more than one default occurs simultaneously.
Exhibit 4.3
Basket default swap – cash flows (first to default)
Periodic payments
Credit Credit
buyer seller
Credit
Yes
default
Credit test
event
payment
No
Basket
reference
credit
instrument
Variations to the first-to-default basket default swap can be found in the market. These
are called Nth-to-default swaps where N represents the second, third, fourth (and so on)
reference security in the predetermined basket to default and against which credit event
payment will be made.
Portfolio default swaps

The portfolio default swap (PDS) is quite similar to the basket default swap. However,
instead of the payoff to the credit protection buyer being determined in size and timing by
62
the first (or Nth) to default reference instrument, the portfolio default swap pays him the
difference between the par and the recovery value of the defaulted reference instruments up
to the value of the first default loss of x% of the face value of the portfolio. This payment
is made irrespective of which of the reference securities and how many of them default to
reach this payment amount. For this coverage, the credit protection buyer will pay a premium
to the credit default seller determined as the product of the PDS premium (quoted in basis
points a year) and the value (size) of the first-loss piece.
Exhibit 4.4
Portfolio default swap – cash flows
Premium payments
Credit Credit
buyer seller
10% of portfolio
(defaults)
Reference
portfolio
As defaults occur prior to reaching the percentage limit of the PDS contract, the port-
folio value against which the PDS premium rate is applied is reduced accordingly with the
periodic premium the buyer is required to pay declining accordingly until the transaction
has expired (either because the protection ceiling has been reached or the term of the contract
has run out).
The protection inherent in a PDS contract can be first loss, second loss, or higher levels
of loss. No matter how many levels of loss protection are applied to a portfolio, the amount
of credit risk remains the same. It cannot be reduced or increased through the application
of credit derivatives. Portfolio default swaps can and do, however, redistribute the credit
63
risk. In fact, the loss distribution function, from which the probabilities of different percentage
losses can be imputed, is a key determinant of PDS pricing.
Portfolio default swaps offer the credit protection buyer a convenient way of acquiring
overall portfolio credit risk protection with a single instrument rather than having to resort
to buying individual contracts on multiple instruments. Of particular significance is its useful-
ness as an important building block for synthetic collateralised debt obligations.
Synthetic collateralised debt obligations

The advent of credit derivatives allowed for the creation of synthetic structured financial prod-
ucts – synthetic collateralised debt obligations (SCDOs) – which imitate the risk and cash
flow features of a ‘true sale’ or ‘cash-funded’ CDO. The main difference between the cash
and synthetic CDOs is that the former is based on a ‘true sale’ of the underlying loans (or
other types of debt instrument) and thus ownership of the loans (as well as virtually of all
their associated risk and return attributes) changes hands from the seller (which is usually a
bank with a credit portfolio) to the buyer (which is usually a newly created company called
a special purpose entity). The SCDO allows transference of risk in terms of desired types,
amounts and time durations in a way that can preserve anonymity as well as the original
bank-customer relationship. The SCDO also has the advantage of avoiding the extra legal
and administrative costs that would otherwise be involved in a ‘true sale’ securitisation.
We begin with a brief description of a traditional cash (‘true sale’) CDO structure as
a reference point with which to compare synthetic structures enabled by the use of credit
derivatives as building blocks applied in their design.
The traditional model usually involved a bank with an existing loan or credit portfolio
which decided to either strengthen its balance sheet or alternatively capture ratings-based
arbitrage opportunities associated with many of its existing loans to move those assets off
its balance sheet. This was generally done by creating one or more SPEs – a new company
(or more than one in some cases) structured so as to be ‘bankruptcy remote’ in relation to
the originating bank – which would buy the loan or credit portfolio and fund this purchase
by issuing securities backed by the portfolio. The originating bank would generally receive
cash in exchange for the portfolio and would usually retain servicing rights in connection
with collecting the portfolio’s future principal and interest payments as they fell due. The
new securities would be structured so as to capture the benefits of risk partitioning and
financial leverage in the form of a subordinated structure. A simple variant would involve
a senior tranche (usually rated by the rating agencies as AAA), one or more mezzanine
tranches (usually rated by the rating agencies as either investment grade below the senior
tranches or alternatively as a combination of investment grade and sub-investment grade
securities), and a residual first-loss tranche (unrated) in the form of equity. As principal and
interest payments from the portfolio are received, they are applied as a cascade or ‘water-
fall’ of payments first to the senior tranche, then (subject to availability) to the next tranche
and so on. To the extent that payment shortfalls occur, losses are applied in reverse order
of the waterfall, first to the equity tranche, then the next level up and so on.
Before turning to a treatment of synthetic CDOs below, a few important differences
between CDOs (cash and synthetic) and the older varieties of mortgage-backed securities
(MBS) and asset-backed securities (ABS) are worth mentioning. These include:
64
Exhibit 4.5
04-DFM-ch04-cpp:Layout 1
Cash ‘true sale’ CDO structure Principal and returns

16/10/08
16:10
Portfolio Portfolio Senior

Originating Loan SPE AAA
portfolio Buy loan portfolio Principal
bank
(often the Sell CDOs
Page 65
Cash Principal
arranger)
Mezzanine
(rated)
Equity first loss

(unrated)

Losses
65
• Whereas MBS and ABS collateral pools were generally locked in at deal closing as static
blind pools of assets, CDOs became dynamic structures which were managed with new
assets being added over time (in fact, in many cases the CDO transaction would often
be closed before the collateral portfolio was populated).
• Whereas MBS and ABS collateral pools tended to be fairly homogenous,1 comprising
large numbers of loans in the pool, thus fairly well diversifying the associated credit risk,
CDO collateral pools at any point in time tend to be both much more heterogeneous
(with different types of loan, not just residential mortgages for example, being combined)
and constructed of significantly fewer loans than older securitisation collateral pools.
• Whereas MBS and ABS securitisations in the past could often make do with only one
or perhaps two SPEs, the dynamic nature and active portfolio management features of
CDOs have necessitated a proliferation of SPEs or trusts for a single transaction in order
to accommodate these features from a legal and administrative perspective.
• Whereas CDOs undoubtedly offer a richer menu of securities with risk and return attrib-
utes tailored to investor appetites through advances in data capture and analytical
techniques, the added precision on which this differentiation is based masks the newer
risks of:
• Loans based on appraisals which had become upwardly biased since the early 1990s,
caused by several changes in the older industry practices which at least had maintained
a better approximation of value.
• The aforementioned relaxation in mortgage loan underwriting standards (‘liars loans’,
‘ninja loans’,2 allowance of higher debt service to income ratios and higher loan to
value ratios), mainly in the sub-prime and Alt A (Alternative A paper – refers to a
‘grade-A’ borrower for which the loan terms carry more risk than normal) segments
but even to some extent in the prime segment as well.
• The combined effects of cash-out refinancing, home equity loans (HELs) and home
equity lines of credit (HELOCs) based on the newly-relaxed LTVs, which when
combined with the overstated appraisal values, resulted in not only higher use of reported
financial leverage but additional hidden financial leverage as well, which not only
impaired the quality of the security inherent in the underlying collateral but severely
weakened the resilience of borrowers in the event of an economic downturn.
• Information loss regarding changes in quality of the underlying collateral resulting from
the total disappearance of the traditional lender-borrower relationship which was not
always being preserved by having the originators retain the servicing function.
• The risks associated with CDOs being dynamic, actively managed, based on collateral
with much more uncertainty and tending to vary considerably in terms of structural
features have been further compounded by the introduction of complex structural features.
In contrast to traditional fully-funded CDOs, SCDOs can be fully funded, partially-funded,

or unfunded. Funding involves the issuance of notes which are sold to investors. Partially-
funded SCDOs evolved with the introduction of a super-senior tranche which essentially
entailed paying a highly-rated institution a premium for accepting higher order or residual
credit risk associated with the SCDO structure. Since this residual risk is generally very
small (has a low probability of occurrence, having been amply protected by earlier layers
66
Exhibit 4.6
Fully-funded synthetic CDO
Protection Principal and returns

buyer
16/10/08
Universe of
credits
16:10
Super-senior
AAA+
SPE
Premium Sell CDS portfolio and Principal
Page 67
synthetic CDOs
CDS Buy collateral
Reference Senior
portfolio
credit AAA
portfolio
Contingent
payments Mezzanine
Collateral (rated)
Equity first loss

(unrated)
Losses
67
of risk protection), the premium paid is very modest and thus not worth incurring the costs
associated with having this layer of protection met through the sale of securities. In fact,
most highly-rated institutions willing to provide this insurance cover tend to view the asso-
ciated premium payments they receive as virtually ‘free money’. The unfunded portions of
an SCDO (whether partial or total) manage to transfer risk without the issuance of secur-
ities and the funds that their sale would otherwise raise for the structure. This transference
of risk is achieved through the issuance of credit default swaps (single-name, basket, port-
folio, or combinations thereof). Premium payments are made to the relevant counterparties
throughout the life of the SCDO but since no funds are raised at the outset, these synthetic
structures do not require that a SPV be established. Quite often, whichever institution is
playing the role of ‘the arranger’ of the securitisation will perform all of the administrative
and management functions associated with the securitisation.
An important design feature in the structuring of an SCDO is the percentage of the
reference portfolio to correspond to each of the tranches in the structure (that is, if we were
concerned about depicting this graphically with pictorial accuracy, we would be concerned
about where to draw the horizontal lines on the right side of Exhibit 4.6). In terms of risk
protection ‘cover’, we refer to the positioning of the tranche demarcations in terms of ‘attach-
ment points’ as we allow risk to flow from the bottom upward through the different tranches
corresponding to successive loss levels (first, second, third and so on) expressed as specific
percentages of the reference portfolio’s face value.
The role of structured products in the post-2000 credit boom and bust
Several features of the new financial instruments, some structural and others market-related,
both greatly facilitated the explosion in collateralised finance as well as changed the overall
systemic risk profile of the financial markets. Among these features, the following promin-
ent ones warrant particular attention.
Standards of care – the early collateralised mortgage obligations (CMOs) on which the
more recent structures were modelled, were subjected to much more detailed due dili-
gence, homogenisation of the underlying real assets (the best examples are the criteria
that the GSEs applied to determine if a mortgage loan was ‘conforming’ or ‘non-
conforming’), standardisation of the various design functions and components (from
appraisal methods to applications of creditworthiness standards), ageing (by way of ware-
housing mortgage loans, for example, so that doubtful new originations could be weeded
out), and general conservatism. As securitisation technology was applied to a broader
swathe of asset types, many short cuts were taken. Some of these were no doubt the result
of laxity, some the consequence of a strong need to generate volume, and others because
the inexorable expansion of securitisation to collateral types not previously attempted
steadily involved pioneering effort for which the old guidelines were simply not relevant
and new guidelines were constantly being made up dynamically on the basis of newly
acquired experience. In the large majority of these new transactions it would not be until
the first massive crystallisation of risk occurred that the need for industry reform would
become evident.
68
Exhibit 4.7
Un-funded synthetic CDO
Protection Principal and returns

buyer
16/10/08
Universe of
credits
16:10
Super-senior
Premium
AAA+
Page 69
CDS Contingent
Reference Senior
portfolio
credit payments AAA
portfolio
Mezzanine
(rated)
Equity first loss

(unrated)
Losses
69
Opacity – since the first CMOs were issued in the 1980s, several factors contributed to an
increasing opacity in connection with securitisation. To be sure, the richness of the US, UK
and continental European securities markets which allowed ever more efficient approaches
to the separation and pricing of different types of risk gave rise to increasing transaction
complexity. Then the process of obtaining ratings from the Rating Agencies for securitisa-
tion transactions brought about a substitution in the ways in which investors assessed CDO
risk. Whereas prior to the Rating Agencies becoming involved in this market, investors
sought to understand in considerable detail the nature of and the interrelationships among
the various ‘moving parts’ of a securitisation structure and in particular the attributes of the
underlying collateral, once individual CDO tranches became rated, a considerable amount
of investors’ own due diligence was relaxed.
As it turned out, despite substantial investment by the rating agencies in models and
data capture and analysis in this connection, their own involvement with the asset class
simply was not long enough to have allowed them to experience much of the outlier risk
lurking in the fat tails of the associated return distributions. Furthermore, with the intro-
duction of synthetic structured finance products which avoided the need for portfolio ‘true
sales’, protection buyers jumped on the advantages that the resulting opacity held for rela-
tionship banking. In effect, risk transfer in connection with entire portfolios of loans could
be achieved without ever having to notify bank clients regarding what had been done. The
advantages of being able to preserve confidentiality in this connection became an all too
convenient rationalisation of appeasing investor concerns regarding risk in ways other than
having to reveal to them the precise details contained in the underlying loan files.
Paradoxically, while there is no doubt that more information was being provided to
investors than early CMO structures provided, the available information was of a different
nature. It was ‘rolled up’, so to speak and presented in terms of generalised profiles to meet
explicit measures of diversification and ‘granularity’ but without revealing the identities of
the underlying loan obligors. Advances in product and computation technology made the
inherent trade-off seem like a better than fair exchange while obscuring the fact that spurious
precision had in many cases been achieved at the expense of any improvement in the mean-
ingful appreciation of the full set of true risks. In the case of many of the SCDOs which
precipitated the distress in major financial institutions in the US, the UK and continental
Europe, the extent to which underlying reference mortgage credits were vulnerable to the
same common risk factor – the impact that an increase in interest rates would have en masse
on obligors’ ability to service those loans – seems to have been significantly downplayed
if not obscured outright.
Leverage – financial leverage was much easier to detect under the old structures. Often a
cursory look at the balance sheet was all that was necessary. The number of times by which
the debt on the balance sheet exceeded the equity would quickly indicate the degree of
magnification to be applied to prospective returns (and to prospective losses). In the case
of homogenous mortgage loans, overall financial leverage involved both the LTV ratios of
the mortgage loan borrowers as well as the gearing ratio inherent in the CMO structure, for
example. In connection with synthetic structures, not only did financial leverage become
more complex and elusive to detect, it also tended to increase.
70
Financial derivative products of any kind are high octane – they all involve significant
financial leverage. In fact this is one of their main attractions, as they allow an investor to
take a synthetic position in the referenced underlying assets with minimal employment of
capital. The greater the financial leverage involved, however, the greater the exposure to
risk. To the risk of default loss must be added the risk of illiquidity. Situations often arise
in which a modestly levered investor would have the flexibility to weather a fall in asset
values until such time as they recovered whereas the levered investor would be forced to
liquidate at an unfavourable point. To the extent that the financial leverage inherent in a
securitisation is largely embedded in credit derivatives, an additional risk exists in that
massive changes in financial market price levels can render valuations of entire portfolios
of collateral or risk protection totally indeterminate as happened in 2007 in US banks and
during the Northern Rock bank crisis in the UK.
Derivative multiplicity – when securitisation structures could only be done through a true
sale, an important one-to-one correspondence existed between the underlying assets and the
collateral pools which they could form. The advent of credit derivatives and synthetics
ruptured this correspondence, effectively removing any limit on the number of times that
many loans and credits could be used as collateral (directly or indirectly). Just as commod-
ities futures contracts at any given point in time can in their totality vastly exceed the quantity
and value of physical collateral in existence, the same is true of financial derivatives such
as credit derivatives. Without for a moment diminishing the suffering of home owners in
the US who faced or are still facing prospective foreclosure on their homes, the numbers
of homeowners thus affected (still between 5% and 10% of all outstanding mortgages at
the time of writing) greatly understated the magnitude of the financial market crisis.
The change in the game rules which not only allowed credit derivatives to be written
on single-name securities but to place bets on the new market indices in credit risk basic-
ally removed the ceiling on mortgage-backed (and indeed broader loan-backed) risk
products. This phenomenon was not limited to the mortgage sector but has been extended
to commercial real estate, commercial paper borrowings of corporations, credit card receiv-
ables, leases, corporate distressed debt, and many other financial instruments. In short, many
of the same credits such as sub-prime loans and Alt A Loans which carried high risk due
to defective underwriting practices formed the base of an inverted pyramid of structured
finance products. Adding to this was the self-referential aspect mentioned above (see Chapter
3, under ‘Identifying financial market distress’) by which tranches of older CDOs were often
packaged as part of the underlying collateral pools supporting these transactions.3 The signifi-
cance of these instruments is that in comparison with standard CDOs, their payoffs can be
highly nonlinear. And indeed, they are not just susceptible to the number of credit defaults
in the structure but importantly to the distribution of defaults as well.
Market liquidity – yet another aspect of recent securitisations which rendered the finan-
cial markets highly vulnerable to the inevitable inflection point in the growth of housing
values has to do with today’s building blocks for securitisation and their effect on financial
market liquidity. In the days of cash or true-sale securitisations, asset-backed securities were
sold and traded in the national bond markets of the US, the UK, and major western European
71
countries. Liquidity in these issues on an individual basis as well as in terms of their share
in overall financial market liquidity was subject to ups and downs but buyers and sellers
could generally find one another under a broad variety of market conditions. The market
segments in which the secondary market trading in bonds took place had the benefits of
many of the functions of well organised markets as described in Chapter 2.
The introduction of credit derivatives changed this focus greatly. Notwithstanding their
recent popularity and explosive growth, credit derivatives are traded on OTC markets in
which dealers match buyers and sellers. While ample information on credit derivatives is
generated, they are subject to most of the limitations of other derivatives markets as in many
cases they are not traded in the same volumes or with the same continuity of price discovery
and consolidation of order flow enjoyed in, for example, the US or UK markets for govern-
ment bonds or traded equities. As virtual insurance contracts, their pricing in many cases
depends less on mark-to-market practices than on mark-to-model.
Whereas factors which could impair securities values in connection with traditional
CMOs and CDOs could be resolved through suitable changes in prices in the securities
markets, most of the moving parts of SCDOs derived their values and thus pricing in the
OTC markets and through model updates. This meant that more could go wrong in the event
of major developments which might unexpectedly cause market liquidity to suddenly ebb.
As property values in the US began to retrace, the impact of such drying up of market
liquidity created precisely the kind of uncertainty surrounding valuations of structured finance
instruments as to precipitate market panic. This spilled over to some extent into the organ-
ised markets for traded securities (stocks, bonds, notes and short-term paper) but fortunately
the contagion was limited in both its reach and duration.
To make matters worse, many of the banks and other lending institutions on which many
of the structured securities depended for their off-balance-sheet liquidity reserves in the form
of lines of credit have been adversely hit by deteriorating market conditions even leading to
ratings downgrades for these banks. Because, with recent trends in the provision of broad
financial services, these banks have been active in various capacities in the securities markets,
this has reduced both their ability and willingness to continue to supply liquidity. As value
impairment spreads out to possibly crystallise risk in adjacent financial areas such as in
connection with the mono-line financial insurance providers, municipal finance, student loans,
credit card debt and so on, it remains to be seen the extent to which further panic and related
declines in market liquidity will precipitate widespread financial market distress.
The securitisation explosion and its influence on global financial

markets
The entry of banks into the securities markets is not entirely new. Commercial banks have
long tapped the domestic (and even at times the international) securities markets for specific
purposes. They have even supplied specific assets from their balance sheets in the form of
collateral against which securities have been issued. However, it has only been a relatively
recent development, commencing in the late 1970s in the US and later in Europe, that securi-
tisation has been a recurring activity for many commercial banks and for some has come
to be a core business activity as well.
72
This resulting fusion of an important part of the business of traditional financial inter-
mediaries with relatively new products offered in the securities markets represents an
important change in the financial landscape which can be seen in an increasing number of
countries. It is a phenomenon that is spreading as best practices, enabled by economic and
financial sector reforms, are adopted more broadly. It is also a phenomenon that should not
come as a surprise as even as early as during the 1990s, international commercial banks
were finding that traditional commercial banking activities (taking deposits and making
loans) were steadily becoming the least profitable of their activities.
As will be shown below, the international risk-management framework provided by
Basel II is further acting as an important catalyst in this connection, making the quest for
better economy of banking activity through larger size and a broader array of financial ser-
vices a survival imperative.
What started with residential mortgages in the US and was facilitated by the trans-
formed functions of the GSEs, the Federal National Mortgage Agency (or ‘Fannie Mae’)
and the Federal Home Loan Mortgage Corporation (or ‘Freddie Mac’) soon spread to other
categories of financial assets to create a diverse menu of asset-backed securities. As previ-
ously mentioned, a rich array of assets such as automobile leases, credit card receivables,
corporate commercial paper programmes, commercial real estate mortgage loans, and even
various types of insurance products became the raw material for structured finance obliga-
tions. What propelled this activity further in countries such as the US, the UK, and a few
others where robust money markets and bond markets already existed, was the creation of
a significant secondary market in the trading of these new securities and with it the burgeoning
of related ancillary service industries – specialised insurers, appraisers, asset management
firms, rating agencies, trustees, financial derivatives underwriters and traders and so on.
With time and success, an increasing number of countries began putting in place the
various components of financial infrastructure to accommodate home-grown securitisation activ-
ities. At the same time, the technology was being applied by the global financial institutions
to categories of assets in countries where not all of the preconditions for local securitisation
were in place. However, at least the legal underpinnings with respect to the enforcement of
financial contracts were sufficient to allow them to pool assets from those countries within
larger international conduits or other types of securitisation vehicle and to subsequently add
the other features required for offering asset-backed securities within a global market setting.
The residual and possibly distinguishing risk associated with structured finance arises,
if not from its complexity, then certainly from a significant degree of opacity involved in
its creation – complexity and opacity are frequently confused for one another. Structured
finance products from the outset, tended to elude the acute understanding of most people
other than those intimately involved with them regularly in one way or another. In contrast,
the general public and the media have had centuries of familiarity with stocks, bonds and
other more conventional financial instruments. As the industry grew and new ways of separ-
ating, pricing and marketing risk were introduced, the complexity of the associated structures
exploded. The growth in employment of specialists on the sell side of these products, engaged
in the design of structures with ever-expanding moving parts was met by the employment
of large numbers of analysts of these structures both at the rating agencies and in the insti-
tutions forming the investor base for these new products.
73
As mentioned above, with greater focus on the structured features, attention turned away
from the details surrounding the underlying. Even before the first signs of possible under-
writing deficiencies became evident to the more wary, sponsors of securitisation transactions
were streamlining the process of pooling assets. In many cases, during the earliest transac-
tions what was information that was subjected to the scrutiny of institutional investors in
the data rooms of the sponsors before the closing of a transaction, came to be taken on face
value, if not on faith, regarding the characteristics of underlying assets. The architectural
design of the edifice became paramount with little attention paid to the quality of the ma-
terials going into the building blocks. After all, the historical transition matrices from the
rating agencies, developed from more than a decade of experience with structured finance
transactions, were expected to illuminate the true risks involved in ways never available to
investors in the earliest transactions. Such assumptions may have been warranted if nothing
had intervened in the interim to dramatically change underwriting practices.
Risk mitigating features of early securitisation transactions tended to be through on- or
off-balance-sheet enhancement or were options which were embedded in the debt-like obli-
gations issued by securitisation vehicles. Embedded options often have features that are quite
similar to today’s actively traded derivatives. However, as covenants in broader legal docu-
mentation for securities, their value was determined as a derived demand – that is their
value was usually imputed as the difference between the price of the security with the option
feature and without. It was the parallel explosion in financial derivatives markets, notably
for swaps and credit derivatives, that the pricing of hedging features became explicit. This
development had the added advantage of allowing the launching of synthetic securitisation
as described earlier in this chapter.
Let us review briefly some of the main features and benefits of synthetic structures.
Whereas cash or fully-funded securitisations involved ‘true sale’ of the assets to a bankruptcy-
remote entity, an SPE, synthetic securitisations can be designed with or without an SPE,
with or without funding and because they rely on the use of credit derivatives for risk
transfer, they do not involve a true sale of the assets. This flexibility has value for many
investors as well as for securitisation sponsors. One of the main benefits of transferring risk
through the use of derivatives is the preservation of banking relationships with the original
borrowers. In fact, in many cases, the borrowers do not even need to be informed of the
derivative transaction which offsets the credit risk their loans represents on the balance sheet
of the lending institution, as would be necessary under a cash or ‘true sale’ securitisation.
Notwithstanding these benefits, however, the synthetic form has some drawbacks as well.
First, some investors may be constrained by law or by their own policies from transacting
in derivatives, which could present problems for them participating in synthetic securitisa-
tions. Second, to the extent the structure depends on derivatives markets for valuation and
validation of the instruments used to transfer and hedge risk, any event which impacts liquidity
in the credit and derivatives markets becomes possibly even more intractable than when the
same safeguards were covered by physical enhancement (collateral) or through embedded
options. In other words, synthetic securitisation has enormously attractive features as long as
the associated markets on which they depend remain relatively free of financial distress.
The more complex the securitisation structures with significant value interdependency
of the different tranches arising because of their associated payments waterfall, the more
74
susceptible these structures become to financial market distress and the ebb of systemic
liquidity. Moreover, the ramifications of financial distress are far-reaching and difficult to
ascertain ex ante. For example, imagine that a residential mortgage securitisation (whether
of the cash or synthetic variety) was made possible through insuring some of the risk to
ABS-holders of potential credit events (including but not necessarily limited to payment
default on the part of residential borrowers). Then from the investors’ perspective, they will
have paid for the insurance which will only have value to them if they can count on being
paid certain contractually-determined amounts should those credit events occur. If the credit
event (‘payment default’ in our example) occurs but some other mitigating action is taken
by third parties (for example, the government) to mitigate the perceived burden to the
borrowers (such as by making partial payments, freezing interest rates, or extending the
maturities of loans by fiat), then considerable ambiguity and with it additional risk arises
regarding the payout which investors are expecting (and to which they feel entitled) for
having already made their premium payments on the ‘insurance’.
Depending on the nature of the actions, the compensation investors receive in respect
of the credit event can be complete, partial or denied. To the extent such thwarted claims
also entail dependency relationships throughout a securitisation structure and its attendant
payments waterfall, the potential for payment disruption, for the sudden inability to esti-
mate the value of related asset holdings and for a swell of legal claims all to result is
palpable.
What the foregoing means is that the added complexity of tightly coupled (and to some
extent ‘self-referential’) markets makes effective policy response to financial market distress
much more challenging than it was when financial instruments simply comprised stocks,
bonds, and money. Governmental action aimed at ameliorating systemic financial distress
needs to be adequately comprehensive such that material second-order effects are not ignored
and so that they do not produce deleterious consequences of such a magnitude that the cure
becomes worse than the malady.
Box 4.1
Collateralised mortgage obligations (CMOs)
The virtue of ‘home ownership’ follows not too far behind that of ‘freedom’ and ‘democracy’ as an
important tenet of the American way of life. In this spirit, the thrift industry, characterised by the
Savings & Loans (S&Ls) and related institutions, was spawned as a way of ensuring a steady supply
of finance in order to extend home ownership to as many as possible. When the S&L system
imploded, new sources and new delivery mechanisms for residential real estate financing were
needed. The GSEs (Fannie Mae and Freddie Mac) became central to a new housing finance system
which rose from the ashes of the S&Ls. For homes, their associated mortgage loans and borrower
profiles, which all conformed to certain criteria, the GSEs offered to buy the loans immediately from
the lender after they were originated. They then pooled these loans in special purpose entities (initially
these were ‘grantor trusts’) and issued what were called pass-through securities of a single class to
institutional investors.
Because a key feature of mortgage lending included the flexibility to the borrower to refinance
the loan in the event of credit becoming cheaper (that is, during subsequent periods of lower market
75
interest rates), this carried with it the risk of prepayment which was worrisome if not problematic
for many institutional investors. It was in response to the problem of how to address the needs of
such institutional investors that the CMO was born in the early 1980s. It entailed repackaging (and,
indeed ‘re-securitising’) pools of mortgage loans in ways which would allow the structuring of slices
(or tranches) of risk as well as claims on the payment flow in imaginative ways to meet the various
needs and appetites of different types of institutional investor. The efficacy of CMO structures resides
in the following features:
• Re-securitisation of the obligations of a simple pass-through class of security, often involving the
creation of two SPEs to achieve ‘bankruptcy remoteness’ and favourable tax treatment.
• Creation of a senior-subordinated structure of securities with each class of security comprising a
‘tranche’ with different risks and claims to reward. The earliest structures had three tranches repre-
senting a senior tranche, a junior tranche and a residual tranche. The latter was equity-like in
nature and frequently referred to as ‘toxic waste’. Later issues, enabled by breakthroughs in
computing speed and power as well as by an investor base which had gained sufficient famil-
iarity with these structures as to be able to discriminate among alternative offerings of risk,
reward, and liquidity, actually allowed some issues to offer more than 100 classes of securities
in connection with a single CMO structure.
• Credit enhancements both on-balance-sheet and off-balance-sheet and applied at the level of indi-
vidual components of the collateral package as well as at the level of the overall collateral
portfolio.
Further refinements included stripping out interest payments from principal repayments into securities
called interest-only (IO) strips and principal-only (PO) strips, planned amortisation class (PAC) bonds,
and targeted amortisation class (TAC) bonds which provide respectively greater certainty surrounding
maturity and call features as protection against downside risk.
By applying financial engineering to the cash flows associated with an underlying mortgage
pool, issuers and their deal structuring teams were able to extract the last nickel out of any given
collateral pool in ways that were previously unimagined.
The global market for collateralised debt obligations

Exhibit 4.8 shows the explosive growth of the market for CDOs. Increasingly, large invest-
ment-grade issues get placed internationally, adding breadth and depth to the global market
for structured finance products.
From just over $250 billion in face value in 2001, the global CDO market has surged
to almost $2.5 trillion by 2007.
The symbiosis between risk markets and securities markets

(strengths and weaknesses)
The market for alternative risk transfer (ART) products

Peter Bernstein identified an important historical demarcation occurring with the discovery of
ways to manage risk statistically.4 This gave rise to the insurance industry as we know it today.
It further spawned an industry of financial derivatives which as stand-alone products or in
76
Exhibit 4.8
Global CDO market
3000
2500
16/10/08
16:10
2000
Page 77
1500
$ billion (estimated)
1000
500
0
2001 2002 2003 2004 2005 2006 2007
Year
Includes notional values of related derivatives
77
conjunction with other products allow for new approaches to hedging and speculating. The
use of these products to soften or even offset fluctuations in the pattern of valuations and
market prices of financial assets has developed into an important industry. However, similar
techniques and structures are applied to handle the management of risk arising out of natural
and even man-made calamities. For example, the advent in the 1990s of the Catastrophe
Exchange (or CATEX), an adjunct of the Bermuda Stock Exchange, is one such example, in
which large casualty and property insurers were able to trade or ‘lay off’ excessive exposure
to a single category of risk (for example, hurricane risk for earthquake risk – both of which
tend to be geography-specific).
From this, it was a relatively short step to the structuring and issuance of ‘CAT’ bonds
or catastrophe bonds whereby insurers have been able to fund insurance protection against
catastrophes through syndication of categories and tranches of risk with sophisticated insti-
tutional investors. This ability to reach out for financing beyond their own industry has
availed insurers of not only valuable new sources of financing but has the added advantage
of positive diversification benefits by spreading much more broadly than in the past at least
the financial burden (if not the personal, emotional, and physical burden) of large concen-
trations of catastrophe risk.
From the viewpoint of an economy and financial system, such developments contribute
to greater potential stability and presumably greater systemic resilience in the event that
major natural or physical catastrophes crystallise. An important word of caution, however,
is warranted. If the nature of catastrophe originates in the financial markets themselves, the
tight coupling, which the linkages between securities markets and such derivatives entail,
has the potential to magnify financial vulnerability and ultimately financial market distress.
This is because while the catastrophe risk market provides innovative ways to protect against
physical event risk, this does not cover the crystallisation of financial market liquidity risk
which in certain circumstances could accompany a major physical catastrophe.
To the extent that the newer financial products to insure against catastrophe entail trade-
able securities, they form an increasingly integral part of the financial market and thus need
to be considered when monitoring factors possibly leading to distress in financial markets.
There is, however, an important distinguishing feature between the types of events that
can impact a ‘CAT’ bond and those affecting other types of financial assets involving market
risk. Whereas a catastrophe represents an outlier, an extreme event, which can certainly
materialise, it is rarely seen to involve a series of closely-spaced recurring events – an earth-
quake may involve aftershocks but usually becomes history after a few days, similarly with
a tsunami or other natural catastrophe. Financial distress, on the other hand, can just as
readily result from either a single cataclysmic event (rare) or from a series of draw downs
(more common), representing a phenomenon all too familiar to gamblers – a ‘run’ of luck,
whether good or bad. In fact, the run of adverse market behaviour is insidious as it can
eventually confer as much damage as a single cataclysmic event but with less fanfare.
Moreover, the cataclysmic event may paradoxically result in less damage if trading systems
are frozen or so-called ‘circuit-breakers’ kick in, which is not likely to be the case with a
series of cascading drops in market value.
In sum, the main advantage of these new risk products is the weak or even negative
correlation between these risk products and more traditional financial instruments. The dis-
78
advantage, of course, is that for the most part, these new instruments appear to be relatively
untested5 in terms of their reliability in providing the insurance cover for which they were
designed.
The importance of the rating agencies in development of structured

finance markets
When the majority of business loans were held to maturity on the books of the credit-
granting institution (which were usually, but not always, banks), credit assessment was an
individual and more importantly a proprietary undertaking. Information regarding borrower
credit capacity was opaque at best. What distinguishes capital markets from other systems
of finance (such as bank-dominated systems) is that information is transformed from propri-
etary to in essence a ‘public good’. This is not to say that proprietary information does not
exist or cannot be commissioned. However, its shelf-life tends to be very short and in a
relatively short amount of time it passes into the public domain. Where this does not happen,
significant costs of acquiring information are involved, which reduce liquidity and the further
development of nascent markets.
The other precondition for the development of a liquid market for asset-backed secur-
ities is a high degree of standardisation. This has more than one dimension to it. The first
is the more obvious one of lowering structuring costs by introducing economies of scale
associated with such functions as, for example, credit review. The other and arguably more
important dimension is the informational value of standardisation. It is important for rating
agencies and investors to know that at each stage of the transaction design the resulting
outputs are meaningfully comparable and reliable. For example, if residential mortgages are
selected from across an entire country, it is important to know that professional real estate
appraisers have followed the same procedures and conventions for attaching values to the
underlying assets and have applied them in an independent and unbiased manner. Similarly,
those institutions involved in the origination of loans need to be applying comparable stand-
ards to assessing creditworthiness of borrowers. Assembling pools of hundreds if not
thousands of assets for a single securitisation transaction can only be both a cost-effective
and informationally-meaningful activity if rating agencies and investors have reasonable
confidence that they are comparing like with like. This becomes even more crucial as succes-
sive tranches of securities with differentiated risks and claims are introduced into a
securitisation structure.
While the public nature of information on borrower quality is an important cornerstone
of a well-developed bond market generally, it becomes even more crucial in the case of
securities backed by structured finance transactions and entities. The rapid growth of this
market was enabled by the dedicated response to these needs on the part of the global rating
agencies (mainly Standard & Poors (S&P), Moody’s Investor Service, and Fitch Ratings).
By providing benchmark credit ratings with guidance as to an assessment of credit risk,
necessary credit enhancement and appropriate pricing on a transaction, the rating agencies
reduce the due diligence workload of investors as well as an important component of trans-
action costs.
Among the attributes and risks considered by the rating agencies are:
79
• sovereign and currency risk;

• liquidity risk;
• eligibility criteria for asset substitution or replenishment;
• ring-fencing (possibly in the form of a ‘true sale’ or alternatively the creation of a secu-
rity interest, use of a trust, or a two-tiered structure);
• taxation; and
• bankruptcy remoteness of the transaction entity or vehicle.
Ratings approaches include:6
• actuarial basis;
• loan-by-loan analysis;
• benchmarking;
• single event;
• binomial expansion;
• Monte Carlo; and
• weak link.
Generally, the rating agencies require that each type of risk in the payment structure is
isolated and addressed (often by third parties). They also account for any additional or
residual risks introduced into the structure by third parties or ‘counterparties: through the
use of a ‘weakest link’ approach, enhancements are appraised on the basis of requiring the
credit rating of third-party guarantors being a minimal level which is usually at least as
favourable as, or sometimes higher than, that of the issuer.
The rating agencies use somewhat different approaches to assessing credit risk and the
need for credit enhancement. S&P takes a more probabilistic approach based on frequency
of default without illuminating how much of loss might be incurred in the event of a major
credit event occurring. Moody’s on the other hand, takes an ‘expected loss’ approach which
attempts to quantify the maximum loss that could occur in connection with different scenarios.
Fitch combines the two approaches with greater emphasis on probability of default at the
senior end of a structure while trying to ascertain ‘expected losses’ at the deeply subordin-
ated end of a structure.
For better quality structures during relatively normal times, the default-probability
approach works fairly well. The ‘expected loss’ approach, however, proves the more rigorous
analysis of the two extremes in the event of a major disruption in the functioning of the
market or even a market ‘meltdown’.
In addition to ascertaining the credit characteristics of a pool of securitised assets, the
rating agencies also take into consideration the potential need for liquidity facilities. Usually,
liquidity facilities are designed to cover one-and-a-half to two years of debt servicing needs.
They make sense even where significant external credit enhancements have been incorpor-
ated into the structure because third-party guarantors often will only pay interest when it
falls due in the event of a default leaving outstanding principal to be paid until the legal
maturity date of the underlying securities. However, it is important to note that ratings pertain
to the quality of credit risk and do not attempt to evaluate prevailing market liquidity.
80
But while the credit rating agencies have been long on models and methods, they have
been wanting in self restraint. Significant lapses have occurred in their management of
conflicts of interest and indeed of turning down ratings assignments for some issuers and
transactions which with hindsight should have been considered as still being in the proto-
type stage. Given their pivotal role in the functioning of today’s global credit markets,
significant improvements in oversight of the functions they perform are needed and can be
expected to be the focus of regulatory reform.
Structured finance and underlying credit markets
Box 4.2
Tight coupling: integrating structured and traditional financial instruments
The securitisation of financial obligations since the early 1980s spawned an industry not only for
packaging debt instruments but for new originations of short and long-term debt. The associated risk
could be quickly transferred from the creditor to, in many instances, a new vehicle in order to satisfy
the seemingly insatiable institutional appetite for structured securities.
Structured securities, however, are not for all markets. They are crafted. Their design, having
been the result of financial engineering, can be (and usually is) complex. They perform best in stable
and controllable environments. The wisdom of attempting such structures only as conditions prudently
warrant has not always been heeded.
Part of the problem has been that the mounting complexity of these structures, in large part
enabled by technological and product advances in the US (and to a lesser extent in the UK), has
invited institutions and individuals to participate with insufficient prior experience and who therefore
have been learning as they go. New ways of thinking about risk with concomitant ways to dissect,
repackage and sell it have tended to allow many practitioners to confuse the mastery of detail with
the ability to control. Even the sources of real risk have not always been clearly appreciated. The
detail depicted in the bond arithmetic describing the cascading of payments in a structure’s water-
fall unfortunately will not capture the liquidity available to the different legal claims on the waterfall.
The availability of market participants to trade in these claims, thus providing market liquidity for
them, is a function of a number of things which define market breadth and depth throughout the
relevant portions of the yield curve.
As a number of successful securitisation transactions set the pace, new ways were found to over-
come previous problems. First, the earlier transactions, particularly in the mortgage market, often
did not have the benefit of sufficient data with which to measure credit risk. Warehousing and data
capture helped address this, but this took time. As the rating agencies gained familiarity based on
longer time series of data, transactions could be assembled and marketed faster. Many of the afore-
mentioned changes in the global financial markets also did their part in contributing to the voracious
institutional appetite for structured finance paper. The problem of transparency also reared its head.
In many cases, banks had been reluctant to sell assets as part of a securitisation programme because
of the difficulties this might cause for bank-client relationships. With the advent of swaps and credit
derivatives, however, this problem was solved. It simultaneously solved the problem for those juris-
dictions where the tax and regulatory treatment of asset sales was not particularly favourable.
The benefit of allowing securitisation to take place in conditions where there had previously been
resistance was enormous. But new types of risk, less discernible to those accustomed to thinking
81
primarily in terms of market and credit risk, began to mount. The main culprit was risk due to market
liquidity or sudden and unexpected lack thereof. It is difficult to say exactly why this risk was so
badly overlooked. One explanation is that on most ‘normal’ days there is a lot of opposing thought
in the market. This is good. This is what tends to balance the number of buyers and sellers as well
as the collective intensity of demand and supply of financial instruments without moving prices exces-
sively. Another possible explanation is that the designers of structured finance transactions felt that
they dealt regularly with liquidity and its risk. In fact, they do. The problem is that their concern
over liquidity in the majority of situations tends to be at the level of the product or the holding rather
than at the overall market level itself. When you are fixated on navigating shallow waters, it can
be too easy not to notice that the tide has gone out.
The adherence to modern portfolio theory and its assumptions of normality of the distribution of
returns was probably a contributing factor to many investors being blind-sided. In any event, while
liquidity measures – both on-balance-sheet and off-balance-sheet – could be (and were) put in place
to handle those instances when the cash flows from the underlying were insufficient to meet sched-
uled principal and interest payments on CDOs for example, this had nothing to do with having
overall market liquidity recede for all such claims to the point that valuation and price discovery
was left totally indeterminate. Such events were considered outliers, something to be found way out
in the fat tails of deformed probability distributions. As outliers, they were explicitly addressed neither
in the architecture of CDO structures nor in the detailed financial engineering. To use a term popu-
larised by Nassem Nicholas Taleb, they were ‘black swans’,7 which even if contemplated, were
treated as if they would be so rare as to probably not be encountered in one’s lifetime, or at least
during the life of the investment.
Nonetheless, the advent of synthetic securitisation caused an explosion in the creation of credit
derivatives. But much the same as some of the lopsidedness encountered with portfolio insurance in
the 1980s because of asymmetries between securities markets and derivatives markets, a similar
‘tilt’ was developing post-2000 in structures which relied on combining assets and their associated
cash flows in the loan market and the sizeable credit derivatives market as a way of hedging and
packaging risk.
At some point, as systemic problems materialised, the impersonal, contractual entitlements to the
proceeds of the insurance built into credit default swaps and total rate of return swaps were frus-
trated by the political pressure for major lenders to apply forbearance to numerous sub-prime
borrowers who were faced with losing their homes. In fact, in a pre-election environment in the US,
political talk of alleviating debt burdens was not directed to those already in default. Proposals were
on the table to help those who would imminently feel the squeeze of adjustable rate mortgage loans
resetting from their initial teaser rates to higher interest rates. For borrowers, this seemed like welcome
relief. For the many institutions, including pension funds and educational institutions which had
purchased securities from mortgage-backed SCDOs, the risk protection they thought they had
purchased as part of their investments was either being, or in imminent danger of being, ruled
invalid. To make matters worse, to the extent that institutional investors and private investors held
shares in financial institutions which had invested heavily in structured finance securities, the resulting
indeterminacy resulted in the financial equivalent of blunt force trauma to their portfolios.
To have what amounts to many trillions of dollars in debt serve as the underlying for financial
derivatives is one thing. To have those derivatives combined with much of the debt itself to structure
new instruments, constitutes a tighter coupling within the financial markets than would seem to exist
simply on the basis of examining international statistics on volumes outstanding of different types of
financial assets.
82
The transformation of credit markets from essentially a system characterised by bank lending
to homeowners, consumers, and businesses to a system characterised primarily by bank-
originated loans which have been packaged or re-packaged as collateral to back
publicly-traded securities such as has taken place in the US and the UK (and to an increasing
extent in some continental European countries as well) has introduced new types of systemic
risk. To be sure, the new form of disintermediation has provided a healthy impetus to capital
markets. But at the same time, the separation of different categories of risk and the effec-
tive ‘outsourcing’ of the management of these risks calls for greater clarity regarding credit
events, associated actions and resulting payoffs.
For example, a loan payment default under the simple banking model could easily be
handled with forbearance (such as in the case where the defaulting borrower had been an
important client). In the extreme, the bank manager has the latitude to manage the loan
account in ways that can be described as ‘ever-greening’, even if this is recognised to be
generally imprudent.
With the growth of asset securitisation, however, banks which originate loans, sell them
and then retain servicing rights, no longer have the latitude to manage accounts this way.
Complicating matters is the extent to which the new structures resort to external or third-
party enhancement. A credit event which entitles an investor to a payout is something that
can only be mitigated or ‘forgiven’ with considerable caution.
For example, an investor holding a tranche of a CDO who relied on a combination of
the economics of the structure, the rating agency assessment reflected in the assigned credit
rating, and the external enhancement built in to the structure of the transaction, is not likely
to be indifferent nor silent regarding unilateral acts of forbearance or de facto ‘refinancing’
which deprives him of a payout to which he is legally entitled under the terms of, for
example, a ‘credit wrap’ from a monoline insurer.
Complicating this even further is the fact that in structures with cascading payment
‘waterfalls’, any action which modifies the cash flow at a point in time is bound to have
repercussions throughout the entire interlocking senior-subordinated structure as well as for
affected securities holders at future points in time. In fact, any tendency to intervene in such
structures carries with it the potential to trigger a legal and technical nightmare in connec-
tion with legal entitlements as well as how and in what sequence securities holders are to
be paid from any modified payment profile. Alternatively, if, for whatever reasons, investors
are required to bear the associated losses of government intervention, then this could easily
cripple the market for some of these derivative products. In this connection, disadvantaged
investors may well become like the cat that sits on the hot stove – although he will never
sit on a hot stove again, he will also never sit on a cold one again either.
The difficulty of hedging against sudden illiquidity

The task of protecting assets in a portfolio and even the portfolio itself from liquidity risk
carries with it challenges which are distinct from those of other types of risk. We have seen
that market risk can be addressed by combinations of asset diversification and hedge instru-
ments. This is because movements in market prices lend themselves to measurement in ways
which allow combinations of these tools to incorporate fairly reliable offsets to the risk of
83
adverse price movements. With regard to interest rate risk, hedge products (options, swaps,
swaptions, and securities such as ‘reverse floaters’) and funding diversification can play
somewhat similar if not identical roles. The advent of credit derivatives has met an enor-
mous need in providing protection against credit risk.
While certainly one aspect of liquidity risk management involves ways to manage assets
which are already recognised as being fairly ‘illiquid’, the main challenge arises in connec-
tion with how to protect against sudden reduction in the liquidity of a portfolio either because
of unanticipated changes in the individual liquidity of the assets, the cash flows generated
by the portfolio, the cash outflow demands associated with the portfolio, or combinations
thereof. In other words, liquidity management involves anticipating not only likely cash
flows (in and out) but unlikely ones as well.
The following represent some of the key considerations in tactically managing liquidity
risk.
• Effective measures of the appropriate amount of liquidity protection an institution should

have must come from the institution’s liquidity risk management framework (see Chapter
8, under ‘Developing the institutional capacity to monitor and manage liquidity risk’).
• Liquidity reserves should be chosen not merely as those assets which are the most
marketable but should take into consideration their tenor; this is because longer-dated
securities tend to be more sensitive to market fluctuations than short-term securities.
• Both financial returns on liquidity resources and accounting aspects need to be taken into
account. For example, if securities are sold to generate cash, this may constitute a tax
event, depending upon the accounting treatment chosen for the securities in the first place
(that is, whether they are tradeable assets or to be held to maturity).
• Borrowed funds may be designated to meet liquidity needs but this needs to be done
with the understanding in mind that additional indebtedness creates a potential new
demand for liquidity rather than merely represent a source of its supply.
• Liquidity can and should be managed on both sides of the balance sheet.
Finally, relative assessments of degrees of liquidity among different assets being considered
as reserve assets are complicated by the fact that liquidity problems can arise for a variety
of reasons. Just considering the distinction between problems with funding liquidity in
connection with a single asset and the case in which broader financial market liquidity
recedes during a market correction, for example, serves to underscore this point. And since
different assets involve different degrees of suitability depending on the circumstances, a
broader more comprehensive approach to managing liquidity risk as described in the next
section is required.
Best practices in institutional liquidity risk management

Leonard Matz and Peter Neu8 summarise the elements which characterise current best prac-
tice among banks in North America and Europe regarding liquidity risk management.
• Cash flow-based liquidity gap analysis, including behavioural adjustments for each
currency and region.
84
• Stress and scenario analysis.

• Limit system and limit breach escalation processes.
• Analyses of the diversification on funding resources.
• Fund transfer pricing.
• An independent oversight of liquidity and management by a liquidity risk control unit
that regularly reports on the liquidity status to senior management.
• A contingency funding plan.
• A liquidity policy that documents methodology, processes and responsibilities.
An important aspect of liquidity and its sufficiency is that it is not enough merely to have
the capacity to meet imminent expected needs, it is equally essential to satisfy market percep-
tions as to this sufficiency. This is particularly true in the case of certain types of financial
institution where the use of financial leverage and dependence on significant ‘dead storage’9
of short-term liabilities heighten the risk of a material shift in market perceptions.
Structured finance, specialisation and workout capacity

As structured finance and ART products and their associated markets grow, it is becoming
less clear as to who holds not only the risk but enjoys the rights and remedies to pursue
payment. When banks and other financial institutions held loans on their books to maturity,
there was no ambiguity in connection with this question. If a certain percentage of loans
to businesses and consumers had problems, it was the bank itself which had to work things
out. Consequently, most banks created special groups to handle distressed assets. Even in
institutions that were quick to provision and to write off doubtful loans at very early signs
of trouble, the additional contributions to annual profit from those activities involved in
restructurings and recoveries could be significant. With widespread securitisation, however,
those financial institutions which now see themselves as specialists in loan origination no
longer have this need. For those which have transitioned from traditionally using their balance
sheet to originating loans for subsequent sale to larger specialised buyers, the disbanding
of their special assets groups entails a valuable loss of know-how and skill and in some
cases institutional memory as well. For those which established their businesses as invest-
ment rather than commercial bankers from the beginning, problem-solving skills related to
investments in jeopardy range from underdeveloped to non-existent.
Even the large institutions buying the tranches of CDOs and other forms of securitised
receivables have in some cases focused more on establishing active trading desks rather than
problem-loan workout capacity. Many of them prefer to trade their way out of a situation
at the first sign of trouble or alternatively to write off the problem asset. To the extent that
public securities representing claims on structured finance transactions change hands among
institutions either through further re-packaging, active trading or a combination thereof,
having the in-house capacity to mend or resolve problems in the underlying collateral or
indeed the structures they back is spotty at best. Most of the larger banks have this capacity;
but many others do not and do not seem to be convinced of the need. Furthermore, the
growing popularity of synthetic securitisations enabled by, among other things, the explo-
sion of the credit derivates market, has tended to underscore this perception. To the extent
85
that large institutions see pools of impaired value which might be realised if not normalised,
some have shown a tendency to outsource this work from time to time but only on a sporadic
basis. The costs of these responses, however, are significant because of the resulting loss
of institutional memory. After all, it has always been accepted industry practice in connec-
tion with securitisations that the originating institution would retain the servicing rights.
This makes sense from the viewpoint that originators not only knew the borrowers but knew
their respective loan accounts intimately as well. While such a natural advantage is not
absolutely exclusive, the cost advantage has been well recognised. Major advances in data
capture in connection with loan origination and subsequent account monitoring no doubt
have helped reduce this advantage significantly in recent years.
Viewed from the perspective of financial markets’ systemic characteristics, the capacity
of financial institutions to repair or resolve their own problem assets can have salutary effects
on boom-bust dynamics. The most compelling argument is that such an approach usually
preserves the life of many companies and thousands of jobs which tend to face greater
terminal risk if left entirely to the liquidator. Admittedly, the value conservation often involves
continued exposure to risk. But it can help dampen the amount of distress that is experi-
enced at the nadir of credit cycles and crashes and this has compensating value even if more
difficult to measure and substantiate.
Specialised institutions have emerged in recent years to invest in distressed assets. Some
act as vulture funds, turning a quick profit usually through liquidation of the assets. Others
(admittedly, fewer in number) are more benign to the extent they seek longer-term and more
‘constructive’ approaches with a view to capturing higher returns through going-concern
solutions to the extent possible. They also contribute to more positive system dynamics.
They either free up real assets to be put to work or alternatively remove legal encumbrances
causing assets to be underemployed. They also help stabilise financial markets more gener-
ally as their activities tend to be countercyclical in nature.
1
Not only for having conformed on the basis of strict underwriting standards but for having been ‘seasoned’ for
a large portion of anticipated pre-payment and default risk while warehoused – a practice that has suffered in
recent years.
2
The term ‘ninja loan’ refers to a loan in which the borrower has ‘no income, no job and no assets’. The term
‘liars loan’ refers to a loan made in which the borrowers, often with the encouragement of realtors or mortgage
brokers, make false declarations regarding their income and net worth.
3
Such securities are referred to in the industry as CDO2 or CDO-squared.
4
Bernstein (1996).
5
This is in no way meant to detract from the performance or usefulness of these instruments to date. It merely
acknowledges that they have not been around long enough to provide the same degree of real world stress testing
and thus actuarial comfort that usually accompanies more traditional securities.
6
Deacon (2004, p. 20).
7
Taleb (2007).
8
Matz and Neu (2007).
9
By ‘dead storage’ (which is analogous to the water in a reservoir below the level which comprises ‘active
storage’) is meant the comfort that attaches to, for example, a bank having a large percentage of depositors who
are prepared to leave their deposits on account without redeeming them. The greater this percentage by volume,
the more financial leverage the bank can prudently incur.
86
Part 2
Country cases and global trends

Chapter 5
Country case histories of financial

market distress
The incidence of currency, banking and twin crises in the world since the 1970s now numbers
in triple digits. Some countries have had multiple crises over time. Some crises at a point
in time have involved multiple countries. In the following pages of Part 2, fifteen stylised
cases of recent crises since the 1970s are presented. They have been selected with a view
to shedding light on some similarities in terms of causes and effects, as well as some differ-
ences. No attempt has been made to be comprehensive in terms of providing a full account
of each episode, neither in terms of the symptoms of the problem nor the causes. Those
personally familiar with each of them will no doubt therefore be able to identify in their
own recollections some amount of incompleteness in the stories told. For this, your forbear-
ance is requested. Hopefully, this does not include error in fact.
Spain (1977)
The year 1975 marked a watershed in Spanish political, social and economic affairs with
the death of General Francisco Franco, who had ruled all of Spain with an iron hand from
1939 to that date. Over the next two years, radical institutional change took place, involving
transition from fascism to democracy and from a highly regulated economy to one that
became much more market-oriented.
To set the context for what happened in the financial sphere, it is instructive to consider major
changes in the political and legal spheres. For centuries, Spain had been ruled by monarchs and
dictators in ways which have been described by many (including Douglas North, Avner Greif and
Gonzalo Caballero Miguez) with the single word ‘depredation’. The essence of transition, above
democracy and above economic liberalisation, was the move from a social model in which
‘depredation’ predominated to one guided by social contract. In short, this meant the overlapping
removal of predatory practices on the part of a ruling elite and the establishment of enforcement
of private property rights and contractual undertakings via the rule of law.
When the effects of the first oil crisis spread internationally in 1973, Spain’s economic
authorities and its business sector were both in denial regarding the severity of the shock
and this response was in large measure responsible for the severity of the dislocation that
followed. The Spanish authorities simply did not pass on the higher costs of imported oil.
Spanish businesses, on the other hand, were slow to react because of the prevalence of state
intervention in a host of business decisions, including protectionist measures which they
expected would no doubt be fortified as things got worse. Consequently, the widespread
practice of artificial price manipulation, combined with the practice of covering mounting
89
Part 2: Country cases and global trends
fiscal deficits through recourse to central bank financing along with unbridled wage demand
by workers who were shielded from the price effects, together unleashed strong inflation.
The peseta was devalued in 1976 but widespread price indexing eroded any gains in
competitiveness that the devaluation might otherwise have afforded the country’s exports.
More austere measures were put in place in 1977 with the Moncloa Pact, which entailed
further devaluation of the peseta with moderately tight monetary policy, an incomes policy
and the beginnings of structural reform. However, Spanish industry did not manage the situ-
ation well. Consequently, the effects of continuing inflation and further weakening of Spain’s
international accounts were further exacerbated by the second oil crisis of 1979. Higher
inflation, increasing deficits, mounting unemployment and stagnant output were accompa-
nied by general economic uncertainty which resulted in the private sector cutting back on
investment with stagflation enduring over three years.
Until the early 1960s, Spain’s banks had been virtually frozen in number and were
highly regulated in terms of deposit and lending rates and banking products offered. The
Franco government, recognising the weaknesses of the sector, had eased up on the restric-
tions to new banks entering the sector in the early 1970s with the result that over the ensuing
few years the number of banks in the country approximately doubled to about one hundred.
Starting with the first international oil shock (1973) and throughout the interim years
prior to the second shock (1979), the macroeconomic imbalances, which had been building
up in the Spanish economy, led to the drying up of financial liquidity, first in the smaller
institutions but after months passed, it spread to some of Spain’s largest banks as well. The
weaknesses in Spain’s banking sector, which rendered them unable to withstand these external
shocks, are described below.
For years the Spanish banks had lent to consumers and local businesses without the
benefit of sound lending practices. Credit risk, the most problematic of the various types of
risk, mounted both because the new entrants into Spain’s banking sector did not have the
experience and skills to assess and manage credit portfolios and because of the heavy concen-
tration of loan risk with industrial groups as practised by the established banks – a practice
which was particularly flagrant with those banks owned by conglomerates. In fact, many of
the banks had come to be owned by industrial groups. This meant that companies within
the group were given priority with respect to loans, irrespective of their financial ability to
repay. Market risk was not a particular problem as interest rates throughout this period were
regulated. Consequently, related lending was high, doubtful or problem loans were ‘cured’
by capitalising the unpaid interest and in many cases bank managers resorted to providing
new loans to borrowers in payment default, out of which past loans could be kept current
at least for a while, and inadequate account supervision was widespread.
As the impact of the successive shocks was felt, problems which showed up at first in a few
loans in the banks’ credit portfolios quickly spread to others. Furthermore, the banks were not
required to follow norms and standards with respect to loan classification nor apply appropriate
provisioning against doubtful and non-performing loans. It was common for many loans which
had not paid interest for years to be reported as sound earning assets. Moreover, fraudulent
lending, representing operational risk, was also a problem as even bank managers often had
personal companies to which they channelled credit. In many cases, this was done against
collateral that was either inadequate or nonexistent. Risk management was also deficient to
90
Country case histories of financial market distress
nonexistent and was not given priority since bankers felt secure in the expectation that the
government would provide protection. Overall bank regulation was very weak. By the time the
banks started to experience liquidity problems, many of them were already insolvent.
The worst impact of this crisis occurred between the years 1978 and 1983. The Spanish
authorities responded, starting in 1978, with ad hoc measures. A Corporación Bancaria was
formed in which the Banco de España (Spain’s central bank) provided half of the funding
and private commercial banks the other half. This new institution (which later had a deposit
guarantee fund merged with it) bought out insolvent banks for a token amount, determined
the size of the ‘hole’ in their balance sheets, wrote off share capital against these losses
(thus wiping out the previous shareholders) and raised new capital in which it participated.
It then restructured the acquired banks by selling off saleable assets attempting recoveries
where possible and either seeking buyers for the banks or, alternatively, presiding over their
orderly liquidation. This formula was applied to all of Spain’s troubled banks at the time
with the exception of Rumasa, which was so large and extensive in its holding (it controlled
about 20 banks and a few hundred non-financial companies) that it required nationalisation
and a separate plan of resolution. These solutions spared Spain’s bank depositors signifi-
cant losses with the financial burden largely spread among the country’s taxpayers.
As the worst of the crisis abated, the Spanish authorities eventually turned to tightening
up banking rules and regulations in a number of areas. This adjustment took time, however,
and coincided with much of the effort in international banking circles to frame the core
principles for effective banking supervision which came to be embodied in the Basel I
Accord. Basel Core Principles, 25 in number, have been grouped in seven main topical areas
as follows: (1) objectives, autonomy, powers and resources; (2) licensing and structure; (3)
prudential regulations and requirements; (4) methods of ongoing supervision; (5) informa-
tion requirements; (6) remedial methods and exit; and (7) cross-border banking.
Chile (1982)
When General Augusto Pinochet overthrew the socialist government of Salvador Allende in the
bloody coup of September 11 1973, Chile was whipsawed overnight from having an economy
run through pervasive state intervention to the extreme ‘hands-off’ neo-liberal approach
introduced by Pinochet’s technical advisers, labelled ‘the Chicago Boys’. This latter sobriquet
was in reference to the philosophical leanings the advisers had absorbed during academic
exchange programmes studying under Milton Friedman at the University of Chicago.
In short order, the prices of more than 3,000 goods and services were freed to be determined
in the market with only a handful of essential goods with thin markets continuing to endure
government control. Moreover, numerous trade restraints were dismantled, including an
elaborate system of preferential tariffs (which was replaced with a nominal 10% across-the-board
external tariff), non-tariff barriers and special importing privileges enjoyed by state-owned
enterprises. Of the more than 500 state-controlled enterprises in existence in 1973, only 15
continued to operate under government ownership until the early 1990s. It would later become
significant that for a variety of reasons, the way the privat-isation was done did not result in a
broad shareholding of these companies among the Chilean public. To the contrary, as only a few
bidders were repeatedly considered in connection with the majority of privatisation transactions,
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the organisational result of this massive transfer of the country’s means of production was the
rapid formation of large, diverse, and extremely powerful family-owned conglomerates, which
came to be known in Chile as ‘Los Grupos’ (the Groups).
Most Chilean banks were also privatised in 1974. Interest rates were freed in 1975 and
opaque restraints on bank credit were also removed. In fact, measures which liberalised the
country’s financial sector are cited as having contributed significant fragility to the finan-
cial system which would ultimately exacerbate its failure. It is a theme that is familiar in
other Latin American countries as well. When banks and other financial institutions are not
only privatised but given free rein too quickly, they tend to go on a lending binge. They do
this because the liberalising measures kick in too quickly without allowing enough time to
introduce and have the banks assimilate the right controls and processes emanating from
appropriate regulatory and governance structures. Their approach to risk tends to be char-
acterised as temerity since, importantly, their years under government bureaucracy during
which they were sheltered from the consequences of failure in the market, left them without
the internal institutional memory and experience regarding the actual consequences of bad
lending and investing decisions.
To maintain fiscal balance, the new regime replaced a complex tax system with a simplified
value added tax (VAT) which brooked no exceptions and lowered government spending from
about 40% of GDP to just a little over a quarter. These cutbacks in government spending
combined with a spike in real interest rates to as high as 40% a year as demand for short-term
credit outstripped the new liberalised supply together meant that real investment in the economy
was to be neglected for several years. Consequently, the Chilean economy moved steadily to
close what had been sizeable and highly inflationary fiscal deficits to the point that it ran central
government budget surpluses from 1979 to 1981, forcing inflation to a single digit by the end of
that period.
A key component of the economic package was the fixing of the nominal exchange
rate at 39 Chilean pesos to the US dollar in 1979. The rationale, popular in mainstream
economic thinking at the time was that, for a small open and market-oriented economy,
using the exchange rate as ‘a nominal anchor’ would ‘break the back’ of inflation and would
force Chilean inflation to converge with US inflation. It did not happen as anticipated. This
was because, despite the Herculean liberalisation effort, structural rigidities in the Chilean
economy remained, resulting in the process of price convergence becoming much more
protracted than had been expected. The upshot of this was twofold. First, Chilean exports
were severely penalised by the resulting loss in international competitiveness as inflationary
pressures transmitted a relative price disadvantage in the major export markets via the fixed
nominal exchange rate. And second, the new freedom introduced not only with respect to
international trade but financed through short-term credit unleashed a consumer import boom
the likes of which the country had never experienced. To make matters worse, much of the
credit used for consumer imports was dollar-denominated because of government commit-
ments to maintain the exchange rate. Anecdotal stories abounded of young office workers
in government ministries as well as in private companies buying imported Ford Pinto auto-
mobiles with dollar-denominated loans from the local banks as but one example.
Significantly, as Chile’s total foreign indebtedness surpassed its GDP, the lion’s share
of this was private borrowing, with public sector debt representing less than one-third of
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the total. During the heyday of this credit build-up, New York (and some European) commer-
cial bankers routinely visited Santiago to extend a succession of lines of dollar-denominated
credits to Chile’s newly-privatised banks. These managed liabilities became a significant
motive force driving the consumption boom, although a significant portion of these loans
were also made available by the Chilean banks to the newly-formed conglomerates and on
increasingly preferential terms (certainly with regard to priority assigned in connection with
their availability if not actually in terms of lower interest rates) as the latter came to be the
new owners of a number of these domestic banks.
At the crest of what had been labelled ‘the Chilean Miracle’, the systematic adjustment
of the Chilean economy simply did not unfold as economic theory had suggested. The
consuming public went on a spending binge. The conglomerates spent freely as they sought
to expand as well as consolidate their monopoly power. The new and newly-privatised banks
ramped up their credit portfolios, frequently lending to businesses which had already become
insolvent. Exports were sluggish and foreign borrowing went through the roof.
As the credit overhang became a matter of increasing concern, the banks started to
show signs of distress. Consequently, the government closed a few, intervened several but
most importantly, assumed the foreign obligations of the private banks. This meant that
public and publicly-guaranteed debt, for which the country had every right to be proud on
the eve of the crisis, quickly tripled this figure both in dollar as well as in terms of its share
of GDP virtually overnight. The irony was that in the interest of not abandoning its economic
model, the Pinochet government, by picking up the tab for the country’s private sector
foreign borrowing, effectively socialised the party (‘la gran farra’ – the big party) which it
had unwittingly helped the general public and conglomerates to hold. And this was after
having overthrown the previous government for its political inclination. But while the adjust-
ment did not occur in the strictest neoclassical way, occur it did!
The year 1982 was when numerous problems surfaced. Over 800 bankruptcies took
place in that year which was a few times more than the average failure rate of previous
years (although, this comparison is misleading as under the socialist government, failures
were less likely to be reported). The trade deficit was mounting as the value of imports
outstripped exports. Importantly, international interest rates had begun to rise, which started
to turn off the tap of external credit from the New York and European banks not only to
Chile but indeed to all of Latin America.
With the balance of payments and the central bank accounts showing stress cracks, on
June 20 1982, the government devalued the peso with a maxi devaluation (with the peso
going from 39 to the dollar, to 155 to the dollar). Thereafter it was adjusted based on a
policy of daily devaluation, eventually falling by roughly 80% of its early 1982 value. For
the entire year, 1982’s GDP outcome was a precipitous drop of over 14%. By 1983, unem-
ployment surpassed 30% and that figure obscured those who were underemployed. For
example, numbers of people with university degrees eventually wound up sweeping streets
for wages well below their skill levels. But well before those numbers became available,
successive rounds of loan defaults as well as the aforementioned business failures prompted
the government to announce each month a few industries or sectors for which debt forbear-
ance would be extended. The effect of this was to accelerate the pace of defaults as those
who might have found the financial capacity to continue servicing their debts held off making
93
payments in the hopes that their sector would be announced as being a beneficiary of forbear-
ance in the coming months.
As commercial bank NPL portfolios climbed both in numbers and volumes, the govern-
ment bought them out, transferring treasury obligations to the banks, effectively nationalising
the debt. The process of debt resolution became highly protracted for several reasons. First,
although under Pinochet many things had been liberalised, the capital account was not one
of them. In fact, this was an era when restrictions on capital mobility (other than for foreign
direct investment and commercial bank credit) were considered prudent, at least for what
were considered at the time as ‘Third World countries’. The international banks were in full
retreat, and to the extent they were lending in Latin America at all, this had come to be
known as ‘involuntary lending’ with the express purpose of getting their old loans repaid.
It is curious that this euphemism of what would have been considered to be ‘ever-greening
the account’ had it been applied to a corporate client at home and most likely avoided in
countries with well-developed banking cultures, somehow became permissible and accept-
able given the magnitude of the amounts at risk and the fact that the accounts were outside
the home countries.
Liquidity within Chile had dried up. Although numerous businesses should have been
placed in bankruptcy to allow their assets to be liquidated, this was not happening. The
reason was that with pervasive illiquidity and a high rate of insolvency, no one had any
money to buy the assets even at a ‘fire sale’. Moreover, the multilateral lending institutions
were constrained by their charters to finance only what they called new gross fixed capital
formation (economic terminology for new real investment as opposed to the transfer of
existing capital assets). The World Bank did change its policies in 1984 by extending a
$150 million financial restructuring loan to Chile expressly for the purpose of financing
such asset transfers among those businesses which had failed and those which might benefit
from their real assets at discounted prices. The problem was that bankruptcy laws were
missing or inadequate and even foreclosure law, as it was, couldn’t handle a sufficient
number of cases to make a difference. Nor in an atmosphere of governmental willingness
to treat financial distress with forbearance was it politically or socially easy for bankers to
go against the grain and be seen to be evil harbingers of a painful adjustment process that
many had come to believe could be forestalled indefinitely if not avoided outright. An addi-
tional problem, and one that was to be repeated in other countries with similar financial
crises, was that the exchange of assets, whereby the economic authorities accepted non-
performing loans at face value in exchange for treasury securities, succeeded in strengthening
the banks’ balance sheets but without necessarily injecting much-needed liquidity into the
economy.
As the crisis worsened, the government switched its approach from one of a purely
‘laissez-faire’ approach to national economic management with orthodox policies to one
which allowed for some heterodox measures, including an attempt to involve privatisation
through ‘people’s capitalism’. This policy allowed common citizens to hold shares in the
remaining state-owned enterprises so as to discourage the formation of new conglomerates.
Attribution analysis, which poses challenges even for gauging the performance of asset
managers, is especially difficult when applied at the level of macroeconomic management.
As it turned out, the Chilean economy recovered and then went on to greater strength. Full
94
recovery took a little over five years, which was both quick and successful in comparison
with many other countries experiencing similar crises. Importantly, reforms enacted based
on this experience led to Chile enjoying the deepest capital markets in Latin America with
a market-capitalisation-to-GDP ratio which had exceeded 130% by the mid-1990s (in contrast,
Mexico’s ratio was significantly below 100% while Argentina’s was less than 20%). Although
economists tend to share an increasing number of similar views as their profession has
become more rigorous, it is a discipline which nonetheless has different schools of thought.
Consequently, the main causes of the Chilean financial crisis tend to be debated even to
this day, although with time, the ardour with which the debate is conducted has lost much
of its intensity. Among the generally accepted causes, and therefore lessons for posterity,
are the following.
• The pace of liberalisation was attempted both with a speed and a disregard for sequencing
that would not be attempted today. This was in part the need to quell resistance by striking
hard and fast but an equally compelling explanation was that at least some of the academ-
ically-trained economists who headed Chile’s economic team confused their relatively
simple macroeconomic model for a much more complex and complicated reality.
• Assumptions in economics of small, atomistic producers and consumers, all acting ration-
ally and all tending to maximise their utility and profit on which many of the policy
actions were predicated simply did not conform with reality with its preponderance of
large, powerful conglomerates put in place by the government’s own actions.
• The assumption of a private financial sector which operated on the basis of prudential
norms providing financing on the basis of arms-length dealings unswayed by related
lending and applying sound risk management principles was totally belied by the fact
that many of the banks and other financial institutions had become part of the conglom-
erates. The conglomerates had representatives on bank boards which would vote their
parent institutions new loans from ‘their bank’ with impunity, even to the point of ever-
greening the older loans. Bank managements, beholding to the parent companies for their
jobs, were only too glad to ration credit to the parent at higher interest rates, particu-
larly at times when the bulk of their remaining clientele was either defaulting or on the
brink of defaulting on their loans. The lesson here was that certain minimal regulatory
measures must be in place before financial liberalisation can prudently be introduced.
• Using the exchange rate as a nominal anchor in combination with trade and financial
sector liberalisation, if undertaken without due regard for existing structural rigidities,
can not only vitiate international competitiveness but also encourage a surge in credit-
financed imports which will undermine the intended structural adjustment and weaken
the government’s ability to defend the currency peg. It was a recurring theme and a
mistake that other countries would also make.
United States Savings & Loan (1985)

An unlikely segment of the US financial system would not only produce one of the largest
financial crises in history but would wind up costing the US taxpayer and the financial
95
sector an estimated $153 billion by the time the full tally was made. It was the Savings &
Loan (S&L) crisis which showed up as a problem in 1985 and which would take another
five years before the then newly-elected George H.W. Bush and his administration would
effectively deal with it.
In fact, before it almost caused the demise of the US financial system in its entirety, the S&L
industry would precipitate such a major change in the structure and organisation of the financial
system between the 1960s and the early 1990s as to make it virtually unrecognisable.
Coming out of the 1929 Great Depression, the US banking industry in the early 1930s
was regulated in ways that would be totally unfamiliar today. Commercial banks were
restricted in the types of business financing they could do. Moreover, significant new regu-
lations were introduced for the issuance and trading of publicly-traded securities. This
regulatory tightening was in response to the severity of the damage caused by that crisis.
It must be remembered that the stock market crash was not only devastating in terms of
the loss in market value reflected by the drop in the market indices, but also the hardship
to many was magnified by the loose practices in the securities industry, including but not
limited to the ability to borrow up to 90% of the market value of a trade. Consequently,
when the overall market began to plunge, the widespread use of financial leverage did not
just extinguish a portion of investor wealth as it would during later corrections. Instead, it
totally wiped out many personal investors, some even to the point of committing suicide.
Consequently, the legislative and regulatory safeguards put in place during the decade
of the 30s, particularly in the country’s financial sector, were designed to ring-fence and
therefore effectively compartmentalise many areas of financial and economic activity. These
were areas in which the legislators felt that the previous unbridled workings of a free market
were the cause of the failure and its resulting social cost. Like most responses of their kind,
the tendency was to overshoot, with a view to protecting people not only from financial
predators but from themselves as well. The new legislation, in fairness, however, was also
aimed at rebuilding investor confidence which had been so badly shaken. Some well-known
examples of the legislation passed during the decade include:
• Federal Home Loan Bank Act of 1932, which was established to charter and supervise
federal savings and loan institutions (S&Ls); it also created the Federal Home Loan Banks
which were authorised to lend to S&Ls.
• First and Second Glass Steagall Acts (the latter renamed as the Banking Act of 1933),
which among other things separated types of financial market activities among different
types of financial institution and established the Federal Deposit Insurance Corporation
(FDIC).
• Securities Act of 1933, which ruled that: (a) securities destined to be offered or sold
were to be registered, (b) investors were to be provided significant information in connec-
tion with securities offered or sold, and (c) deceit, misrepresentations, or fraud in the
sale of securities were to be prohibited.
• National Housing Act of 1934, which established the Federal Housing Authority (FHA)
and aimed to stimulate home ownership through S&L financing and by insuring the loans;
it also established the Federal Savings and Loans Insurance Corporation (FSLIC) which
was operated by the Federal Home Loan Bank Board (FHLBB).
96
• Securities Exchange Act of 1934, which governs those activities which are legal in the
secondary trading of stocks, bonds and dentures and specifies those activities which are
not legal; it further regulates various organisational forms in connection with the trading
of securities, including exchanges, platforms, securities associations, self-regulatory organ-
isations (SROs), brokers and issuers.
• Investment Company Act of 1940, which set the standards by which investment compa-
nies, including mutual funds, were to be formed and operated; it treats three types of
investment company: (1) face-amount certificate companies; (2) unit investment trusts;
and (3)management companies (of which the mutual fund is the probably the best known
form).
In this regulatory environment, home mortgage loans were obtained from small savings and
loan associations which took in savings deposits and lent those funds at market-determined
rates to residential home buyers. The interest rates which these institutions were allowed to
pay depositors in order to capture savings were regulated by the Federal Reserve’s Regulation
Q from the 1960s until the early 1980s when it was removed. This effectively put a ceiling
on those rates. Consequently, in times when market interest rates were high, the financial
markets would see an outflow of funds from the S&Ls as well as from deposit accounts of
the commercial banks into the capital markets instruments in search of better yield. This
process came to be known as disintermediation (as funds flowed out of the financial ‘inter-
mediaries’ and directly into the capital markets). When market interest rates dropped to
levels below the Regulation Q thresholds, then a process of re-intermediation took place as
the S&Ls experienced significant inflows. Although the S&Ls could borrow from the Federal
Home Loan Banks during times when deposits were declining, this nonetheless created
higher risk of volatility as well as sudden spikes in liquidity risk.
The controls on interest rates were initially put in place to dampen competition between
banks and S&Ls. The fly in the ointment, however, was the advent of new money market
funds which could offer depositors market rates, thus diverting substantial funds away from
the S&Ls. Moreover, as market rates climbed, this had the effect of shrinking the value of
S&L portfolios of mortgages that had been originated at low interest rates. This threatened
the solvency of a number of these institutions. It was the second oil shock of 1979 and the
consequent spike in interest rates (US government rates reached 16% a year at one point) that
sounded the death knell for this type of financing which was based on pronounced asset/liability
mismatches. Many of the S&Ls would have closed sooner and in larger numbers had it not
been for the serious understaffing on the part of the regulatory authorities. Instead, ways were
found to continue cutting the thrifts extra slack and in the process weakening them further
while at the same time encouraging moral hazard with greater risk-taking. Not only were
capital adequacy ratios reduced but the S&Ls were extended new freedom to expand their
activities into new potentially profitable but significantly risky areas. S&L managers who at
least understood the home mortgage business after years of involvement were now becoming
exposed to investments in which they had no experience and in many cases not even an under-
standing of the business model and its risks. These were projects such as tourist resorts, planned
residential communities, and skyscraper office buildings. Moreover, ways were introduced to
pump up net worth and to spread out certain types of charges.
97
Ceilings on deposit insurance were also raised, which encouraged even greater moral
hazard. The main bulwark against bad business choices were management integrity and risk
management practices. These proved less than up to the task, as an increasing number of
institutions allowed their managements to develop bad practices in connection with both
risk taking with regard to new loans and the management of risk once taken. The entry into
commercial real estate, where the business dynamics and risks are quite different than in
the home mortgage business, challenged S&L managers well beyond their capabilities in
many cases.
In this environment, blatant corruption also played a key role. Some estimates place
losses due to S&L fraud at as high as 15% of the total S&L losses. To some degree, this
happened after the government eased a number of restrictions regarding S&L ownership.
The combination of sector attributes described above became highly attractive to certain
types of investors and managers who saw an easy way to make quick returns through a
highly-levered form of financing in an industry which had by that time developed fairly lax
regulatory practices. During the brief period from late 1982 to 1985, the industry grew by
56%.
After a relatively benign year in 1983, the rest of the 1980s saw a series of regional
problems threaten the viability of S&Ls around the country. Texas S&Ls, with their survival
closely linked to the fortunes of the oil industry, were among the first to falter as the initial
boom in oil activity sparked by OPEC II (1979) began to peter out. A softening in the real
estate market in the south west added to the financial problems in numerous thrifts. Thereafter,
adverse conditions in key segments of the US farming sector began to show up in the loan
portfolios of many S&Ls in the mid west and other states dependent on agriculture. The
fluidity with which different economic problems seemed to move around the country resulted
in a similarity in the perverse dynamic experienced throughout the country’s entire thrift
industry. That was the combination of a rising rate of non-performing loans in conjunction
with a pronounced decline in collateral values.
The regulatory authorities, mainly the FHLBB, tried belatedly to tighten up on the
riskier activities of the industry but the damage had already been done. By 1986, the FSLIC,
despite federal government capital injections of $15 billion in 1986 and $10 billion in 1987,
became insolvent as the magnitude of the problem vastly outstripped its resources. By the
late 1980s, it did manage to come to the rescue of distressed S&Ls with assets of close to
$100 billion. The authorities, however, also resorted to encouraging numerous mergers and
acquisitions as an alternative to liquidating those which could not be given further injec-
tions of federal funding.
The government rescue package for the industry was announced by the newly-elected
US president George H.W. Bush. This was followed by the US Congress passing the Financial
Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989. Through the enact-
ment of this federal law, the FHLBB and FSLIC were abolished and the key institution it
created was the Resolution Trust Corporation (RTC). The new institution was created with
the view to strengthening and redistributing regulatory and supervisory oversight for the
industry. The RTC was established to preside over the closing of the remaining distressed
thrifts which had not been resolved by either support from the FHLBB and FSLIC or alter-
natively through merger and acquisition. From the proceeds of those closures, including
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recourse to a significant portion of the insurance that had been backing depositor accounts,
the RTC also channelled payments to S&L depositors.
From about 1986 until 1989, the S&L crisis had already cost the US taxpayer about
$125 billion, involving close to 300 thrifts which were bailed out by the FSLIC. Exhibit
5.1 shows the number of cases resolved by the RTC and the associated amounts in terms
of total assets outstanding at face value over the period 1989 through 1995.
Exhibit 5.1
Resolution Trust Corporation S&L cases resolved: 1989–1995
No. of Face-value
Year S&Ls of assets ($billion)
1989 318 135

1990 213 130
1991 144 79
1992 59 44
1993 9 6
1994 2 1
1995 2 4
Total: 747 399

Source: Curry and Shibut
Consequently, the US S&L crisis, involving asset failures of close to half a trillion US
dollars, imposed an enormous weight on the US economy, the country’s taxpayers and its
decision makers. The final bill of about $87 billion was clearly felt, but, as Alan Greenspan
points out, was an amount that was ultimately far less onerous than had been anticipated
all along, largely because of the RTC’s successful distressed asset sales.1 Out of the ashes,
however, massive overhaul was achieved of the country’s home financing system. These
changes would pave the way for a whole new industry of asset securitisation in which resi-
dential mortgages would act as the pioneer that a broad range of financial assets would
eventually follow.
United States Black Monday (1987)

It is curious, if not a testament to the sheer size of the US economy and its capital markets,
that the largest stock market decline in the country’s history not only came in the middle
of a banking crisis but was not generally treated by either news commentators or econo-
mists as being caused by it. The S&L mess was still being worked out with, as indicated
above, many fearing a price tag which would be in the hundreds of billions of dollars. This
debacle, however, tended to upstage serious problems which were brewing in the country’s
commercial banks and which in fact were on a larger scale than those in the thrift industry.
99
Many of the commercial banks had tackled high-risk lending with the same enthusiasm as
the newly-deregulated S&Ls. A major development in this connection was the creation of
a multi-billion dollar junk bond industry by Michael Milken, which involved numerous
financial institutions, including commercial banks, in the financing of corporate takeovers.
Consequently, although junk bonds were not entirely the cause of bank distress, as the junk-
bond sector encountered difficulties which together with other types of risk impacted bank
balance sheets, numerous failures among smaller banks occurred in the second half of the
decade. And this came after so many banks, mostly the large New York-based powerhouses
but also many smaller regional banks, had been badly burned by the Latin American debt
crisis which started as early as in the second half of 1982.
Volumes have been written on the causes of the Black Monday crash. It is a subject
for which an ongoing debate continues. To sort out the reasons proffered, it is perhaps useful
to distinguish between the incidence of the crash and its severity.
Regarding what caused the incidence of the crash, US obligations, foreign and domestic
had mounted during the 1980s during a period when the dollar remained robust. Just prior
to the crash, the dollar was coming off its highs at a time when the geopolitical situation
was marked by even more characteristic uncertainty than usual. Then the Federal Reserve,
under its newly-appointed Chairman Alan Greenspan, raised interest rates to contain signs
of inflationary build-up. The economic thinking at the time was that, assuming a stable
exchange rate, an increase in the discount rate should signal a tighter monetary stance, which
should translate into cutbacks in spending, which in turn should ease off on inflationary
pressure. In accordance with the theory of rational expectations, however, this would only
work as long as the majority of actors in the drama consider the economic authorities’ ability
to stabilise prices and the economy to be credible. Uncertainty on this score, whether due
to internal domestic reasons or geopolitical ones, can greatly upset the reasoned causality.
Economic analysis of macroeconomic variables over too short an historical period would
likely miss the relationship between the international value of the dollar and the interest
rate over the several years prior to 1987. As mentioned previously, the dollar after all, had
been receding from its highs. A longer retrospective, however, would have pointed out the
inexorable appreciation of the dollar against major currencies throughout the decade. Without
becoming distracted by trying to identify quantitatively appropriate reference points for
concepts of currency overvaluation versus fair market valuation, in qualitative terms it is
safe to say that even if ‘overvaluation’ is only in the minds of investors, then the stronger
a currency’s exchange rate for a given set of fundamentals, the greater the risk of subse-
quent depreciation. Mark Mullins makes an interesting case for a strong US dollar in
combination with balance-of-payments contributing to the conditions leading up to the stock
market crash.2 Again, the economic wisdom at the time was that in an open economy, even
if a higher interest rate does not dampen spending (on both consumption and investment)
as much as it would in the case of a closed economy, the foreign capital it would attract
would have a salutary effect in that it would help maintain a stable exchange rate. When
significant outstanding debt is added to the equation, particularly in the form of public sector
obligations, the resulting quasi-fiscal deficit this entails at some point upsets the orderliness
of this set of relationships. It does this by calling into question the economic authorities’
ability to manage the situation to a satisfactory equilibrium. Moreover, the US stock market
100
saw the Dow Jones Industrial Average, an important proxy for the entire US capital markets,
increase steadily by over 12.5% a year from 1980 until October 5 1987, just two weeks
before the onset of the crash. Consequently, some observers relate the US economy and its
fundamentals, particularly the appreciation of its currency combined with what many were
increasingly seeing as an overvalued stock market, to setting the stage for the onset of
investor fears which set the stage for the stock market correction. While there are those who
would cast their explanation strictly in terms of macroeconomic fundamentals (without
relying on financial indices) and others who take a strictly financial markets perspective,
both holders of dollars and holders of financial assets denominated in dollars, no doubt saw
their broader holdings as becoming increasingly at risk. Consequently, it was the securities
market rather than the foreign exchange market in the United States in October 1987 which
gave vent to the adjustment that market participants seemed to feel was needed.
Regarding the severity of the crash, the culprits singled out as deserving of most of the
blame were portfolio insurance and program trading. The advent of financial futures, and
subsequently options on futures, without a doubt revolutionised professional portfolio
management. Whereas previously the management of risk in portfolios of actively-traded
securities relied on asset diversification, short selling (but only in those types of institutions
where short positions were allowed), and effective control of the use of financial leverage,
the ability to offset long positions with short positions in combinations much more closely
tailored to individual institutional investor needs was nothing short of revolutionary.
Portfolio insurance, which is also referred to as ‘dynamic hedging’, involved an invest-
ment strategy whereby if an investor had a portfolio of long positions in a basket of stocks
and the market began to decline, then futures on stock market indices would be sold with
the cash thus generated offsetting any further declines in the market. Further declines would
trigger additional sales of futures. The problem was, however, that once the market started
to decline, then the price of a single future sold would drop, requiring larger volumes of
the futures to be sold to achieve the same hedge. Additionally, with enough portfolio managers
adopting the same strategy, successive sales of futures tended to exert even more downward
pressure on the price of a futures contract.
Program trading was the modality through which portfolio insurance was executed.
Many tend to use the term loosely for any kind of trading involving a computer. This,
however, is not entirely accurate. Others have defined it as involving a predetermined set
of steps or ‘program’, such as an algorithm which can either be executed mechanistically
by an individual or by a computer. The NYSE defines program trading as a ‘wide range of
portfolio trading strategies involving the purchase or sale of 15 or more stocks having a
total market value of $1 million or more’. But while the NYSE definition does not make
specific reference to the use of computers, in fact, nearly all program trading involves trades
determined and executed by computer programs.
Among the various trading strategies involving program trading, three in particular
became popular. These were duration averaging, portfolio insurance, and index arbitrage.
In either bull markets or in markets in a trading range, the effect of portfolio insurance
and program trading was to increase liquidity in the stock market. As arbitrage opportunities
were spotted and exploited, the effect was that hedging and arbitrage activities ensured continu-
ous convergence between stock market valuations and valuations of the same securities in
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the futures markets. In bear markets, particularly as stock price declines begin to accelerate,
portfolio insurance conducted through program trading tends to confer ever decreasing bene-
fits to investors as market conditions deteriorate. The problem was that precipitous drops in
stock market prices do not allow portfolio insurance to kick in to provide the full amount of
coverage initially envisaged. This left large portions of stock portfolios fully exposed to market
risk. When stock prices drop sharply, this reduces liquidity both in respect of stocks but also
with regard to futures contracts even more. At some point, if stock price changes are large
enough, this causes major discontinuities in the futures market, at which point the price of a
futures contract becomes indeterminate.
Many critics of program trading blamed it for the 1987 stock market crash. They claimed
that the trading strategies embodied in the computer coding resulted in the blind or mind-
less selling of stocks as market indices declined, thereby magnifying the drop in prices.
There was another aspect of program trading which contributed to the severity of the
crash, particularly in connection with the portfolio insurance trading strategies. The strate-
gies involved applying a hedge across two distinct markets organisationally and geo-
graphically. The underlying securities in portfolios were traded in New York – mainly on
the NYSE but to an increasing extent on the exchange operated by the fledgling but growing
Nasdaq. The hedges, which were stock futures, not being securities but rather financial deriva-
tive contracts, were traded in Chicago on the Chicago Board of Trade (CBOT), the Chicago
Mercantile Exchange (CME), and the Chicago Board Options Exchange (CBOE).
When news becomes available, the futures exchanges in Chicago are where one can
expect the heaviest action. At the same time, however, volatility in the price of the under-
lying, which in this case was determined back in the New York stock market, plays a key
role in price determination for futures and options. When financial markets are experiencing
a normal day, trading strategies which span these two markets are manageable. But the
‘normalcy’ masks a very fundamental difference between the two. The time horizons and
corresponding response times of participants in the two markets are vastly different. For
most futures traders, if the long term is not the end of the day, it certainly is not too many
days into the future. More importantly, they tend to respond very fast to even the smallest
divergences in prices. Equity investors, on the other hand, even though recent years have
seen the shrinking of their time horizons on average, will often take positions with their
time horizons measured in several months if not years. These longer horizons on average
tend to make their responses relatively much more protracted (certainly as viewed by a
derivatives trader) even when markets are in turmoil. Anecdotes abound of communications
breaking down between futures traders and equity traders at the height of the crisis in large
part because of differences in horizons and normal response speeds.3 Added to this was the
imbalance caused when trading was suspended in one or the other of these markets, which
also meant that the ability to effectively manage hedged positions across these two markets
would be similarly suspended.
Norway (1987)
In the mid-1980s, Norway introduced substantial deregulation of its banking sector. The
commercial banks had been restricted in terms of both quantity of credit they could extend
102
as well interest rates they could charge on loans as well as pay on deposits. The deregula-
tion, which began in 1984, involved relaxing reserve requirements, allowing the inclusion
of subordinated debt in determinations of capital adequacy, and effectively opening the
country to new foreign as well as domestic banks. During 1985 and 1986, interest rates
were freed to be determined by market forces and competition among banks was generally
eased as were restrictions on branch expansion. These developments led to bank lending
growing by 12% a year over the 1984–1986 period, which was about three times the average
growth rate in the years immediately prior. The bulk of the loans, moreover, were origin-
ated by newer and smaller banks and savings banks which lacked the experience and the
skills of Norway’s larger traditional banks. Cases of fraud among these transactions were
also significant.
Bank loan losses started to mount in 1987, which quickly brought an end to the credit
expansion. This coincided with a drop in the international price of oil, resulting in many of
the assets in the oil sector which had been pledged as collateral losing value and thus exacer-
bating the losses. Bankruptcies in the country exploded from about 1400 establishments in
1987 to almost 3900 in 1988 and crested at over 4500 in 1989. These failures took place
in fishing, construction and the service sectors (real estate, restaurants, hotels, and trans-
portation).
During the late 1980s when the crisis first started to unfold, Norway did not have
national deposit insurance (the banks had private arrangements in place to handle liquidity
shortfalls but these were limited in their ability to deal with the size of crisis that was
brewing) nor was adequate regulatory institutional capacity in place to deal effectively with
a financial crisis. What made matters worse was that after a number of smaller banks regis-
tered difficulties in the first few years of the crisis, the banking sector encountered a second
wave of banks in jeopardy toward the end of the decade. This occurred as the softening in
international oil prices, the economic slump being felt in neighbouring countries and tensions
mounting in connection with the Persian Gulf crisis together forestalled the country’s ability
to obtain capital from the outside.
Although in 1990 it appeared that the worst was over, further rounds of bank losses
and no alleviation from foreign capital in sight put the entire banking system at risk of
collapsing. The Norwegian government finally stepped in with laws requiring troubled banks
to write down their capital, making it possible for the government to intervene insolvent
banks.
This was Europe’s first banking crisis since the 1920s and many of the bank owners
and managers were not entirely clear as to what needed to be done to mitigate the crisis
when the earliest warning signs became visible. Moreover, both government and the private
banking industry itself were not in favour of a strong role for the government, preferring
instead to allow the industry to adjust by itself as necessary. And when the government did
become involved, the changes it wrought on the sector were long-lasting. It forced the
dismissal of entire boards of directors and senior management; it caused the replacement
of principal shareholders as many of the latter saw their capital totally wiped out as loan
losses were applied to writing down capital. And banks were forced to cut back on branches
and on costs as part of a sector-wide restructuring process. Bank stocks listed on the Oslo
Stock Exchange (OSE) did not recover to their pre-crisis levels until around 1997.
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Finland and Sweden (1991)

Although Finland and Sweden are two distinct sovereign countries, their economies experi-
enced many of the same developments depicting a process of boom and bust in tandem.
Their governments, moreover, introduced similar, if not identical, policy initiatives virtually
simultaneously. Consequently, in terms of understanding the financial crisis both countries
shared which began in 1991, there is advantage in considering the countries together.
The two countries had experienced bouts of inflation and high inflationary expectations
since the early 1970s. This phenomenon combined with regulated low nominal interest rates,
resulted in significant investment misallocation as a consequence of low or negative real
interest rates. Financial repression and a pervasive lack of knowledge or even an instinct
for risk management and prudent financial practices was found throughout the economy –
in financial institutions, non-financial enterprises, and the general public.
Following major devaluations, precipitated by the first and second oil crises of 1973
and 1979, which had been considered failures, both governments were committed to main-
taining a fixed exchange rate as a nominal anchor for the domestic economy.
The domestic credit market was deregulated in both countries in 1985. However, neither
country tightened either its fiscal or monetary policy in conjunction with financial deregu-
lation. This combination of factors gave rise to higher inflationary expectations, a lending
boom and a commensurate surge in real estate values which outpaced consumer prices.
Because real estate was commonly pledged as loan security, as real property prices rose, so
did collateral values and consequently the amount of borrowing. The economies of the two
countries consequently boomed for a while.
Then in 1990–1991, the boom turned into a bust as an ill-timed relaxation of the capital
account which coincided with a rise in real interest rates elsewhere in Europe (fanned by
German reunification), triggered a massive capital exodus from Finland and Sweden.
Both countries pegged their currencies to the European currency unit (ECU) in 1991,
which placed restrictions on their ability to apply monetary policy. Consequently, as the two
governments found that they had to defend their exchange rates against speculative attacks
and capital flight, interest rates rose dramatically, resulting in high positive real rates of
interest. Thus the effect of depressing asset prices, particularly real estate, started a down-
ward spiral in property sales and credit contraction. Wealth effects included reduced
consumption, increased savings, increased unemployment and lower growth in output.
Government revenues contracted, public spending rose and both governments experienced
a dramatic increase in the public sector deficit.
The crisis reached its worst point in 1992 when both currencies were subjected to
massive speculative attacks, precipitating full-blown currency crises in the two countries.
Finland floated the markka in September of that year and Sweden floated the krona in
November. These actions checked the fall of the two economies and turned the main macro-
economic aggregates around the following year with the exception of unemployment which
remained high for several years thereafter.
The two crises in which the banking sectors played an important role spread to the
international currency markets. It is important to note that both countries had financial
systems which were dominated by banks. Consequently, developments in their respective
capital markets, while negative, were not central to how the crises played out. Banking
104
illiquidity was precipitated as it became obvious that non-performing loans were truly prob-
lematic and as collateral values started to fall. And when the crises turned into currency
crises, liquidity dried up as massive capital flight occurred even as interest rates were forced
significantly higher. Massive devaluations finally helped the two economies to re-equilibrate
but this was only after significant damage had already been wrought.
Japan (1992)
Japan’s economy at the beginning of the decade in the 1990s showed signs of overtaking
that of the US. Products based on advanced engineering such as automobiles and high tech-
nology such as televisions, sound systems and computer hardware, which once invited
international derision, became renowned for their quality and reliability and coveted by
western consumers. The run up in the international value of the yen continued steadily over
several years. Concurrent with this, Japanese trade surpluses mounted as the export-led
strategy paid off. This strategy, however, was waged as a virtual military campaign with
Japanese goods sold in international markets benefiting from a combination of disguised
subsidies as well as significant cross pricing. For example, large agricultural equipment and
machinery sold in developing countries was frequently bundled with concessionary financing
and technical assistance. As the yen appreciated and the Japanese war chest burgeoned,
Japanese overseas investments ranging from controlling interests in foreign companies to
prime real estate in downtown New York and European capitals served as a form of real
portfolio diversification.
The country’s industrial and financial structure had its roots in the pre-World War II
era, during which period several industries formed alliances to enhance the economic power
of their group. Although these groups were dismantled by the Allied forces at the end of
the war, new groups formed to become the main fabric of the Japanese economy during the
expansionist period of the Meiji, Taisho and early Showa eras. The new groups tended to
be formed so as to integrate their activities horizontally, vertically, or in some cases, both.
The fact that each group had its own bank had two effects: (1) it forestalled companies
going directly to the capital markets; and (2) it greatly discouraged hostile takeovers. Some
of the additional structural features of the economy in the post-war period were:4
• banks tended to be smaller in size and poorly capitalised;

• the system of cartels created a set of interrelationships and ‘understandings’ among groups
which were very complex, tended to be opaque and greatly restricted domestic compe-
tition;
• government financing, especially through postal savings, played an increasingly impor-
tant role; and
• The central bank was run as an executing arm of the ministry of finance.
While other countries (such as the Scandinavian countries) had somewhat similar economic
groupings, one feature which distinguished the Japanese model was that the Japanese banks,
while having a relationship which was essentially one of extending credit to their group
105
companies, tended to hold significant quantities of shares in those companies they financed
which were not part of their respective groups.5 Another was that although many other coun-
tries had export sectors of varying size and competitiveness, Japan’s entire economy was
geared up for export-led growth. The success of this strategy over several decades produced
an overall growth rate which more than compensated for the societal or welfare costs that
the Japanese citizenry was called on to pay in order to support the associated organisational
structure. At the risk of oversimplifying the situation, workers received job security and
were rewarded through the wage increases that a growth economy allowed even though their
savings were rewarded sparingly in order to contain the costs of maintaining the export-led
strategy.
Measures were introduced, starting in the 1970s, aimed at liberalisation. These were
taken over time by the Japanese economic authorities primarily with an external view. They
were to lay the groundwork for elevating the status of the yen as an important internationally-
traded currency and not especially to promote competition and efficiency in domestic markets.
These efforts culminated in an amendment in the Diet in 1980 of the Foreign Exchange
and Foreign Trade Control Law of 1947. This allowed the Euroyen and yen-denominated
foreign bond markets to function freely with an offshore market for yen established in
Tokyo.6 Along with this reform, interest rates were deregulated. Certificates of Deposit (CDs)
were introduced in 1979, time-deposit rates were freed and eventually interest rates were
deregulated for all liquid accounts, with the exception of cheque accounts. Short-term external
borrowing was also permitted around the mid-1980s.
But the reforms described above nonetheless masked a banking structure and culture
which continued to function much as it did several decades before. Moreover, the ministry
of finance held sway over the banks for which they were both regulator and supervisor in
ways that far exceeded comparable powers in other countries.
With a national effort aimed at propping up those companies which were chosen to
lead the export effort, it should not be surprising that a significant share of companies thus
chosen were not efficient. Credit was channelled to them under the structure described above
and when weaknesses in their financials became evident, more support was directed to them.
This approach worked as long as the surpluses were being generated from exports. However,
as the debt mounted, it exceeded the capacity of the economy to sustain it as the contagion
of non-performing loans spread like wildfire throughout the banking sector. As the problem
became recognised by the banks and the economic authorities, it became increasingly diffi-
cult for the government to maintain the momentum with which it was channelling support.
As this crossover point was reached, the problem loan portfolio, which was systemic in
nature, crystallised and the slide in asset values and in widespread financial distress accel-
erated. Moreover, as the crisis made itself felt on the macroeconomic indicators, property
values (the main form of collateral for bank loans) were falling which only served to worsen
the collapse.
Many say that Japan’s financial bubble showed signs of bursting in 1990 when the
Topix index fell. However, it was not until the Nikkei index in 1992, followed closely by
international investors, began its descent from its high of about 39,000 to its eventual low
of about 13,000 that the dimensions of the problem were made aware internationally. A key
question was why the authorities were so slow in addressing the collapse. Many of those
106
spectators familiar with western economies and financial systems were puzzled why, for
example, the Japanese government did not play a more decisive role in tackling the problem
of non-performing loan portfolios.
Certainly one of the key factors which made this problem so intractable was that the
labyrinthine network of relationships and obligations arising out of the keiretsu system as
well as the Japanese business culture – both of a legal and a social nature – rendered loan
obligations much more entangled than they might have been. This complexity was in sharp
contrast to the western way of conducting lending on the basis of arm’s length transactions.
In the latter case, bad or doubtful loans can be much more easily foreclosed upon, assuming
the foreclosure laws and enforcement systems are in place.
A second factor which made dealing effectively with the non-performing loan port-
folios so difficult was that banks simply had not made provisions for the bulk of the loans
which became infected. A combination of not being required to have a proper loan classi-
fication system in place and the latitude the banks had for applying judgment (which meant
finding excuses for why loans were not impaired) in clear cut cases where loans were not
being serviced, conspired to leave the banks with enormous sums to write off. The fact that
these sums exceeded regulatory capital meant that they would have to raise massive new
injections of capital, which was especially onerous for those banks with foreign branches
and operations which therefore were required to meet the Bank for International Settlement’s
(BIS) 8% capital adequacy requirements at the time. For those banks only operating domes-
tically, they still had to maintain capital adequacy of 4%.
Financial deregulation was introduced without having first in place an effective system
of prudential regulation. The situation gave rise to significant moral hazard with banks taking
inordinate risks in the expectation that the ministry of finance would come to their rescue.
The process of deregulation was protracted, during which time the Japanese government
realised that it would be neither feasible nor prudent to guarantee all banks against failure.
As the size of the non-performing loans problem and bank losses worsened, many deposi-
tors harboured doubts as to the government’s ability to stand good for the entire banking
system. It was not until the government was able to publicly reassure the country that no
depositors would lose, increase deposit insurance fees and introduce a ¥30 trillion bailout
package that depositors finally became convinced that a credible safety net was in place.
The financial crisis, however, cannot be explained entirely by weaknesses in the banking
sector. Clearly, the economic boom was fed by the bubbles which were created both in the
real estate market and in the stock market. With regard to real estate, property prices had
increased throughout the post-war period to the point that it was widely believed that they
could only go in one direction indefinitely. This confidence made property the ideal collat-
eral for the banks and indeed other financial institutions. Furthermore, the speculative excesses
in the real estate and stock markets were highly intertwined.
Macroeconomic policy mistakes also played an important role. Throughout the decade
of the 1980s, the Japanese economic authorities were single-minded regarding the need to
reduce budget deficits and run a budget surplus. Consequently, at those times when they
deemed it appropriate to provide economic stimulus, the entire brunt of this stance fell on
monetary policies characterised by very low interest rates. The effect of maintaining low
interest rates for an extended period was to fuel the real estate and stock market bubbles.
107
As we will see below in connection with the US sub-prime crisis, sustained periods of nega-
tive real interest rates tend to give rise to asset bubbles which eventually burst. Then as the
Japanese authorities started raising interest rates beginning in 1989 in a series of moves,
sharp interest rate increases served to puncture the bubbles in the two markets, precipitating
a deceleration in growth until the economy came to a virtual standstill.
The other mistake that Japan’s economic authorities made was to misinterpret the
economic downturn as just the down phase of a normal business cycle that would ultimately
be of relatively short duration. This caused them to act too late and then too harshly when
they did act. In fact, the whipsaw effect of sudden tightening was to produce an overkill
which not only caused economic stagnation but further depressed the real estate and stock
markets and caused the number of non-performing loans to increase.
A third factor in Japan’s protracted economic crisis was the global dimension of its
international role as a creditor nation. Having run budget surpluses and trade surpluses for
a number of years, the country was dependent on investing those surpluses abroad. However,
the continued appreciation of the yen resulted in cumulative yen-denominated losses on
those investments abroad. These losses, which were comparable in size to that of the banking
sector’s losses on bad loans placed enormous pressure on the structure of the Japanese
economy. Coupled with a strengthening global trend to deregulation of the financial sector,
it opened the doors to many foreign banks, insurance companies, investment companies,
and funds to compete in Japan’s own domestic market on terms and conditions which were
at odds with the time-honoured ways of doing business within the country. Moreover, as
the behemoth American and European financial houses spread their activities globally,
capturing economies of scale and scope in conformity with the new paradigm of ‘global-
isation’, they achieved this through massive spending on (and the steady introduction of)
new technology that took the Japanese banks and institutions time to adopt and master.
The slide continued throughout most of the 1990s. It took until 1998 for the govern-
ment’s concerted efforts through comprehensive financial reform which finally paid off
post-2000. For a variety of reasons, of which the foregoing provides a partial description,
the crisis was one of the worst in modern global history and cost what had seemed to be
one of the strongest countries economically an entire decade of economic and financial
progress.
Mexico (1994)
The Mexican financial crisis, which had been building up for some time but was precipi-
tated in December of 1994, shared some of the economic causes which had led to Chile’s
financial crisis a little over a decade earlier. Of course, two political assassinations of prom-
inent politicians, one in March 1994 and another in September, followed in October by a
standoff between the Mexican government and rebels in connection with an uprising in the
southern state of Chiapas in a pre-election year, served as catalysts.
Mexico in the 1990s suffered from financial liberalisation that was premature or at best
it was policy that was applied ‘out of logical sequence’. The 1991 re-privatisation of the
banking sector called for the formation of financial groups. In fact the banks were mainly
bought by stockbrokerage firms which arguably overpaid in terms of price-to-book-value
108
ratios and financed these purchases with significant financial leverage. Consequently, in addi-
tion to other sources of moral hazard, the banks were under enormous pressure to book assets
and took risks to earn leveraged returns. While the financial sector was growing its own
weaknesses, the public sector was sowing the seeds of future distress by financing govern-
mental operations through the issuance of tesobonos. These peso-denominated debt instruments
looked a lot like many past issues of Mexican bonds. But, they differed significantly in that
their redeemable value was fixed in US dollar terms. Moreover, their maturities were stag-
gered in such a way that significant repayments fell due early and over a number of months.
The dynamics of the assault on the Mexican peso in the mid-1990s are often described
with more emotion than perhaps is warranted. US-based institutional money managers are
often blamed with having ‘punished’ the country for having misled them regarding the
government’s ability and resolve to manage the currency within the established bounds. To
be sure, the recurring sexenio phenomenon of economic investment and growth which plateaus
in the year leading up to the final year of each six-year cycle in which presidential elec-
tions are held, was a known characteristic of the national economy. It should be remembered
after all that Carlos Salinas had stabilised the economy, bringing inflation down to single
digit levels and both budgetary and current account deficits going into 1994 were well within
those percentages which would have made leaders of the G7 countries proud to have for
their own economies. After all, for this and other achievements, Time magazine had just
declared him ‘Man of the Decade’.
Consequently, to the extent the widening and eventual abandonment of the currency
bands for the peso caught investors unawares, this has been attributed to the fact that if
there was one key macroeconomic indicator that was not made available to investors and
the general public it was the level of foreign exchange reserves. Mexico began 1994 with
over $30 billion in reserves. These were down to $6 billion and falling by the time the
props under the peso were removed in December of the same year. Macroeconomic funda-
mentals, therefore, were not the cause of ongoing worry for international investors during
most of 1994. Certain structural features such as a weak banking system heightened by
political uncertainties in an election year, the murder of a popular presidential candidate
(Donaldo Coloso), and the uprising of the indigenous population in Chiapas that year have
also been cited as important factors in the crisis that followed.
When the Bank of Mexico removed the support from the peso, this set in motion a
chain reaction. Interest rates spiked, borrowers quickly became unable to meet their debt
servicing obligations, bank non-performing loans surged and severe weaknesses in the capital
structure of the country’s commercial banks were exposed. In the months leading up to and
during the earliest part of the crisis, an examination of the country’s financial statistics
showed that repo-financing, which had been robust for some time, exploded to volumes of
activity which became several-fold their previous levels. It was (or should have been) an
early indicator of the accreting systemic risk in Mexico’s financial sector. Among the hardest
hit were the many homeowners who had financed the purchase of their homes with adjustable
rate mortgage loans (including features permitting negative amortisation). During 1995, appli-
cable mortgage interest rates surged at one point to as high as triple digit levels from levels
which were in the low double digits. This unleashed a popular backlash. Borrowers, who
took no issue with their obligation to repay principal, felt betrayed by the government as
109
they watched helplessly while their inability to pay the suddenly higher interest payments
begin to inflate through the effect of interest compounding. Their rapidly accumulating
indebtedness imposed an unforeseen burden well beyond their capacity to fully repay.
As the crisis wore on, portfolio capital, which had been attracted to the country in
earlier years, massively flowed out of the country.
But why would professional foreign investors react so virulently to currency devaluation? In
contrast, throughout the early 1990s, Brazil had enjoyed substantial portfolio capital inflows
despite steady currency depreciation more or less in line with its high and chronic inflation rate
which throughout that period measured in thousands of percentage points on an annualised basis.
Institutional investors are constantly faced with an array of risks and for this reason practise
portfolio diversification and apply rules and norms which generally mitigate even the worst risks
in terms of their overall impact on institutional portfolios. It was the failure to ‘come clean’ with
the true state of the Mexican economy that some observers attribute to the seeming vengeance
with which international money managers withdrew funds from the country during 1995. There
may be an element of truth to this explanation.
An alternative explanation, however, may be equally as compelling. Starting in February
1994, the US Federal Reserve began a sequence of interest rate hikes which continued
throughout the decade. During this period, the technology sector in the US was booming
while at the same time US mutual funds and other types of investment company held less
than 15% of their holdings in emerging market securities, of which Mexico represented only
a few percent at the most at any point in time. The percentages involved, even though signifi-
cant for Mexico, from the viewpoint of institutional investors were not large enough to be
the main focus of their attention. As long as market conditions in the emerging market coun-
tries were on an up trend, there was no reason to withdraw money from those markets.
However, with the continued buoyancy of the technology-led US stock markets even despite
the steady rise of interest rates, rebalancing institutional portfolios as the initial signs of
distress occurred in Mexico, at least with hindsight, seems to have been the prudent thing
to do. Of the two primordial emotions – fear and greed – the truth as to which of them
actually dominated in the ensuing capital flight decisions (fear of things worsening in Mexico
or greed for sharing in the mounting gains to be made by upping the stakes in the tech-
nology boom) may never be fully known.
As the financial crisis in Mexico crystallised, critical weaknesses in the country’s
commercial banks and their related financial groups became painfully evident. The following
are representative of the structural developments which contributed to these weaknesses since
the early part of the decade of the 1990s.
• The financial institutions act of 1991 encouraged the formation of financial groups in
which leasing and factoring companies, commercial banks, insurance companies and
brokerage firms were brought together under a single interlocking ownership structure.
• This fostered the traditional practice of high rates of related lending, with board direc-
tors within the financial group being the recipients of as much as one-fifth of all lending
in the years leading up to the crisis. The prevalence of other large highly-diversified
groups operating in the real sectors with strong linkages to the financial groups added
further complexity and tighter coupling to business relationships.
110
• The financial group structure also encouraged regulatory arbitrage whereby prudential norms
and other limitations imposed by laws and regulations in certain types of institution could
be easily side-stepped by booking the transaction through another financial institution within
the group – one whose business model exempted it from the rule in question.
• As was done by the banks in Chile over a decade earlier, the commercial banks borrowed
dollar-denominated loans from New York and European banks and lent the proceeds to
both companies and consumers in the form of dollar-denominated obligations. While this
avoided running a foreign-exchange mismatch on their books, it nonetheless traded
currency risk for credit risk but with a clientele which had limited experience and skill
for judging currency risk. More importantly, many of the Mexican banks’ borrowers
simply had no foreign-currency-denominated earnings themselves, leaving them highly
exposed to financial hardship when the devaluation finally came.
• As the crisis became full blown, the Mexican economic authorities intervened in the
country’s financial sector in ways which were reminiscent of the Chilean government’s
intervention of the mid-1980s. A recapitalisation fund, FOBAPROA (Fondo Bancario de
Protección al Ahorro or ‘Banking Fund for the Protection of Savings’), was put in place
which operated a voluntary recapitalisation programme (PROCAPTE short for Programa
de Capitalización Temporal de la Banca, which was a temporary programme adminis-
tered by FOBAPROA to recapitalise banks), whereby the owners of the banks could
recapitalise the banks in order to meet capital adequacy requirements through the issuance
of convertible bonds. The call feature of these bonds meant that if the banks did not stay
within certain narrow performance bands, the government would be able to trigger the
call option embedded in these bonds, in which case they would be effectively nation-
alised. The government’s recovery programme involved allowing banks to exchange NPLs
for government securities. Ultimately more than $40 billion in NPLs were placed in a
pool to be resolved separately in a newly-created entity (similar in some ways to the
Resolution Trust Corporation, which had been set up in the United States in connection
with the S&L crisis). But while the newly-exchanged government securities greatly
improved the quality of the banks’ balance sheets, they did not address the general lack
of liquidity in the market, the effect of which was to slow the rate of recovery.
• Unlike in the Chilean case, however, the Mexican government paved the way for the
eventual opening of Mexico’s banking sector to foreign bank ownership. As it happened,
the Spanish banks, having gone through what had been recent consolidation in their
country’s own financial sector, were looking for opportunities abroad. This development
was in no doubt testimony to the severity of the Mexican financial situation as it occurred
not without some political sensitivity. While colonial history may have been all but
forgotten between some of the other European imperial nations and their former colonies,
when it comes to doing business, Spanish and Mexican relations over centuries have
tended to involve long memories. Thus, when it became publicly known within Mexico
that large Spanish banks were destined to become the new owners of Mexico’s top banking
names, it was common to hear references to ‘the Second Spanish Invasion’. However,
the acquisitions were made relatively smoothly. The Mexican financial crisis, conse-
quently, afforded the Spanish banks some excellent opportunities to acquire banks at
bargain prices which allowed them to pursue their strategies to gain a foothold in Latin
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America. They were to make similar acquisitions in other Latin American countries as
well, notably in Argentina. In Mexico (and the other Latin American countries on which
they focused), the Spaniards enjoyed the advantages of common language which made
post acquisition merger and integration of operations much smoother. But more funda-
mentally they were able to apply their recently-acquired experience with massive financial
sector consolidation and rationalisation to beneficial effect within Mexico’s model of
financial groups. Whereas the previous owners of the groups tended to book transactions
throughout the financial institutions comprising their group in ways that were not always
comprehensible (at least to outsiders), the new management teams installed by the Spanish
banks applied the principles of rationalisation by institutional specialty in ways which
boosted profit margins and increased overall efficiency.
Mexico has not always felt blessed for being a next door neighbour to the United States. During
the financial crisis of the mid-1990s, however, this proximity was undoubtedly an important
determinant of the size of the assistance package the country received from the US Government
and the IMF. That package ultimately reached a figure in excess of $50 billion. The Clinton
administration was not acting altruistically in arranging this bail-out. Indeed, it was fully mindful
of just how quickly the cost to the US economy would surpass this amount as a consequence of a
surge in illegal immigration if the peso were allowed to continue its fall unchecked as well as if
Mexico became unable to settle post-NAFTA (North America Free Trade Agreement – the treaty
having been signed by the US, Canada and Mexico in 1993) obligations with the United States.
Argentines, whose economy was subjected to the buffeting caused by the spread of the Tequila
Effect, a name given to the contagion effect of Mexico’s financial distress as it spread to other
Latin American countries, named after that country’s popular alcoholic beverage, were vocal in
their opinions that what they perceived to be the asymmetrical treatment they received was based
on the fact that their economic fate was not anywhere near as crucial to US interests as was
Mexico’s. This sentiment was to surface again during the harsher Argentine crisis of 2001–2002.
If there was one thing the Mexican crisis did, however, it was to launch a new wave
of economic thinking in Washington (not just within US government circles but within the
IMF, World Bank and economic think tanks) emphasising the vulnerability in Latin America
to financial crises because of insufficient savings. The Bretton Woods institutions took up
the mantle of how to encourage the Latin American economies to bolster savings and thereby
reduce their vulnerability to further macro-financial problems.
All that was necessary, however, was to wait until 1997 when the East Asian crisis cast
doubt on the ‘incontrovertibility’ of this new wave of thinking. After all, it had only been
in the 1980s that the Asian Miracle had been heralded for which the main contributing
factor to this success had been touted as being the region’s exceptionally high savings rates.
This meant that further search was needed for an alternative framework to explain the main
causes of (as well as to identify appropriate policies for averting) financial distress.
South Korea and East Asia (1997)

It seemed that no sooner had the Mexican financial crisis (which began in December 1994
with the ensuing Tequila Effect making its impact felt over the next few years) done its
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worst than several East Asian economies suffered financial crises which threatened the total
collapse of their economies. This account focuses on a few of the commonalities which
these countries shared in connection with their respective crises and concludes with an addi-
tional examination of South Korea’s experience during this episode. Additional information
on each of the countries in East Asia can be found in some of the references listed in the
bibliography.
The spate of East Asian financial crises began in Thailand on July 2 1997 when following
the decision of the Thai authorities to float the baht, that currency collapsed. It then spread
to South Korea and Indonesia. Together, these three were the countries most severely affected.
Substantial economic injury was also endured by Hong Kong, Malaysia, Laos, and the
Philippines. China (PRC), India, Taiwan, and Vietnam escaped pretty much unscathed. Japan,
was still coping with sizeable problems of its own dating back to the beginning of the
decade but was not particularly impacted by this chain of events.
Economists are divided as to the root causes of this East Asian group of crises. Names
of prominent academics can be found on both sides of a debate on whether government
policies and structural features of these economies were primarily to blame or whether specu-
lators and herding behaviour are the real culprits in the story. In this latter connection
(speculation and herding as the predominant cause), the proponents of this explanation point
to the heightened sensitivity of many international investors to the region’s investment climate
as Hong Kong was returned to China on July 1 1987, which was the day before the baht
came under speculative attack. Locally, many East Asian nationals who lived through this
period are also highly critical of the IMF even if that institution only became significantly
involved in response to the initial panic and therefore cannot be included among the root
causes.
Among the economic policies cited as being responsible for East Asia’s problems were
included: (1) a heavy dependence on imported capital for growth rather than on increases
in factor productivity; (2) maintenance of high short-term interest rates to attract the external
capital flows needed to finance growth; (3) excessive reliance on ‘hot money’ rather than
on FDI or other forms of longer-term financing; (4) maintenance of a fixed exchange rate,
pegged to the US dollar, which once the US dollar appreciated would erode their interna-
tional competitiveness; (5) a variety of distortions which favoured certain industries over
others, leading to insolvent companies which were not being allowed to fail or liquidate;
and (6) financial policies which were repressive and which created a protective environment
for weak financial institutions with inadequate risk management which came to see their
role in these societies as one of ‘entitlement’.
As with several countries in Latin America, both during the international debt crisis of
the early 1980s and then again during the Tequila Effect in the mid-1990s, the higher
domestic interest rates not only attracted the sought-after external capital but gave rise to a
sizeable ‘carry trade’ with the local banks extending dollar-denominated loans to numerous
businesses and individuals as well. While some of these borrowers were exporters whose
foreign currency earnings would cushion them against local currency devaluation and subse-
quent rounds of depreciation, many of them had no direct dollar earnings to cushion the
eventual impact. Prior to July 2007, the strong credit expansion helped create an unsus-
tainable bubble in the local asset markets, which when it imploded precipitated a rapid
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depletion in the foreign exchange reserves of these countries resulting in an inability to

maintain their exchange rates.
It took virtually no time at all, following the sharp drop in the value of the Thai baht,
for the other currencies in the region to come under speculative attack and lose value as
well. The IMF became involved with a series of programmes aimed at stabilising the curren-
cies of the region. Unfortunately, the policies which the IMF required the East Asian countries
to adopt in return for its support were seen by many in the region to be ill-fitted to what
these countries actually needed. High interest rates advocated by the Fund, for example,
simply were ineffectual in reversing the massive haemorrhage of capital once it had begun.
Furthermore, local government officials debated long and hard against fiscal tightening by
saying that Keynesian-type spending was needed instead to prevent a downward contrac-
tionary spiral. In this connection, they cited typical US responses during its several financial
crises over the years. They also objected to what they perceived as IMF attempts to force
them to copy the western model of capitalism with its greater emphasis on capital markets.
Consequently, in addition to debating strenuously in connection with the prescribed macro-
economic measures, they also resisted many of the policy and regulatory reforms covering
banking and securities which the IMF included in its conditionality. These arguments,
however, did not sway the IMF – at least at the outset.
The IMF did modify its stance on some of its conditionality when it became apparent
that some of the measures were not working. In particular, the IMF was criticised for having,
at least initially, misjudged the role of high savings propensities in the East Asian economies
in conjunction with its requirement that the countries adopt a tight fiscal stance. The economic
stimulus that budget surpluses were expected to contribute simply did not show signs of
happening – at least not as fast as needed. Moreover, in recommending high domestic interest
rates, the objective of which was to attract the external capital needed to defend their belea-
guered currencies, it seemed that many if not all observers were caught unawares as to just
how high these rates would need to go in order to offset the inexorable raising of US interest
rates by the US Federal Reserve that was going on at the time. In point of fact, the US
economy, certainly because of (but not just because of) higher interest rates was a much
more attractive destination for foreign investors on several counts (for example, one import-
ant aspect was that the technology-led stock market boom in the US was then going from
success to success with no apparent end in sight).
Korea’s economy, leading up to the financial crisis of 1997, showed a number of signs
similar to those in Mexico. It also had some very important differences. The country followed
a model resembling the post-war Japanese model of ‘policy-based finance’. In essence, this
entailed partnership between large industrial groups (often family-owned and with their own
commercial bank within the group) and the federal government in which the partners ‘picked
the winner’ as to which sectors and products would receive preferential financing, chan-
nelled by the commercial bank, in order to underpin an export-led strategy. Investments
were not chosen to maximise profits but rather global market share in order to capture the
strategic and longer-term benefits of both economies of scale and the learning curve.
In Japan, the groups were ‘keiretzu’. In Korea the groups were called ‘chaebols’.
Contrasted with groups in western countries, the policy-based financial model they followed
incurred iceberg risk7 (in place of market risk) which accreted slowly and inexorably on
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group balance sheets. For example, leading up to the 1987 financial crisis, Korean banks
were simultaneously aggressively funding the corporate expansions of the country’s largest
corporations while the banks were experiencing very high rates of NPLs on their loan port-
folios. These balance sheets (of the banks and many conglomerate companies) were not
open to the public. Furthermore, accounting practices in East Asia exacerbated this systemic
weakness. Whereas the conservatism built into, for example, US GAAP and the International
Financial Reporting System (IFRS) called for carrying assets on the books at the lower of
market price or book value, the accounting treatment in Korea and Japan permitted add-
itional rounds of borrowing to be supported by increases in equity resulting from unrealised
profits based on current market prices. The fact that, as Shiller points out,8 Japan saw its
real estate values inflate in a single year by more than all of the country’s GDP and Korea
experienced the same phenomenon more than once during the 1990s, provides an indica-
tion of the power of speculative dynamics which facilitated the accretion of systemic risk
in Japan and Korea.
The consequences for all of East Asia were pronounced and enduring. Certainly in
Thailand, South Korea, Indonesia and Malaysia, not only did their currencies undergo substan-
tial depreciation, their stock markets and real estate markets drop sharply and their banks
suffer insolvencies but their per capita income levels declined in all cases as well. The
recovery from the financial crisis took longer than it did for countries in other parts of the
world such as Latin America. This may be in part because of the more complex relation-
ships associated with policy-based finance models and the added time consequently needed
to resolve the widely pervasive distress experienced by numerous companies as well as the
asset markets. In part, it may also be attributable to a shift in geographic focus on the part
of many large global institutional investors – mainly to China and India.
Russia (1998)
At the beginning of 1998, the Russian economy had a number of structural weaknesses.
However, considering how far it had come and the direction in which some of its main
macroeconomic indicators were pointing, it seemed poised to vindicate the heroic efforts
that had been made in its transition from state planning to capitalism. Its trade accounts
were in reasonable balance, inflation had been reduced significantly over the three previous
years, output was moderately on the rise, the currency was being managed within a narrow
band and substantial support from international institutions was in the making, including
the World Bank, the IMF, the London Club and the Paris Club.
In August of 1998, however, the ruble came under speculative attack which would cul-
minate in the country defaulting on both public sector and private sector debt. The factors
which would cause this need to be viewed in terms of structural weaknesses in the Russian
economy which created the vulnerability in the first place and the events which acted as a
catalyst to precipitate the crisis.
Real wages had fallen. Direct foreign investment had tapered off. Political problems
were responsible for the dilatory progress in regulating the natural monopolies. A substan-
tial portion of its foreign assets in the form of a legacy of debts owed to Russia by communist
countries were of questionable value and furthermore were overstated in terms of an old
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official Soviet exchange rate no longer relevant. And most of all, tax collection was highly
inefficient causing the public sector deficit to remain at a high level. Moreover, the country
was faced with rising international debt servicing payments coming due over the near term.
As if these problems were not enough, international oil and non-ferrous metal prices, on
which Russia depended for a significant portion of its export revenues and public revenues,
softened in December 1997.
Whether these developments would have precipitated the crisis by themselves is not
entirely clear. However, a major factor which changed the game rules for Russia was the
financial crisis in Asia which started during 1997. In a short span of time, western European
interest rates rose and international investors started nervously scrutinising their global port-
folio holdings sensitised by their problems in Thailand, Korea, and Indonesia. They began
casting a much more critical eye in connection with any other country which might be the
next domino to fall because of similar kinds of financial weakness which had brought on
the crises in those countries. Russia, it seemed, filled the bill.
Occurrences which undoubtedly aggravated international investor perceptions of Russian
investment risk included several miscommunications to the international press. These
concerned the state of the country’s ability to meet its imminent debt payments as well as
the sufficiency of its reserve position to defend the currency. If these news items were not
the actual trigger for starting the capital flight, they certainly intensified it. Moreover, these
developments were further aggravated by certain political and diplomatic actions which were
perhaps given a more dire interpretation by investors than they deserved. As the situation
worsened, emergency meetings of the Duma, Russia’s parliament, only served to push investor
confidence even lower.
As capital flight intensified, another development which compounded the problem was
the impact Russia’s crisis exerted on the large hedge fund Long Term Capital Management
(LTCM) which had taken highly-leveraged combined long and short positions in pairs of
international bonds with a view to exploiting the expected convergence in their market prices.
LTCM at its pinnacle, had a net worth of about $5 billion. However, it had borrowed in
excess of 25 times that amount (over $125 billion) to fund its positions in these issues. It
was not the size of LTCM’s position in Russian paper that was the main problem. It was
that when the Russian economic authorities declared a debt moratorium on August 17 1998,
this caused panic in the international bond and currency markets. Consequently, many of
LTCM’s convergence trades became stalled with the prospect of the hedge fund having its
equity wiped out because of its highly-levered capital structure.
The 1998 Russian debt moratorium triggered an outflow of capital which spilled over
into the stock market and financial markets for other assets. When the default on Russian
state obligations (GKOs – Gosudarstvennye Kratkosrochnye Obligatsi) occurred, this created
sizeable losses in several domestic banks which correspondingly led to them defaulting when
depositors attempted to liquidate their accounts. The situation resulted in panic which led
to a pronounced devaluation of the ruble with spiking consumer prices (as a result of
consumer demand having a high import component), falling real wages, leading to sharp
contractions in demand and output. The subsequent recovery took several years, although
fewer than in the case of many other countries because of the recovery in world oil prices
working in Russia’s favour. In any event, the crisis resulted in a significant cost. Most
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importantly, however, it revealed the enormous challenge Russia faced at the time in achieving
further fiscal and structural reforms.
The recovery process was weakened by the fact that a number of government leaders
who were associated with reform were driven from office and approaches to mitigating the
crisis have been eclectic at best. Economic growth of over 8% in 2000 and 5% in 2001,
were helped by improvements in the country’s terms of trade, mainly in the prices of hydro-
carbons and other commodity exports, as the country’s import-substitution efforts brought
results. This allowed the country to achieve balance in its external trade accounts and a drop
in inflation from percentages, which were almost at three-digit levels during the height of
the crisis, to the low-twenties.
Brazil (1999)
In January 1999, the Brazilian economic authorities abandoned the relatively tight bands
within which the real was managed, as a consequence of the capital flight that steadily built
up during the latter part of 1998. What distinguished this financial crisis from early ones
in Mexico, East Asia and Russia was that it was a currency crisis that did not follow on in
the wake of a banking crisis. In fact, by several measures of strength, Brazilian banks
remained not only solvent but well-capitalised and only moderate users of financial leverage.
Instead, the crisis involved the effects of higher interest rates combined with Brazil’s chronic
problems of the interest burden of its large and growing debt levels and intractable fiscal
management problems.
Regarding Brazilian debt, not only did the country have a large stock of foreign-currency-
denominated external debt on the eve of the crisis but years of severe macroeconomic
instability, marked by over three decades of very high and chronic inflation, resulted in a
large stock of domestic debt as well. Much of this debt which had been previously indexed
was converted into an outstanding stock earning relatively high real rates of interest at the
time of the 1994 Real Plan, which was the stabilisation plan the Brazilian government intro-
duced, based on a new currency called ‘the real’ which replaced the former ‘cruzeiro’. The
interest component on both foreign and domestic debt was a source of vulnerability for
Brazil’s economy not the least of which because it rendered an already complex and
intractable fiscal situation that much more precarious.
To begin with, Brazil’s fiscal system was characterised by what was called ‘fiscal feder-
alism’, wherein even when the federal budget was balanced or in surplus, the spending
habits of the country’s politically powerful states (and to some degree the municipalities)
more than offset the fiscal stance at the centre. Quasi-fiscal deficits (which refers to the
interest component, both domestic and foreign, incurred on public sector debt) and large
deficits arising out of pronounced imbalances between state and municipal level revenues
and outlays, combined with an abundance of legal restrictions on the federal government’s
power to change a legacy of inter-governmental transfers, resulted in a highly complex fiscal
problem which perpetually defied sound management. In the case of the Brazilian states,
what allowed them to undertake and finance activities beyond the confines of normal budget-
ary financing was the constitutional entitlement that each state had of owning and operating
its own state bank. Consequently, instead of the country having one central bank, in fact it
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had at least one more bank in each state which enjoyed some of the powers of the Banco
Central do Brasil. Moreover, the relationships these banks often had with some of the
country’s large groups (empreiteiros or construction companies, as well as manufacturing
and service groups), which were well-connected to federal and state politicians, added further
complexity to and often counterbalanced economic policy and regulatory measures. In effect,
this resulted in a much more complicated set of arrangements than a traditional macroeco-
nomic examination of monetary and fiscal policy would otherwise suggest.
Consequently, when first the Asian financial crisis unfolded in 1997, followed by the
Russian crisis in 1998, the Brazilian authorities responded in the same way that many other
countries did. It raised interest rates with a view to preventing capital flight because of inter-
national investor nervousness. However, whereas higher interest rates should have worked as
described, owners of capital, both Brazilian and foreign, became even more nervous as they
interpreted the higher interest rates as a direct threat to Brazil’s ability to manage its fiscal
position, a requirement for it to be able to manage its relatively fixed exchange rate. This was
despite an announced fiscal reform package, which seems to have not been perceived as being
sufficiently credible. At the same time, the fact that Brazilian financial institutions held Russian
debt obligations on which a moratorium had been declared in the second half of 1998 increased
the fragility of the country’s finances. The seed which crystallised this risk is seen by many
observers as being when the Governor of the State of Minas Gereis, Itamar Franco, a past
president of Brazil, stopped payments on state debt owing to the federal government, which
prompted several other governors to follow suit.
Once the Brazilian authorities devalued the real and accompanied it with other meas-
ures to contain the situation, the country’s finances and its economy recovered quite quickly.
That this was possible seems attributable to two main factors. First the country’s commer-
cial banks were well capitalised and not in crisis. And second, as an indication of the
sophistication of Brazil’s financial institutions after years of dealing with the risks of high
inflation, of the close to $100 billion in foreign liabilities held by Brazil’s private sector on
the eve of the crisis, about three-quarters were hedged. About 85% of these hedges were
in the form of indexed securities and about 15% were done through foreign exchange deriv-
atives. Thus while the country did suffer lost production and some financial loss as a
consequence of this currency crisis, major dislocations of the kind experienced by countries
having banking or twin crises were minimised.
United States dot-com (2000)

The world has seen millions of inventions. Only a relative handful, however, stands out as
truly revolutionary in their impact on the future course of mankind. Guttenberg’s printing
press was one. The internet, sponsored by the United States Defense Advance Research
Projects Agency (DARPA) was undoubtedly another. Once it became apparent, that a publicly-
accessible internet supporting the World Wide Web had the potential to transform life on
earth in both imaginable and even in what had been previously unimaginable ways, a modern-
day version of ‘tulip mania’ was spawned. Some of the first, and indeed a significant number
of subsequent internet-based or web-based enterprises were absolutely astounding in terms
of their novelty and profitability. But like many crazes which occurred in the past and which
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will no doubt take place in the future, speculators were all too ready to bet on form without
proof of substance. Although with the benefit of hindsight it is tempting to scorn those who
bet heavily on companies which had already reached atmospheric valuations at the time
they bought in as having been imprudent or naive – and there may have been some who
deserve such labels – some pretty heavyweight institutions and investors of repute were
among their ranks for reasons which cannot be dismissed strictly as imprudence or naivety.
Strategies based on treating dot-com equity plays as a portfolio of ‘financial options’, as
described further below, possessed a rationale not too dissimilar to that underpinning the
drilling strategies of global oil companies: not all bets are expected to pay off, but the ones
that do should more than compensate for the others.
A mistake often made in analysing new things by using ways which have been proven
on the old is that we assume the same paradigms are at work. Established bricks and mortar
companies after all have historical earnings and often dividend payouts which can be projected
into the future with some degree of confidence (as long as one is prepared to consider fore-
cast bands). As many critics pointed out, whereas the traditional economy companies were
not able to escape the gravitational pull of low double-digit PE ratios and single-digit price-
to-sales ratios, the new economy companies were enjoying high prices before the first sales
were even realised, recognising full well that profitability was something that would take
even more time.
Internet enthusiasts knew that they were dealing with a development with unknowable
and possibly unlimited potential. Moreover, the internet possessed attributes which when
focused on many traditional tasks could levitate efficiency and effectiveness beyond anything
known previously (Amazon.com book sales is but one example. Google and its knowledge-
based products is another).
Conventional analysis was confronted with a dilemma. With so many unknowns asso-
ciated with uncharted waters, traditional fundamental stock analysis was not much help. An
analogy might be that the dot-coms were like newborn infants, all of whom have the poten-
tial to be president one day. In contrast, the old economy companies were like either young
or middle-aged adults who, if they had not as yet distinguished themselves academically or
in other fields, would likely have limitations on their career prospects which are easy for
others to see.
Yet, just because much was unknown, this did not mean that no thinking was required.
Many sophisticated investors did wind up throwing money at new dot-com ideas, recog-
nising that many of these ideas were not much more than conceptual (what was termed in
the financial press as ‘vaporware’). But they placed their bets in line with sound option
theory. If one spread the bets around on ideas with high risk but virtually unlimited poten-
tial, then a payoff on only one would more than compensate for all the other failed ideas.
The trouble was, however, that the game was not limited to sophisticated investors such as
the venture capitalists of Silicon Valley. The initial public offering (IPO) instead became a
way of opening the market to the rank and file who by then had read or heard on TV of
the opportunities for incalculable wealth. And they wanted in.
Unfortunately, many stock market investors did not apply the same disciplined risk-
mitigating strategies of the institutional investors. Indeed, there were some types of institutions
as well which behaved remarkably the same as the most naive private investor. The reason
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that the founders of the dot-com startups were keen to share the wealth, unlike many of
their predecessors of past generations was that they did not need to cede much as a percentage
of their enterprises before the collective exuberance buoyed market valuations of their
remaining holdings to astronomical levels while still affording them majority shareholder
control. Business history has seldom offered many such opportunities for entrepreneurs to
have their cake and eat it too.
The question then arises as to how the high stock market valuations were able to occur
in the first place. Following on the heels of other technology successes of the early and
mid-1990s (for example, Microsoft, Dell, Apple, Intel, and Applied Materials), some of the
better-publicised IPO successes (AOL, Amazon, Yahoo, Netscape) presaged the even greater
wealth at stake in connection with the internet. This set off a modern-day equivalent of the
California gold rush. The new ways of doing things not only applied to the appropriate type
of financial analysis but spanned things as diverse as proper revenue recognition and office
dress codes – the approach to both (as adopted by enterprise founders but which quickly
reached the status of an international ‘meme’) being casual.
One aspect that was not widely publicised (although became a topic of study in several
financial publications) was the restriction of the exercise of stock options (captured in what
were termed ‘lock-up agreements’) until specific exercise dates, many of which tended to
coincide. Indeed, this restriction, relegated to contractual fine print, has been shown to have
the effect – by, among other things, greatly narrowing the float – of driving share prices
beyond heights that market momentum alone would have explained. Once exercised, however,
with the market momentum for dot-com shares reaching the financial equivalent of their
apogees, all that was left was the sound of liquidity being sucked out of the market as the
share prices commenced their descent.
As in so many of the manias historically recorded over centuries, it was not that market
participants were unaware of ‘the disconnect’ between intrinsic value and market price. It was
that greed and exuberance dominated fear of trend reversal, carrying prices to daily new heights.
As described above, in such scenarios market liquidity tends to flow. Once the first sign becomes
evident of it starting to ebb, however, investors en masse turn like a school of minnows
exhibiting signs of ‘swarm intelligence’. The virulence of the crash (which ultimately became
a ‘crash and burn’ scenario) was ensured by the fact that the assets – those things that generally
comprise security against which claims can be ultimately settled – were not tangible. Unlike
professional service firms and even precursor technology companies, these company ‘soft’ assets
did not even walk out the door at night to go home to their families. Instead, what settled for
assets were in many cases mere concepts, many of which were no more than visions of what
might have been, which like a Ponzi scheme can make the first participants wealthy from just
the sheer momentum of the mania’s initial surge – provided they were smart enough to cash out
before the turn. However, as prices plummeted, the values on the asset side of their balance
sheets popped rather than plunged, affording virtually nothing in most cases to slow the fall.
What has just been described is yet another example of boom and bust. What qualifies it as a
counterpoint to examples from market examples based on traditional financial assets is that
there was no clear guidance as to fair value for investors to gauge, neither initially, in connection
with the build-up, nor later for the collapse. Consequently, it produced a boom-bust cycle of
great and unpredictable amplitude.
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Argentina (2001)
The Argentine financial crisis of 2001 and 2002 was branded by the media as possibly the
greatest financial meltdown in recorded history. Whether or not it represents in absolute
terms the largest erosion of value is less important than the fact that it culminated in the
virtual annihilation of the country’s middle class. What makes this so amazing is the addi-
tional fact that Argentina in 1905 was possibly around the fifth richest country in the world
in terms of its estimated GDP per capita. This meant that at that time it outranked Spain
and Italy, the two main sources of its immigration, and even what today comprises the
OECD countries.9
After years of political and economic turmoil during which annual inflation had remained
high and had even surpassed 2000%, Argentina’s president Menem introduced the
Convertibility Law in April 1991. The effect of this was to peg the country’s peso to
the US dollar at a rate of one to one to be managed automatically under the strict regime
of a currency board. The ‘convertibility’ associated with this regime meant that the central
bank was obligated to buy foreign exchange reserves or pesos on demand by Argentine
residents and the pesos thus paid, once in circulation or in local bank accounts, determined
the size of the country’s money supply. This feature essentially deprived Argentina’s central
bank not only of an active role in pursuing monetary policy but indeed the function of
‘lender of last resort’ as well. The architect of this arrangement was the country’s then
finance minister Domingo Cavallo.
As Mishkin, commenting on the Argentine crisis, points out:10
‘Convertibility was a gamble to promote institutional reform that would kill four
birds with one stone: it would (1) keep inflation under control, (2) promote banking
reform to strengthen the financial system, (3) make labor and product markets more
flexible, and (4) promote fiscal responsibility. Convertibility did, for a time, help
kill the first two birds, but it did not even wing the last two.’
For the Convertibility Law to succeed without developing vulnerabilities, all four of the
aforementioned objectives would have needed to have been met. The introduction of the
peg easily achieved the first. Regarding the second, the Argentine financial authorities
surpassed most other countries in terms of the far-reaching bank regulatory and supervisory
apparatus they put in place. As part of this framework, five main elements were the focus
of efforts to strengthen the banking system.
• Banks were required to issue subordinated debt to be retired only after all other debt,
thus providing a better barometer in connection with the risk they had assumed.
• Measures were introduced to ensure regular and reliable internal and external bank audits.
• Consolidated supervision of financial groups was introduced.
• Measures were introduced to improve the quality and dissemination of information on
the banks’ activities.
• Mandatory annual credit risk ratings for banks were to be performed by credit rating
agencies registered with the central bank.
Capital requirements were actually set to be more stringent than those required by the Basel
I Accord at the time. Additionally, to ensure adequate banking system liquidity, Argentine
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banks were required to maintain at least 20% of all short-term deposits (maturing in less
than 90 days) in the form of secure and liquid international assets or as interest-earning
deposits with the central bank. New legislation which allowed troubled banks to be closed
down ultimately strengthened the remaining financial system as some twenty insolvent banks
were closed in the five years between 1995 and 2000. The banking system further under-
went consolidation with the overall system shrinking from 166 banks to 89 over the same
time period, as weaker banks were also taken over by stronger ones.
As in other Latin American countries, large business groups also exerted dispropor-
tionate political and economic power. Furthermore, the trade unions, which were also deeply
enmeshed in the country’s politics, thwarted the aim of making labour and product markets
more flexible. The political practice of keeping many ‘connected’ employees on public enter-
prise payrolls who only showed up at the end of the month to collect their pay cheques
(called ñoquis after the bread dumplings usually eaten at the end of the month when poorer
workers’ pay had run out) was but one example of labour practices which would resist
reform.
Given the automaticity of the currency board regime and the co-existence of wage and
employment rigidities, the mechanism for adjustment through wages was missing. This did
not deprive the system of an outlet for adjustment, however. It simply made it a much more
brutal one. In fact, an aspect of the currency board and the Convertibility Law which magni-
fied the effect of eventual shock was the prevalence within both the public and private
sectors of liability dollarisation.11 When business owners saw their cash flows dry up from
loss of competitiveness, which was exacerbated during periods when the US dollar appre-
ciated against the currencies of other countries with which Argentina primarily traded, those
business owners either reduced the size of their operations or closed down their businesses
entirely. The automatic feature of the currency board worked just fine even if more muscle
was being excised than fat. Consequently, automatic adjustment found its outlet via falling
Argentine output and escalating unemployment.
And numerous pockets of graft as well as diverse vehicles serving as ‘safe harbours’
for fiscal resources (which were diverted or ‘parked temporarily’) became sources of extra-
budgetary public spending. These totally undermined fiscal discipline. Indebted emerging
market countries generally have less latitude to run protracted fiscal deficits than advanced
countries because of their indebtedness to foreign bondholders. Unlike the Latin American
debt crisis of the 1980s when most of the external debt was advanced by large commercial
banks, the concept of ‘involuntary lending’, a term heard frequently in financial circles
during the 1980s, largely disappeared from the popular lexicon. This was because the thou-
sands, if not tens of thousands, of bondholders involved, might be burnt once but they were
not required to go back for more. Consequently, the spectre of ‘debt intolerance’ hung like
a sword of Damocles over Argentina as well as other emerging market countries with chronic
fiscal imbalances.
In addition to deficit spending attributable to the administration, a serious structural
weakness of the Argentine economy was the fiscal division of responsibility between the
federal government and the provincial governments. Unlike the United States, or indeed
many countries characterised by ‘fiscal federalism’, Argentina did not require its provinces
to run a balanced budget nor did the federal government have effective control over the size
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of their deficits. Consequently, with an historical track record of the federal government
bailing out the provinces on more than one occasion, there was every incentive for the
provinces to spend beyond their own revenue-generating capacity. Without this having been
addressed from the outset of the Convertibility Law is with the benefit of hindsight a serious
oversight.12
What began with serious fiscal imbalances was exacerbated by deteriorating terms of
trade. This undermined Argentine international competitiveness in connection with its exports
of agricultural commodities and food products (edible oils, wheat and corn) as well as
aluminum. It was followed by external shocks including the Russian crisis and collapse of
the Brazilian real which made Argentina even less competitive and also caused capital
flowing into Argentina to dry up. Shortly thereafter, the US dollar appreciated by 10% which
hammered Argentine competitiveness further. Domestic interest rates soared to as high as
36% a year with prevailing rates on Argentine government bonds reaching 1,000 basis points
above US treasuries.
As the recession took hold, this caused Argentine government revenues to drop precip-
itously thereby aggravating further the fiscal imbalance. At the same time, the sharp drop
in GDP meant the country’s debt-to-GDP ratio was increasing sharply with foreign investors
eyeing the situation with mounting concern. With the country’s apparent probability of debt
default rising significantly, international investors needed a higher interest rate in order to
compensate them for the additional risk they were bearing. Although an IMF bailout package
provided temporary respite by way of dampening spreads between Argentine debt and US
treasuries, it was short-lived as Argentina went through a series of finance ministers and
other senior officials as a consequence of their inability to win public acceptance of the
necessary austerity measures that would be needed to equilibrate the economy. Not only
had the population felt let down by the government’s inability to honour its commitment to
its economic policy but many had personally sacrificed their employment while at the same
time were seeing the complete evaporation of their life savings and indeed their middle class
status. Additional austerity was simply not a convincing solution irrespective of promises.
The interest rate differential kept on climbing.
In March 2001, Domingo Cavallo was appointed again as finance minister. He tried
several times to postpone the inevitable – a collapse of the currency, a wholesale repudia-
tion of the national debt, or both – and to engineer a soft landing, but to no avail. He
amended the Convertibility Law, allowing a more favourable exchange rate for exports by
pegging the peso to a basket of currencies rather than to the dollar alone, as well as providing
exporters with subsidies while imposing a tax on imports. He introduced measures to enable
the banks (as well as induce them) to hold more government paper than they would be wont
to do otherwise. As an example of one such measure, commercial banks were prohibited
from marking to market their holdings of government paper which in effect increased signifi-
cantly their capacity for holding these obligations. On the other hand, by being allowed to
satisfy their liquidity requirements with government paper paying high interest rates, they
stood to profit nicely provided the bubble did not burst. By the end of 2001, the banks’
holdings of government paper reached 20% of their assets, effectively doubling in percentage
terms from their 1994 levels. Further measures were introduced which removed the limita-
tion on the central bank from acting as a lender of last resort, thereby compromising its
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perceived independence from the government. With deposit insurance in Argentina being
limited, a number of depositors began withdrawing their funds from the domestic banks.
Prior to the full onslaught of the financial crisis, Argentina’s banking system had been
opened to foreign ownership with a number of European and US banks represented in the
country. While there had been no explicit promise involved, many in Argentina believed, as
it turned out erroneously, that foreign ownership would somehow guarantee the full support
of the casa matriz (headquarters) of the foreign banks. This support, however, would tend
to have its limits, which the crisis ultimately tested to the maximum. As spreads between
Argentine government obligations and US treasuries spiralled further upward, reaching well
over 2,000% at their highest point, the government introduced a curb on bank withdrawals
called the corralito (meaning ‘little fence’) which limited depositors to the equivalent of
$250 in cash for their weekly needs. Small businesses, such as street vendors and service
providers as well as others among the poor, were especially hard hit as they traditionally
depended on having cash on hand to conduct their businesses and were outside of the normal
credit stream in any event. This was followed by what has been called ‘pesofication’ of the
debts of banks and public enterprises that had been contracted in dollars, resulting in dollar
assets being converted by fiat into about a third of their contracted value. That this was
possible politically was abetted by the fact that foreigners’ banks held 70% of domestic
bank assets. But it nonetheless represented major repudiation of property rights by the
Argentine government, which was not the first time this had happened in the country.
As what had been one of the strongest and best-managed banking systems in the
emerging markets underwent the blunt force trauma of a series of governmental actions and
external shocks, the stage was set for a collapse of the currency board, the currency and
the economy in what would be one of the most brutal financial cataclysms in memory.
The most damaging legacy, although one which the country will no doubt overcome
one day, has been the blow to public confidence in the rule of law as it pertains to upholding
property rights and financial contracts. After all, the upholding of property rights with the
conjugate principles of exclusion and appropriable use are the cornerstones of any market-
based economy and the inviolability of financial contracts is all that separates a world of
reliable financial instruments from the armed neutrality that accompanied barter transactions
of a distant and barbaric past.
Lebanon (2002)
Those who have read Taleb’s book, The Black Swan,13 will likely recognise many events
which were considered as highly improbable occurrences but which did nonetheless tran-
spire, as qualifying to be considered ‘Black Swan events’. Perhaps a little less familiar might
be those examples he also considered as falling in this category as well – the non-occurrence
of highly-probable happenings. If one such non-occurrence deserves recognition in this
category, it is the fact that Lebanon’s economy has been able to avoid a meltdown for the
last several years. It is included here to show that while bank runs, currency attacks and
stock market crashes all involve distress in financial markets and strain on the economic
and social fabric of a country, distress can result even if an economic meltdown is somehow
avoided.
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Lebanon’s geographic beauty, cultural attractions and service infrastructure made it an

attraction to westerners as well as to people from the region for years. Over decades, Lebanon
had built a reputation for its well-managed banks protected by strong secrecy laws. In fact,
for this reason it became viewed by many wealthy individuals and interests in the Middle
East as a safe haven, much along the lines that Switzerland had enjoyed for centuries. All
this was marred by the civil war which erupted in 1975, which involved several political,
religious and ethnic factions, and which only came to an end with the Taif Accord in October
1989.
After the war, the Syrian military occupied the country to prevent further outbreaks of
hostilities among the country’s various factions. Growth slowed to a standstill. But the most
significant indicators of the stresses wrought on the country’s economy included total debt
which by 2002 had surpassed 170% of GDP and a budget deficit which reached over a
quarter of GDP. Many observers, including foreign creditors and rating agencies, concerned
at the precarious edge on which the Lebanese economy balanced after having witnessed the
meltdown in Argentina, wondered whether or not the country might not follow the Argentine
example and slip into a major financial meltdown followed by financial chaos.
Among the country’s external risk factors at that time were:
• increasing Syrian involvement in the country’s affairs;

• escalating of hostilities between Israel and the Palestine Liberation Organization (PLO),
as Lebanon would be right in the way;
• other factors dampening both tourism to Lebanon as well as growth of other service
sectors, which are the mainstay of the economy;
• slowdown in remittances and capital transfers, if not outright reversals, in connection
with the country’s nationals living abroad; and
• adverse commodity price movements.
Additionally, the country exhibited a number of internal risk factors:
• worsening public sector deficit (which was expected to occur either through the govern-
ment’s inability to contain public spending, problems with the VAT yield, or both);
• delays in producing revenues from the country’s at that time incipient privatisation
programme;
• deposit withdrawals by residents combined with capital flight and its expected adverse
impact on the exchange rate; and
• failure to revitalise the economy.
The country’s banking sector worried many at the time in view of the following perceived
weaknesses.
• Despite the banks being well run, the country was over-banked.
• Banks were overly exposed to the public sector – capital adequacy ratios were distorted
– since they tended to understate this risk (appropriate risk weightings should most likely
have been around 20% in connection with the government debt which they held).
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• Although currency mismatching was virtually nonexistent, this was achieved by the banks
through mounting credit risk.
• Term mismatching at many banks was high with maturity gaps reaching several hundred
percent of the banks’ equity.
• NPLs, which as a percentage of total bank loan portfolios had crept upward close to
20% and which were mainly concentrated in the construction sector, continued to rise
while lending-borrowing spreads were narrowing, threatening the viability of the banks.
The unique aspect of the Lebanese situation was in connection with the country’s diaspora.
Many of its citizens had over the years moved to other parts of the world and over time
some of these had achieved enormous wealth. It had long been traditional for these Lebanese
expatriates to not only send remittances to family members back in Lebanon but to transfer
sums back to Lebanese banks to be invested in the home country. This made the character
of Lebanon’s capital accounts quite different from that of Argentina or most other countries
for that matter. Capital inflows, while mobilised by entrepreneurs with indisputable commer-
cial and financial savvy, were also subject to loyalties which transcended economics alone.
United States sub-prime (2007)

If there is one key phenomenon which distinguishes the 2007–2008 sub-prime crisis from
past financial crises, it is the formation of a very broad bubble on top of a narrower bubble
in a single asset market. Specifically, while the pain of homeowners in distress is very real,
severe and palpable, the credit bubble which formed on the back of mortgage loans (both
prime and sub-prime), sucking many other types of financial instrument into the maelstrom,
is widely pervasive, potentially several times more massive than the bubble in home values,
and seems virtually inescapable. From a macroeconomic perspective, no-one would have
believed on an ex ante basis that credit default problems in the residential housing sector
amounting to no more than perhaps 5% of homes, and when examined strictly within the
frame of the real estate market, would ever be able to rock if not derail the US and UK
economies. The problem was that the United States financial sector, after its substantial
deregulation in the late 1990s and the advent of important new markets for structured finance
products, embarked on a relentless pursuit of extracting profits from the generalised credit
function. The trampoline for this concerted effort was the success during the late 1980s and
throughout the 1990s of the collateralised mortgage obligation.
The sub-prime financial markets crisis

The eighteen year bull market which began in 1982, ended in mid-2000 as the dot-com
bubble imploded like a black hole dragging into its interior the global equity markets which
had crossed its Schwarzchild radius.14 During the run-up phase, the US economy went from
success to success, driven by the spending patterns of the American public and American
corporations. Economists trained in earlier times that consumption was a function of income,
found themselves modifying significantly their explanations of the new consumption. Wealth,
previously assumed to derive for most people from salaried income and interest paid on the
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portion of this income that was saved, was now seen to grow as the result of a bubble in
the financial assets markets with family spending no longer constrained by the wages of
labour earned by the breadwinners alone. A wealth effect became steadily more significant
as households saw their 401K plans (one type of tax-sheltered retirement savings plan for
employees), and even their portfolios that were not sheltered from taxes, grow at unprece-
dented rates.
The impact was unequivocal. The international equity market correction was a major
blow to the US economy as it was to much of the world economy. But its impact was cush-
ioned by the making of another asset bubble – the US housing market. Like most economic
phenomena, the US housing boom post-1991 was possible because of many conditions.
Some economists have credited the ‘peace dividend’. This was the release of resources previ-
ously committed to the arms race during the Cold War to peaceful uses, among which
housing benefited greatly. Others stress the role that the Japanese carry trade played
throughout most of the decade of the 1990s. It was certainly attributable to these develop-
ments in part, but it was due to additional factors as well. As the leading proponent of
centrally-planned closed economy – the Soviet Union – dismantled the entire edifice which
had housed its way of allocating resources, many of its newly-independent constituent
republics, its satellites and indeed other communist countries followed suit. One by one, in
fairly quick order, these countries began adopting free-market, and even capitalistic systems
which were becoming much more open than before. It was the global economic equivalent
of having all the dams in a mountainous country’s river system removed or flattened. It
meant that domestic prices among countries, like the water levels in our river analogy, would,
after initial chaos, move much closer together, quickly eliminating the extreme highs and
lows even if not on a path to full convergence. It may possibly help explain (even if enough
data points still are missing to unequivocally prove) why, following the dissolution of the
Soviet Union, cases of hyperinflation throughout the world have virtually disappeared.15
In any event, real housing growth throughout the nineties and the years immediately
after the turn of the millennium was phenomenal. It must be remembered that this was in
spite of the US Federal Reserve raising interest rates five times during the period. But if
there is one thing about economic cycles, it is that public appreciation of what is dear and
what is cheap is a relative notion. The US had suffered during the 1970s and into the 1980s
from the phenomenon of ‘stagflation’. During that period, interest rates had reached and for
some time remained at double digit levels. Of course, real interest rates (nominal rates
adjusted for the current rate of inflation) are what count. Even though many people often
tend to be misled by what the classical economists (Marshall and Pigou, for example) called
‘money illusion’, it seems that developers and investors were aware that real interest rates
remained a bargain. Therefore, even though nominal interest rates started their seemingly
inexorable climb from 1994 throughout the remainder of the 1990s, this did not deter home
buyers nor home builders whose recent memories were still etched with the higher double
digit inflation rates only a few years earlier. As mentioned above, during this period all
Americans were living the technology-led dream – even those who did not achieve the same
super-rich status as the growing cohort of successful entrepreneurs in Silicon Valley. The
fact that the correction in the equity markets soon brought about another bout of monetary
ease with lower interest rates, and which was reinforced thereafter by the need for again
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easing credit immediately following the devastating attacks of September 11 2001 in the
United States, only served to maintain the steady demand for bigger and better housing –
both to live in as well as becoming an alternative form of investment for many who no
longer felt comfortable with stock market investing.
As mentioned in Chapter 4, throughout this period, the US mortgage market was under-
going a major transformation. In fact, it was a transformation that was being emulated in
other countries. The transformation involved the increasing specialisation of banks, brokers,
appraisers, insurers, rating agencies, ‘warehousers’, structurers, and marketers of the rela-
tively new mortgage-backed securities. All of these functions, to the extent they were present
in older and more traditional mortgage financing and used to be performed under a single
roof, were now being performed by networks of specialised financial boutiques and compa-
nies in ways which introduced an incredible combination of market-based efficiency and
flexibility.
Concurrently, changes in the financial landscape were militating in favour of economies
of scale and scope in financial institutions providing the bulk of the financing for, among
other things, the housing juggernaut. And a significant part of the efficiencies achieved by
large financial institutions was attributable to the benefits of securitisation and other forms
of structured finance. With increasing concentrations of power through size, competition –
at least in its initial stages – can be brutal and this case was no exception. Those providing
mortgage funds were constantly looking for new ways to capture share of wallet and to
accommodate those potential borrowers who don’t quite qualify for conventional mortgage
loans. This quest was further encouraged by a new-found social and political awareness of
the need to do more for minorities, including finding new ways of making home ownership
more readily within their grasp.
Up to this point, US home mortgage loans had tenors from 10 to 30 years, payable
monthly as a constant annuity payment which blended payments to interest and principal,
carried an interest rate that was fixed until final maturity, was not assumable (which meant
that if you sold the house before the mortgage was paid off, you had to pay off the mort-
gage out of the proceeds of the sale, leaving the buyer to arrange his own financing), the
fixed interest rate could be reduced by paying points up front, was granted on the basis of
stringent eligibility tests including maximum loan-to-value ratios, income tests, net worth
tests and so on, and required the borrower to take out private mortgage insurance if the
purchase down-payment was less than a certain percentage of the sale price. Not only did
borrowers have to prove their income-earning capacity and net worth but were constrained
to debt service payments (principal and interest) of not more than 28% of their verified
gross income. If the mortgage loan was below a certain size and the home and financing
met other criteria, it was considered to be a ‘conforming’ loan which could be sold imme-
diately after origination to Fanny Mae or Freddy Mac to be included in one of their mortgage
pools for eventual securitisation.
The new products in contrast began to sprout numerous features which varied consid-
erably from traditional mortgages. One of the most prominent changes was the concept of
the adjustable rate mortgage (ARM). These mortgages carried an interest rate that was
expressed as a certain number of basis points above an interest-rate benchmark such as the
US prime rate. As the prime rate changed, so too did the mortgage rate applied to monthly
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house payments. This meant that the certainty of having a fixed monthly housing payment
over the life of the mortgage loan was removed in favour of, at least initially, lower monthly
payments. A feature which enticed even more borrowers away from the competition was
the ‘teaser rate’ which was usually well below the market rate for the first one or two years
before a higher market-oriented rate ‘kicked in’. These products are offered in the prime
mortgage market, in which those people who constitute the best credit risk have their mort-
gage financing needs met. But they were also, and perhaps especially, offered to what came
to be called the sub-prime and Alt A markets – that section of the mortgage market where
borrowers have certain attributes which make them a bigger risk than those who qualify for
prime lending. Rates for sub-prime borrowers are higher than those available to prime
borrowers, to reflect the added risk. Additionally, interest-only and negative amortisation
loans were also made available to help ease some of the monthly financial burden.
But it wasn’t as though with lower initial (including teaser) rates that sub-prime home-
buyers would choose housing which allowed them to pocket the savings resulting from a
lower monthly outlay. Instead they were often encouraged by market participants – from
real estate agents to mortgage brokers to funding institutions – to strive for as much house
as would take them with the low teaser rate to their limit as determined by the ‘eligibility
criteria’ of their lending institutions. At the same time, other criteria and mortgage under-
writing procedures were being significantly relaxed in practise, even if they were not officially
sanctioned. The information borrowers were providing in connection with their annual earn-
ings and net worth positions was not being checked as it had been in the past. LTV ratios
were being breached in various ways – some by turning a blind eye to the size of the
primary mortgage loan and in many cases by counting second mortgages and related lending
as homeowner equity rather than as part of overall indebtedness.
The reason for this relaxation of lending standards was twofold: first, competition was
fierce, becoming highly volume-driven. And second, professionals working in various parts
of the mortgage loan industry convinced themselves and their clients that the resulting risk
was minimal given how ‘hot’ the market was and the likelihood that even under the worst
unforeseen circumstances, either the owner or the lending institution would be able to unload
the property on very short notice at a significant capital gain.
Moreover, with the practice of ‘reverse red-lining’ – where lenders would now mark
off disadvantaged urban areas for special attention instead of conscious avoidance as they
often did in the past – resonating with policy-makers and the general public, it became
easier to make the case for easing the traditional financial safeguards built into mortgage
lending in order to extend the reach of these initiatives. Of course, once the housing finance
industry was able to convince the relevant oversight bodies to accept easier lending criteria
in the case of minority buyers, it was not such a big step to ease the lending criteria applied
to other borrowers as well. And for several years, it all seemed to work just fine.
While the general public scrambled over the details in a virtual menu of optional mort-
gage features, a more penetrating fact seemed to go unnoticed. Interest rate risk, which had
traditionally been borne by the bank, had now been transferred to the homeowner. Moreover,
it did not seem to be a major concern that sub-prime borrowers were often overly exposed
to this interest rate risk to the point where even a modest rise in the reference rate would
render them unable to make their monthly payments in full (in many cases interest payments
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calculated by using the higher interest rate would even exceed the borrower’s monthly
income).
Again, the lack of concern was based on a confidence born of the robust growth in
national housing prices. It was always assumed that housing prices would simply never turn
downward but would at the very worst experience a soft landing. In this view, there would
still be sufficient market liquidity at the higher prices to allow owners to sell quickly and
profitably if they had to.
The other side of the US mortgage market became caught up in the securitisation craze
that was sweeping the country as first the cash-based CDO and then the SCDO were repli-
cated at an accelerating rate. If it even looked like a financial obligation, then there were
those who felt that it could be packaged and sold as part of a collateral pool for structured
finance securities.
Paradoxically, while those in the industry designing and marketing the new structures
prided themselves on the increasing sophistication and precision with which important risks
were being separated, packaged and sold, at the same time, however, several aspects of this
new financing wave involved the seeds of systemic risk that were left unattended and that
would swell to gigantic proportions.
• Widespread betrayal of trust16 was perpetrated by financial institutions on their clientele.17

Both the media and congressional hearings revealed horrific stories of unscrupulous real-
tors, mortgages brokers and lenders taking blatant advantage of low-income minorities
through numerous unfair practices masked by voluminous and virtually incomprehensible
legal documentation.
• New issues of structured securities involved structures which were becoming increasingly
complicated, were not readily transparent and understood by the average investor, and
arguably with the benefit of hindsight were not even sufficiently understood by many of
the industry’s specialists.
• With the advent of synthetic securitisation, financial leverage was being applied on a
stratospheric scale in ways which were no longer transparent.
• The exploding credit derivatives market enabled the large institutions to undertake the
associated risk transfer on a grand scale that simply would not have been possible when
financial guarantees and ‘insurance’ products could only be obtained through a few mono-
line insurers which were constantly mindful of protecting their triple A ratings.
• Interest rate risk had been ‘successfully’ passed from ‘professionals’ to unsophisticated
homeowners.
• Mortgage loan origination standards had been lowered substantially and in a number of
cases have even been shown with hindsight to have been fraudulent, if not merely decep-
tive.
• Home appraisals, which in earlier years were conducted by registered, independent and
professional appraisers, were increasingly performed by either ‘in-house’ or compromised
appraisers who succumbed to the pressures of lenders.
• Institutional risk assessment of these structures suffered because much of the detailed
information and due diligence that was considered essential to marketing the earliest cash
structures was relaxed and instead rating agency tables based on over a decade of
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historical transactions – similar but different for reasons which unfortunately became apparent
too late – provided many with false confidence in their appreciation of the risks involved.
• Finance professionals, large institutions and ‘sophisticated investors’18 in many cases
relaxed prudential norms by structuring and investing in excessively heavy concentra-
tions of sub-prime-backed structured securities.
• Many of the structured securities were collateralised not only by new sub-prime mort-
gage loans but by CDO and SCDO securities previously issued, which meant that when
risk materialised the excessively tight coupling of valuations of like securities tended to
amplify and accelerate the value contraction to the point of producing pricing disconti-
nuities and even curtailed the ability to appropriately update the valuation of entire
portfolios.
The Post-2000 US housing boom

Several factors contributed to the greatest real estate boom in world history.
• The dot-com bubble burst in March 2000. This was closely followed by a major correc-
tion in the equities markets. Fearing a recession, the Federal Reserve began lowering the
Federal Funds rate throughout 2001. Then, following the terrorist attack on the United
States on September 11 2001, the Federal Reserve continuing lowering interest rates.
Throughout 2001, it brought the Federal Funds rate from 6.5% to 1.75% in 11 steps in
order to stabilise severely battered consumer confidence.
• Inflation, which had been beaten if not completely vanquished, was running at low rates,
resulting in negative real interest rates.
• Traditionally, when banks originated and held mortgage loans on their balance sheets to
maturity, the yield curve would be upward sloping, reflecting the accreting risk associ-
ated with successively longer loan tenors. As financial engineering changed the structure
as well as the economics of term lending through a steady stream of new structured
finance instruments, the resulting efficiencies forced effective medium-and-long-term
nominal rates steadily lower. This further reinforced the prevalence and magnitudes of
negative real interest rates in connection with real asset financings. At times, it also
produced an inverted yield curve as well.
• Residential real estate values are highly sensitive to the interest rate used to discount
future values because of the widespread use of significant financial leverage (in the form
of mortgage debt). When interest rates are tightened, this has the effect of dampening
real estate values. Conversely, real estate values become non-stationary, tending toward
higher values when real interest rates remain negative for some time. The US tax advan-
tage to homeowners of allowing interest payment deductions reinforces this tendency for
housing values to seek ‘equilibration’ at higher levels.
• International efforts to tighten the regulatory capital requirements for banks, as manifest
in Basel II, created a strong incentive for many banks to find ways to ease, if not avoid
outright, the effects of this tightening. This, in conjunction with the financial de-regula-
tion permitting universal banking, gave rise to the sea change to pursue fee income over
interest income.
• Favourable regulatory and tax treatment of asset securitisation afforded US (and European)
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banks with a way to conserve on bank capital while bringing in lucrative fee income in
connection with the origination and sale of mortgage loans. Many other categories of
loan also offered benefits through securitisation as well. This transformation in the struc-
ture of the credit industry involved a significant element of regulatory arbitrage as the
new products were not as tightly regulated as traditional bank lending activities were
becoming.
Additionally, the housing boom had important features as an asset bubble which distin-
guished it from other asset bubbles such as the stock market bubble of the 1990s.
• It involved much more leverage than even LTV ratios suggested as borrowers were able
(and in many cases encouraged by lenders) to take out second mortgages, HELs, and
HELOCs. The resulting ‘house of cards’ (no pun intended) led some observers to describe
the phenomenon as homeowners turning their houses into ATMs.
• Home ownership, is much more pervasive than direct holdings by the American public
of stocks and bonds. Furthermore, homes are not only most families’ largest asset (both
in terms of absolute value as well their total wealth), they are widely used as collateral.
These facts tend to make consumer wealth highly vulnerable and sensitive to adverse
economic developments.
• Mortgage loan underwriting standards for sub-prime borrowers and Alt A borrowers were,
under the guise of product innovation, allowed to deteriorate sharply. While some of the
innovations were the result of creative marketing, others were the result of unmitigated
greed and fraud. Examples of new products and features aimed at broadening the afford-
ability of home ownership included:
• ARMs with a variety of combinations of fixed and variable features.
• Negative amortisation loans with unpaid interest being tacked on to outstanding prin-
cipal at exorbitant rates.
• Teaser rates which dramatically lowered the initial monthly outlays required, and, which
combined with other relaxed origination standards, allowed borrowers to maximise the
house value and associated mortgage loan size they would assume but which reset one
or two years later at rates which often greatly surpassed the borrower’s credit capacity
by integer multiples (in a flat market there would be no rational justification for such
behaviour; in a bubble, however, this behaviour was not only rationalised by borrowers
but encouraged by realtors and mortgage brokers as a ‘can’t lose’ way of getting in
on the booming real estate market. In some ways, this behaviour could be viewed as
similar to ‘momentum trading’ in an upward trending stock market).
• Relaxation of LTV ratios and PITI (principal, interest, taxes and insurance) to monthly
income ratios during loan origination.
• Easing on the enforcement of standard escrow accounts to make sure funds were avail-
able to pay property taxes and insurance.
• Admissibility as well as the aggressive promotion of add-on loans to cover fees, closing
costs, and even the down payment (with various attempts to disguise what was being
done) in many cases in connection with home buying.
132
If there is one common characteristic about asset bubbles, it is that it is difficult if not
impossible to prove their existence (especially to those who are in denial) until well after
the fact. And then it is often too late.
The forces which shaped the conditions giving rise to a massive asset bubble post-2000,
however, transcend housing alone. In physics, a fulcrum is a point about which leverage is
applied. Undoubtedly, the US housing bubble of recent years is anchored in the indiscrim-
inate use of leverage. And if there is a fulcrum involved in connection with the larger
financial bubble, then housing finance has to be it.
Undoubtedly, escalating real estate values deserve top billing as a contributor to the
speed and ease with which the bubble inflated. But they represent part of a broader credit
bubble which was enabled by cheap money and geared to unprecedented multiples creating
what has been termed ‘a wall of money’. Moreover, since the numeraire has been the world’s
reserve currency – the dollar – this has tended to obscure the fact that at least a significant
portion of the financial bubble is the mirror image of a 50+ percent erosion of the dollar’s
value against the world’s main currencies since the year 2002.
This bubble was spawned through a combination of the following.
• Banks redefining themselves with the help of structured finance products as they shifted
their focus from less lucrative commercial lending to more profitable fee-generating invest-
ment banking activities.
• Consumer behaviour driven by a new wealth effect which was aided and abetted by credit
card companies in most cases owned by the same banks seeking to conserve regulatory
capital through innovative means and new forms of business.
• Private equity funds and hedge funds availing themselves of possibly the cheapest financing
throughout their existence to create and seek out highly leveraged transactions in the form
of ever larger target companies for which they could profit through leveraged buyouts.
In fact, private equity had for years been characterised by the creation of investment
companies which would invest millions, or perhaps tens of millions of dollars at most, in
unlisted small and mid-market companies post-venture-capital stage. In today’s parlance, it
has come to be synonymous with leveraged buyout transactions for which private equity
investments for each company figure in the many billions of dollars. The ‘wall of money’
arguably resulted in too much money chasing too few deals. As the most popular form of
planned exit for these larger companies was generally the IPO, this was good for the stock
market. It buoyed the major stock indices and possibly created a second wave asset bubble
(shortening the duration of the trough after the dot-com collapse) which went largely
undetected because of the primary focus on the more spectacular housing bubble.
Box 5.1
Sources of systemic risk and contagion in a housing crisis
One of the more attractive features of residential mortgage financing is the concept of homeowner
equity inherent in the criterion of LTV ratio. Simply put, a borrower who has a sizable and growing
equity stake is going to make the effort to service the loan in accordance with the mortgage contract
133
so as not to risk losing their underlying asset and accumulating wealth. In Wall Street jargon, this
is referred to as ‘having skin in the game’. Indeed, the practice of setting LTVs varies among coun-
tries to allow more or less in a statistical sense for variations in value which can occur while keeping
homeowner equity positive under a very high number of alternative economic scenarios. This statis-
tical sense can be acquired through highly detailed quantitative analysis or based on impressionistic
judgment by those in the industry informed by memory. However, where there have not been major
lapses from the standards set, nor from other important loan origination norms, the concept of home-
owner equity as a motivator for keeping mortgage loans from default has been part of the bedrock
of successful mortgage lending.
There is another aspect, however, that receives less attention. The homeowner motivation previ-
ously mentioned does not just apply to their willingness to service the loan. It also applies to their
willingness to repair and maintain the asset – that is, the home and surrounding property – in order
to preserve its value. The diligence with which this is done can vary greatly in accordance with
personal habit as well as financial means. But the same rationality which seems to work for keeping
one’s mortgage payments current also would seem a valid assumption for not wilfully allowing the
private property in question to suffer harsh depreciation in value.
Perhaps a reason that more attention is not paid to this aspect is that mortgage loan default,
which is usually contemplated as an isolated occurrence (rather than as a systemic event affecting
thousands), is depicted as being ‘curable’ within a relatively short period of time. In countries where
the mortgage market functions properly, foreclosure laws generally support the assumption that before
too much erosion in value of the underlying asset can take place, it will change hands. If the mort-
gage loan was ‘assumable’, the assumption that the buyer’s freedom from financial impairment would
work similarly to how the initial owner was motivated before falling on hard times, seems logical.
If the mortgage loan is not assumable, then the sale of the home whether done voluntarily or through
foreclosure accelerates the realisation of the initial mortgage loan, which would be the case, for
example, in most if not all mortgage securitisations.
The hidden risk that is not generally contemplated as it affects asset values and market prices,
however, is when something drives a wedge between chronic and widespread mortgage loan defaults
and imminent home resale, crystallised either by the fear of foreclosure or the act of foreclosure
itself. This happens when housing market liquidity dries up. When a severe downturn occurs in the
housing market and this either precipitates or is accompanied by severe financial distress in the resi-
dential mortgage loan market, a new type of risk emerges. It is the risk of further home value
deterioration. This can occur because many owners find themselves in the same boat of not being
able to service their loans, not being able to find buyers because of the dynamics of a severely
depressed housing market, not being evicted nor foreclosed on by their lending institutions because
of the pervasiveness of the problem, yet simply not having enough income or wealth to spend what
needs to be spent (spending which they had, or would have, done in normal times) to preserve the
home’s value. In a falling housing market, when foreclosures do occur with a longer lag than normal,
the new and lower house prices – partly lower due to the market but also lower due to disrepair
– send further signals to an already distressed housing market with positive feedback reinforcing
further the rate of decline in home prices generally.
During the height of the US sub-prime crisis, many homes were either neglected, abandoned,
became the object of vandals, or suffered other serious degradation beyond just normal wear and
tear. Media accounts also covered a number of situations in which recently foreclosed and aban-
doned homes were gutted by scavengers in order to strip out the copper tubing for resale. While
the housing market is heterogeneous, it is important to bear in mind that when fire sales occur, this
134
cannot help but have a further depressing tendency on other homes in the neighbourhood, irre-
spective of the quality of their upkeep.
Contagion is felt heavily in other ways as well. For example, the tendency for mortgage lenders
in Miami to avoid lending outright or alternatively to place strenuous requirements in connection
with new mortgage loans to finance condominium apartments in 2008 in the wake of the sub-prime
crisis has had such an effect. For example, some lenders are avoiding financing the purchase of
condominium apartments completely while among the rest many will not lend unless a building is
over 70% occupied. Of course, borrowers unable to meet the requirements can find private financing
but at much higher interest rates and usually have to be willing to put as much as 50% down (as
high as 70% for foreigners) to secure financing.
Such contributions to the downward spiral in home prices in those areas most affected are
extremely difficult to separate and measure but nonetheless exert their influence as part of the
ensemble of forces responsible for the protracted downward slide in prices of what was the hottest
market in years.
Box 5.2
Criminality in the sub-prime crisis
On January 30 2008, coinciding with a Federal Open Market Committee (FOMC) meeting expected
to culminate in a further interest rate reduction, Neil Cavuto of FOX News interviewed several guests
regarding an ongoing FBI investigation into criminality on the part of fourteen companies involved
in the sub-prime mortgage area. The problem extended beyond mortgage origination, where the FBI
had been investigating suspicions since mid-2007, to those involved in the securitisation of mort-
gages. The prospects for economic fallout, irrespective of further monetary ease, are that developments
can be expected to follow the pattern experienced during the Enron, Adelphi, Tyco, Worldcom and
Global Crossings scandals. In each of those cases, first there were allegations of fraud, followed
by investigations into criminality, followed by litigation, inquiries into insider trading and successive
rounds of this sequence for a number of corporate entities in a domino effect.
Post-2000, the regime of low interest rates in the US not only contributed to the boom in
housing values but it also encouraged cash-out refinancing (or equity release) with home-
owners tapping the equity in their homes to the tune of almost $1 trillion.
Many blame speculators for the asset market bubbles of recent years. Undeniably, specu-
lation played a role. However, a more fundamental shift in mindset was perhaps even more
responsible for the problem. One of the main changes in the post-2000 era was the effect of
the Gramm-Leach-Bliley Act of 1999. By removing the regulatory partitions from the provi-
sion of financial services, resolution of the many inherent conflicts of interest previously
recognised (and safeguarded against) by law were now entrusted in the name of self regu-
lation to almost any company meeting the minimum requirements of calling itself a financial
institution. While many of the larger and reputable banking names had performed respon-
sibly under the limitations imposed by the Glass-Steagall Act of 1933, the surge of new
institutional forms, new players and new financial business combinations created a totally
new topography for the financial landscape. It became a landscape which would provide
ample regulatory ‘dead zones’ to shelter blatant conflicts of interest from regulatory scrutiny.
135
As mentioned above, the concept of ‘fiduciary responsibility’ became one of the first
casualties of a new regime which even if it did not start out that way, soon became one based
on wholesale predation. Moreover, this regime was rationalised under the euphemism of
financial sector liberalisation. Until the signs of impending distress became evident, criticism
of the liberalised regime invited emotional accusations of being socialist or anti-capitalist. The
irony is that while the regulatory debate among industry practitioners and regulators often
became mired in detail such as appropriate gearing ratios and the definitions of what should
constitute regulatory capital, a more fundamental and flagrant error was all but ignored. That was
the incredible naivety19 in entrusting the management of the panoply of opportunities for conflict
of interest under the new financial services supermarkets largely to the participants’ own
judgment – that is, too many of these matters were left to be decided by those who stood to
benefit the most from exploiting these conflicts of interest.20 Among those institutions bent on
the task of fleecing the American consumer, focusing the policy debate on the need for them to
have enough regulatory capital (rather than attending to the flagrant lapses in ethical conduct)
simply meant ensuring that the perpetrators remained financially strong enough to prosecute the
task at hand. And in the absence of proper supervision, it should not be surprising that even
some of the more reputable names in banking felt the competitive pressures sufficiently to join
in on some of the less defensible practices.
During early 2007, as the Federal Reserve began to raise interest rates, US housing
prices started showing the first signs of sputtering. As the bubble first showed indications
of deflating, government officials, homeowners, the banks and the media all talked about a
soft landing. Although a few observers warned about the likelihood and possible conse-
quences of a hard landing, few heeded these warnings. As the year dragged on, early defaults
and information regarding the number of homeowners who were expected to be adversely
affected by mortgage teaser interest rate resets began to spread worry in the financial markets.
In fact, a few economists and analysts were warning of the credit bubble generally and the
housing bubble in particular. August 2007, however, marked the turning point when first a
large US home loan provider (American Home Mortgage) filed for bankruptcy protection
and a few days later a prominent European bank (BNP Paribas) suspended redemptions in
connections with about €2 billion (about $1.35 billion) in some of its investment funds
which were heavily exposed to US sub-prime credit. These developments as well as warning
signs at a few other financial institutions prompted actions on the part of both the European
Central Bank (ECB) and the Federal Reserve to ease credit to calm the financial markets.
The following month, the Bank of England intervened to prevent the distressed Northern
Rock bank, which suffered a liquidity crisis caused by its heavy exposure to US-issued
mortgage-backed obligations, from creating massive panic in the country’s financial markets.
As mortgage payment defaults began to mount in the United States (predominantly in
the sub-prime segment of the market), the effect was to spread the distress among an
increasing number of large financial institutions which had taken aggressive positions in
structured finance paper, backed in many instances by riskier mortgage loans.
Initially, as the first wave of payment defaults occurred, some observers noted that
although it posed a serious situation for those homeowners who were the most financially
overextended, the extent of the problem should not be inordinately widespread as not much
more than 5% of the 44 million outstanding US mortgages were considered to be sub-prime.
136
As the portfolios of mortgage-backed paper held by large financial institutions in the United
States and Europe became distressed at an increasing rate, what became noteworthy was
that the write-offs being reported were quickly adding up to integer multiples of not only
the size of the defaults but even the entire outstanding values of the loans thus affected by
arrears.
The following developments provide an indication of the dimensions of the problem,
as it unfolded.
The housing crisis
• By early 2008, the United States residential housing market had a backlog of about 4
million homes up for sale.
• At the same time, about 1.1 million or roughly 2.5% of all outstanding mortgages were
already in foreclosure. An increasing number of these occurring throughout 2008 have
been from the prime loan segment of the market.
• The housing finance industry, as recorded in testimony before the United States Congress,
at that time anticipated another three million payment defaults to occur by mid-2009, of
which about two-thirds (close to two million) would result in the associated mortgage
loans going into default – mainly precipitated by the contractual timing of mortgage
payment resets in connection with ARM mortgages which would cause borrowers’ payment
capacities to be exceeded.
• By the end of the 2nd quarter of 2008, foreclosures exceeded 1.2 million mortgages
(about 2.75% of outstanding mortgages) and the mortgage loans with one or more overdue
payments of more than 30 days reached an all-time high of 6.41% of outstanding mort-
gage loans (affecting close to 3 million homes) while some 730,000 mortgages having
at least three payments past due were not yet in foreclosure.
• Until the backlog in housing supply can be reduced, house values, which had already
experienced a decline of over 20%, are expected to drop even further.
• As increasing numbers of sub-prime mortgage loans showed signs of becoming distressed,
many banks which had either sold outright, or had otherwise transferred the associated
risk away of the mortgages they had originated, were suddenly being required by legal
and accounting conventions to bring back on their balance sheets their exposures to these
assets which had been effectively quarantined in SIVs or other SPEs through the process
of asset securitisation.
• Home refinancing was becoming paralysed because: (1) many banks were feeling the
pinch on their regulatory capital and were under enormous pressure to retrench by reducing
the size of their credit portfolios, irrespective of creditworthiness of their clients; (2) most
of the defaulting borrowers either had virtually no equity in their home to begin with or
had seen it evaporate with declining housing prices as to make them ineligible for mort-
gage refinancing to the extent that the problem of what the industry calls ‘upside down
mortgages’ (a mortgage for which the outstanding balance exceeds the resale value of
the home); (3) even prime borrowers with ARM mortgage financing who wanted to lock
in interest payments were being turned down for refinancing as the crisis got under way;
and (4) with widespread speculation among industry practitioners reported on a daily
137
basis in the press regarding expectations that home prices still had a significant way to
fall, this contributed to the added reluctance to lend on the part of even those lender
institutions which still had balance sheet headroom theoretically available for mortgage
refinancing.
The financial crisis

At the time of writing the credit crisis in the United States has crystallised, following a
spate of failures of several large banking and insurance institutions, with indications that
the distress is spreading internationally. It has been labelled by some in the media as the
worst financial crisis the country has had to face since the Great Depression. Furthermore,
it has culminated in a $700 billion government recovery proposal which is currently being
negotiated by the two main parties during the last weeks of a closely contested bid for the
presidency. President George W. Bush has called on all Americans to support the proposal.
Numerous foreign financial institutions and government officials have expressed support for
the idea of a rescue package, recognising the peril to which the global financial system is
currently exposed. Many United States citizens are less convinced. Strong arguments that
the financial institutions, which through unbridled greed precipitated the crisis, should be
allowed to fail in order to contain moral hazard are met with equally strong arguments that
the current and unprecedented tight coupling throughout not just the US but the global finan-
cial system as well, calls for extraordinary intervention on a massive scale. As appealing as
the former argument may be to many, the attendant risks seem to argue in favour of the
path of intervention. Focus has rapidly shifted therefore to questions of how much (rather
than whether) government involvement is needed and the form which it should take.
As 2008 began, the financial crisis showed signs of deepening as a series of banking
institutions heavily involved in mortgage origination showed signs of trouble. During the
ensuing months and throughout the summer of 2008, several US and some European finan-
cial institutions with significant holdings of mortgage-backed securities (MBS) racked up
close to half a trillion US dollars in mortgage-related losses. A brief chronology of the main
events during the year leading up to the proposal is presented below.
• January 11 2008. Bank of America announces that it will buy Countrywide, the largest
originator of US sub-prime mortgage loans for a price of $4 billion which staves off the
latter institution’s likely bankruptcy.
• March 16 2008. JP Morgan Chase & Co bought Bear Stearns Co in a deal arranged and
backed by the US federal government.
• July 11 2008. Federal regulators seized IndyMac after it succumbed to falling housing
prices and accelerating rates of foreclosure combined with tighter credit.
• September 7 2008. The US federal government seized Fannie Mae and Freddie Mac,
eventually supporting them with what could amount to up to $100 billion (each) bailout
programme.
• September 10 2008. Lehman Brothers announces it is for sale but after unsuccessful
negotiations with a few prospective buyers and a clear signal from the US government
that a bailout will not be forthcoming, the floundering investment bank declares bank-
ruptcy on September 15 2008. This event shakes the world financial market.
138
• September 16 2008. The US government announces an $85 billion emergency loan to

prop up the ailing American Insurance Group (AIG).
• September 18 2008. Britain’s Financial Services Authority (FSA) banned short sales of
the stock of 32 companies until the middle of January 2009.
• September 19 2008. The SEC halted short sales of almost 800 financial stocks for a
period of ten days (which could be extended by an additional 30 days) and tightened
rules concerning trading disclosure. This action and that of the FSA the previous day
(which both regulatory bodies claim are only temporary measures) have been reinforced
by large pension funds in the UK and the US announcing that they would no longer lend
shares in connection with a number of designated companies. Together, these actions
have severely cramped the hedge fund industry.
• September 19 2008. United States Secretary of the Treasury Henry Paulson proposes a
financial recovery plan by which the US government would establish a fund with $700
billion to buy distressed mortgages from financial institutions. Although many politicians
and senior government officials see the need for action, public support is not readily
forthcoming, the main issue being why taxpayers should be asked to shoulder the addi-
tional burden while those who are seen as responsible for the debacle escape relatively
unscathed and may even have the opportunity to gain from the ordeal.
• September 21 2008. The short selling ban spreads to other countries including Holland,
Taiwan and Australia with other countries considering similar types of restrictions.
• September 25 2008. Washington Mutual, with help from the US government, sells its
deposits and some of its branches to JP Morgan Chase.
• September 26 2008. US government regulators seize Washington Mutual which enters
into bankruptcy.
The credit crunch

Some of the ways the financial crisis is affecting United States residents generally include:
• Home mortgage loans, home equity loans (HELs) and home equity lines of credit
(HELOCs) are becoming much more difficult for borrowers to obtain. Not only are many
banks no longer lending because of severe capital constraints, those that are lending are
applying much more stringent eligibility criteria including larger down payments (with
lower loan-to-value or LTV ratios, more thorough verification of income and net worth
claims, more thorough property appraisals and higher credit scores).
• Credit card companies are reducing spending ceilings and charging higher fees and penal-
ties. To some extent this is partially offset by stores which are relaxing store-provided
credit in order to stimulate sales.
• Automobile financing is getting tighter with larger down payments generally required as
well as fewer and less generous ‘teaser’ rates being offered. Many automotive lenders
are reducing the repayment period resulting in higher monthly payments.
• Working capital financing is becoming tighter as larger firms find the market for asset-
backed commercial paper issues affected by many of the same problems and uncertainties
affecting mortgage lending and smaller firms are faced with much tighter and more strin-
gent bank lending conditions.
139
The financial recovery plan

Negotiations over the details of the plan are ongoing as of this writing. The plan envisages
granting powers to the United States Secretary of the Treasury (‘the Secretary’) to purchase
mortgage loans and mortgage-related assets (defined as residential or commercial mortgages
and any securities, obligations, or other instruments that are based on or related to such
mortgages, that in each case was originated or issued on or before September 17 2008).
The duration of these powers is to be two years from the enactment of the Act. The powers
would also permit the Secretary to create institutions and to hire staff and financial institu-
tions to act as fiscal agents as required.
An important issue the US Treasury will face once the Act is approved will be the appropriate
price at which assets will be purchased. Many banks and other financial institutions targeted to
derive relief from the plan are currently holding mortgage-related assets on their books at deeply
discounted book values. However, the value of these assets in many cases is so precarious in
current market conditions as to suggest they could fall significantly more in value in the near
future. This is largely due to the fact that housing prices in the US have not yet reached a bottom.
Consequently, prudence would suggest that the Treasury should pay prices for many such assets
well below that at which they are currently being held on the books of the troubled institutions.
Lower prices would also certainly be appropriate with regard to protecting the interests of the US
taxpayer. However, purchasing these assets at lower prices would likely exacerbate the distress
already being experienced by these institutions, thus possibly weakening the plan’s effectiveness
in stabilising the financial institutions it has been designed to help. One suggestion has been that
the Treasury could offer to pay a price mid-way between a prudent low price fully reflecting risk
and uncertainty and the current book price. It might reflect, for example a price consistent with
realisable value if the assets in question were held to maturity by the Treasury. While this would
certainly redistribute the burden somewhat, it would also tend to reduce the liquidity of the
purchased assets from that which could be expected if assets were purchased at fully risk-adjusted
prices.
Another major issue, and one which is the current focus of congressional negotiators,
is the amount of relief the proposed plan will provide troubled home owners and the form
such relief might take. If the mechanism for providing relief is envisaged to include changing
the current terms of mortgages and mortgage-related assets acquired by the Treasury (such
as extending maturities, lowering the contractually-determined interest rates on these instru-
ments, or combinations thereof), such actions, to be effective, will likely involve the daunting
task of trying to balance the ‘right’ (politically acceptable) amount of relief with the amount
which is needed to ease the distress. This will call for careful distinctions between prospec-
tively salvageable and unsalvageable loan accounts, a task made difficult by the extent to
which many loans have already been sold into the secondary market and servicing rights
having been transferred as financial institutions have become distressed and have themselves
been sold or gone into bankruptcy. Alternatively, a more broad-brush approach to extending
relief to home loan borrowers could involve either tax rebates or one-time payments which
would avoid the complication of revising numerous loan contracts. In addition to the problem
of ascertaining how much relief is appropriate, given the mounting economic difficulties
(with rising consumer prices, increasing numbers of employee layoffs and other signs of a
weakening economy), it is not clear the extent to which mortgage relief provided in an unre-
140
stricted form would succeed in putting home owners back on a sustainable course.
Specifically, uncertainty exists as to whether they would resume fully servicing their mort-
gages instead of spending relief cheques on other essentials.
Representatives of both political parties have expressed the need to ensure that resources
destined for financial recovery are not used to reward or provide ‘golden parachutes’ for
senior executives of financial institutions availing themselves of the relief. Most would agree
that such a restriction is only fair. The important issue is whether it is enough. From the
viewpoint of discouraging moral hazard, capping executive remuneration alone would seem
to be insufficient. Simply forgoing bonuses or rich separation packages yet being allowed
to keep their jobs (even though a few executives have been fired, complicity with respect
to many of the problems no doubt was involved among many who were spared) in return
for resolving major distress occurring on their watch still seems like precisely the kind of
asymmetric payoff which led in the first place to the excesses which helped spawn the
current financial crisis, whereby owners and managers (with ample political quiescence, if
not support) have been at least tacit advocates of privatising gains while socialising losses.
In this latter connection, however, recent probes by the United States Federal Bureau of
Investigation (FBI) into the possibility of fraud at the recently-failed financial institutions
(some 20 firms have been reported as being under investigation) may, depending on their
outcome, significantly weaken any remaining incentive attached to excessively risky as well
as predatory behaviour. This remains to be seen.
Looking to the near future, the United States is once again entering a phase in which
greater rather than less government involvement in the financial sector is on the upswing.
As one after another major Wall Street name has become distressed and has been swal-
lowed up by other financial institutions, some see this as the death knell for the stand-alone
investment bank. Of course, those who blame the investment banks for many of the current
problems are taking solace in this development. It may well, however, mask a greater risk
– the risk within universal banking institutions generally that a wider array of financial activ-
ities creates more possibilities for conflict of interest which can quickly elude the current
regulatory framework. In this connection, new legislation and financial regulation is being
prepared aimed at:
• addressing many of the excesses described above in connection with mortgage lending
practices;
• tightening the underwriting and risk management practices as well as accounting treat-
ment of investments related to structured finance operations; and
• reforming the operations and conduct of the credit rating agencies, particularly in connec-
tion with conflicts of interest and disclosure.
A practical typology for the country case histories

Exhibit 5.2 presents a summary of the fifteen country-specific cases described above. While
differences in geography, differences in chronology and differences in economic structure
all lend a degree of individuality to each of these stories, a few common and contrasting
themes warrant attention. Again, it is not intended to be exhaustive in this connection.
141
142
Exhibit 5.2
A chronology of recent financial crises (1977–2007)
Source of
Premature Introduced
Currency financial Exchange Prevalance Real estate Credit
Year Bank crisis financial inflation

crisis market rate regime of groups bubble boom
liberalisation indexing
distress
Spain 1977 Y Y n/a Managed Y Y N Y Y

16/10/08
Chile 1982 Y Y B Fixed Y Y N Y Y

United States S&L 1985 Y N n/a Flexible N N N Y N
United States Black Monday 1987 Y N S Flexible N N N Y N
16:11
Norway 1987 Y Y n/a Fixed Y Y N Y N

Finland and Sweden 1991 Y Y n/a Fixed Y Y Y Y N

Japan 1992 Y N S Flexible Y Y Y Y N
Mexico 1994 Y Y B Managed Y Y N Y Y
Page 142
South Korea and East Asia 1997 Y Y S Fixed Y Y Y Y N

Russia 1998 Y Y B Managed Y Y N Y N
Brazil 1999 N Y B Managed Y N N N N
United States dot-com 2000 N N S Flexible N N N N N
Argentina 2001 N Y B Fixed Y Y N Y N
Lebanon 2002 N N n/a Managed Y N N N N
United States sub-prime 2007 Y N B Flexible N N Y Y N
n/a = not applicable

B = bond or debt market
S = stock market

If one begins with emerging market countries, with two exceptions (Brazil and Argentina)
in our sample which we will describe below, premature financial liberalisation permitting
unrestricted bank lending before the necessary rules and practices were firmly in place,
inevitably gave rise to banking crises. Since in these examples the countries involved were
operating with either fixed or tightly-managed exchange rates, the banking crises soon gave
rise to or were overlapped by currency crises. Furthermore, the prevalence of economic
groups or conglomerates21 played an important role as a countervailing force acting against
the effects of monetary and fiscal policy being applied by the respective countries’ economic
authorities. In countries such as Spain, Mexico and Norway, where the groups were never
strategically in partnership with government, this occurred as orthodox economic policy
measures were simply thwarted by the fact that the authorities in these countries did not
take the power structure adequately into account as they coped with their financial crises.
In contrast, in Japan and other East Asian countries, where the policy-based finance model
was applied, public-sector and private sector decisions and actions occurred in concert albeit
with an accretion of systemic risk over many years.
The two exceptions to the banking and currency twin-crisis episodes in emerging market
countries, were Brazil and Argentina. In both of these cases, banks were well capitalised
and distress became directly manifest in currency crises and the securities markets (mostly
the bond or credit markets). In the case of Brazil, banks had been managed conservatively
for some time. In fact, they had to be in order to survive the three decades of high and
chronic inflation the country experienced between 1964 and 1994. Consequently, when the
external shock occurred in 1999, the banks were well-capitalised and had avoided the massive
lending binges that had attended the financial liberalisation in countries such as Spain, Chile,
Mexico, and Norway. Argentina, on the other hand, had developed sound banking practices
out of the necessity imposed by its currency-board arrangements. The country had other
vulnerabilities but the banks, although suffering eventually from the sheer enormity of the
meltdown, were not the main cause.
The main distinctions between emerging market countries (the European countries are
included in this group based on the fact that their crises occurred when their financial markets
could still be considered emerging) in one grouping and the United States and Japan in
another is that external debt in the former group was preponderantly in foreign currency,
making exchange rate vulnerability that much more pronounced.
The US examples are all interesting considering that the country’s financial markets are
the standard for the rest of the world. Because the dollar is the world’s reserve currency, it
is important to bear in mind that numerous currencies have been pegged to the dollar. The
dollar, however, is not pegged to any of them. The consequent flexibility inherent in the
dollar internationally provides an enormous and valuable cushion for the effects of both
policy mistakes and shocks. In each of the US financial crisis episodes, a combination of
both economic policies and speculation were involved. However, a particularly interesting
aspect is that the most recent distress situation (reflected in the sub-prime credit crisis)
contains errors of both omission and commission in terms of macroeconomic policies and
regulatory framework and which had been visible during past crises in other countries. Two
concrete examples include: (1) the real estate bubble in Japan caused by allowing real interest
rates to remain negative for a protracted period (as happened in the United States post-
143
2000); and (2) the issues surrounding the countervailing power of large conglomerates in
several countries (notably, Spain, Chile and Mexico) from which the US authorities might
have drawn useful lessons before removing the partitions separating the provision of finan-
cial services via the Gramm-Leach-Bliley Act of 1999.
01
Greenspan (2007).
02.
Mark Mullins, ‘Meltdown Monday or meltdown money? Causes of the stock market crash,’ in O’Brien and
Datta (1989, pp. 43–64).
03
Bookstaber (2007, p. 21) colourfully describes the frantic attempts by futures traders attempting to coordinate
with equity traders who were either in meetings or out for coffee when the action was at its height.
04
Cargill (2000).
05
Nakamura (2002, p. 7).
06
Richard Nakamura, ‘The big cleanse: the Japanese response to the financial crisis of the 1990s seen from a
Nordic perspective’, Working Paper No. 149, June 2002.
07
See Osband (2002) for an insightful, thorough and entertaining description of this type of risk.
08
Shiller (2005).
09
Andres Solimano, ‘Development cycles, political regimes and international migration: Argentina in the twentieth
century’, CEPAL Santiago Chile, January 2003 (Table 1).
10
Mishkin (2006, p. 107).
11
Calvo (2005, pp. 143–4).
12
Mishkin (2006, p. 14).
13
Taleb (2007).
14
The Schwarzchild radius represents the distance from a mass beyond which an approaching object cannot escape
the mass’s gravitational pull.
15
Zimbabwe, of course, is the recent exception with early 2008 official estimates of inflation surpassing 100,000%
a year and some independent mid-2008 reports claiming that inflation had exceeded one million percent a year.
16
Since the passage of the Gramm-Leach-Bliley Act of 1999, not only did the walls come down between inter
alia commercial and investment banking activities, not only did banks pursue fees rather than interest earnings,
but this shift was accompanied by the most flagrant violation of the rights of the financial sector’s customers,
notably in home mortgage origination but in many other areas as well. It was the massive, if not total, aban-
donment of the concept of fiduciary responsibility. From real estate brokers, to mortgage brokers to others in
the mortgage finance food chain, the principal focus was to pursue fee income and share of wallet – the borrower’s
– to the detriment of any consideration of the borrower’s financial well being and ultimate solvency. This also
applies to the global credit card companies as amply reflected during congressional hearings on the matter. It
also applies to the failure of credit rating agencies to identify and resolve their own conflicted roles. It applies
as well to those who sold overly-rated CDO securities in larger amounts than prudentially advisable to institu-
tional clients without adequate disclosure of all of the true risks.
17
The various service providers seem to have completely ignored the fact that apart from abrogating the customary
role of their fiduciary responsibilities to their clients, protecting the borrower from becoming financially over-
extended should have been considered a priority simply on the grounds of being ‘good business’ because it
reduces the risk of borrower insolvency. In other words, it’s the smart parasite that doesn’t kill the host.
18
Sophisticated investors are defined by securities law in the US as individuals who can demonstrate that they
meet certain income and net worth criteria and who either possess or are considered to possess along with their
financial advisers the requisite knowledge and experience for investing in certain offerings which are generally
larger and riskier than those offered to the general public.
19
As a thought experiment, it would be interesting to speculate whether or not those same policy-makers who
were content with these arrangements would have accepted without protest a referee in a major sporting event
on which they were betting (such as the Super Bowl) who was known to be a close relative of the captain of
one of the two teams.
144
20
Examples of conflicts of interest in the financial sector are numerous and arise out of different combinations of
financial services. Representative are some of those which were behind scandals of recent years such as invest-
ment banks stuffing their managed brokerage accounts with difficult-to-place underwriting issues; research analysts
blatantly recommending stocks with questionable fundamentals but which represented key account relationships
for their underwriting departments; credit rating agencies involved in both the ‘buy’ and the ‘sell’ sides of
complex transactions for structured finance products, to name a few.
21
It should be noted in Exhibit 5.2 above that the column indicating whether or not a country experienced a preva-
lence of groups refers to situations in which the relative size of groups materially distorted the conduct of
economic policy during the crisis. In this connection, in the four United States cases, an ‘N’ was assigned
because even though large groups can be found in the US, they are not so large relative to the US economy to
create the kinds of distortion found in the emerging market countries or Japan.
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Chapter 6
Financial globalisation – global trends

and the new functions, institutions and
markets and their importance for
financial market distress
The migration of liquidity – how sustainable are emerging capital

markets?
Globalisation exerts an impact on financial markets in a variety of ways. Some of the effects are
clearly visible and operate quickly. As barriers to international trade and the flow of capital have
been dismantled, many countries have benefited from the stimulus to real investment and
economic growth which has accompanied this process. The process of globalisation, however,
has not happened without contributing pain and discomfort to the unprepared. Livelihoods,
which previously had been protected, not only fell victim to the competitive superiority of goods
and services enjoying global brand recognition but even had to suffer the insult added to injury
of having those brands now produced within their own countries. These issues have been well
documented in the press and a number of recent books on globalisation.
The opening of borders to capital flows, however, has had mixed results when it comes
to its stimulus to organised stock markets in emerging markets countries. A countervailing
tendency has been the increasing migration of large companies in countries like India, Brazil,
Mexico, to name a few, to list and launch share issues on the major international exchanges,
especially in New York and London. Using data from 3,000 firms across 55 emerging market
countries, Levine and Schmukler1 found that the effect of companies in these countries cross-
listing, issuing depository receipts or raising capital in international stock markets was to
reduce the domestic trading of the share of these firms in the home markets. Furthermore,
in addition to reducing domestic liquidity for these companies’ shares, trade diversion within
domestic markets occurred as investors and traders shifted out of trading in other domestic
firms and focused more on trading in other international firms.
From the viewpoint of overall market behaviour, the aforementioned liquidity migration
results in heavier concentration of trading in a limited number of securities. Acting as strange
attractors, trading volume increases in the shares of international firms also has the capacity to
accentuate extreme events where markets tend to become less stable and therefore susceptible
to boom and bust dynamics. The attendant characteristic of such episodes is the sudden ebb of
market liquidity which tends to reinforce positively herd behaviour. Furthermore, as trading
volume is drawn away from emerging markets exchanges, their capacity to act as a safety valve
146
Financial globalisation
for extreme behaviour becomes diminished as arbitrage opportunities tend to dry up with
reduced liquidity – certainly in the quantities required to meet or offset the large institutional
positions involved. It also helps explain why the observed returns in financial markets
internationally have tended to show stronger correlation than in the past.
Basel II and its ramifications

The Bank for International Settlements unveiled Basel II in June 2004, a voluminous and
wide-reaching capital-adequacy framework. Its scope and reach are much broader than its
precursor, Basel I. Whereas Basel I only addressed credit risk at the outset with an important
amendment in the mid-1990s to capture aspects of market risk in trading books, Basel II
provides a much more comprehensive treatment of risk. Basel II separates risk into the following
dimensions: credit risk, market risk and operational risk. Moreover, it has an entire chapter
dedicated to the treatment of securitisation and its products. Furthermore, whereas Basel I was
aimed primarily at commercial banks, Basel II aims to bring a much wider array of financial
institutions under its influence. It has three main pillars: (1) minimum capital requirements;
(2) strengthening of official supervision; and (3) strengthening of market discipline.
A major consequence of Basel II, implementation of which is still ongoing in many
countries, is to crystallise the competitive advantage of scope and size. For those banks large
enough to defray adequately the costs of maintaining substantial statistical research, analysis
and risk management functions which are necessary for applying internal-ratings-based (IRB)
approach to risk measurement, ample scope exists for reducing the capital required to back
various types of assets. For all other institutions which are too small to justify developing
such in-house capabilities, a standardised approach is available which provides schedules of
capital requirements for different categories of assets on terms that may in many cases be
more conservative than those which the institutions applying IRB will be able to justify.
Consequently, this has launched a trend toward industry consolidation as well as M&A
(mergers and acquisitions) activity for financial institutions, as stronger banks and financial
institutions set out to acquire those which best fit their augmented business strategies.
The quest for size has important consequences for market behaviour and risk attributes.
The more benign capital requirements which size can confer has already shown the increased
appetite for risk on the part of large global institutions. After all, if less capital is at risk
and size matters, then larger exposures also promise the possibility of larger returns. As
fewer but more powerful global institutions fish in the same pond for structured finance
products (and their underlying assets), this creates a concentration of risk along new dimen-
sions not previously contemplated under the older prudential norms. It also means that with
larger exposures, the potential for individual institutions to have their solvency threatened
by the materialisation of the risk associated with outlying events (involving large losses but
low probabilities) has gone up appreciably and is not geographically confined as in the past.
If only one or two large institutions suddenly find themselves in the position of having
to unload significant volumes rapidly, the potential for spooking the herd is significant and
ever-present. As we discussed in Chapter 4, the complexity of many of today’s structured
finance products in terms of ownership, rights, remedies, and valuations of underlying assets
suggest the potential for protracted confusion and distress as crises unfold going forward.
147
At the time of writing, these symptoms are clearly discernible as the United States’ finan-
cial crisis deepens.
Banks and the end of entitlement

If there was subtlety to the recovery of financial institutions in the aftermath of the 1997
East Asia crisis, it was that the recovery was not merely a question of quantitative recovery.
The fabric of the financial system in Asia changed dramatically as well. In large measure,
this was a natural outcome of having many western institutions (governmental and private)
play a role in the recovery. The policy-based finance, which had helped the Asian Tigers
achieve rapid economic growth and asset accumulation, was also recognised by most (with
the benefit of 20/20 hindsight) as involving too much systemic risk. New injections of foreign
capital into the banking and other financial institutions of Thailand, Korea and Indonesia,
for example, happened in exchange for changes to bring many of these institutions more in
line with similar institutions operating in the West. The large volumes of related lending,
disguised loans, interlocking ownership structures in violation of what in other countries
would have been prudential norms, all had to go – or at least be dampened down signifi-
cantly. Accounting practices in a number of cases were modified as mark-to-market practices
were simultaneously introduced.
The advent of Basel II provided further impetus to these changes and not just in East
Asia. The changes meant that the old protective barriers which allowed the commercial
banks and other financial institutions of East Asia to enjoy strong monopolistic elements in
conducting their business domestically would be dismantled. The regime which rose from
the ashes of the Asian Crisis meant that the banks and financial institutions not only were
exposed to new competition from large foreign institutions, they quickly became acquisi-
tion targets for many of them. As these developments unfolded, the stodgy, club-like
‘rent-seeking’ status enjoyed by the region’s financial institutions was transformed in a short
period of time into professional internationally-aware (if not internationally-oriented) competi-
tive institutions, driven more by the newly-felt need of providing quality product and good
customer relationships than by the complacency of picking the low-hanging fruit previously
afforded by their positions of entitlement. This additional force contributing to the quest for
size and participation in global markets further impelled the deepening of interrelationships
among geographically-diverse financial institutions and markets.
Financial institutional form follows function

Even before the major financial crises of the late 1990s, global financial institutions were
recognising the strategic value of rethinking their focus and concomitant organisation. The
upheaval throughout the global financial system brought about by technological change
unleashed a series of innovations in finance. Two basic premises accompanying this change,
as analysed by Crane, Froot and Mason are:2
• Financial functions are more stable than financial institutions – that is, functions change
less over time and vary less across borders.
148
• Institutional form follows function – that is, innovation and competition among institu-
tions in the execution of specific functions ultimately result in greater efficiency in the
performance of those functions; this in turn determines the best ways for the institution
to organise (that is, its ultimate form) so as to preserve its efficiency and competitive-
ness.
They go on to identify six main core functions in finance as being:
1 To provide ways of clearing and settling payments to facilitate trade.

2 To provide a mechanism for the pooling of resources and for the subdividing of shares
in various enterprises.
3 To provide ways to transfer economic resources through time, across borders, and among
industries.
4 To provide ways of managing risk.
5 To provide price information to help coordinate decentralised decision-making in various
sectors of the economy.
6 To provide ways of dealing with the incentive problems created when one party to a
transaction had information that the other party does not or when one party acts as agent
for another.
Clearly, the largest institutions combine all of these functions. However, the advantage of
shifting the focus from primarily one of form (the institution) to one of function is that a
clearer view is afforded of what needs to be done to achieve dominance or at least strong
leadership as a basis for competition. By concentrating on each of these functions, newer
and superior products can be designed to help achieve more efficient resource allocation.
At the same time, this framework does not preclude combining functions within an appro-
priate institutional setting in ways that address evolving relationship-banking needs for those
institutions which compete for ‘share of wallet’. Continuing advances in technology support
both superior product and superior customer experience in varying combination so as to
enable effective global competitive strategies of the best of breed institutions.
Global imbalances and its mirror image: the rise of sovereign

wealth
Economic liberalisation and globalisation have produced significant increases in inter-
national trade and capital mobility. Of these two forces, capital movement is the more fluid
and massive of the two. The electronic placement of large institutional bets on asset price
movements as diverse as spot exchange rates, long-term bonds, equities and financial deriva-
tives not only happens instantaneously but can be reversed just as quickly. Capital flows
have also likely been responsible for financing the build-up of massive global imbalances
over the better part of the last decade. These notably are the twin US deficits (budgetary
and external) and the mounting foreign reserve surpluses of emerging Asia and the world’s
petroleum exporters. The continuing nature of these global imbalances comprises a source
of systemic risk. It is not clear how long the situation can endure nor is it obvious as to
149
whether the global financial system will seek a new equilibrium quietly, via a ‘soft landing’,
or harshly with widespread economic shock and dislocation. Moreover, the very nature of
risk that this phenomenon entails is sufficiently new as to likely elude having been captured
in the statistical analyses applied by either the rating agencies or many institutional analysts.
More than 50 sovereign wealth funds (SWFs) covering 40 countries are now in exis-
tence with a significant number of them having been created in the past few years. These
funds were established to manage the excess portion of foreign exchange reserves over and
above amounts generally kept on hand for purposes of ensuring sufficiency for import
payments and stabilising the exchange rate. The more than $3 trillion in ‘wealth’ that the
associated excess reserves represent (which is over and above the approximately $7 tril-
lion managed with a primary view to facilitating trade and other short-term
balance-of-payments liquidity needs) constitutes an amount that is available for discre-
tionary purposes of a long-term nature including pension obligations and intergenerational
wealth transfer.
The new institutional realities
A financial supercollider
Science fiction has for some years contemplated the possibility of downloading human traits,
including personal memory, in the form of digital information which could be used for repli-
cating a person’s personality in another body or even in an artificial device. This has not
yet happened. The idea invites disbelief. But, it was not that many years ago that the same
incredulity would have been sparked had anyone suggested that the day would come when
most of a person’s entire wealth would take electronic digital form. With the dematerial-
isation of the ownership of financial securities, which has spread to derivative products as
well, the future has already arrived. Financial assets and liabilities in connection with things
as diverse as bank accounts, stockbrokerage accounts, mortgage loans and insurance bene-
fits, to name but a few, are now all handled digitally. Hard copy, which used to be the only
proof of existence, is now like a snapshot. It is something created on demand at a moment
in time, but outside of this simply does not exist and for the vast bulk of transactions, it is
simply not essential.
But while wealth in cyberspace seems ubiquitous, a reality is that the institutions involved
in collecting and transforming that wealth into a variety of financial forms will not only
survive but can be expected to thrive. It is useful to examine briefly some of the main devel-
opments and trends which are shaping the institutional landscape of the global financial
markets going forward.
Creditors (banks, syndicates, and institutional lenders). Direct lending on the part of
banks and other types of lending institutions has long played and will continue to play an
indispensable role in financing the economic activities of modern economies. For one thing,
although debt financing in the financial markets through the issuance of such instruments
as bonds and corporate paper has achieved significant efficiencies aided by the breadth and
depth of debt markets in an increasing number of countries, limitations apply.
150
• The front-end costs of issuing marketable securities still remains an obstacle to smaller
companies or entities wanting to incur debt in amounts below certain volume thresholds.
• While the financial markets often provide the most efficacious source of debt financing
for larger borrowers rated as investment grade, market appetite for assuming the credit
risk of both new issuers and financially-weaker issuers often means that the overall costs
of market-based financing are excessive for these issuers.
• To the extent that financial markets have tended toward more streamlined ‘covenant-light’
bond indentures for a variety of reasons (for example, based on speed, cost, standardis-
ation and so on), this tendency further raises the hurdles for new and sub-investment-grade
borrowers to access the financial markets.
• Companies which have private closed-capital structures and are sensitive to the kind of
information disclosure required of publicly-held companies sometimes are reluctant and
even unable in some cases to meet the reporting and disclosure requirements associated
with public issuance of securities.
The aforementioned limitations make institutional lending more attractive to many compa-
nies as a result. As part of their improved risk management practices, banks and other
institutional lenders have relied on loan syndication to an increasing degree, even though
this practice has been in existence over centuries.
With a tendency toward universal banking becoming the norm, direct lending repre-
sents a financial service which is increasingly being used as a key building block for
structured finance products. This means that loan origination and credit portfolio manage-
ment practices are being increasingly organised and implemented with a view to financial
institutions being able to extract value through fee income of various kinds. The speed at
which this happens seems to be decided by: (1) a country’s legal regime; (2) its macro-
economic stability; and (3) the breadth, depth and liquidity of its financial markets, especially
its debt markets.
At the end of 2007, the value of traded financial securities globally was of the order
of $165 trillion. With this as a point of reference it is instructive to examine the relative
importance of the main types of financial institutions as well as a few observations in connec-
tion with each.
Mutual funds. The year 1992 was an important year for mutual funds in the United States.
It was the year in which at about $2 trillion, the total volume of assets under management
(AUM) in mutual funds surpassed the value of US bank deposits. Today, the size of mutual
fund AUM has reached $26 trillion, of which about $12 trillion is in the United States.
Moreover, their investments span the globe and virtually all types of investment. In contrast,
M2, a monetary aggregate which includes money in circulation plus demand deposits, time
deposits and savings deposits in the United States is today just over $7 trillion.
The Investment Company Act of 1940 provided for the creation of three types of investment
company: (1) face-amount certificate company; (2) unit investment trust; and (3) management
company. The most common of the management company variety (a category which is
residually-determined as any type of company which is not one of the first two categories) is
the mutual fund company. Mutual funds are mostly open-ended. This means that investors enter
151
and exit through the creation of new mutual fund shares and the redemption of outstanding
shares respectively. This is a sharp distinction from the closed-end investment company with a
fixed number of shares which are issued and subsequently traded on a major exchange.
The mutual fund industry was the product of modern portfolio theory. It has been organ-
ised and indeed regulated with the express view in mind of allowing asset managers to work
with ‘beta’. Until some of the newer financial products (such as 130/30 funds (a fund which
assumes a 130% exposure to its ‘long’ holdings by selling short securities equal to 30% of
its net value) and certain types of exchange traded funds (ETFs)) were introduced which
allow mutual fund managers to avail themselves of certain alternative investment features,
the mutual fund industry was confined to taking long positions in traded securities. Since
portfolios with higher betas were synonymous with higher risk, this meant that active manage-
ment was the way in which managers tried to distinguish themselves from others in the
industry. Relative to the industry’s size, there are surprisingly few examples of mutual funds
which can consistently outperform the market with indeed most underperforming it after
the costs of operating their funds are deducted.
Other services, such as research, cheque account privileges, private pension manage-
ment and even online services such as cash management and bill paying features, have all
helped offset the performance issue. For many mutual fund customers, the ‘one-stop shop-
ping’ feature which these large companies offer them for their financial needs amounts to
a highly attractive draw. These companies also offer efficiencies through their enormous
capacity for internal ‘cross trading’, a capacity which has given rise in a number of instances
to them creating dark liquidity pools within a single ‘mutual fund family’ organisation (see
Chapter 2, under ‘Evolving characteristics of financial markets’).
While they offer daily liquidity, in comparison with other market-based financial prod-
ucts, mutual funds lack the immediacy that is now available in connection with trading in
the shares of many highly liquid ETFs and closed-end funds. Moreover, mutual fund redemp-
tions at the close of a business day can involve slippage that is hard to predict with any
accuracy as well. Furthermore, they are increasingly faring poorly in comparisons with ETFs,
for example, in terms of the transparency in connection with their dynamic portfolio manage-
ment and trading activities. And actively-managed mutual funds tend to at least complicate
(if they do not actually exacerbate) tax management for their retail investors. It remains to
be seen how much of an inroad competing products such as closed-end funds and ETFs
will make into the market space shared by mutual funds.
Pension funds and insurance companies. Worldwide pension fund AUM are currently esti-
mated to be in excess of $26 trillion. In contrast, insurance company AUM are currently
over $17 trillion. Together these institutional sources of finance comprise about three-
quarters of the global asset management industry (mutual funds, pension funds, insurance
and other investment funds). Because these funds involve assets which are managed so as
to meet either defined or actuarially-determined liabilities, management approaches tend to
differ from those applied in the case of mutual funds and other forms of investment company.
For example, liability-driven investment (LDI) techniques are pursued by many of the large
fund managers responsible for managing pension and insurance portfolios. The LDI approach
involves selecting assets on the basis of the liabilities (in terms of magnitudes and timing)
152
that the asset manager must meet rather than by funding asset-based strategies with liabil-
ities which minimise costs. There is an ongoing debate regarding the efficacy of such
approaches. However, to the extent that asset selection based on expected-value approaches
ignore, downplay or otherwise discount fat-tail extreme events, these institutions need to be
mindful of the potential for boom-bust dynamics to place additional stress on portfolios
chosen for their safety features instead of return maximisation.
Private equity (venture capital and buyout funds). In 2007, private equity investments in
funds are estimated to have exceeded $1.1 trillion. This reflects ample growth in this cate-
gory in recent years as increasingly larger buyout transactions (some as large as being in
the tens of billions of dollars) swelled total AUM for PE to its current levels. Recent devel-
opments which have complicated size estimates include tendencies: (1) for PE firms and
even some of their funds to open up their capital structures by listing on major stock
exchanges; and (2) for hedge fund and private equity firms to merge in the pursuit of symbi-
otic benefits. This has attracted attention in many quarters for stronger regulation of this
investment type.
Hedge funds. Although they started out as virtually clandestine entities operating under a
cloak of secrecy in a club-like environment as they managed private wealth for the very
rich, today’s hedge fund industry with AUM estimated at in excess of $1.5 trillion has
morphed into a very different institutional profile compared with its earlier one. As mentioned
above, many hedge funds have either acquired PE firms, PE firms have acquired hedge
funds, or global bulge bracket banks have both PE and HF (hedge fund) operations under
one corporate umbrella. These developments have made estimation of disaggregated PE and
HF AUM and even relevant performance indicators that much more challenging. As mentioned
above, mishaps in recent years (such as LTCM and Amaranth) which roiled the inter-
national financial markets have focused attention on the hedge funds so much so that several
countries, the US, the UK, and prominent continental European countries among them, are
contemplating legislation to tighten the regulatory control which their governments can bring
to bear on this form of investment vehicle.
Sovereign funds. As discussed above (see under ‘Global imbalances and its mirror image:
the rise of sovereign wealth’), the seemingly inexorable accumulation of reserves in oil-
producing countries and Asian countries following aggressive export-oriented policies is
giving rise to new institutional players in global finance. With a total of about $10 trillion
in reserves, surplus countries see these divided into those pools managed traditionally by
central banks for external trade and other balance-of-payments requirements (currently about
$7 trillion) and excess reserves managed separately either beyond the purview of a surplus
country’s central bank or at least ring-fenced within the central bank and managed with a
longer-term view (currently in a global aggregate amount in excess of $3 trillion). Some of
these funds will use a large portion of these resources internally within the owner country.
Others have a strong outward focus with a view to diversifying their investment holdings
out of the owner country’s national currency. In most, if not all, cases, the vast amounts
that these new institutional entities command mean that they have the potential to wield
153
considerable influence internationally. Considering that they are totally owned by their own
governments, the role these funds can play in the economic and political affairs of other
countries has raised concerns in a number of quarters. The fears regarding SWF misbe-
haviour which have been voiced are based more on identifiable risks than on past examples.
Whether or not the potential for abuse of power is translated into action remains to be seen.
However, in view of the vast amounts of resources that SWFs can mobilise to invest in a
single country or even project, the potential for aggravating if not precipitating financial
crises bears close monitoring.
Corporate governance paradigms

The role, duties and responsibilities of corporate board directors are weighty. As they pertain
to board directors at financial institutions, they are that much more so. While banking law
has evolved over many centuries such that most countries today are comfortable with the
behaviour expected of bank directors, many institutions in the field of financial investment
are relatively newer. US-style mutual funds, large pension funds, hedge funds, and closed-
end and exchange-traded investment funds were all creations of the 20th century. The
widespread popularity of some of them such as the ETF did not really happen until the 21st
century. Even if they have not all been recently introduced, the important point is that they
have morphed into larger and numerous participants in today’s financial markets, eclipsing
banks as the preferred repository of financial savings and wealth. Those who buy their prod-
ucts and services are many and are members of the consuming public. Or they are employees
of other related companies. In this connection, the usual representational role for board
members departs from the traditional corporate finance model. For example, in the case of
the typical real-sector corporation, board directors tend to focus their decisions on what is
best for the common shareholders to whom they owe a fiduciary responsibility (even if in
distress they are also obliged to act in the interests of the company’s creditors as well). In
the case of those financial institutions which are asset managers, the responsibility also is
fiduciary but it covers a broader sweep of stakeholder classes than in the case of the tradi-
tional corporation. Mutual fund directors are responsible for protecting consumers, who in
the case of this type of institution are the fund’s own investors. Pension fund directors are
responsible for protecting the interests of active members, deferred pensioners and benefi-
ciaries of the pension plan.
The concept of fiduciary responsibility can be subdivided into three broad categories:
governing, managing, and operating. This is particularly relevant in an organisational struc-
ture as can be found in most asset management institutions where, as mentioned above,
various functions are either contracted or are brought together in a network of relationships.
The paradox which bears explanation in the United States and the United Kingdom (as
well as parts of continental Europe) is how the grave lapses in overall governance and manage-
ment guidance, particularly as it relates to the market for structured finance products, of some
of the world’s top financial institutions could have occurred in two countries noted for being
global leaders in connection with their capital markets institutions and their associated gover-
nance structures. Banking laws in both of these countries have been used as models on which
much of the emerging world has based its legislation. Furthermore, the evolving legislation
154
and regulatory framework for the United States mutual fund industry has been considered
unrivalled internationally. In fact, the sharp organisational division of labour in the housing
finance market in the United States should have been able to draw upon the thinking that
went to framing mutual fund rules and regulations and moreover should have benefited from
that industry’s regulatory experience. Specifically, mutual funds function with very few
employees, relying instead on the outsourcing of nearly all of the functions involved in
creating and managing a family of funds, which is not too dissimilar from how home mort-
gage financing is conducted today. While there have been a few recent lapses in professional
behaviour in some of the mutual fund industry’s member firms, in large measure the industry
still remains for the most part a solid example of sound governance. Much of this has to do
with time-honoured industry norms and restrictions, such as the adherence to diversification,
restrictions against the use of financial leverage and the practise of disciplined rebalancing
of portfolios to maintain asset allocation strategies and choices of style.
Let us examine areas in which the quality of corporate governance is likely to undergo
scrutiny in future. The power enjoyed by board members is derived exclusively from joint
action. In contrast, the duties of individual board members are several. They can be broadly
categorised as:
• ensuring that director interventions and actions are guided by the principle of ‘acting in
bona fide’;
• ensuring that the conduct of director responsibilities is always executed in accordance
with ‘proper purpose’;
• identifying and avoiding situations which would impair ‘unfettered discretion’; and
• awareness (and proper handling) of potential ‘conflict of duty and interest’.
Board directors are of two types: interested and independent. Relevant legislation in coun-
tries with mature financial markets calls for a minimum number (determined as a percentage
of the total) of independent directors on a board. Independence means no affiliation with
the fund, its investment adviser, or its principal underwriter. Additionally, to qualify as an
independent director, an individual must satisfy a number of additional criteria.
Industry best practice includes the following.
• For those institutions with multiple funds, a movement away from individual fund boards,
each board with its separate slate of directors. Best practice entails either pooled (or
unitary) boards whereby the same individuals are directors for all boards of funds within
the family or complex or alternatively a clustered board structure whereby different groups
of individuals will serve as directors on all funds of a particular type within the family
(for example, one slate for all equity funds, another for all bond funds and so on).
• Independent directors comprise a majority (ideally two-thirds) of a fund’s board.
• Former officers or directors of a fund’s investment adviser, principal underwriter or other
service providers are not included as prospective independent directors.
• Individuals to fill independent director slots are nominated by a board’s incumbent inde-
pendent directors and independent directors choose one or more ‘lead independent
directors’.
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• Fund directors are invested in the funds on whose boards they serve.
• Fund boards adopt policies on the retirement of directors.
• Fund directors evaluate the board’s overall effectiveness from time to time.
• Independent directors have qualified investment company counsel, independent of the
fund’s investment adviser and other service providers and they have express authority to
communicate and consult with the fund’s independent auditors and other experts.
• Mechanisms are in place, such as a required annual questionnaire, for monitoring the
continuing ‘independence’ of each independent director in terms of his or her relation-
ships (including possible relationship changes affecting their immediate families) with
their funds’ service providers and their affiliates.
• Boards have adequate insurance coverage for directors’ and officers’ errors and omissions
and/or indemnification to ensure the continuing independence and efficacy of its inde-
pendent directors.
• Independent directors establish the appropriate remuneration for serving on fund boards.
• All new directors receive orientation regarding their funds and are expected to remain
up to date in connection with industry and regulatory developments.
Both regulatory requirements and industry practices call for high levels of care and skill
being exercised on the part of board members. The question naturally arises as to whether
(or at least to what extent) this was the case regarding the boards of directors of those
companies and financial institutions which were hardest hit during the ongoing credit crisis
in the United States and Europe. It certainly involves the issue of whether or not risk manage-
ment, for all of its apparent sophistication, needs to be revisited in terms of appropriate
board oversight. While risk management functions and board oversight were probably effec-
tive in connection with assessing and managing market risk for a range of market outcomes,
weaknesses would seem to have existed in connection with their treatment of operational
risk (the moral hazard and fraud issue), outlier risk, and liquidity (both funding liquidity
and market liquidity) risk. It seems safe to assume that these areas will receive much closer
scrutiny by the boards of financial institutions going forward.
Thoughts on powershift
John Gage is credited with the term ‘the internet is the computer’ in the 1990s, which may
have seemed a little too philosophical at the time until the proliferation of just about every-
thing with an online version made its meaning patently clear. In similar fashion, the information
revolution (or better yet, explosion) did to the investment banks what the web did to the
personal computer. Just as economic and political power based on information shifted from
computational speed to ubiquitous access, financial market information – ranging from basic
price discovery to macroeconomic, sector and technology assessments – became available to
just about anyone. The upshot was that those who wished to trade or invest in the financial
markets needed the investment banks less and less. While new issue underwriting remained
a core business, many of the stock broking and financial advisory functions which had been
so lucrative in the past no longer could compete with the discount and online services which
had been sliced, diced and repackaged in a variety of ways by new economy firms, many of
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which had the luxury of not having to cover the overheads to which the bulge-bracket banks
now found themselves fettered. Straightforward banking waned steadily in terms of profitability.
To compensate, major changes were essential.
Consequently, in this environment, the quest for economies of scale and scope became
relentless. To the extent that proprietary and client trading were principal activities, it meant
that the sizes of individual exposures mushroomed beyond anything that was imaginable in
the industry prior to the latter part of the 1990s. The stakes became high as globally-
operating financial behemoths set their sights simultaneously on larger market shares and
wringing out the last nickel on every transaction. This trend not only increased the size of
securities transactions but became an engine of growth for high-octane derivatives. One such
market was the swap market for debt instruments denominated in different currencies and
with different bases for calculating interest. The first such commercial swap had been trans-
acted by the World Bank and IBM in 1970. By 2007, the international swap market topped
$300 trillion. The other major market which exploded onto the scene was the market for
credit derivatives, which took the plain vanilla swap and added some highly attractive features,
allowing them to fuel the newly burgeoning international securitisation phenomenon. A later
arrival on the financial landscape, the credit derivatives market went from about $900 billion3
in 2000 to over $45 trillion by end-2007.
The opportunities for carry trades which these markets spawned became to a large extent
self-realising. The institutions needed to transact the volume to cover the fixed costs of their
global infrastructures. Normally, economics courses teach that finance is derivative to real
capital formation. At some point, however, the largest institutions engineered a decoupling
of this relationship in a self-serving, even if survivalist, tendency to grow the market for
new financial product. While, without a doubt, various real sector booms can lay claim to
some of this growth in both financial securities and derivatives, there was another feature
of structured finance which helped turbo-charge its growth. That was the cannibalistic aspect
of issuing structured finance securities which include securities of similar structures of the
past. Many of the collateralised debt obligations (CDOs) since the late 1990s have to varying
degrees collateral pools comprising tranches of securities issued against similar structures
of slightly older vintage. In a number of cases the tiering even involved multiple layers. In
essence, because of the complexity of an increasing number of structured finance deals on
the sell side and as well as the matching complexity and size of relative value plays on the
buy side, the previous sharp dichotomy between what were securities and what were deriv-
atives was becoming increasingly obscured. From a risk management standpoint, the
ramifications were that not only was the traditional financial disclaimer that ‘past perform-
ance was no indication of future returns’ applicable but indeed that current structures
contained risks not even contemplated in many cases in past structures. At the macro-
economic level, it also meant that ratios of financial activity to real activity reached
unprecedented heights. The manifestation of this delinking was that as the housing boom
lost impetus, with first residential real estate values levelling off followed by the
multiplicative impact on new home sales and housing starts with escalating foreclosures
not far behind, the implosion within mortgage-backed securities was magnified to the
point of threatening the viability of numerous large financial institutions on both sides of
the Atlantic.
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Current developments in financial markets

In this section, we will examine some of the recent and ongoing developments which are
or will be instrumental in shaping global financial markets.
Fund shares (from mutuals to corporatisation through ETFs). Whether it is mutual soci-
eties, partnerships or proprietorships, a discernible trend is evident. The tendency is toward
the corporate form and transformations of older organisational forms into corporate form
are increasingly under way. It affects a diverse array of institutions whether it be stock
exchanges, venerable investment banking partnerships (for example, Goldman Sachs), hedge
fund firms and private equity firms, or mutual fund conversions to exchange traded funds.
Derivatives desks (from OTC to organised exchanges). Increasingly, financial derivatives

will be offered on organised exchanges. As this transition occurs, many of the problems of
transparency, price discovery, and liquidity experienced in the OTC market can be expected
to be resolved. Additionally, the margin and trading discipline enforced by major exchanges
can be expected to introduce risk-mitigating features to this market.
Trading. Trading in securities and derivatives has experienced a veritable explosion. The
main issue going forward is whether or not the growth witnessed in recent years can be
sustained. We have seen the tyranny of choice with regard to consumer products. For example,
at the risk of hyperbole, it seems that there are almost as many choices of breakfast cereal
as there are investment styles, alternative hair products as there are investment fund choices,
and models of running and athletic shoes as there are hedge funds. The commercial in-
genuity this reflects has been hailed as progress. It ignores, however, a fundamental fact. That
is, that there is only so much output to generate the disposable consumer income to buy all
of these things. At some point market success has to become zero sum – that is share of
wallet can only be captured at the expense of someone else’s loss. Furthermore, ballooning
measures of financial depth (ratios of financial assets to real GDP) have demonstrated the
boom-bust dynamics inherent in the fact that there are only so many ways that real output
can be shared irrespective of the creative ingenuity reflected in financial products. For
example, the number of mutual funds available to investors in the United States is an integer
multiple of the number of companies registered for public trading on the nation’s stock
exchanges. And, of course, the open interest in financial futures and options contracts at
any point in time is represented by an even higher multiple of the available underlying
assets. As the combinations of potential and actual multi-leg trades proliferate, this suggests
that at some point the resources available for investment become spread thinly across a
multitude of choices with the result that not all can enjoy the liquidity that was presumed
at their creation.
Dark pools. We have already dealt with the matter of dark pools of liquidity in connection
with trading in financial securities. As energy and commodity prices continue to balloon,
public attention is increasingly focusing on a more sinister dark pool. That is the trading
in energy derivatives enabled by the ‘Enron Loophole’. Freewheeling speculators – mostly
hedge funds and the specialty trading desks of some of the largest of the bulge-bracket
158
global banks – have been able to amass enormous gains through unregulated trading in the
global energy derivatives market. It all came about in 2000 when the United States Congress
passed the Commodities Futures Modernization Act with language which effectively removed
the word ‘energy’ from previous legislation which had established the eligibility criteria and
rules of conduct for participating in agricultural and energy derivatives trading with regu-
latory oversight provided by the Commodities Futures Trading Commission. Some observers
attributed this change as a political concession to Enron, the now defunct energy trading
company, which wanted to develop an electronic trading platform for trading energy deriv-
atives. It also spawned the creation of InterContinental Exchange (ICE), which is a
London-based unregulated electronic platform where trades are neither regulated nor reported
and lack the disciplined approach to margin found on regular international futures and options
exchanges. Because of the opacity of energy derivatives trading, precise data are not easily
available. However, some industry observers have estimated that as much as 75% of all
energy trading is unregulated.
Theoretically, commodity speculators can play a benign role by anticipating imbalances
between supply and demand and helping to ease the path to adjustment. However, this is
the case for economies and markets which are relatively stable and functioning at near equi-
librium. The situation during major economic dislocations, with economies functioning in
regions further removed from fundamental equilibrium, involves the financial equivalent of
throwing fuel on the fire. The resulting turbulence from powerful speculation interposed
between demand and supply throughout the supply chain has every potential for increasing
market fibrillation leading ultimately to financial market distress. With regard to the prospects
for reining in the power of today’s energy speculators, unfortunately, it may be that the
genie is already out of the bottle. The dilemma for legislators in the United States (or any
other country for that matter) is that even if they manage to close the regulatory loophole
through amendatory legislation in their own country, it is not clear how effective this would
be in terms of curbing what has since become a truly global business conducted largely in
cyberspace.
Carbon credits. Since the Kyoto Protocol, an international agreement on climate change,
was adopted in December 2007, some 170 countries, covering over 60% of global emis-
sions of carbon dioxide and greenhouse gases (GHG), are signatories. In general terms, the
purpose of the agreement is to elicit commitments from signatory countries in connection
with emissions reduction targets and their subsequent increases over time. Developed coun-
tries have more demanding targets while developing countries have less demanding targets
or are free from limitation in a number of cases. The idea of including ‘flexible mechan-
isms’ prominently featured an international market-based system by which countries can
purchase GHG emission reductions from financial exchanges, from projects which reduce
emissions in developed signatory countries under the agreement’s Clean Development
Mechanism (CDM), from other developed signatory countries, or from developed signatory
countries with excess allowances. This system has been defined as a ‘cap and trade’ system
that imposes national caps on developed country emissions. Most countries translate these
caps into sub-targets at the level of individual entities such as pulp and paper mills or power
generation plants.
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Financial investors are key participants in this system since emission allowances and
carbon credits are in fact tradeable instruments with transparent market-determined prices.
These instruments can be bought for speculation purposes on the spot market or can be
linked to futures contracts. Trading activity in connection with allowances and carbon credits
promotes price discovery and liquidity, sending valuable price signals which help businesses
plan their real investments. It is a market which has grown significantly, involving major
financial institutions and private traders in what in 2007 was estimated as a $60 billion
business.
The agreement runs out in 2012 with negotiations under way for a subsequent recom-
mitment period. It has its critics as well as its proponents. For example, the United States
and Kazakhstan were the only two signatory countries not to have ratified the agreement at
the end of 2007. Criticisms have been levelled at the realism involved in some of the targets
and caps which have been established under the framework. Clearly, this has had the poten-
tial for distorting valuations in a market-based system. Moreover, it is misleading to speak
yet of a single market for carbon credits as what has emerged instead are parallel efforts
with linkages of varying degree. For example, Kyoto has enabled several developed coun-
tries to join force in creating sub markets, of which the European Union formed the first
such grouping. In January 2005, the European Union Emissions Trading System (EU ETS)
was launched.
Because of the relative newness of the agreement and the added reality that registra-
tion, certification and preparation of real investments all take time, most transactions in the
carbon credit markets to date have been forward transactions involving purchases made at
discounts. Moreover, non-Kyoto carbon markets have emerged or are expected to be in effect
imminently. Industry participants tend to be sanguine regarding the prospect for these various
parallel markets to integrate eventually into a single carbon market. However, despite the
growing importance of the issue of global climate change, progress in this connection is
not without various types of associated risk. From the viewpoint of increasingly global and
interconnected financial markets exhibiting tight coupling, anything which adversely affects
carbon credit valuations and market liquidity must be viewed in terms of the potential to
transmit such disruption (and possible distress) to other segments of the financial markets.
1
Levine, R., and Schmukler, S., Internationalization and Stock Market Liquidity, NBER Working Papers 11894,
National Bureau of Economic Research.
2
Crane, Froot and Mason (1995, p. 4).
3
Tavakoli (2001, p. 5).
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Part 3
Lessons for policy-makers

and portfolio managers
Chapter 7
Lessons from financial crises for

policy-makers
Thoughts on contagion
A variety of views exists among economists as to what defines contagion and how to deter-
mine if it is in play. The behaviour of asset prices in the countries where contagion is
suspected is clearly one area on which observers have focused. Some believe that conta-
gion occurs when the volatility of financial assets in one country leads to higher volatility in
another. Another group asserts that contagion occurs when a stronger than usual co-movement
occurs between a number of economic and financial indicators in two or more countries.
These indicators include, in addition to asset prices, such quantities as capital flows, interest
rates and exchange rates. Yet another view involves focusing on the mechanism by which
these fluctuations are transmitted from one country to another following the onslaught of a
financial crisis in the country that was first to experience the distress. The main explana-
tions of how contagion is transmitted seem to be grouped into price effects, income effects,
and financial linkages with the latter exerting influence either through information, distress
or both. Countries with large macroeconomic imbalances tend to be more vulnerable than
others. Countries which are dependent on the same large international and highly-leveraged
lending institutions often exhibit symptoms of financial contagion after a financial crisis
unfolds in the first country among them. Additionally, contagion tends to spread globally
once developments have a significant impact on asset prices in the major international finan-
cial centres (such as New York, London, Hong Kong). Until that happens, signs of contagion
tend to be confined geographically.
Among the lessons learned are the following.
Packaging pain
Where significant inflation is a problem, an exchange-rate regime based on a commitment
to a crawling-peg adjustment (one type of exchange-rate anchor) can be a practical approach.
But if the volatility which such an arrangement mitigates is only the first wave, followed
with a lag by shocks or other factors which produce further volatility, then the main risk is
that the initial success can produce a complacency which may make the country even more
vulnerable. Let us be specific. In most cases, the policy response package will include several
measures in addition to the exchange-rate mechanism. Some of these will no doubt be
painful. Decisions to raise tax rates, to impose new taxes and to reduce public spending are
but a few clear examples. Even if the financial authorities enjoy the decision-making
autonomy or have been successful in selling the broader public on the need for some harsh
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Part 3: Lessons for policy-makers and portfolio managers
medicine, political pressures will mount to ease the severity of the measures if early results
suggest that most of the danger has passed. The main advice is as follows.
• Undertake a comprehensive assessment of the likely full extent of the crisis as well as
‘worst-case’ scenarios in conjunction with the emerging crisis and the various policy
responses being contemplated.
• Make sure a fair and even-handed portrayal of the risks is communicated clearly and in
a timely way to those who need to know.
• Ensure that both monitoring systems and decision-making systems suitable to the gravity
of the situation are in place before embarking on implementing the policy response.
• Have a few ‘fall-back’ measures to rely on in case that either (a) political pressure to
ease off becomes too strong to resist, or (b) the severity of the crisis becomes greater
than expected.
• Be prepared to stay the course, paying due regard to the importance of sound commu-
nication.
Financial liberalisation
Policies and actions aimed at liberalising the domestic financial markets and opening the
capital account to free capital flows should be undertaken only after adequate measures have
been put in place to strengthen key financial sector institutions (particularly the capital
adequacy of the country’s main depository institutions) and implement a solid prudential
system.
Liberalisation of capital flows should be based on thorough consideration of the appro-
priate sequencing in connection with the eligibility criteria for opening share ownership to
foreigners and the extent to which foreigners may obtain controlling positions in the owner-
ship of the country’s key financial institutions. Moreover, freeing capital movement should
not just be for incoming capital but needs to make provisions for ease of dividend and
capital repatriation as well.
Liberalising and modernising domestic institutions should not be limited to the finan-
cial sector. Reforms in other markets should if not precede outright then at least parallel
those in the financial sector. Legal reform should permit the clear recognition, as well as
facilitate transfer, of property titles, including those associated with intellectual property and
should assign priority to laws pertaining to real estate ownership and transfer, collateral to
secure borrowings, foreclosures, and bankruptcies. Additional effort should be focused on
the institution building needed to support efficient markets for major commodities and key
goods and services.
The completeness of policy packages

A policy response package needs to be viewed not as a collection of measures or instru-
ments which are independent of one another but as an ensemble with a significant degree
of coupling. This means that due regard should be paid to whether or not all essential
components are present and to obvious precedence relations. For example, in a country
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Lessons from financial crises for policy-makers
which opts for a currency-board arrangement, fiscal discipline needs to be in place if not
before then at least at the outset. Failure in such a case (which includes failure to rectify
the situation as expeditiously as possible), as evidenced in Argentina, means that it becomes
simply a matter of time before the automatic adjusting feature of the currency board becomes
unsustainable or worse.
If it can be seen or argued that such interrelationships among policy instruments are
not present, then the package cannot be considered to be a cohesive or defensible ‘programme’
but rather a hodgepodge or ‘Christmas tree’ of actions. Examples can be cited in which a
comprehensive economic programme of a certain number of policy actions was announced
in the press only to be followed by news updates suggesting that the programme would go
forward minus one or more of the actions. If the programme as originally announced made
sense (that is, was structurally ‘indecomposable’), then the failure to act on some of its
components should imply either a rendering of it to be unviable or alternatively significantly
less beneficial in its impact. On the other hand, if such a news update either states or implies
that the programme can deliver essentially the same outcome as was anticipated before the
removal of some of its components, then the original design can only be deemed to have
contained questionable redundancy.
When countries develop financial crises, traditionally the main concern has been to
stabilise the economy – generally meaning to prevent an escalation in inflation and unem-
ployment – until the overall economy can grow again. In many smaller economies with high
propensities to import goods and services from the outside, currency depreciation is seen
to contribute to domestic inflation.
Macroeconomic challenges in smaller economies

Historical review of financial crises shows that even as the domestic currency was depreci-
ating, inflation would often distort relative (real) price signals resulting in continued reliance
on imports. If the country was primarily an exporter of raw materials or of other exports
having characteristics which may have prevented total export proceeds from growing as fast
as total expenditures on imports, then domestic currency depreciation would often worsen
rather than resolve the structural imbalance between domestic and external sectors.
Furthermore, the extent of the country’s external indebtedness in foreign currency had a
significant bearing on whether the currency depreciation would improve or aggravate its
economic situation as well.
As emerging-market countries opened their capital accounts to the exterior in terms not
only of direct foreign investment but portfolio investment as well, beginning rounds of depre-
ciation would stoke speculative fears causing foreigners and nationals alike to flee the
domestic currency through capital outflows. The resulting impact was often as not faster
and more brutal than the impact on the economy from trade adjustments alone.
The policy instrument to achieve the necessary stabilisation favoured by many orthodox
economists, particularly within the International Monetary Fund (IMF), was the domestic
interest rate. The argument was that an increase in domestic rates was needed – relative to
international rates (where very often benchmarks like US Prime or Libor were used) and
also relative to the current and anticipated rate of currency depreciation – in order to
165
encourage foreign investors to invest in the country and domestic investors to keep their
money in the local currency. Moreover, higher domestic rates would discourage total spending
(or ‘absorption’ in economic jargon, which includes both expenditures on consumption as
well as on real investment). These two effects would often be enough to slow appreciably
the rate of depreciation in countries which did not have a fixed-exchange rate mechanism.
In countries committed to fixed exchange rates, it stanched the haemorrhage of reserves
needed to defend the currency against speculative attack.
Of course, the resulting belt tightening usually had a depressing effect on the country’s
economic growth until individuals, businesses and institutions (both foreign and domestic)
started to appreciate and act upon the new economic opportunities available under a more
stable domestic economy. If the size of the increase in interest rates needed to achieve this
stabilisation was too large and too onerous to stabilise and foster growth in the economy,
then quite often the economic authorities in the country would first implement a maxi-
devaluation before setting relatively tight monetary policy variables in order to give the
programme a chance to work. This, it was argued, was preferable as a one-time shock to
the economy with ameliorating policy actions taken simultaneously or very soon thereafter
to prevent a loss of the confidence that was needed to keep financial capital within the
country. Allowing the status quo, it was further argued, would inexorably erode public con-
fidence in the economy and the domestic currency through a vicious circle and downward
spiral in the value of the currency and key economic variables without a clear view where
exactly would be the new and significantly-lower equilibrium point.
Considerable controversy has accompanied such policies. Because they have often been
implemented at the encouragement or at least with the quiescence of the IMF, they have
often been identified in the press and the economic literature as typical IMF policy pack-
ages, often with critical admonishments that they tend to represent a ‘cookie-cutter approach’
applied with a ‘one size fits all’ mentality. Such criticisms may well contain a kernel of
truth. After all the IMF has itself adjusted its policies over time based on positive intro-
spection. On the other hand, many of the arguments calling for significant deviation from
such prescriptions often are based on frustration arising from mistrust of the national
economic authorities or represent well-meaning if misguided concern for the impact of such
programmes on disadvantaged groups. By saying ‘misguided’, it is meant that in many cases
the benchmark against which the adverse impact is measured is taken to be the status quo
rather than a harsher set of measurements associated with an economy in freefall. While
this is not always the case, prudence strongly argues that neither advocates of orthodox poli-
cies nor their opponents be given a free pass without being required to ‘do their homework’
and defend their claims.
In this context, if orthodox economic policies are to be convincingly taken to task, it
should be on the merits of a balanced comparison with the alternatives. In this connection,
a distinction is appropriate between those deficiencies of a distributional nature and those
of a systemic nature. In simpler terms, if an economic programme entails a policy package
which stabilises an economy and allows it to grow but its policies inflict significant hard-
ship on certain segments of the population which in society’s view deserve protection (such
as the poor, the elderly and children), then the deficiency of the programme is called ‘distri-
butional’ (it ‘distributes’ the costs and benefits of a programme which is successful in
166
providing the desired macroeconomic stabilisation and stimulus in ways questioned by society
precisely because of their ‘distributional’ impact). On the other hand, an economic programme
which has deficiencies of a ‘systemic’ nature is one which fails even to provide the requis-
ite stabilisation and subsequent stimulus (or does so only at an exorbitant cost) irrespective
of its distributional impact.
In fairness, policy packages based on orthodox macroeconomic prescriptions which have
been applied to financial crises in many countries have actually worked in quite a few cases.
It should be noted, however, that in those countries where these policies were the most
effective, structural problems were usually the cause of factors which lie outside of the
financial sector or its institutions. The burden of adjustment would consequently be spread
across many people, businesses and institutions. To the extent that certain groups deemed
to be vulnerable and particularly at risk were expected to suffer excessively, other elements
of an economic programme would often be introduced. Many of these measures are often
called ‘heterodox’ measures as they involve significantly more selective government inter-
vention in the working of the economy than a strictly ‘orthodox’ view would call for. For
example, policy actions to either introduce or to bolster the ‘economic safety net’ to protect
the poor, the elderly, or other disadvantaged groups became quite common in both IMF and
World Bank operations contributing to a country’s economic programme to address a finan-
cial crisis.
Certain economic programmes (including some sanctioned by the IMF) can be faulted
for having failed on systemic grounds in countries in which financial institutions have been
severely weakened prior to introducing the kind of policies of austerity described above.
The reason for this is that the policy actions justified to defend a beleaguered currency so
as to avoid capital flight tend to threaten the viability of financial institutions suffering from
combinations of nonperforming assets and highly levered capital structures. When these
institutions either are or include among their number commercial banks operating domesti-
cally, at risk is not only investors’ stakes in these institutions but the country’s very payments
system itself on which all sectors ultimately depend.
Tight money and financial weakness

Let us take a moment to examine the pressure points on which tight monetary policy, espe-
cially higher interest rates, exert their influence on weak financial institutions and ultimately
the economy.
First, higher domestic interest rates impose an additional cost on domestic producers.
If a certain number of them are already having financial problems resulting in late or failed
debt servicing payments, then higher interest rates can quickly aggravate this situation. It
is not just a matter of the higher interest payments alone. Higher rates and signs of finan-
cial impairment on the part of business borrowers can induce suppliers of short-term credit
to stiffen credit terms or remove access to credit by refusing to roll over short term financing,
as one example. Such hardship can quickly augment the quantity of contractual debt ser-
vicing payments falling due which are not met. Moreover, as this phenomenon tends to be
pervasive, affected business borrowers can experience declines in sales, ageing in their
accounts receivable, increases in their own accounts payable, or combinations thereof, as
167
their own customers similarly experience financial contraction. Consequently, many firms
will feel the credit crunch in terms of reduced sales and incoming cash flow as well as in
their cost structures. Moreover, if a country has foreign indebtedness with foreign-currency-
denominated financial obligations falling due in the very near or short term, then it takes
very little to nudge the sentiments of investors (foreign and domestic) enough to precipi-
tate a flight of capital based on a sudden loss of confidence in the country’s ability to service
its foreign debt.
If companies are already showing signs of financial distress at a fixed exchange rate
and then additionally have to face the prospect of inability to meet their debt-servicing obli-
gations because of higher domestic-currency-denominated debt service payments due to both
higher domestic interest rates and a depreciation in the exchange rate, then even the slightest
deceleration of net capital inflows can give rise to a self-fulfilling currency crisis caused by
capital flight. To the extent that much of the private sector indebtedness is associated with
companies which produce primarily for the local market yet have foreign-currency-
denominated indebtedness, this intensifies the aforementioned risks. This is because when
local banks on-lend foreign borrowings to non-exporting domestic clients in loans denom-
inated in the same currency, this is to avoid the risks of currency mismatches on the banks’
balance sheets. But such actions do not eliminate or even necessarily reduce lending risks.
They substitute risk whereby the banks avoid currency risk by assuming credit risk. If, on
the other hand, most of the private-sector foreign indebtedness is that of exporters, the posi-
tive effect of currency depreciation in enhancing their international competitiveness becomes
a mitigating factor.
To the extent that a sufficient number of local banks’ borrowers are experiencing the
same hardship and have caused the banks’ NPL portfolios to swell beyond a certain threshold,
then the banks and other lending institutions have coping mechanisms which tend to further
exacerbate the problem. They do not necessarily stop making credit available to all their
customers. Instead they ration it to those larger and more important clients who are still in
sound financial health. They do this in order to contain the infection rate of nonperforming
loans. In some cases, they may even raise lending rates to preferred customers to help
compensate for the erosion being felt through rising NPL ratios. Frequently, however, such
a move can exacerbate the problem as it is likely to lead to adverse selection. This means
that the only customers who are willing to accept the higher rates are those with potential,
but likely as-yet-undetected, weaknesses. After all, the clients with solid credit ratings will
seek other cheaper sources of finance. Adverse selection, operating most likely with a lag,
will without too much delay contribute to higher NPL ratios.
Alternatively, some banks may in desperation take to ‘evergreening’ the accounts of
their best but troubled customers. In a full-blown crisis, however, this often amounts to
nothing more than placing larger bets which postpone the time at which the critical reck-
oning takes place. Usually this is because the gravity of the customers’ problems are not
strictly cured with an extension of time but become structural instead, leading to insolvency.
However, this practice magnifies the severity of the adverse impact when subsequent rounds
of debt rollover reach some critical point, simply because too much good money has been
thrown after bad. In countries with sound banking legislation and regulation, the practice
of evergreening is no longer as blatant as it used to be in the past. But the test that proves
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the rule is not what happens under normal conditions but rather during the rare events when
entire financial systems in a country are in a state of distress.
As banks and other lending institutions start to feel the stress of a major credit crunch,
they find that they need to resort increasingly to interbank borrowing/lending. How this
unfolds during a major financial crisis, however, depends on the extent to which the sover-
eign either explicitly or implicitly guarantees or backs the senior obligations of the country’s
depositary institutions. To the extent that they are willing to do so, it is usually justified on
the grounds of protecting a key component of national infrastructure – the country’s payment
system, without which a considerable amount of commerce totally breaks down. However,
if the sovereign is not prepared to cap this liability, then the coping mechanisms of banks
attempting to either postpone or hopefully elude the inevitable can swell this liability out
of proportion to the country’s fiscal capacity. The resulting budgetary impact if the sover-
eign then stands behind its banks can very easily precipitate a sudden loss in international
confidence in the country’s ability to maintain economic and currency stability. Such was
the case in Sweden in 1992, when the country’s prime rate spiked at close to 50% a year
in a country that had not known inflation other than in the low single digits.
On the other hand, the economic authorities can ‘intervene’ the banks, as they did, for
example, in Chile in 1983. While this can avoid wholesale acceptance of the banks’ liabil-
ities on the part of the authorities, at the same time it affords the government control of
daily decisions regarding the priority to be assigned to bank obligations. Bank intervention
has certain advantages but also has its disadvantages. It tends to be conducted more along
the lines in which a corporate receiver would handle a failing company. In other words,
decisions are taken to effect an orderly liquidation of the most pressing liabilities and along
with them the assets. It does not contemplate activities aimed at stimulating the growth of
the bank’s business nor even necessarily a commitment to running it as a ‘going concern’.
The appropriate role for fiscal policy at the outset of a financial crisis is another contro-
versial topic. While the fiscal austerity envisaged by the IMF in connection with Mexican
(1995), Russian (1998), and Brazilian (1999) programmes was generally accepted as being
appropriate, similar conditions applied to Thailand, Indonesia and Korea met with signifi-
cant resistance both from the economic authorities of those countries as well as from local
business interests. As it happened, even the IMF recognised the need for rethinking the
appropriate fiscal stance after a brief period into the programme, after which it targeted
fiscal ease. What had not been contemplated was the sharpness with which international
capital would recede from these troubled countries and the resulting drop in imports. What
had happened at some point during the 1990s was that the world had gone from one in
which international capital flows were primarily in the form of official flows and private
direct investment (that is, mostly multinational corporations building factories in what then
were called ‘third-world’ countries) to one in which most, if not all countries, became highly
interconnected by flows of private portfolio capital in the form of banks loans to foreign
companies, international bond and share issues, and a relatively new breed of investment
funds which would channel private capital into primarily equity investments in what came
to be known as the ‘emerging market’ countries.
The consequence of the associated removal of many of the frictions and rigidities which
had kept these latter types of capital close to home was that investor reactions to many
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national level policies which in the past had been strictly a ‘domestic matter’, became in
some cases a strong countervailing force to the expected domestic response. For example,
fiscal austerity used to be an appropriate measure to help curb overheating of an economy
characterised by excess demand. With the involvement of large international investors in
emerging market countries, a sudden change in the sentiments of these investors – such as
fears that IMF-sanctioned government policies might be recessionary and depress their invest-
ment returns – could easily of themselves precipitate an exodus of capital with an even
faster and more virulent adverse impact than that which they anticipated. In short, the inter-
national investors’ actions could staunch spending drastically (both domestically and on
imports) to the point of precipitating a recession and financial crisis that the measures were
intended to mitigate through a self-realising dynamic process.
Thoughts on orthodox and heterodox economic policies

An analysis of post World War II financial crises would not be complete without looking at
the roles played by the two main Bretton Woods institutions – the IMF and the World Bank.
These institutions were created at the end of World War II by way of a meeting of the
major powers in Bretton Woods, New Hampshire (including 44 allied nations and one neutral
country – Argentina – with the United States and Britain in leadership roles, each of these
two countries with a multilateral economic plan for the group to discuss). The mandate of
the IMF was to foster the stability of international exchange rates.1 That of the World Bank
(or officially, the International Bank for Reconstruction and Development) was to finance
the reconstruction of Europe after having been devastated by the war. After no more than
a few years, the World Bank began to extend its activities beyond Europe. It made its first
loan to a developing country, Chile, in 1948.
With time, the mandates of the two institutions came to overlap partially. This was
because the World Bank’s board of directors (which in terms of membership is essentially
the same as the IMF’s board) came to recognise that the prospects for the success of the
development projects brought to it for financing would be that much greater if the recip-
ient country were to follow sound economic policies. Naturally, encouraging sound economic
policies was a cornerstone of the IMF’s activities to ensure a stable set of international
exchange rates and prices.
It was not long before many economists both in the developed countries as well as in
the less-developed recognised that there were many features of developing-country economies
that simply did not work the same way that they did in the economies of, for example, the
US and the UK. Development economics, therefore, became a more respectable discipline
as a consequence with the World Bank’s research department leading the fray in analysing
the statistics from its member countries to show the kinds of special action that was needed
on the part of economic authorities in those countries to make things work.
It should be remembered that with the advent of the mainframe computer and the concur-
rent development of certain quantitative tools in applied economics such as the input-output
tables for national economies, even mainstream economics in the developed countries was fairly
tolerant of government intervention. After all, one of the Bretton Woods founders, John Maynard
Keynes, had espoused policies applied by the Roosevelt administration in the US that was
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instrumental in getting the US out of the global depression of the 1930s. Similar influence had
been applied and felt in the UK and Europe as well. Additionally, the US had mounted massive
programmes of ‘planned’ assistance, based on government intervention in Europe (via the
Marshall Plan) and in Japan during the Reconstruction Period following the armistice.
Outside London and New York, if major works were to be undertaken, there were no
reliable financial markets to play the role of financing them. Major things worth doing called
for direct government action. Thus in the early days of the Bretton Woods institutions, it
was considered natural for governments to invest in and indeed to operate businesses as
diverse as textile mills, steel mills, airlines, and even travel agencies. This left the roles of
the Bank and the Fund reasonably unambiguous with a reasonably clear division of labour.
Policy evolution
A confluence of factors subsequently gave rise to what came to be known as a distinction
between ‘orthodox’ approaches to national economic management and more ‘heterodox’
approaches. The entrenchment of the Cold War from about the late 1940s onward was
accompanied by harsh mutual antipathy between capitalistic (or ‘market-based’) and social-
istic approaches to economic management. The more nominalist views of the West were
that by protecting individual rights and freedoms, governments should be limited in the
extent to which they could determine what was good for people. This is all relative, of
course. It was never that the western governments were totally ‘laissez-faire’ in their orien-
tation but rather that they felt compelled to respect the interests of the large owners of
capital in their countries. In contrast, the Soviets, the Chinese, and all the countries which
became Second-World satellites, having either killed or forced into exile their capitalists,
felt no such compunction. Moreover, communism (an extreme form of socialism) envisaged
the need to exert control over most, if not all, aspects of economic life in the name of the
greater good. In short it was a system based on a very high degree of economic interven-
tion, not to mention control in the political, cultural and philosophical spheres as well.
Many of the countries in Asia and Africa (and indeed some in Latin America from time
to time), which were members of the Bank and the Fund, also leaned towards socialism
and communism to varying degrees. In fact, many of them coalesced to form the Association
of Non-Aligned Countries, which basically meant that they did not want to be formally
recognised as being either pro-West or pro-Soviet. In this way, they were able to keep their
options open regarding who they received aid from but tended definitely to operate mixed
economies (that is, they ran their economies with a significant degree of government direct
intervention combined with a market economy operating for some goods in some sectors).
For the Bretton Woods institutions to function, some element of compromise was deemed
necessary if not inevitable. The influence of the largest shareholder, the US, backed by the
UK and often Japan as well as some of the western European countries and Canada, made
sure that the economic principles being applied adhered to a significant degree to at least
much of the orthodoxy inherent in sound macroeconomic management.
In the early years, the Bank financed many of the large business enterprises undertaken by
national governments because this was the most reliable way it could obtain the sovereign
guarantee needed to back its term loans. As an increasing number of prominent western (and
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western-trained) economists served in the institution’s upper echelons, the Bank’s policy
orientation underwent perceptible change. In the early 1980s, in line with a slogan exemplifying
the new policy orientation which could be summed up as ‘Get the prices right, and the rest will
follow’, the Bank ramped up its efforts to have borrower countries implement economic reforms
which were much more free-market oriented rather than ‘dirigiste’. Trade liberalisation was
encouraged. Financial liberalisation was encouraged. Privatisation of public sector enterprises
(PSEs) was encouraged. And the vehicle to achieve this was the policy-based lending operation.
The granddaddy of policy-based lending operations was the infamous structural adjustment loan
(the ‘SAL’ in the institution’s own jargon). However, a cottage industry of sectoral policy-based
lending operations also popped up in addition to the SAL. In many respects, this new array of
lending instrument had similarities with important features of traditional IMF standby agreements
(SBAs). They comprised balance-of-payments loans justified on a combination of the borrowing
country’s macroeconomic fundamentals and the new economic policy initiatives it was prepared
to implement as the basis for receiving the loan. This was in sharp contrast to conventional project
finance whereby a project agreement is signed with very detailed components financed by the
Bank and an institutional entity representing the borrower government. In all but some special
cases, the World Bank usually only financing the foreign exchange component of the project.
The East Asian influence

It is worth reflecting on yet another geopolitical influence on the Bretton Woods institutions
which unfolded throughout the 1980s. That was the East Asian view, led by Japan and
followed by the rapidly-rising Asian Tigers, which posed an alternative economic paradigm
to that which came to be called ‘the Washington consensus’. The latter was seen as eulo-
gising the virtues of a highly-decentralised, free-market system with a strong capital
market-led financial system. It is important to point out that this conceptual model was
further seen as extolling profit maximisation as the predominant corporate objective.
Even prior to World War II, Japan had an ‘organic’ form of social organisation involving
large groups called zaibatsu. These involved government and large industrial conglomerates
which usually included a captive commercial bank in their midst. After World War II, from
the zaibatsu’s ashes, phoenix-like, arose a new group form, known as a keiretsu. The modern
keiretsu formed a locus of power across the powerful Japanese ministry of international
trade and industry (Miti), a group of related industrial companies and a group commercial
bank with interlocking ownership.
The strategic model the keiretsu pursued was termed ‘policy-based finance’. It involved cor-
porate executives from the particular industrial groups (there were a number of such groups) work-
ing with Miti to ‘pick the winners’ among products and industries, to ensure that preferential pol-
icy treatment would be directed to them and to launch them on an export-led programme of glob-
al expansion in pursuit of capturing market share. Profit maximisation was secondary. The ra-
tionale was that by capturing more market share than the group’s international competitors, the
group would also capture the economies of scale and scope which attend maximum size and which
would allow them to constantly dominate their competitors in the international market. Well-
disguised government subsidies and other policy favours, ensured the group a large enough cash
‘war chest’ to conduct a global marketing campaign as though it were a military one.
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In Japan’s case, many of the cross-pricing techniques which were applied with keiretsu
inputs could also be applied to good effect in winning procurement awards in connection
with multilaterally-financed projects in Third World countries or in competing with other
bilaterally-supported initiatives. By embedding financing and training components in project
cost, they were able to under bid the competition in ways that were often difficult to unravel
let alone determine as to whether or not they were covering their costs.
The relevance of this geopolitical influence was that political support was not uniformly
positive to have the Bretton Woods institutions actively promote domestic capital market
development within its member countries. First there were those member countries of the
two institutions which were philosophically opposed to private capital on grounds of socialist
ideology. And added to this were countries in Asia which saw the potential for what had
been a successful strategic approach for them, based on export-programming, being under-
mined if the multilateral institutions starting calling for widespread reforms to promote
domestic capital markets and market-driven financial institutions.
If the Washington consensus model or framework is best characterised by financial
market efficiency driven by the rapid assimilation of constantly-changing and relatively trans-
parent financial reporting regarding product information, the ‘policy-based finance’ model
was the epitome of opacity. Captive bank financing, interlocking ownership and numerous
compensating policies on the part of government conferring preferential treatment fuelled a
phenomenally long thirty-year run of economic growth. Until the first warning signs appeared,
the success was so remarkable that it even motivated western institutions and economists
to write books on the ‘Asian Miracle’. For those accustomed to analysing financial market
risk, this phenomenal growth was achieved ostensibly without visible risk.
As it turned out, however, all of the risk had been assimilated within Japan’s banks and
its group organisational structures. It was hidden from the public and was totally systemic
in nature. This became painfully apparent when first the Nikkei Index crashed starting in
the early days of 1990 and this was subsequently followed by a downward spiral of the
Japanese economy to a fraction of its former measure. It was the intricacy and complexity
of not only ownership relations but offsetting transactions among many institutions and enti-
ties which made this model so devastating in its collapse. Difficulties in tracing myriad
obligations throughout a system built on subtlety and designed to obscure rather than reveal
information placed not only many assets but also subsequent actions in limbo. Coping mech-
anisms were aimed more at passing the responsibilities to others and avoiding loss taking.
The situation gave rise to wholesale ‘denial’. This and the fact that company valuations had
been parlayed on a pyramid of market-price-based accounting rather than more conserva-
tive original cost, combined with an enormous bubble in the domestic real estate market
conspired to draw out the economic malaise for the better part of a decade. Similar patterns,
although none of such long duration, were discerned in Thailand, Indonesia and South Korea.
Development policies post-1971

After the abandonment of the gold standard (and its variant, the gold exchange standard),
led by President Nixon in 1971 and followed by a succession of countries, the IMF’s task
became much more challenging as it encountered no end to the number of cases of ‘special
173
pleading’ regarding the macroeconomic policies needed to stabilise exchange rates. It too,
with its ownership being shared by a large number of countries of differing political orien-
tation, gradually accommodated many of the requests of member countries to include
developmental policy actions in its programmes (and not merely stabilisation measures) in
recognition of the many structural deficiencies impeding development. Consequently, the
IMF introduced its structural adjustment facility (SAF) which was later accompanied by
what is called an extended fund facility (EFF).
These new programmes, which were generally introduced in collaboration with World
Bank staff, had three types of conditions: (1) prior actions (which were actions which had
to be completed as the basis for the IMF’s board approving the programme); (2) perform-
ance criteria, which were the ongoing, time-bound, monitored actions under the programme
and constitute the basis for the country to draw down tranches of financial resources against
the IMF credit; and (3) structural benchmarks, which were monitored actions not easily
measured and therefore not forming a conditional linkage to the financing but which nonethe-
less would serve as the basis for discussion between IMF staff and the country’s economic
authorities. Institution-building constitutes a typical example of a structural benchmark.2
Among the policies of interest to both the World Bank and IMF in their structural
adjustment operations, usually aimed at improving the efficiency of resource use or of
improving distributional equity among different segments of the population of the borrowing
country were policies and actions aimed at:
• liberalising external trade;

• liberalising the country’s capital account by removing impediments to capital flows both
in and out of the country;
• selection and implementation of an appropriate foreign exchange regime and mechanisms
for related transactions;
• reform of the tax system and the structure of fiscal expenditures (on both current and
capital account);
• reduction, if not outright removal, of major rigidities and distortions in domestic labour
and goods markets;
• privatisation and the rules concerning the management and operation of remaining PSEs;
• strengthening of the social safety net in such areas as health, education, pensions, insur-
ance and so on;
• reforming and strengthening corporate governance;
• strengthening and liberalising financial institutions and markets; and
• safeguards in the areas of environment and safety.
Some observers tend to consider the plethora of structural measures as palliative measures.
They are measures chosen selectively to achieve certain ends (stabilisation followed by more
healthy economic growth) in ways that were expected to be less brutal than relying exclu-
sively on massive devaluation accompanied by fiscal austerity and tight monetary policies.
Of course, the more moving parts any system has, the greater the opportunity for things to
go wrong. In some cases, the problem may have been that the Bank and the Fund did not
understand adequately the full set of causal relationships involved and possibly even their
174
second-order effects. In many others, however, the ultimate success of the programme selected
was predicated on the assumption that the implementing bodies would execute the meas-
ures with due regard for economy and efficiency not to mention with probity. Such
assumptions were often found wanting. Unfortunately, when the sickness gets worse instead
of better, it is too easy to blame the medicine (and the doctor) rather than the patient for
having self-medicated in ways which were not prescribed. Consequently, there is today a
sizeable international constituency, comprising some politicians of member countries,
academics, non-governmental organisations (NGOs) and others who blame the Bretton Woods
institutions for financial crises. In fairness, while it would undermine credibility to suggest
the Bretton Woods institutions were blameless in all cases, by far the majority of cases
where financial distress led to full-blown crisis involved a significant degree of self-
infliction by some members or segments of the societies in question. The task of finding
ways to avoid or mitigate those forces causing financial crises and distress in the financial
markets would benefit far more from a balanced and responsible analysis of what actually
happened when crises occur and what can be learned for the future than from focusing
exclusively on either assigning or avoiding blame.
Sequencing economic liberalisation

If high-level governance is considered responsible for either averting or contributing to finan-
cial crises, then it seems necessary to examine a particular type of decision which has been
criticised by many as accelerating if not outright causing financial market distress. That
decision is the order in which a process of economic liberalisation to a predominantly free-
market economy is sequenced. It is a decision that has been most commonly found in what
today are called ‘transition economies’ (many readers will have known them formerly as
‘communist countries’). But it can even be found in developed countries as ideas and even
technology change the game rules.
While it is beyond the aim of this book to provide comprehensive analysis with recom-
mendations concerning macroeconomic policies, a description of some of the main issues
facing policy-makers related to the topic of sequencing and some of the relevant lessons
learned are presented in the spirit of a benchmark. When one or more countries show initial
signs of impending financial distress, then comparisons with how the policy-making of recent
history in those countries has conformed to the lessons learned should help identify warning
signs and vulnerabilities to help guide decision making – both for future policy-making as
well as financial portfolio management. The latter topic we will address in the next chapter.
Based on a combination of international experience and the collective wisdom of econo-
mists, a preferred sequence is as follows.3
First, before domestic capital markets are freed up for making loans and borrowing money,
the government’s finances, at least at the central government level, should be balanced. But,
why, the critical reader should well ask? Are not the world’s most prominent capital-markets-
led economies frequently deficit economies? Encouraging the economic authorities to pursue
fiscal balance with resolve, for a transition economy, is like telling an accident victim to
walk on a treadmill. There will be discomfort if not pain. But more importantly, the need
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to do so is crucial. It is to develop a capacity of control (in the victim’s case, it is muscle

control; in the transition economy’s case, it is fiscal control) which may have completely
atrophied during years of command economy. This is needed to avoid large deficits with a
view to achieving and maintaining stable prices. It is a capacity which will be critically
needed once the control by fiat is removed. In cases where government deficits spiralled
out of control following financial sector liberalisation, it was often because the governments
in question failed to develop this capacity, leaving a significant gap between policy pronounce-
ments and implementing ability.
To achieve this successfully, transitioning governments need to develop a broad but
reasonably low tax base, a trained, competent and adequately-equipped internal revenue
service, and systems and programmes for communicating to the general public their tax
obligations as well as the changes in rules from year to year. On the expenditure side, to
the extent that greater decentralisation of spending authority within government exists or is
contemplated, procedures and mechanisms need to be put in place to ensure that govern-
ment departments or entities do not exceed their budget allocations and are accountable for
what they do spend. Equally important is to bring all public spending under the oversight
of the parliament or the legislature. To the extent that off-budget spending is permitted, this
clearly thwarts fiscal policy and leads to pressure on the central bank to create high-powered
money, which becomes inflationary.
Second, depository institutions should be free to set interest rates paid on deposits and
charged on loans without excessive reserve requirements and interference from government.
The speed at which the country’s banking system (depository institutions responsible for
money creation through fractional-reserve banking) are opened to freely lend to the general
public and private-sector companies should be phased with regard to the degree of disci-
pline observed in the daily conduct of these groups. If there is serious risk of loans not
being repaid because of a tendency to engage in fraudulent activities or excessive risk-
taking, then consumers and businesses should be encouraged to seek non-bank or
self-financing for some time until the credit climate improves. This can take years in some
cases.
Third, the monetary authorities should move without delay to improve the functioning of
the payments system (transactions among banks and with the general public) and the deposit
side of things. This is necessary for both households and private (newly privatised) compa-
nies to gain comfort in holding domestic currency whether in cash or in bank deposits
instead of hoarding goods as private caches or as inventories.
Fourth, before a variety of debt instruments, particularly ones of longer maturity, can be
developed, a country needs to put in place suitable laws covering commerce, indebtedness,
foreclosure, bankruptcy and security (collateral). Suitable institutional capacity to admin-
ister these laws also needs to be put in place. Also, demonstrated price stability needs to
be in place for a sufficient length of time for prospective bondholders to have the confi-
dence that they will be repaid and that the returns they earn will not have suffered undue
erosion as the result of inflation. Countries like Brazil from the mid-1960s onward tried to
176
circumvent this need by developing sophisticated systems of inflation indexing in connec-

tion with many things, including all financial obligations other than those of very short term
(usually under three months). However, the inflation this spawned and the deleterious conse-
quences it unleashed over three decades should serve as clear warning against the advisability
of considering such an approach.
Fifth, banks need to be strengthened and eventually privatised. Strengthening involves

ensuring they have adequate capital, sound governance structures, appropriate systems and
procedures for managing both sides of the balance sheet, and strong comprehensive risk
management systems and functions which adequately inform management, the bank’s govern-
ance bodies and the regulators. Such strengthening takes time. The transition from state
ownership to full private ownership may therefore require time. During this interval, however,
strong recapitalisation should be a priority.
Sixth, trade liberalisation (defined as replacing quantitative restrictions with import tariffs
and export subsidies) should go in parallel with the decontrol and stabilisation of prices of
domestically-traded goods and services. However, unifying the exchange rate so that all
exporters and importers effectively pay the same price for foreign exchange should be under-
taken before removing controls on who should be an exporter and who an importer. This
latter control is usually administered through a regime of export and import licences, in the
most extreme cases of control on a product by product basis and in the slightly more liberal
cases, under an open general licence (OGL) regime.
Seventh, ‘Only when domestic borrowing and lending take place freely at equilibrium (unre-
stricted) rates of interest and the domestic rate of inflation is curbed so that ongoing
depreciation in the exchange rate is unnecessary, are the arbitrage conditions right for allowing
international capital mobility.’4 If restrictions on foreign exchange conversion and inter-
national capital movement are removed prematurely, either excessive capital flight or excessive
foreign indebtedness is likely to result. The qualifier ‘excessive’ is important in the preceding
sentence, as it indicates the exploitation of a larger arbitrage opportunity than the authori-
ties would have expected and that the domestic economy should have to withstand.
Economists tend to explain the distress felt by financial markets and financial crises in
terms of broad macroeconomic forces and policy responses on the part of national (and
sometimes supranational) economic authorities. The emphasis on policy responses, of course,
carries with it the presumption if not the explicit assertion that policy mistakes play an
important role in times of crisis. Good policies, of course, can attenuate the duration and
severity of the adverse impact a financial crisis can have on a country. Bad policies often
have the effect of hastening and strengthening these effects. While there was a time when
such thinking was unequivocal, the advent of globalisation and the scope for numerous and
powerful large global institutions to move massive amounts of capital around the world
almost instantaneously without warning, raises questions as to whether or not stewardship
of either a national focus or with regard to the global financial system means the same as
it once did prior to globalisation and its attendant forces. It is not that policy-makers no
longer have a role, but many have come to realise that in comparison to the size of resource
177
volumes and the ease with which they can be transferred by large global institutions, offi-
cial compensating measures are dwarfed in comparison. Hence, the best policies are likely
those which do the least harm and are left unchanged for as long as possible. Attempts to
engage in game-theoretic strategies to offset institutional actions are quickly rendered impo-
tent. Moreover, such a stance tends to invite successive rounds of government intervention
which cumulatively can result in excessive economic rigidity. Consequently, without totally
rejecting economic policy as a contributing factor which either assuages or exacerbates finan-
cial crises, many financial economists and finance practitioners look increasingly to
behavioural as well as the structural aspects of markets as important determinants of finan-
cial booms, busts, panics and crises.
Prescriptions for individual countries

Peter Isard5 recommends five main actions individual countries should consider taking to
protect against financial crises in a world characterised by globalisation.
1 Devise a sensible strategy for liberalising domestic financial markets and international
capital flows. The main issues needing to be addressed under this action include:
• Determine those steps required to change policies, institutions and regulations for the
functioning of the domestic financial sector and the external capital account; and
• Devise a plan with appropriate sequencing of reforms and institutional responsibilities
for implementing the strategy.
2 Strengthen institutions, information, and the financial and corporate sectors. The agenda
under this action calls for:
• Strengthening the banking system in terms of capital adequacy. However, if a country
does not have other important institutional and cultural safeguards, such as an inde-
pendent legal system and a responsible free press, then the pace of handing discretionary
control to bank regulators may need to be phased.6
• Putting in place laws pertaining to banking, debt, foreclosure, bankruptcy, collateral
and corporate ownership, control, and governance.
• Ensuring domestic price stability and market determination of deposit and lending rates
of depository institutions.
• Determining the information requirements, the institutions and bodies responsible for
collecting and disseminating company, banking and financial market information, and
the laws, regulations and rules needed to achieve the reforms in this area, and the agen-
cies to perform the economic oversight.
A few additional thoughts are presented. The economic authorities in a country may
envisage that its financial system will continue to be defined primarily by its commer-
cial banks for the foreseeable future. Alternatively, it may see advantages in encouraging
a broader array of financial institutions and possibly aspire to eventually having a capital-
markets-led financial system with vibrant stock markets and futures exchanges. In either
case, a strong banking system is an essential requirement. For a financial system with a
significant or even a predominant role for its capital markets, having sound banks is an
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indispensable precondition. Regarding specific actions to strengthen banks, the following

are important.
• For a variety of reasons, bank capitalisation in many frontier economies, and even in
some emerging market economies as well, should be more conservative than interna-
tional standards and practice currently require.
• The widespread practice of related lending should be tackled early and reduced signifi-
cantly to levels which conform to best international practice. It should begin with
restricting lending to bank board members, managers and extend as well to loans to
close friends and family.
• While some degree of grouping commercial banks with other financial services activ-
ities is a discernible trend in much of the world, for countries in the earlier stages of
developing the appropriate laws, regulations and supervisory capacity, they should not
allow or even encourage banks to be part of large economic groups along with other
commercial entities. This practice, in countries like Chile in the early 1980s, Mexico
in the early 1990s, and South Korea prior to the 1997 East Asia crisis, led to a large
credit overhang (with associated lapses in credit quality) which contributed to the finan-
cial vulnerability of those countries. Allowing banks to form a part of economic groups
not only encourages related lending but regulatory arbitrage as well.
• Allowing banks to hold more than a limited percentage (usually between 5% and 10%)
of the outstanding share capital of companies also gives rise to related lending and
should be curtailed. It also increases banks’ potential legal liability because of the
inherent agency conflict in being owners and creditors. Moreover, the greater the equity
stake which banks have in commercial enterprises, the stronger the tendency will be
to weaken credit discipline during early signs of difficulty if such action holds the
promise of preserving at least some of the share value to which the banks are exposed.
3 Adopt sustainable exchange rate arrangements. Achieving a sustainable exchange rate

regime entails the following:
• Unifying exchange rates in countries where multiple exchange rates are in force.
• Determining the best exchange rate regime in terms of the particular strengths and
weaknesses of the national economy. For example, unless a country is prepared to defend
a fixed exchange rate, either with sufficient foreign exchange reserves or alternatively a
commitment to automatic adjustment of the money supply as in the case of a currency
board, it would probably be better off at least initially with a somewhat more flexible
regime. The Argentine decade-long experience with its currency board and convertibility
law provides ample educational value regarding the risks of a country not being able to
commit to and comply fully with all of the conditions required for a currency board to
weather successfully inhospitable political and international events.
• For arrangements involving a nominal anchor, determine the requirements and the suit-
ability of having either a hard policy or a soft one. For a hard policy of adhering to
a fixed exchange rate, ensure that reserves in sufficient quantity and concomitant admin-
istrative functions are in place to defend against the most likely attacks or runs on the
currency. For a soft stance, ascertain if the strength of the economy and the responses
179
on the part of the economic authorities can stand up to the market power of institu-
tional investors who could precipitate a run on the domestic currency should they lose
confidence. Also in this regard, ascertain the flexibility the country would likely have
before causing a loss of investor confidence.
4 Maintain debt discipline, sound macroeconomic policies, and market confidence.
This is an area which varies considerably among countries based on individual country
circumstances. However, any provisions for sound debt management need to start with put-
ting in place institutional arrangements for collecting debt statistics, monitoring borrower
status, undertaking analyses and making projections. It is important to distinguish domestic
debt from foreign debt as well as to identify indebtedness by currency, tenor, terms, and
obligor. To the extent possible, effort should be made to collect information on contingent lia-
bilities and off-balance-sheet operations. Moreover, sound external debt management should
be carefully coordinated with foreign reserve management. Public (including international)
confidence can be maintained through use of global credit rating agencies, and through main-
taining strong investor relationship functions to keep the international media and institutional
investors apprised of developments as they occur as well as to manage expectations.7
5 Open the economy to trade and foreign direct investment in a manner that results in
growth-enhancing activities.8
Not all trade is necessarily beneficial to a country nor is all FDI. Examples abound
of countries which opened their economies to outsiders only to be used as modern-day
‘sweat shops’ with no requirement for foreigners to transfer technology, give the more
skilled jobs to locals (even when people of necessary skills could be found) nor source
material and even many service inputs locally. Paradoxically, some of the East Asian
success stories seem to have been predicated on a high degree of government involve-
ment. However, the numbers of abject failures in the world which abound where
governments took full control of a country’s ‘commanding heights’ are plentiful enough
as to scream caution to those countries contemplating strong government involvement.
A more balanced approach would be for host governments to move gradually on the
trade front by liberalising activity with respect to imports and exports by replacing product-
specific licensing with OGL arrangements and making export incentives specifically
general as not to encourage fraudulent or subsidy-maximising behaviour. In connection
with capital mobility, eligibility criteria for both investors and projects should be set and
administered by competent government departments, rules and regulations should be
communicated clearly to those foreigners who pass muster and are thus allowed to partic-
ipate, and internationally-binding contractual arrangements should be put in place to avoid
possible ambiguity and unpleasant surprises.
Additionally, Isard9 lists six things which should be undertaken to reform the international
financial system.
1 Strengthen the quality and impact of IMF surveillance.

2 Induce changes in the composition of international capital flows.
3 Introduce contingent debt contracts or other mechanisms for hedging against macroeco-
nomic risks.
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Box 7.1
On bank failure
It has been said by Allan Meltzer that ‘capitalism without failure is like religion without sin’. It is a
refrain which has been cited on occasion at international conferences on banking. Even in many
countries which strongly advocate capitalism and the functioning of free markets, when it comes to
banks, there is a great reluctance to allow failure to happen, particularly as a crisis unfolds. It is
instructive to examine differences in stance which have been articulated over decades but which
may not be so dissimilar when economic authorities are called on to decide whether or not to act
and how to act when confronted with ongoing or imminent bank failure.
For many years, the two main organisational models in banking were a unitary banking system
and a branch banking system. The US chose the former, the UK, most of continental Europe, and
British former colonies such as Canada, Australia and India, as examples, adopted the latter. In a
unitary system, banks can be started easily but they are also limited in their ability to expand in
terms of geographical coverage and types of financial services. What these two systems often tend
to obscure is the sharp difference in philosophical underpinnings which gave rise to them. For
example, in the US with its unitary system, banking was seen primarily as a business, while at the
same time its architects recognised some of the deleterious consequences associated with either bank
fraud or bank failure if some supervisory safeguards were not put in place. The UK and continental
approach with its emphasis on size and scope inherent in a branch banking system, envisaged the
public-goods aspect of having a strong and reliable national payments system in place without
denying a role for private capital in their formation and operation.
It has been the risk to the payments system associated with the size of financial institutions which
gave rise to many countries adopting ‘too big to fail’ policies whether explicitly publicised or followed
in a de facto sense, whereby all depositors are protected from the collapse of a large institution.
In actual fact, in most countries ad hoc protection does not stop with depositors but extends to other
creditors and even shareholders as fears of contagion overwhelm even the most daring voices advo-
cating the economic equivalent of ‘natural selection’. The banks know this. This knowledge encourages
excessive risk taking – what is termed ‘moral hazard’. To some degree, every major banking crisis
of the last several decades had elements of ‘moral hazard’. The US sub-prime crisis has been the
most recent at the time of writing and shows signs of it taking place not only in terms of primary
mortgage loan origination but indeed with regard to the repackaged or securitised products which
were placed on the books of many financial institutions in concentrations and amounts which in
many cases exceeded reasonable as well as traditional prudential norms.
Consequently, to the extent that US law and regulation envisages ex ante bank failure without as
much government support contemplated as in other countries, it is because the risk of damage to the
payment system is considered to be contained by the compartmentalisation of risk among many banking
entities. At its peak, the US had over 14,000 banks at one point. The presumption, of course, is that the
kinds of risk involved would not likely involve contagion. While some banks in the US have been
mismanaged and gone under as a consequence of their own particular circumstances, the majority of
bank failures (or even near-failures) have been during a systemic crisis – both in the US as well as in
countries operating branch-banking systems. At such times, as during the Savings & Loan crisis of
1985–1989, significant government support tends to be forthcoming, even if ultimately the problems
prove too much for some banks which must be liquidated. Nearly all of the other instances of banking
crises in other countries (most of which have branch banking rather than unitary banking systems),
significant government intervention occurred without the authorities applying the kind of laissez-faire
quiescence to bank failure that is often cited in prescriptive economic textbooks. In some cases, this
represents social leaning. In many of them, however, it represents the practical as well as political
consideration of not putting a country’s payment system at risk of collapse.
181
4 Address informational imperfections and distorted incentives on the supply side of inter-
national capital flows.
5 Revamp debt resolution procedures.
6 Strengthen the frameworks for development aid and official nonconcessional lending.
When financial crisis crystallises

When financial distress becomes systemic, pervasive problems with the ability to pay rapidly
undergo a transmutation into an even broader problem of lack of willingness to pay. This is
because in the absence of clear cut government action, the logical tendency is for borrowers
to postpone making payments on their financial obligations, irrespective of their liquidity situ-
ation in order to build up a comfortable cash buffer to see them through a period of anticipated
and greater than usual uncertainty. This behaviour is further reinforced by the hope of availing
themselves of expected imminent, even if uncertain, debt forbearance or forgiveness.10
The most important containing action required of government in a financial systemic
distress situation is to make publicly known the nature, magnitude, and duration of its policy
response. This is essential to stabilise the enforceability of contracts.
Strengthening the banks is another priority undertaking. This involves measures to: (1)
promote loss recognition and write-offs; (2) inject fresh capital; (3) separate NPLs from
performing asset portfolios in the banks; (4) encourage consolidation of banks to the extent
possible; and (5) promote institutional arrangements for the creation of ‘bad banks’ (special
purpose entities to house NPLs to be resolved by teams of specialists in loan restructuring
and recovery).
In strengthening the banks during a financial crisis, the economic authorities need to
treat the structural weakness of the nation’s banks and the attendant insufficiency of liquidity
in the financial system, particularly as it pertains to credit, as two distinct needs.
Correspondingly, they will require two distinct sets of policy measures. Specifically, while
allowing the banks to transfer NPLs off their balance sheets in exchange for treasury secu-
rities will undoubtedly strengthen the banks’ balance sheets, by itself it will not increase
the liquidity needed for extending loans to distressed enterprises (and even for basic consump-
tion needs in many cases), the revitalisation of which is essential for minimising the time
needed for economic recovery.
Macroeconomic policy lessons

Some macroeconomic lessons seem to have withstood the tests of time and geography. The
prudence of responsible fiscal management as one such lesson seems irrefutable even if
temporary flexibility in this connection is required from time to time. On the other hand,
some widely-held beliefs such as the priority of adhering to the exchange rate as a nominal
anchor have given way to more flexible policy variants.
One area of macroeconomic policy which deserves special attention, however, is the appro-
priate role for monetary policy. Asymmetries are at work, depending upon the openness of
the economy in question. Tighter monetary stance generally has the effect of tightening the
availability of credit within a country which is closed to portfolio capital inflows. If the capital
182
account is open, then higher interest rates are likely to attract massive foreign capital inflows,
provided that the country’s fiscal stance and debt dynamics are considered by investors to be
manageable. Assuming that international portfolio investors are attracted by the higher interest
rates, the result may be to thwart monetary stance. To the extent that such inflows are converted
and channelled into domestic credit, the higher domestic interest rates will likely give rise to
adverse selection with resources going to those borrowers and activities which are the riskiest.
The case for monetary ease, however, is anything but clear cut. In this connection, the
clarity of thinking about interest rates which was developed in an era when countries were
effectively insulated from the global economy has become increasingly ambiguous.
Transmission mechanisms for monetary policy need to be examined with particular care in
recognition of the reach of globalisation. Specifically, in times of economic and financial
distress, the appropriate setting of interest rates needs to extend beyond just price effects to
include how the effects of such action will be transmitted through the various credit chan-
nels. In the United States, for example (and it is believed that this analysis has relevance
for other open economies), in the aftermath of the bursting of the real estate bubble, it is
plausible to assume that lower interest rates may have a salutary effect on the lending activ-
ities of smaller banks – specifically, those operating strictly within a single state or
geographical region within the United States. The responses of large global banks operating
within the country, however, are more difficult to vouchsafe. For one thing, pressures to
increase their regulatory capital could just as easily be met by the diversion of internal
funds. At the same time, monetary ease (lower interest rates) in the US could just as easily
result in the deployment of resources elsewhere throughout their global organisational struc-
tures to take advantage of liquidity shortages in other countries through profitable carry
trade. It is not axiomatic that the lower interest rates will be immediately destined for more
lending in the United States. The direction, likelihood and extent of the responses of the
global banks will also depend on net currency exposures, which are not always discernible
from their financial reporting.
Financial supervision and regulation

The ongoing credit crisis in the United States provides an invaluable case study from which
to draw a variety of lessons in connection with financial supervision and regulation as an
important safeguard against financial crisis and distressed financial markets.
The Federal Reserve under the chairmanship of Alan Greenspan did a skilful job
throughout his 18-year tenure of fine-tuning interest rates to keep the US consumer price
index from gyrating the way it had throughout the 1970s and early 1980s.11 The Federal
Reserve has been criticised, however, by those who have noted that although consumer price
stability was kept relatively constant, the formation of asset price bubbles was one weak-
ness in the US economy that the Federal Reserve seemed reluctant if not unable to address.
Irrespective of matters of assigning blame, the strength of the argument for having a mone-
tary authority include all prices in the equation to safeguard price stability lies in the true
economic definition of inflation. The term ‘inflation’ has come to be synonymous with ‘price
increase’ in the media and in broader common parlance. The more widespread or compre-
hensive such price increases, the less deceptive they are in providing a sense that inflation
183
is occurring. If on the other hand, such price increases are only partial, then one must look
for the prices of other goods and services which have not increased to begin to better appre-
ciate the degree of true inflation.12 In point of fact, however, inflation is the unrelenting or
inexorable debasement of the value of the currency. General price increases, therefore, are
only the mirror image of that phenomenon. Looked at this way, the responsibility of any
monetary authority should be to address all activities or forces which seek to undermine
the currency’s value, whether such activities occur in the goods markets or the asset markets.
Greenspan refers to this himself in his book The Age of Turbulence.13 He explains,
however, that when it comes to rising asset prices like stock market prices or housing prices,
it is a much more difficult judgment call to distinguish between growth and productivity-
related price increases – that is, price increases justified on the basis of the underlying
fundamentals – and the formation of a dangerous bubble. This argument has ample merit,
especially when considered in the context of the American way of life. Approaches to US
business, banking and life styles in many ways reflect the preamble to the country’s consti-
tution – that is, they symbolise among other things the guarantee, which the constitution
enshrines, to among other things ‘… the pursuit of happiness’. A cynical view might ascribe
a preoccupation with materialism. A more positive interpretation would emphasise the then
fledgling nation’s quest for self betterment in various spheres not least of which is the
economic sphere. In contrast with societal values in other parts of the world, pursuit of the
‘American Dream’ and the constitutionally-inspired freedoms which support it, together
represent an awesome transformative power. But they are attended by a societal ‘impatience’
which give shape to the intensity of this transformative power. When large numbers of
people share such an ethos, it will magnify the amplitude of the periods of boom followed
by bust. And it will both magnify and extend in time the formation of price bubbles in the
asset markets. To be sure, boom and bust dynamics occur in other social settings too. But
the aforementioned social attributes in the United States arguably provide fertile conditions
for economic cycles of greater amplitude. In short, the country’s ‘animal spirits’ as they
relate to entrepreneurship (in Schumpeter’s sense of the word)14 are simply not hospitable
to stasis. In a society in which anyone can aspire to ‘getting ahead of the game’ (and most
do), the political tolerance for governance functions which are viewed as allowing perverse
asymmetries (that is, ones in which sharp losses simply cannot be avoided but recovery will
always be thwarted by ‘prudent’ policies) is limited. Those who have suffered losses fully
expect to be given the opportunity to recoup those losses and then some.
The responsibility of the Federal Reserve has been described as being ‘to take away
the punch bowl just as the party gets underway’. The Federal Reserve is, in fact, em-
powered to quash financial bubbles. When one examines the language of the enabling
legislation, however, the emphasis is clearly on counteracting the actions of speculators. Was
speculation involved in the sub-prime market? With the benefit of hindsight, we can now
answer this question in the affirmative. But, in fairness, until the problem crystallised, much
speculative activity was well disguised. In the real estate markets, the explosive price appre-
ciation was not perceived to be the result of your typical land speculator buying up valuable
raw land and sitting on it undeveloped until a higher price was offered. Home prices after
all were appreciating rapidly as newer, larger, better-equipped and more modern homes were
being continuously offered on the market. Concurrently, the stock of housing, not all of
184
which was being offered for sale, was being steadily enhanced and upgraded by massive
home improvement, financed through home equity loans and undertaken by those who
already owned homes. Where was the speculation in this? Surely, the idea of applying hedon-
istic price indices would justify the value appreciation resulting from the hard work and
productivity of homebuilders and owners alike. After all a precedent for this had been estab-
lished decades ago when it was recognised that the constantly rising prices of new model
automobiles annually were not inflationary but instead could be rationalised on the basis of
a continuous introduction of new and improved features with added value.
On the mortgage finance side, the proliferation of new mortgage products with a menu
of features customised to investor needs as well as the rocket science involved in creating
new structured finance products with credible-sounding risk-mitigation characteristics when
the new mortgage products were pooled, surely involved value addition as well. Moreover,
to the extent that speculation was lurking, it assumed a new corporate mantle of professional
respectability founded on mathematics and incredible detail which belied the traditional vision
of the cigar-chomping speculator buying up securities to create scarcity which could be subse-
quently exploited at an unreasonable profit. As it happened, speculation did occur. But its
true potency is only clear now in retrospect as having been the result of the institutional loss
of a sense of fiduciary responsibility, the ineffectiveness of self-regulation inherent in the
post-2000 rationalisation of financial services, and the complexity of new financial instru-
ments. We know this now. However, it is all too easy to play ‘general after the war is over’.
Four compelling reasons seem to exist as to why a more aggressive Federal Reserve
role would have been much easier said than done during the immediate post-2000 period:
1 Prices of goods and services (their spot prices that is, as distinct from futures prices) for
the most part are considered to be retrospective indicators of value whereas asset prices
are considered to be prospective indicators of value. In other words, in stable economies,
people expect the former to reflect congealed valuations based on the past costs of making
or providing goods and services. In fact, they really don’t want prices to increase and
they even tend to ‘push back’ when suppliers try to revise prices upward for no defen-
sible reason. Asset prices, however, embody the ‘investment promise’ of future return
and when they rise, this is generally considered to be a ‘good thing’, reflecting such posi-
tive factors as productivity increases, general economic growth and even protection against
inflation. The distinction between public attitudes in connection with these two sets of
prices is substantive.
2 It is far easier to defend the Federal Reserve’s role (or that of the monetary authority in
any other country for that matter) of ‘removing the punch bowl’ on the basis of fairly
clear evidence of core consumer price inflation as contained in the inflation indices than
to make an unequivocal case for an asset bubble (prior, that is, to having a clearer retro-
spective based on some evidence of the bubble having either deflated or burst) which
would deprive businesses and investors of the chance to recoup losses from the last down-
turn.15
3 Even if the evidence were firmly in hand that a bubble was forming, the exuberance which
accompanies a bubble would not likely be dampened by the slow and steady tightening of
monetary policy (whether attempted through slow and steady interest rate changes applied
185
in a Wicksellian sense, or by changing the money supply in a monetarist sense) as generally

works in the case of reining in consumption and credit expansion. This would suggest that
the Federal Reserve would need to ‘overdose’ the economy to sober up the party on Wall
Street with a consequential impact on Main Street that would likely border on the draconian.
But most importantly, it begs the question of where control should be applied. If the problem
is one of a financial sector organisation structure which simply affords too much freedom and
too many incentives to engage in moral hazard and use too much financial leverage, then
placing the burden on monetary policy instead of on having appropriate legislation and
regulations in place may best be seen with an analogy. It would be like saying that the only
way to stop a runaway bicycle without brakes heading downhill in its highest gear is by
having a traffic controller suddenly jam the spokes. Instead (and still assuming that the
bicycle has no brakes of its own), a more effective and less calamitous approach would surely
be one of responsibly requiring that a lower (and safer) gear for downhill slopes was selected
in the first place. In the current context, it may also call for tightening the enforcement of
bicycle-rider eligibility criteria as well.
4 Interest-rate increases involved the spectre of abrupt and massive insolvency risks as at
no other time. Specifically, a tight monetary stance (with higher interest rates) will
encourage real sector firms to curb their spending habits. But because they are generally
not very highly leveraged, higher interest rates are not likely to threaten their survival.
Traditional banks, as long as they are well capitalised, are also not likely to be threat-
ened either, even despite their leverage, since the higher rates they need to pay depositors
can usually be covered by higher lending rates to clients. However, the enormous gearing
ratios found in the structured finance bets entered into by the mega-players mean that as
little as a single percentage point increase in interest rates can totally wipe out the capital
in many a structured finance deal. When applied across multiple transactions, a single
percentage point increase in interest rates can threaten quickly the solvency of large finan-
cial institutions as was the case with Bear Stearns in 2007–2008, and larger increases
can possibly threaten even the broader financial system. This new structural reality of
the American financial sector places an incredible onus on a monetary authority such as
the Federal Reserve. The fact that many institutions in other countries invested heavily
in these instrument, magnifies the problem.
The key question then becomes one of whether or not the Federal Reserve should be held
accountable for protecting the value (purchasing power) of the currency rather than merely
for controlling consumer and producer price inflation. The answer must be an unequivocal
‘yes’! However, in order for it to be able to do so without having to face overwhelming
political resistance, better indicators are needed of when bubbles are forming. It is not
enough to be right, the Federal Reserve also has to be seen to be right. And, in this connec-
tion, the time has come for re-thinking the game rules on financial regulation. But before
the executive and legislative branches of government take the decision to apply another layer
of financial sector regulation, a careful and impartial assessment needs to be undertaken of
the enforcement track record in connection with existing regulatory power. It seems prema-
ture to layer on new regulatory powers before ascertaining if and why existing powers have
not been as yet effectively used. And finally, before the Federal Reserve should be loaded
186
with additional regulatory powers (instead of distributing them elsewhere within the struc-
ture of the federal government), the issue needs to be resolved as to the point at which
more directed (microeconomic) regulatory focus would not more appropriately be delegated
to other governmental institutions.
Examining the main components of the current housing-led financial crisis, we find
excessive risk in the following with the potential to spread financial market distress inter-
nationally.
• Sub-prime mortgage loans – with foreclosure notices in 2007 rising to 1.2 million,
significantly more foreclosures are expected as 1.8 million mortgages are scheduled for
resets in the balance of 2008.
• Prime and other mortgage loans – evidence is mounting that the housing finance malaise
is not limited to the sub-prime and Alt A sub sectors; as numerous lending institutions
are being forced by capital requirements and oversight bodies to tighten their risk manage-
ment practices and rebalance their portfolios, many prime borrowers with some of the
features which plague the sub-prime end of the market (ARMs with teaser rates, pre-
payment penalties and so on) are finding it increasingly difficult to refinance their
mortgages with more conventional fixed-rate financing despite their creditworthiness and
the generally affordable level of interest rates.
• Credit card finance – as an increasing number of homeowners are no longer able to
tap the equity in their homes and as those with discretionary income are seeing a dip in
their earnings caused by a faltering economy, many afflicted by rising energy and food
prices are turning to credit cards as a way to cover essential expenditures; in fact, credit
card debt has the potential to become the next major source of financial market distress;
this has the potential to resonate throughout the structured finance portfolios of financial
institutions as credit card debt is also widely securitised.
• Commercial real estate CDOs and real estate investment trusts REITs – many CDOs
and REITs, which have been largely based on commercial real estate are showing signs
of distress; with the US economy looking increasingly vulnerable to a recession, these
securities have every potential of becoming more widely distressed; the underlying real
properties forming the collateral for these securities tend to be much more heterogenous
with risk characteristics which tend to more granular than their counterparts in the resi-
dential mortgage sub sector.
• CLOs (collateralised loan obligations) and CDOs (cash and synthetic) – with most
securitisations involving credit derivatives and financial guarantee insurance from multi-
line or monoline insurers, the risk of widespread insurer credit downgrades hangs like a
sword of Damocles over the structured finance segment of the financial markets; this risk
would be greatly exacerbated if the US economy deteriorates to the point of full-fledged
recession; it would also be vulnerable to rising interest rates (which cause the values of
financial assets to decline) as well, should the Federal Reserve see the need to contain
inflationary pressures.
• Asset-backed commercial paper (ABCP) conduits and SIVs – the portion of the struc-
tured finance sub market relying on collateral in the form of short-term credits such as
leases and asset-backed commercial paper, uses most of the same tools as their coun-
187
terparts in the long-dated end of the market, consequently, they are also vulnerable to
many of the same risks as discussed for longer-dated instruments.
• Monoline insurers and municipal finance – the aforementioned risk of monoline
insurers receiving credit downgrades is primarily the result of risky municipal finance
bond issues to which they are currently exposed; a few major credit events in this
customer market would exacerbate the current stress on the credit quality of these
specialised institutions.
• Student loans – as the current financial crisis spreads into the real economy at a faster
pace, the depressing effect on a range of companies and financial institutions (already
announcing massive layoffs) which normally hire graduating university students are at
risk of retrenching in their hiring; as many student loans have also been securitised, the
impact of a worsening economy not only holds the risk of massive student loan defaults
with the effect of adding to the distress in the structured finance segment of the market
but indeed of curtailing the availability of employment and credit to those still in college
and university.
• Private equity (PE) LBOs (leveraged buyouts) – with the ‘wall of money’ on which
the PE and hedge funds thrive having effectively crumbled, with many of their portfolio
companies currently in financial difficulty, and with institutional investor portfolios in
recent years having become much more exposed than in the past to these less liquid
alternative asset classes, the prospects for lower PE and hedge fund returns deprives many
of the institutions already troubled with distressed structured finance investments with
the diversification benefits which they thought PE and hedge funds should have provided;
while mathematically-computed correlation coefficients between the returns of PE invest-
ments, hedge fund investments and the more traditional holdings in their portfolios may
not be meaningful because of liquidity considerations, at the same time it seems safe to
say that the broader systemic forces at work are currently aligning much more closely
the returns of these different asset classes with one another.
Additionally, reform measures under way in the United States will undoubtedly need to take
into account the following systemic or market features of the crisis.
• The ratio of financial assets to real assets has reached a gearing ratio of 5 to 1 while
financial derivatives piled on top have raised the gearing multiple to as much as 20 times.
• The explosion of credit derivatives means that the bulk of finance today rests on insur-
ance-like contracts rather than on the self-generating cash flows of the main underlying
transactions themselves.
• Credit derivatives are mainly broker-arranged among counterparties without the market
discipline of having daily collateral maintenance performed via an exchange.
• Many of the financial guarantees are in a state of suspense because the triple A ratings
of the guarantors are no longer valid and any event forcing in effect a ‘ratings update’
would have dire and reverberating consequences throughout the global financial system.
• Structured finance is not only built on financial leverage but incorporates unhealthy levels
of collateralised toxic waste from past transactions forming part of the equity-like buffer
on which many new structures are supported.
188
• The potential for moral hazard throughout the financial system has become out of control.
In short, institutions and players who used to have ‘skin in the game’ are no longer
required to do so and moreover are strongly motivated to create and pass off the riskiest
(read ‘poorer quality bordering on fraudulent’) underlying loans and other obligations in
order to satisfy the appetite of deal structurers and their clients for unprecedented volumes
of higher risk securities.
• Even where securitisation arrangers retain the toxic waste on their own balance sheets,
this should not be accepted too readily as satisfying the ‘alignment of economic inter-
ests by having skin in the game’ argument. The real test involves comparing their
toxic-waste exposure risk with the total fee income they stand to gain from the transac-
tion. And this needs to be done on a transaction-by-transaction basis. With many recent
CDOs having progressively smaller residual tranches (often only a few percentage points
of the reference portfolio), arrangers are often financially ahead of the game (from fee
income) even if they totally write down their residual tranche holding to zero on Day
One of the transaction.
• The flip side of the ‘moral hazard’ coin is that with most ‘buy-side’ financial institutions
becoming volume-driven, financial executives need (and at times even seem addicted to)
high-risk product in pursuit of super returns. This is aided and abetted by the pervasive
financial industry practice of awarding mega-bonuses based on annual performance (which
do not need to be repaid if the chickens come home to roost in later years) attended by
the spectre of employment risk for underperformers, which explains the excessive risk-
taking behaviour that rational expectations theory fails so abysmally to explain.
Policy priorities
It is beyond the purpose of this book to provide detailed recommendations for economic
policy-makers and regulators. Nonetheless, for a treatment of financial crises of the recent
past and present to resonate even after the book is closed, it seems useful to take a few of
the lessons drawn from these events to the next step of pointing out a few things which
policy-makers and regulators might give priority consideration, including the following.
• It is time to revisit the need for regulation of the financial sector. As to what should be
the appropriate objectives for a revised regulatory framework, two stand out as essential:
(1) protection of society from fraud and predation; and (2) safeguarding the stability of
the financial system. Beyond this, the oft encountered objective of ‘protecting individ-
uals from themselves’ too frequently involves a tyranny whereby purely subjective norms
and values of the few are imposed on the many. In this connection, better financial educa-
tion, starting as early as in primary school, and enforcing better (where the term ‘better’
means ‘essential and relevant’ rather than ‘voluminous’) disclosure and accountability of
issuers would likely produce more salutary and abiding results than if this is dictated by
regulators.
• The responsibility of the Federal Reserve (and other financial sector regulators not only
in the United States but in other countries as well) should recast their fiduciary respon-
sibilities in the positive rather than in the negative. Specifically, their mandate should be
189
described as one of preserving the stability of the national currency rather than specifi-
cally to deflate asset market bubbles or to control the CPI. The subtlety involved here is
that if protecting the value of the currency (or, alternatively, not allowing the currency’s
debasement) is cast as the broader objective, irrespective of the threat, then the appro-
priate actions by the Federal Reserve and other regulators will be more likely to cover
whatever it takes to discharge that obligation with appropriate policy measures. These
measures will then be triggered when any set of forces threatens to devalue the currency,
whether detected in the behaviour of consumer prices, producer prices, or indeed finan-
cial market indices. Of course, this will likely mean that more needs to be done to gauge
(in terms of agreed norms, systems for relevant data capture and appropriate analyses)
whether or not asset market price indices are giving rise to the formation of bubbles or
can be defended on the basis of economic fundamentals.
• Much more needs to be done to improve upon the alignment of economic interests both
in business generally as well as in the financial sector. This needs to be addressed in the
following areas:
• Measures are needed to remove the current open invitation for moral hazard in exec-
utive bonuses and severance packages. This needs to be done not only in the interest
of treating investors fairly but to avoid the current tendency to ‘privatise’ windfalls and
‘socialise’ losses with the resulting burden on taxpayers.16
• Regulators should continue the emphasis on ensuring that financial institutions adopt
and maintain sound processes and procedures. But beyond this they need to monitor
and ensure that at all levels relying on self-regulation have enough ‘skin in the game’
– but credibly assessed for a change (see last two bullet points before ‘Policy priori-
ties’ above) – for the rationale underpinning self regulation to be credible (as described
above, mortgage finance was woefully lacking in this regard to the extent that the
principle of fiduciary responsibility was observed in the breach).
• The principle of appropriate disclosure and reporting needs to be sharpened and imple-
mented. The answer here is not likely to be one of imposing the burden of frequent
and voluminous reporting of data (as distinct from information). Instead it should be
addressed from the viewpoint of what regulators and the investing public ‘need to
know’ (for prudent risk management) as opposed to addressing it in terms of all the
things they ‘might like to know’.
Global considerations
Some of the main trends and issues which will challenge policy-makers going forward
include:
• Global imbalances and the risks of rebalancing. The key questions in this connection are:
(1) is rebalancing inevitable? (2) if so, in what likely timeframe? (3) what will be the
main risks posed as current surplus countries find their accumulated surpluses dwindling
faster than they anticipated? (4) what are the likely effects on the relationships among
major currencies? (5) what are the likely effects on current patterns of trade in goods
and services?
190
• Potential for the current financial crisis in the US to spread globally. To what extent have
the deficient lending practices observed in the US been applied in Europe and other
regions? To what extent have institutional investors become exposed to the risks of concen-
tration in structured finance?
• If the US enters a full-blown recession, what is the potential for a global recession more
along the lines of the relative severity (if not in terms of other characteristics) of the
Great Depression?
• Prospects for the restoration of trust as it affects key segments of the global financial
markets. What are the prospects for structured finance? To what extent will institutional
investors avoid CDOs and other structured finance instruments or will steeply discounted
prices be sufficient to renew their interest? Can hedge funds be counted on to take up
the slack in institutional demand for structured finance instruments?
• Potential for successive bouts of international protectionism. What are the risks of protec-
tionism in connection with (a) the activities of sovereign wealth funds; (b) international
trade; and (c) capital mobility generally and its treatment by host countries?
01
In the institution’s early years, this was fairly mechanistically determined as the world was on the ‘gold exchange
standard’.
02
Isard (2005, pp. 185–9).
03
McKinnon (1993, ch. 1).
04
McKinnon (1993, p. 10).
05
Isard (2005).
06
Mishkin (2006, pp. 148–9).
07
In this connection, Mexico’s lapse in sharing information on the state of its foreign exchange reserves is attrib-
uted by some as an explanation for the massive flight of capital precipitated at the end of 1994.
08
Isard (2005, ch. 7).
09
Isard (2005, ch. 8).
10
Cruikshank and McGuigan in Buljevich (2005, p. 198).
11
In fairness, Paul Volker almost single-handedly saved the US economy from runaway inflation by shouldering
the burden of adjustment through monetary policy. Although he did this by contracting the money supply to the
point of raising interest rates to double-digit levels, this was necessitated by the standoff at that time between
the executive and legislative branches of government which seemed to constantly thwart the much-needed fiscal
adjustment.
12
Of course, from the viewpoint of those groups in society most affected, certain categories of goods and serv-
ices are more relevant than others. But to the extent that the price increases which distress them the most are
offset by price declines (or stationarity) of other goods and services (which are usually less relevant to those
groups), the problem, although an important one from a social perspective, is not truly proof positive of the
presence of inflation.
13
Greenspan (2007).
14
Schumpeter, J., Economic Theory and Entrepreneurial History. Change and the Entrepreneur (1949).
15
Politically, it would be extremely hard to defend such action’s effect of punishing the innocents (Main Street)
whose relevant reference index (the CPI) was under control just because of the excesses of the perpetrators
(Wall Street) whose reference indices (the stock market averages) were rising for reasons difficult to prove and
thus highly contentious.
16
In 2006, it was reported that the top three individual remuneration packages for hedge fund executives were
each between one and two billion dollars. In 2007, the top three were all over $2 billion. Ironically, when asset
values plummet, any of this income that may have been subsequently invested will likely suffer value erosion
191
but there will be no requirement to pay any of it back as the bets (on which the bonus portions of these pay
packages were predicated) unravel. To the extent such remuneration was in connection with proprietary risk-
taking, this seems only fair. But to the extent it was mainly the ‘carried interest’ portion of investments made
by such individuals on behalf of others who subsequently lost heavily, it strengthens the case for questioning
the current asymmetry which exists as to how gains and losses are (and are expected to be) each apportioned
today in the United States and other mature societies.
192
Chapter 8
Lessons from financial crises for

portfolio managers
The limits to hedging

Hedging is a risk management strategy which has been used for centuries. From the earliest
crude approaches which were based on the principle of risk mitigation although were lacking
in adequately-quantified measurement, both the menu of available hedging products and
their ostensible precision have come a long way. Yet, despite the enormous strides made in
terms of data capture and risk measurement underpinning today’s financial hedge products,
these products suffer from distinct limitations regarding the completeness of the protection
they have to offer.
Without undertaking a comprehensive treatment of the individual portfolio management
tools, the institutional strategies, and the practices of each type of financial institution, a
brief treatment is provided below of some of the strategies and instruments which institu-
tional portfolio managers use. This treatment includes some of the main issues and limitations
which can arise in connection with the strategies, tools and instruments. It is provided as a
basis for portfolio managers to strengthen their awareness of how changes in the way they
combine available tools and instruments with risk management strategies will better protect
their portfolios from the ravages of financial market distress. It is offered in the spirit of a
common refrain heard among securities and derivatives traders to the effect that it matters
less how much one makes than how little one loses.
Why is this important? For one thing, concentrating on controlling losses on each posi-
tion ensures the discipline of having sound systems in place and the ‘readiness’ that
accompanies this discipline. For another, it recognises the reality that, from the viewpoint
of market returns, we tend to live not in a ‘normal’ world but rather in a ‘log-normal’ world
(for example, a 50% loss needs to be followed by a 100% gain to get back to ‘even’). And
finally, as Rebonato1 points out, there is an asymmetry among outlier or ‘fat tail’ events in
that the sharp drops in the composite value of market indices witnessed during major market
crashes are without a counterpart in a positive direction during a market recovery phase.
Markets can and do recover after a major crisis, but this tends to happen in steps. These
steps, moreover, tend to meander and do not occur uniformly in an upward direction.
Consequently, they carry with them risk and uncertainty. This, in turn can prompt protec-
tive – even overly cautious – responses on the part of investors and portfolio managers, who
having been caught unawares during the crash, are determined not to be left in such a posi-
tion again and therefore are inclined to cash in their initial gains early rather than risk a
subsequent loss. Such protective responses can therefore deny those asset holders not
193
practising loss mitigation from realising the maximum recovery of their portfolios that a
rebounding market has to offer.
The main hedging tools available to investors and traders are listed below, followed by
a description of their principal limitations.
• Asset diversification.
• Time diversification.
• Insurance.
• Forwards and futures.
• Financial options.
• Swaps and credit derivatives.
• Short selling.
• Market timing.
Asset diversification. Probably the most familiar and readily applicable form of hedging is
the act of diversifying one’s assets and even activities. In ancient times it was not uncommon
for merchants to bring home wares they had purchased abroad for resale in the holds of
several ships as a way of protecting against the total loss that would result from shipwreck.
Farmers discovered early on that by planting more than one crop, they could mitigate
the adverse impact on their livelihoods if either a single crop failed or became infected with
blight or the market prices for that crop for some reason plummeted around harvest time.
The main characteristic of asset (or activity) diversification on which its efficacy depends
is how the expected (future) returns from each of the assets or activities under considera-
tion co-relate to each of the others. Understanding this was the seminal breakthrough which
first Harry Markowitz and subsequently William Sharpe (in 1959 and 1970 respectively)
made in formulating modern portfolio theory. Without in any way detracting from the bril-
liance of this insight in its day, today with the advantage of hindsight, the idea conceptually
is quite simple (even if computationally a little more involved) as well as highly familiar
to financial practitioners. Yet the simplicity inherent in asset diversification and the quanti-
tative precision which has been introduced in applying it as a risk management strategy also
obscures a different kind of risk. That is the risk that correlations (and their associated
covariances) are not stable parameters. Instead, something causes their underlying values to
shift. This can be the case either throughout a range of market conditions or alternatively
it can occur only in extreme regions such as during a major financial crisis. The former
will usually thwart attempts to achieve optimum returns from an investment portfolio even
if financial distress does not become manifest. The latter, however, will usually result in
diversification failing to protect the erosion of portfolio value as correlations converge to
one and asset values enter free fall together. In short, the value of the hedge will unex-
pectedly dissipate at precisely the moment when it is most needed.
Time diversification. Another tool for hedging risk in an investment portfolio is time diver-
sification. Instead of spreading portfolio resources across a number of independent assets,
the approach involves concentration in relatively fewer assets but with the diversification
achieved by investing at different points in time and consequently at different prices. The
194
Lessons from financial crises for portfolio managers
simplest variants of time diversification strategies are dollar averaging (investing the same
dollar amount periodically in the reference asset at the prevailing price) or value averaging
(investing sufficient resources periodically in the reference asset at prevailing prices to main-
tain the original value of the amount invested) strategies. Such approaches capture the power
of price or value recovery inherent in a harmonic mean associated with the price series for
the reference asset. Its vulnerable point, however, resides in the uncertainty surrounding
whether or not price behaviour of the reference asset is ‘mean reverting’. If prices trend
upward, the strategy is foiled by having to add successive additions of the reference asset
to the portfolio at successively higher prices attended by mounting risk. If prices trend down-
ward, the strategy, although seeming to benefit from steady lowering of the average cost of
the reference asset, may obscure a distress situation from which its price may never recover.
Insurance. As one type of hedging instrument in the financial markets, insurance products
(proper) assume a variety of forms. General property and casualty insurance contracts on
the fixed assets of borrower entities, required to protect the collateral used by such borrowers
to secure their loans with lenders, represent probably one of the oldest forms of insurance.
Private mortgage insurance (PMI) is another important form of insurance which reimburses
the mortgage lender in the event that the borrower defaults on the loan and the foreclosure
sale price is less than the amount owed the lender. At the other end of the financial spec-
trum are financial guarantees provided by multi-line and monoline financial insurance
providers. These are generally applied to the payment streams associated with bonds and
other debt instruments. While insurance policies of different types have generally been found
to be reliable products, they are as good as the quality of the underwriting institution. Their
main risk – counterparty risk – is the risk that the underwriter of these products may default
because of its own financial distress.
Insurance underwriters determine pricing and exposure on the basis of actuarial infor-
mation. As long as markets exhibit signs of stability, the probabilities derived from historical
data provide useful approximations of inherent risk. When systemic risk mounts, insurers
become exposed to the same sources of liquidity risk as the financial institutions and markets
which they serve. In such cases, when structured finance products depend on the ratings of
key tranches within their structures and when these ratings are based on the perceived finan-
cial health and associated credit ratings of the insurers providing the associated ‘insurance’,
then anything which undermines the market’s perception as to the quality of such protec-
tion can precipitate panic selling and cause market liquidity for structured products to
recede. Consequently, even though financial guarantees and other insurance products do not
trade in the financial markets, this does not eliminate their susceptibility to broader systemic
risk.
Forwards and futures. Forward contracts are bilateral contracts to deliver a specific value
amount forward in time from the date of issuance, subject to certain well-defined terms and
conditions. They are generally originated by banks or other financial institutions as a way
of hedging important risks. They are usually held to expiration on the books of the origin-
ating institution. Furthermore, they can and often do contain unique features which render
them illiquid. Futures contracts, on the other hand, are standardised contracts on single
195
names, commodities, and market indices. They trade on the world’s major futures exchanges.
Open interest (which means the value of futures contracts which are in force at a particu-
lar point in time) at any given moment in time can represent values of underlying assets
which are multiples of the associated quantities of those reference assets in actual physical
existence. Such is the enormous leveraging power of this hedging tool. Although futures
markets frequently exhibit enormous amounts of liquidity, this liquidity can suddenly dry
up if the market for the underlying or reference asset becomes too volatile with sudden and
unexpected reductions in its own liquidity. As significant changes take place in the price of
the reference asset, futures prices can move sharply, often in jumps which are much more
pronounced than the incremental price changes associated with the underlying reference
asset. This can curtail the usefulness of futures as a dynamic hedge by either making succes-
sive layers of futures protection prohibitively costly or alternatively, where short-selling is
involved, make associated hedging strategies excessively risky.
Financial options. Today, financial options are offered in a wide menu of characteristics.
They range from plain vanilla puts and calls traded on liquid options exchanges to exotic
options many of which are crafted to complex specifications and held in highly illiquid
fashion on the books of financial institutions or trade over the counter. Option pricing in
the derivatives markets is driven by certain fundamental factors as well as by key differ-
ences in the type of option.
For example, a European option, to which the Black-Scholes pricing model conforms
well, involves a contract conferring a right but without an obligation to either buy (in the
case of a call option) or sell (in the case of a put option) an underlying reference security
at a specific exercise price on a specified expiration date. The European variant requires the
option to be held until the expiration date, at which time it either expires worthless or settles
for the market-determined amount of the payoff.
American options are exercisable at any time throughout their life. Consequently, the
relevant option pricing models tend to be lattice frameworks of which the binomial and
Cox-Rubinstein models are representative.
Bermuda options combine features of European and American options by being exer-
cisable only on certain predetermined dates (usually every month).
Exotic options come in many different forms, some of the more common of which
include:
• Asian option – an option with a payout based on an average over its life.
• Barrier option – an option with a payout determined by whether or not the underlying
reference asset reached or exceeded a certain predetermined price level; it can be a ‘knock-
in’ or ‘knock-out’.
• Compound option – an option for which the underlying is another option.
• Digital option – an option for which the payout is fixed once the underlying reference
asset exceeds its predetermined threshold.
• Down-and-out option – a type of knock-out (barrier) option which expires worthless if
the price of the underlying reference asset falls below a predetermined lower threshold
price.
196
• One-touch option – an option with a full payout once the price of the underlying refer-
ence asset reaches or exceeds a predetermined threshold.
• Quantity-adjusting option, quanto option – a cross-currency derivative with a payout
determined at a fixed exchange rate.
Additionally, active markets in options on futures and swap options (also known as
‘swaptions’), which are options to enter into an interest-rate swap, have rounded out the
hedging instruments open to investors.
Although valuable additions to financial risk management, financial options are also vulner-
able to abrupt changes in the volatility and reductions in the liquidity of the underlying reference
assets as in the case of some of the other hedging instruments described above.
Swaps and credit derivatives. Interest-rate and currency swaps are the two traditional and
best-known types of swap contract. They are traded over-the-counter and provide valuable
hedge protection against interest-rate risk and adverse exchange-rate movements respectively.
Because they did not address credit risk, which was a matter of paramount concern to most
managers of credit portfolios, credit derivatives were introduced to fill this gap.
One of the main limitations of using credit derivatives as the main source of risk manage-
ment and control arises in connection with certain financial institutions constrained by
prudential regulations and norms from holding any financial asset rated lower than invest-
ment grade. Situations can arise in which overall portfolio risk may be manageable as a
consequence of applying offsetting credit derivatives but deteriorations in the quality of the
reference assets prompt the need to unload these positions. Another limitation, of course,
arises in the case of those institutions precluded from taking positions in derivatives, although
as we will see below, new financial products (such as certain specialised exchange traded
funds (ETFs)) have been introduced to overcome this limitation.
Short Selling. As a stand-alone activity, short selling is every bit if not more risky at times
than holding strictly long positions in securities. Combining short selling with long posi-
tions in the right combinations, however, can act as a highly effective hedge. It is a strategy
that is not possible in all markets. For example, many emerging markets countries do not
yet have adequate arrangements for securities lending to underpin short selling. Furthermore,
in markets lacking sufficient breadth, depth and liquidity, the risk is that the securities in
which short selling is feasible may not possess the best characteristics to hedge the rele-
vant long positions. Consequently, convergence plays based on relative value anomalies may
simply become too risky and may need to be unwound precisely at times when liquidity
conditions are the least favourable with larger than anticipated losses resulting. As an alter-
native to direct participation in short selling, a new crop of ETFs have been introduced and
offered which allow investors to take contrarian positions with regard to major indices. Some
of these funds even replicate a doubling in reverse of the performance of their reference
indices. These offer a valuable alternative to address some of the risks of short selling.
Market timing. The debate is far from decided between those who advocate some form of
market timing – that is, getting into the market heavily during the earlier part of an upward
197
market trend and then exiting at or near the peak – and those who discredit the claims that
it is a prudent investment strategy. It may, however, remain an unresolved debate over a
hypothesis which cannot be proven for at least a few reasons.
• Market cycles, even though fairly frequent over a long enough time period, may still not
be sufficient in number to underpin conclusions regarding this hypothesis based on statis-
tical evidence of any reasonable reliability.
• Historical analyses in any event only demonstrate a different question from the one being
posed – even if the market over time presents sufficient opportunities to achieve supe-
rior returns based on timing than would be realised in connection with a ‘buy and hold’
strategy, this does not demonstrate that investors can benefit from it consistently (this
would be analogous to saying that because every horse race has a winner, that this then
demonstrates that giving up one’s daytime job to bet the horses is a sound income-earning
strategy based on ample opportunities). The assertion that market timing constitutes a
valid approach presupposes certain minimal skills which some may have but many do
not (even limiting the population to investment professionals).
• Market entry and exit based on rules, in the hands of proficient traders, can achieve signifi-
cant returns under a variety of dynamic market conditions. However, since such returns are
usually achieved at the expense of asset diversification (because of greater reliance on
trading skills rather than on asset selection skills based on correlations), it is not clear that
significant draw downs in connection with market timing strategies (even if somewhat miti-
gated) caused by sudden market shifts and ebbing market liquidity will be greater or lesser
than would be realised in the case of a properly diversified passive (buy and hold) port-
folio. One argument in favour of market timing is that in a major stock market crash, the
portfolio investments may not simply be exposed to market risk but also bankruptcy risk
which would permanently curtail recovery. A countervailing argument in favour of more
passively managed well-diversified portfolios is that the ability to avoid the multiplicative
and even nonlinear impact of chaining Type I and Type II investment errors2 presumes
possibly unrealistic skill levels as to convincingly suggest that market timing will render
consistently superior results. The problem with the debate when proponents of both sides
try to make their case on the basis of actual market examples is the tendency for both sides
to set up ‘straw men’. Where track records for portfolio managers using the two main
approaches have been selected and compared, it is not always clear that the choices were
always representative of ‘best practice’. Furthermore, such comparisons provide little guid-
ance at all regarding combinations of active portfolio management (including some element
of market timing) with asset allocation, style and diversification decisions.
• All investors can earn systematic returns (less transaction costs), which derive from those
portfolios passively held and exposed to market or systematic risk, whereas in a closed
system active return, derived from portfolios exposed to the risks of active management,
is zero sum (the number and amounts of gains made by outperforming managers rela-
tive to a market benchmark are offset by underperforming managers).
Hedging tools can perform well when the financial markets have ample liquidity. When the
financial markets become agitated, however, with sell-side orders outstripping buyer interest,
198
this causes market liquidity to recede abruptly, thereby weakening the protection that hedging
instruments would normally provide. A useful analogy can be found in secured lending.
When a secured loan goes into default, property serving as loan collateral can be liquidated.
But if the property is auctioned and the bidding is ‘non-responsive’, then either there may
be no bidders or the highest bid may fail by a significant margin to cover the outstanding
value of the loan despite the fact that best estimates of fair value suggested otherwise. The
cause of this inadequacy is the crystallisation of liquidity risk. If the default which precip-
itates the foreclosure is systemic, with real property values also being depressed, then what
was previously considered to be ample security may prove to be unexpectedly deficient.
The use of financial leverage

How much financial leverage is prudent or advisable is a perennial question. Quantification
of appropriate debt-equity ratios or debt-total assets ratios needs to be informed by the
borrowing entity’s expected patterns of cash flow (liquidity) and how well it can control its
costs and its risks. Intuitive and approximate approaches to this question have been steadily
replaced by more rigorous statistical methods. Despite important historical examples of finan-
cial crises which were if not caused, then certainly exacerbated, by excessive use of financial
leverage (two of the most famous of which were the Wall Street market crash of 1929 and
the demise of Long Term Capital Management), it seems the lesson has not been well
learned. To be sure major stock markets have tightened margin requirements in connection
with securities trading by the general public. However, the removal of the silos in which
financial activities had been traditionally conducted, particularly as financial liberalisation
spread throughout the final decades of the 20th century, only served to encourage the circum-
vention of prudential restraint by permitting multiple ways to take large positions with ever
less of one’s own capital at risk by using financial leverage. These are some of the ways
in which this happened.
• The use of derivatives to take sizeable positions in underlying financial assets with expo-
sures to loss far greater than what an unlevered position in the underlying would involve;
for example if a market participant is at the outer envelope of his own risk threshold by
way of holding a position in a stock that could decline by as much as 10% during the
anticipated holding period, then presumably he should only be willing to buy a deriva-
tive such as a futures contract or an option contract with a face value of not in excess
of 10% of the face value of the underlying reference asset as well, as this represents the
value of the option that could be lost if the option expired worthless.3
• Circumventing the restrictions imposed by securities law on the use of margin by
borrowing funds to trade in securities and financial derivatives from other sources such
as credit cards, second mortgages on one’s home, signature bank loans, borrowing against
pension plan holdings, inter-company borrowings within a group and so on.
• Investing in structured finance instruments which involve significant pyramiding of finan-
cial leverage, both in connection with reference assets as well as throughout their complex
structure of tiered obligations.
• Certain types of financial institutions with significant financial leverage on their own
199
balance sheets compound their overall risk due to leverage by investing in assets which
also incorporate substantial financial leverage as well.
• The application of certain investment strategies usually associated with hedge funds which
allow simultaneous leveraged long portfolio positions funded through the shorted portion
of the portfolio (such as in 130/30 funds) tend to resemble hedged positions but because
of imperfect correlations and risks other than pure market risk can magnify the risk due
to leverage.
With regard to the use of financial leverage, portfolio managers should: (1) understand each
asset on the balance sheet in terms of its true use of financial leverage; and (2) use only
as much financial leverage as is consistent with forward-looking risk estimates based on
outlier risk and not simply on the basis of historical time series which may not span severe
albeit low-probability events.
Asset allocation
Several studies have shown, based on analysing decades of portfolio management perform-
ance, that asset allocation decisions account for a very high percentage of portfolio variance.
But the results and the conclusions of these studies need to be accepted and applied with
caution. The use of historical time series tends to obscure (or at least weaken through aver-
aging) many of the recent and rapid structural changes in the global financial system described
throughout this book. The interconnectedness of financial markets geographically as a conse-
quence of globalisation as well as the interconnectedness of sub-markets for different classes
of financial instruments as a consequence of the combined trends in technology and dereg-
ulation have weakened much of the past diversification benefit afforded portfolio managers
by their asset allocation strategies. Moreover, as we plunge deeper into the current period
of financial market distress, it is essential to keep in mind an important shift in the dynamics
of relative asset prices.
When earnings performance of companies and other institutional obligors is robust, debt
and equity markets tend to be weakly correlated. From an understanding of basic finance,
this makes sense. In buoyant or upward trending markets, debt instruments are relatively
safe but are limited by contractual interest rates regarding their potential upside while equi-
ties capture the full advantage of market exuberance. When markets are in a trading range
or are mildly trending downward, the legal protection inherent in the underlying ‘promise’
of a debt instrument buffers it from the fortunes of the market while equities absorb the
brunt of any market retracement. Adverse economic conditions, however, can precipitate a
sudden drop in funding liquidity for numerous borrowers, widespread financial market
liquidity, or in the extreme give rise to increased numbers of insolvencies. When this occurs,
the relevant correlations between debt markets and equity markets suddenly shift upward.
When financial market distress becomes protracted, the spiral of defaults and bank-
ruptcies (both institutional and personal) exerts further upward pressure on the correlation
between debt and equity price changes (returns), driving it inexorably higher. This can also
spill over into similar changes in the correlations between these two asset classes and others
such as financial derivatives (at least for as long as the price discovery function for finan-
200
cial derivatives continues to work) and currencies. This broader distinction and indeed finer-
grained distinctions among debt instruments of varying tenor, risk, return, and liquidity allow
mature and well-developed financial markets, functioning within certain bounds, to consum-
mate transactions and permit continuous price discovery based on rational discernment among
these characteristics. The operative qualifier in the preceding sentence is ‘operating within
certain bounds’.
When financial markets become distressed, they cease to allow such fine-grained distinc-
tions from being made. This results in excessive noise or uncertainty with a concomitant
sudden loss of liquidity in those markets which are most dependent on relative stability. It
particularly affects portions of the debt market and the derivatives markets. Moreover, it
happens much in the same way that a ‘far infrared’ or ‘thermal’ camera, based on sensing
heat differentials, ceases to function effectively when ambient heat converges with body heat
rendering animal life suddenly ‘invisible’ to the camera.
In light of the financial market dynamics described above, even if financial portfolio
managers cannot avoid outright the worst of financial crises, they can likely mitigate signifi-
cantly the brunt of the impact through the following.
• Avoid mechanistic application of historical probabilities in calibrating portfolio strate-

gies, opting instead for forward-looking subjective probabilities even if the added
granularity results in portfolio decisions based on less (mathematically) elegant analyses.
Institutions which currently rely predominantly on quantitative methods in connection
with portfolio management will need to strengthen their investment committees including
decision support systems which allow such bodies to engage as a group in more Bayesian-
type decision making even if it appears to be ‘cruder’ than their current practice. During
troubled times, forward-looking intuitive approaches to decision making guided by expe-
rience are much more likely to dominate backward-looking rigorous approaches based
on spurious statistical precision.
• Incorporate a system of measures to be regularly monitored for gauging liquidity both
for individual positions as well as at the overall portfolio level. For individual positions,
these can include comparisons of individual exposure for each major asset to its relevant
average daily trading volume, ratios of exchange-traded derivatives to OTC derivatives,
and dynamic measurements of market liquidity for each prospective trade such as market
impact calculations and market resiliency calculations. At the level of the financial markets,
indicators of market depth, breadth, ‘immediacy’ and ‘resilience’ should be maintained
and regularly monitored as well. Risk premiums and volatility measures are also impor-
tant indicators of changes in market liquidity. The importance of knowing dynamic
liquidity risk arises because when markets decline sharply, the prevailing market prices
are not necessarily the same as the prices that a portfolio manager can realise.
• From a liquidity-risk perspective, develop alternative risk-management/hedging strategies4
so as to provide greater flexibility in terms of being able to weather conditions of extreme
market volatility with due regard to overall cost. The advantages of dedicating at least
portions of a large institutional portfolio to market-neutral strategies are significant. Whereas
in the past, many financial institutions were prohibited by regulation or by their charters
from applying such strategies, today this restriction has been significantly relaxed by the
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availability of new and innovative investment products. Exchange traded funds which deal
in commodities, options, other financial derivatives and which can replicate the market’s
behaviour either positively or in reverse are but one example. This means that an increasing
number of institutional portfolio managers are free to pursue strategies in the pursuit of
alpha (see below) while tightening their risk management capabilities.
• Configure (or re-configure) strong due diligence functions particularly in connection with
structured finance and emerging market securities and alternate investments (such as in private
equity, hedge funds, and real estate). While ratings should not be ignored, an object lesson
can be learned from the ongoing sub-prime crisis regarding the widespread tendency in recent
years for many institutional investors to focus less on the underlying assets and their funda-
mentals and instead take comfort in credit ratings. Without downplaying the importance of
detailed due diligence and as a starting point, simply knowing the extent to which ‘hot’ sectors
are woefully short on requiring participants to have ‘skin in the game’ (with an associated
open invitation for large-scale moral hazard) should provide a clarion call as to where partic-
ular caution needs to be exercised in assessing impending ‘bubble’ risk.
Are sovereign ratings sufficient or should portfolio managers

develop their own country scorecards?
The combined effect of more countries with significant default risk and companies domi-
ciled in riskier countries going to the international bond markets to raise financing has
stimulated demand for sovereign credit ratings. The two main credit rating agencies providing
these ratings – Moody’s Investor Service and Standard & Poor’s – perform ratings on over
one hundred sovereigns. Country ratings vary from S&P’s AAA (Moody’s Aaa) for the safest
sovereign credits in the world to CCC (Moody’s Caa2) for countries whose obligations
represent the highest risk. Sovereign ratings are also provided for obligations payable in
domestic currency as well as those payable in foreign currency. Sovereign ratings are valu-
able not only to those investors holding or contemplating holding sovereign obligations but
indeed they are also valuable to those investors holding corporate debt from companies or
other obligors domiciled in these countries as well. This is because changes in economic
conditions affecting the sovereign will have an impact on the creditworthiness of issuers
within the country as well. The sovereign rating serves as a benchmark. It further provides
an important measure of currency risk (presumably the difference between comparable issues
of government debt denominated in domestic currency and in foreign currency).
Both rating agencies apply essentially the same criteria in determining country ratings.
These are:
• per capita income;

• GDP growth;
• inflation;
• fiscal balance;
• external balance;
• external debt; and
• economic development.
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In view of the significant amount of resources and effort dedicated to assigning sovereign
ratings expended by Moody’s and S&P’s over time, it is unlikely that any but the largest
global financial institutions could make the case internally to mount a rating system of their
own that could compete with the agencies. However, for institutional investors with size-
able holding in securities denominated in foreign currencies relative to total portfolio size,
there is merit in complementing the information provided by sovereign ratings with inde-
pendent analyses of relevant country information – especially in terms of the aforementioned
criteria used by the rating agencies. As ratings are changed only periodically, institutional
capacity to detect divergences between the current values of country criteria and prevailing
values at the time of the last rating should carry substantial ‘intelligence’ value for risk
management purposes. The fact that studies have found that ratings announcements have an
impact on market spreads further underscores this point.
Active versus passive management and separating alpha

and beta
Much of the economic and financial literature dedicated to explaining the formation of
bubbles and financial crises is based on notions of rationality as applied to generic investors
in relation to the market. Even to the extent that decisions are based on buy, sell or hold
decisions with respect to individual financial securities, the fact that each of these assets
correlates with a broader market index preserves the implicit linkage. As both electronic
communications and financial technology exploded onto the scene, ways for finance profes-
sionals to place bets on components of risk and return seemingly de-linked from market
performance proliferated.
It was William Sharpe’s seminal work5 on portfolio theory which showed that risk could
be decomposed into two components: (1) idiosyncratic risk, particular to the financial asset
in question which should at least theoretically lend itself to being diversified away; and (2)
market risk (or systemic risk), which exists for all financial assets to greater or lesser degree.
By applying linear regression analysis, Sharpe demonstrated that systemic risk can be meas-
ured as the regression coefficient relating financial asset returns to capital market returns.
As the most common Greek letter assigned to the associated slope of the line defined by
the regression equation was ‘beta’, then ‘beta’ became shorthand jargon ever since for cohorts
of MBAs and finance graduates as well as industry investment fund managers. If a finan-
cial asset – a stock, for example – has a beta that is greater than one, it is considered to
be systemically more risky than an investment in the market itself. A stock with a beta of
less than one is considered to be systemically less risky than the market. Of course, meas-
uring beta depends very much on which market index is chosen as representative of the
market, as well as the length of the time series used in the regression analysis.
The analysis was not limited to individual stocks. It was particularly useful as well in
connection with the performance of an entire investment portfolio. The measurement of beta
for an investment portfolio provided a very useful indication of its risk relative to overall
market risk. The intercept term in the aforementioned regression equation was similarly termed
‘alpha’ – which was the Greek letter most commonly used in econometrics for intercepts. As
a constant, totally unrelated to the market’s behaviour, alpha was a measure of portfolio
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performance that was explained by things other than the market. When applied to the histor-
ical performance of investment portfolios, alpha became a measure of the portfolio’s return
which could be attributed to the manager’s skill. The higher the alpha, the more skilled the
portfolio manager. Used in conjunction with one another, alpha and beta become powerful
measures of relative performance. They served to guide investors in choosing among the thou-
sands of investment funds available as well as provided an important industry benchmark for
rewarding portfolio managers.
Recognising that the systemic (market) risk component of financial assets remained
after idiosyncratic risk had been hedged away and that it was the difference between their
fund’s returns and the market’s returns which would determine their annual remuneration,
generations of finance professionals sought ever more imaginative ways of extracting ‘pure
alpha’ from their portfolios to the extent that institutional mandates permitted. Although
there continues to be ongoing debate in some quarters regarding the extent to which pure
alpha is all that’s left, the rise of relative-value trading, spread trading and market-neutral
trading catered to the appeal of placing bets on narrowly identified and confined risks with
many of the other risks being hedged away. Consequently, the logic to support a ‘buy, hold,
or sell’ decision, which would normally seem compelling based on fundamental and tech-
nical factors when viewed strictly from the perspective of a simple long (or even short)
position in a single asset, very often tends to be subjected to an ‘override’ when that same
position represents but one leg of a more complex trade, involving compensating components.
Because of the tight regulation of financial institutions to be found in countries with
mature financial markets, those entities having the flexibility to pursue the most creative
investment strategies in pursuit of alpha have traditionally been hedge funds. As highly
opaque pools of private capital which have not been subjected to regulation to the same
extent as other entities participating in the financial markets, they have been free to engage
in short selling, apply financial leverage and combine financial securities with derivatives
and other hedges in order to carve out the specific types of risk they sought to hold in
pursuit of superior financial returns.
Several developments in recent years have placed the hedge funds under increasing
public scrutiny to the extent that politicians in the US, the UK and in continental Europe
are increasingly making the case for subjecting them to greater financial regulation. To be
sure, recent trends in hedge fund and private equity mergers have heightened hedge fund
visibility as well as have contributed to the debate. However, new financial institutions and
products are now appearing as prospective tools for those types of institutional and retail
investor previously deemed ineligible by regulatory decree from participating in the afore-
mentioned strategies enjoyed by the hedge funds.
Of particular note is the 130/30 fund. The 130/30 fund in many ways resembles the
traditional long-only closed-end fund which was fully dedicated to taking long positions in
debt and equity securities. Additionally, however, after becoming 100% invested in long
positions, they are permitted to sell short up to 30% of their net asset value (NAV), the
proceeds of which can be applied to the long end of their portfolio. This in effect allows
them to capture beta as well as alpha. Under competent management, they hold the prospect
of producing superior returns to the normal beta gained from traditional asset management.
However, in the hands of inexperienced or less skilled managers, they also hold the poten-
204
tial to aggravate losses by failing to achieve beta returns while producing negative alpha
should the long-short convergence inherent in their structure become elusive.
At the time of writing the 130/30 fund industry is of the order of between $50 billion
and $60 billion. The bulk (perhaps as high as 80%) apply quantitative strategies while the
remainder (20% or thereabouts) use fundamental long-short strategies. Importantly, shares
or participations in these funds can be placed under an ‘Undertakings for Collective Investment
in Transferable Securities’ (or UCITS) structure with large institutional investors otherwise
barred from following such strategies directly themselves. These funds are also available to
retail investors who otherwise would not meet the net worth and net income tests normally
required for admission to a hedge fund. Many observers in the fields of traditional and alter-
native asset management are predicting an explosion in the growth of demand for these
funds in the coming years.
It is important to note that when a large portion of the financial markets is characterised
by multi-component trades in large individual institutional exposures justified on the basis
of the compensating nature of the transaction’s hedges, then the market becomes that much
more vulnerable to events which act like an electric current applied to an electromagnet.
For example, prices of individual securities and indices for larger groupings of securities
(including market indices and sector indices) very often surge close to option expiration
dates when traders with ‘short’ positions scramble to cover their positions buying shares of
the relevant underlying securities. Specifically, in ‘normal’ periods (howsoever defined), weak
or negative correlations among markets and instruments provide the ready building blocks
for effective hedges. This is analogous in the case of the electromagnet to highly tempered
steel in which the atoms are randomly arrayed in the absence of an electric current passing
through the steel. Key international events, acting analogously as the application of electric
current to the steel of the electromagnet which aligns the medium’s atoms in a single direc-
tion, tend to align the returns of assets otherwise not strongly correlated to the point where
all correlations tend to unity. Collapses in international currencies such as in Mexico in
1994 and 1995, East Asia in 1997, Russia in 1998, and Argentina in 2002 constitute ex-
amples of such events which rendered many hedges ineffective and worse. Indeed like the
mathematical variant of the derivative which in the absence of smooth differentiability of
the underlying function becomes indeterminate, the financial derivative loses the basis for
value determination and hence its liquidity when markets for underlying assets become
highly agitated to the point of creating discontinuities.
Even when compensating legs of a trade involve opposite positions in essentially the
same securities, the real risks may actually extend to events or developments which are not
readily contemplated when the trade was designed. Such things as liquidity risk, the credit
risk of counterparties, especially those providing ‘insurance’, sudden changes in volatilities
of the component instruments, tracking error resulting from parameter shifts and changes
in presumed correlations and so on, do not readily attract attention at the outset. Yet in the
case of some of the more notable meltdowns, they have tended to become ‘the straw that
broke the camel’s back’.
The larger institutions with quant desks cannot be faulted for having lacked models. The
problem in a number of cases, however, is that the models treated the associated risk as if
it was a truly exogenous phenomenon. In point of fact, those with billions of dollars in
205
exposure concentrated in relatively few markets assume the role of ‘trend setters’ not only
because they can move the markets with their own actions due to the volumes they command
alone, but because knowledge of their actions becomes a bell-wether by which other market
players are guided. This converts market activity from resembling a tatonnement to more that
of a large game among strategists. This means the equations for demand and supply become
systems of differential equations with a strong self-referential component.
For large institutional players to extract sufficient profit from relative-value trades to
justify their involvement, enormous exposures are involved. From a risk management perspec-
tive, the explicit and implicit hedges involved in these transactions significantly mitigate the
degree of risk which would otherwise be attributed were the same amounts involved in uni-
directional long or short bets. But from the perspective of the potential impact that such
complex trades can have on the daily float and associated liquidity of the involved secur-
ities of which they are comprised, notions of myriad buyers and sellers having to reach
some pricing consensus are relegated to textbooks of the past. In fact, examples such as
those emanating from Long Term Capital Management as well as a few involving some of
the better known financial powerhouses (such as Travelers, Smith Barney, Salomon), demon-
strated only too palpably the vulnerability of seemingly large, liquid markets to sudden
developments within the organisational confines of a single institutional player. This under-
scores the need for financial institutions to measure and monitor liquidity and liquidity risk
– as imperfect as such measurements may be – on a regular basis. As Bookstaber notes,
‘The real risk is the one you can’t see’.6
Developing the institutional capacity to monitor and manage

liquidity risk
What then is required for financial institutions to develop the institutional capacity to monitor
and manage liquidity risk effectively?
Ensuring adequate liquidity comprises two groups of actions: (1) actions to reduce as
much as possible net cumulative outflow (NCO); and (2) maximising free eligible assets to
offset remaining NCO.
Furthermore, best practice segments liquidity risk into three categories. Each is best
viewed as a separate type of liquidity risk:
1 mismatch or structural liquidity risk;

2 contingency liquidity risk; and
3 market liquidity risk.
Managing liquidity risk in a financial institution is a key undertaking which not only needs
to be integrated with the other facets of risk management but with the daily exigencies of
funding and profit maximisation as well. It is the responsibility of the financial institution’s
board of directors and its senior management to ensure that an appropriate liquidity risk
management strategy, organisational structure, and procedures are in place as key elements
of a liquidity risk management framework, which should comprise the following.
206
• Liquidity risk management strategy – the strategy, which should be well-communi-

cated throughout the institution, should focus on the general approach to liquidity risk
management and should further identify quantifiable and qualitative targets.
• Liquidity risk policy – the policy, which should be reflected in a written policy docu-
ment and made widely available throughout the institution, should spell out the main
principles of the strategy in terms of the ‘do’s and don’ts’ in connection with the day-
to-day management of liquidity risk; while it would provide greater specificity than the
strategy, it would leave detailed treatment of procedures and quantitative limits to the
procedural framework (described below).
• An appropriate organisational design – the institution’s organisation should be retro-
fitted to ensure that the liquidity risk management function is well integrated with other
business, finance and risk management activities in ways which will achieve the liquidity
risk stance set forth in the strategy and policy statement.
• A procedural framework – the framework, which should be reflected as appropriate in
the institution’s operations manuals, should provide a clear mapping of responsibilities and
authorities regarding the execution of liquidity risk management procedures and approvals.
• Limits – the board of directors should ensure that the risk limits set for ongoing activ-
ities and new initiatives reflect in a practical way the expression of the institution’s overall
risk stance as set forth in the strategy and policy statement; the limits should form an
integral component of the procedural framework.
• Internal control procedures and audits – the control process advisably should be based
on maintaining independence between ‘position management’ and ‘position monitoring’
with the control unit ascertaining if daily transactions are within established risk limits
on the basis of liquidity-risk gap analysis; it further includes procedures for notifications
as well as management referrals and sign-offs within the organisation in connection with
detected limit breaches of varying magnitude and duration.
• Monitoring – an effective control function involves the control unit having the mandate
and the tools (including the right data, reliable data feeds, and timely reports) based on
a reliable monitoring process conducted at least on a daily basis; it is particularly impor-
tant that information on multi-leg transactions (especially where daily use of repo’s, credit
derivatives and various complex hedging strategies are employed) is captured and reported
in a complete and transparent way so as to enable accurate assessment of unencumbered
asset positions and associated liquidity gaps.
Effective management of liquidity risk must start at the top. This requires it to be a priority
matter for a financial institution’s board of directors. Not only must the board proactively
seek information and management action in connection with liquidity risk management, it
needs to develop its own collective expertise on the matter. This is usually done by consti-
tuting an asset-liability management committee of the board. A board of directors (and its
constituent asset-liability management committee) of a financial institution that is effectively
managing liquidity risk will generally be found to be doing the following.
• Directing the financial institution’s senior management to draft a strategy document for
managing liquidity risk to be submitted to the board for discussion and approval which
addresses such topics as:
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• objectives for managing funding risk by major categories of tenor (short-term, medium-
term, and long-term) and contingency risk;
• objectives in connection with managing concentration risk, taking into account the
specific nature of the institution’s business;
• approaches for managing across multiple currencies – both in terms of overall expo-
sures as well as with regard to specific needs and safeguards for individual currencies;
and
• identification of specific management tools and responsibilities within the organisation
for liquidity risk management.
• Ensuring that a written policy statement reflecting the liquidity risk management strategy
is prepared by management, approved by the board to its satisfaction, and is communi-
cated throughout the financial institution.
• Ensuring that a liquidity risk management procedures and control framework is put in
place by management and that compliance with the limits and norms is being assured.
• Ensuring that reporting to the board and its relevant committees is done not only on time
and with sufficient accuracy but with the appropriate detail and analysis and in the format
best suited for ensuring that liquidity risk issues are being properly addressed.
• Undertaking periodic reviews which ‘take stock’ of how effectively the strategy, policy,
procedures and control framework are achieving the liquidity risk stance which the board
collectively considers to be appropriate; this also includes examining reasons for frequent
breaches of established limits, identification of possible unnecessary rigidity or slack in
some of the rules and procedures, any ambiguities or vagueness in connection with risk-
management responsibilities which may be impeding sound management, and
identification of any other sources of previously unforeseen risk which warrant attention.
1
Rebonato (2007).
2
The clearest example of chaining Type I and II errors is when you exit a stock which subsequently surges
upward only to invest the liquidated cash in another stock which thereafter plunges. It happens, even to the best.
3
It should be noted, of course, that to the extent derivatives positions are systematically traded (or rolled over)
in accordance with sound risk management criteria well before final expiration in order to preserve value, the
corresponding exposure in value terms that is deemed prudent can be higher than suggested in this example.
4
For example, if portfolio has a long exposure in an index fund which is hedged by derivatives, the same combined
exposure can be achieved by replacing the derivative hedge with a reverse market-index ETF.
5
Sharpe (1970).
6
Bookstaber (2007, p. 50).
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Chapter 9
Conclusion
The severity and incidence of recent financial crises has understandably provoked a call
from numerous quarters for more action on the part of regulatory authorities. Moreover, as
the international effects of financial distress in real estate and structured finance at the time
of writing in early 2008 claim new victims at an alarming rate, these events are attended
by relentless surges in energy prices and basic commodities. In fact, the transmission of the
associated costs of these price increases is spreading rapidly to many other goods and ser-
vices at a time when growth does not seem to be the principle cause. Fears of stagflation
– a term not used since the 1970s – have been resurrected and vocalised with frequency.
What many feel we are now experiencing in the first-half of 2008 is the formation of
a commodity bubble. Others emphasise important global demand-supply imbalances inherent
in both the inexorable depletion of non-renewable resources combined with the effects of
population pressure and an explosion in new consumption originating in the emerging market
countries (mainly BRIC – Brazil, Russia, India, and China). As we saw in some of the
historical country examples described in Chapter 5, proof positive of a bubble may not be
possible until we are able to view the current situation retrospectively. The distinction between
these two world views, however, is substantive. It is one which policy-makers will need to
address and decide on one way or another. This must happen sooner rather than later and
no doubt it will have to be without the benefit of complete information in this connection
if yet another wave of financial distress following in the wake of the havoc wrought by the
currently-unfolding sub-prime crisis is to be ameliorated. This is because the appropriate
policy responses in the case of the former explanation (bubble theory) would seem to be
quite different from those based on the second (structural imbalances). Moreover, the propo-
nents of free-market economics would and still do argue in favour of letting the markets
sort things out. Such a response is, if not ill-informed, then disingenuous at best – at least
if it means leaving problem resolution entirely to ‘the invisible hand’.
The financial markets have become increasingly complex. They have incorporated struc-
tures involving rigidities (which some authors have termed ‘tight coupling’). It is not difficult
to find a number of examples which demonstrate that because of the combination of
complexity with rigidity with risk and uncertainties arising from unknowns, more regula-
tion (than the status quo) can exacerbate rather than assuage market behaviour. This, however,
does not logically imply that nothing should be done. If regulatory action is presumed to
be synonymous with the layering on of more detailed rules without necessarily being based
on a marked improvement in the underlying knowledge regarding their causative nature in
a range of situations, then such action would be ill-advised. This, however, smacks of setting
up a ‘straw man’. On the other hand, if changes in regulation were to take a page from
other high-risk sectors such as the pharmaceutical industry, one might envisage certain
209
prudential actions being taken in conjunction with the introduction of new financial prod-
ucts and their financing.
The analogy with the pharmaceutical industry is especially informative in terms of the
epistemological framework for regulation. At a time when most countries have bought in
to the efficacy of free markets as the preferred system for resource allocation, how does the
call for increased regulatory oversight square with such a view? In this connection, one can
draw on the philosophical and legal underpinnings for control aspects of the modern limited
liability corporation. In those sectors or industries in which among all classes of stakeholder,
shareholders unequivocally bear virtually all residual risk, then they have the final say, within
the confines of the law, regarding decisions affecting the company. It is because of this role
of ‘residual risk taker’ rather than the label of ‘shareholder’ or ‘owner’ per se that motivates
this custom. Where residual risk, however, spills over so as to be held by other classes of
stakeholder, then legal custom is for those classes to share appropriately in decision making.
For example, when the individual corporation becomes financially distressed (which gener-
ally means it has indebtedness which cannot be serviced or repaid as legally ‘promised’),
it is not uncommon to hear the expression that ‘the lenders are now the owners of the
company’. This happens in a de facto sense even prior to or without the formality of a debt-
to-equity conversion having already taken place. It means that custom dictates that because
lenders have passed from being exposed to the limited risk inherent in either their loan
agreements (for banks) or bond indentures (for bondholders), while at the same time the
limited liability feature of the modern corporation has extinguished equity and thus trans-
ferred further residual risk from the original shareholders to a different stakeholder class,
then the lenders should have more say in decisions affecting the company.
Are there other examples of residual risk takers? Indeed there are. Many of these can
be found, for example, in industries known to involve significant safety or environmental
risk. The pharmaceutical example applies. But one does not need to venture so far from
finance to find precedent in this connection. The very regulation of banking, as well as the
underwriting and trading of financial securities and derivatives is based on recognition that
there are those included in the ranks of the general public who are at risk beyond just those
who are directly involved in the financial markets and who are owners and managers of
financial institutions. In all of these cases, where those potentially affected include various
groups drawn from the general public, it has been virtually a universal norm for the govern-
ment to act on their behalf in a regulatory role. Because the potential impact of bad decisions
at the company level does not end with wiping out the owners of companies and institu-
tions providing products and services in these sectors, even in what are termed predominantly
laissez-faire societies, the case has long ago been made and accepted that government has
an appropriate regulatory role to play. Both the degree and nature of that role should be
scaled and oriented in ways that effectively address as well as are commensurate with the
size and nature of the risks involved.
The old textbook description of financial market risks in terms of neat taxonomies of
stocks, bonds, money market instruments and even with adding some of the newer ones like
mutual fund shares, money market shares and so on, with descriptions of how they differ
from one another in the assumption of atomistic markets, no longer cuts it. As we have
seen in previous chapters, new products, new and multi-leg trading strategies, and enormous
210
Conclusion
new concentrations of institutional power together conspire to create risk through sudden
and virtually unpredictable shifts in market liquidity, aided and abetted by increases in
massive financial leverage inherent in the new product and institutional forms. Complexity
is not necessarily bad. Nor, for that matter, is financial leverage. What is bad, is failure to
appreciate and to communicate to those whose trust is at stake the nature and likely conse-
quences of the full range of risks involved. An analogy would be the introduction of a new
curative drug which has neither gone through the appropriate testing nor been sold with
cautionary warnings regarding suspected side-effects. The recent explosion of CDOs leading
to the sub-prime crisis is one such example. The information asymmetry masked the facts
that new vehicles had been created and populated with mortgage loans possessing features
that departed significantly from the more prudent transactions of the past. Loan origination
standards were relaxed because the enormous carry trade inherent in a runaway housing
boom seemed to offer a more immediate and ostensibly superior ‘collateral’ in the form of
the prospects of being able to sell or liquidate the underlying property with solid gains
should the need arise. Moreover, financial obligations issued in connection with these struc-
tures were further given a good-housekeeping seal of approval by the rating agencies based
on statistical data and techniques derived from experience with seemingly similar products
but which, as it turned out, bore little resemblance to reality.
If there are historical lessons to be drawn from past financial crises for government
economic policy-makers and investment portfolio managers jointly, they would include these.
• The weak and negative correlations among financial assets and instruments which underpin
modern portfolio approaches to diversifying away risk under normal market conditions
tend to be thwarted in distressed markets as financial crisis unfolds. This is because those
same correlations tend to converge to one, becoming elusive when they are most needed
and as all financial asset prices tend to enter a state of freefall together.
• Specific detailed rules and regulations cannot always be counted on to produce salutary
results. Depending upon their specifics, they may, in fact, worsen a crisis by precipitating
the realisation of known and in some cases un-anticipated risks. Moreover, as we have
seen during the US credit crisis which is currently focused on the sub-prime mortgage
market, with respect to a number of the areas for which there have been calls for increased
regulation, laws and regulations already exist but they were either ignored or poorly
enforced.
• The burgeoning of new and innovative ways to transfer risk means that those creating
financial claims and thus presumed to be the object (and therefore whose behaviour is
assumed to be the target) of policy and regulatory measures may no longer be those most
affected by those actions; in some cases, with a little effort, the new ‘stakeholders’ can
be approximately identified; in others, however, the identity even as a class of those to
whom the risk has been redistributed is likely to remain obscured indefinitely. The caveat
to policy-makers and regulators is: Do not let your reach exceed your grasp.
• What drives markets, particularly in times of stress and eventual distress, is the pursuit
of liquidity. Information plays a role, to be sure, but principally as a bellows for the fire
of liquidity preference. An asymmetry often exists between information as ‘good news’
which does not necessarily increase market liquidity and information as ‘bad news’ which
211
can dry up market liquidity almost instantaneously. While volatility of price changes is
a highly familiar measure to portfolio managers and one which factors into their deci-
sions, the volatility of daily trading volume often tends to be less so. Sizes of investment
positions which are calibrated in terms of the number of days’ trading that are required
to exit the position should take into account the potential effect on trading volume and
available liquidity. This can benefit from seeing how in the past the trading volumes
and available liquidity for the asset in question responded to a range of types of news
as well as to reductions in overall market liquidity as well. It underscores the importance
of knowing your markets in terms of which participants are the usual suppliers and
consumers of market liquidity and identifying the trends in and events affecting changes
in these roles.
• Financial leverage has a valuable role to play, provided that those who assume the leverage
have convincing control of their risks and costs. And most importantly they should also
have a meaningful stake in the outcome – not just on the way up but on the way down
as well. While recent years have seen improvements in risk management to cover more
types of risk and with increasing rigour, this seeming control tends to be misleading. The
greatest risk when markets become spooked is that of liquidity risk for which adequate
hedging instruments have yet to be developed. The related assumption that the associ-
ated risks of a transaction, a group of transactions or an institution are being controlled
adequately to justify the degree of financial leverage being applied, includes yet another
assumption that safeguards are in place to ensure that the necessary market liquidity
required to allow effective hedging to function will indeed be available. As financial
markets become distressed, market liquidity rapidly recedes, often to the point that buyers
can only be found with drastic reductions in price. Sound advice in this connection would
be to heed the old warning that: Sometimes the best hedge is simply not to be long
the underlying.
• Private sector solutions to critical societal needs such as pensions and health insurance
seem attractive when only the efficiencies of the market are extolled. The simplistic view-
point of consumers somehow voting with their dollars rewarding the efficient and the
competent and punishing the less efficient and incompetent does not even work all of
the time in those areas and for those consumers where outcomes are less critical. It is a
ticking disaster waiting to happen for retirees and the infirm. On informed and intelli-
gent reflection, allowing unfettered market forces to instil discipline in the financial
markets should have no more appeal than the case for removing government regulation
of pharmaceuticals on the basis that consumers will force change by switching suppliers
as a result of their displeasure when they discover the presence of rat poison in the cough
syrup.
A case in point was when a number of politicians and media pundits in the 1990s
recommended that the United States follow the example of Chile (which had already
been followed by other Latin American countries) with its privately-managed pension
system. This thinking was predicated on the assumption that the necessary lessons had
been learned from past crises. It is frightening to imagine the personal distress that might
have been wrought on pensioners had this advice been heeded and their pension savings
been managed by many of the same institutions which have recorded sizeable losses
212
Conclusion
during the sub-prime crisis and which are currently queuing up to seek shelter under the
US government’s proposed financial recovery plan. As long as higher-sigma events are
discounted as being too improbable to happen, then the case for the efficacy of unbri-
dled markets gains strength through deception. A longer and more analytical view of
historical financial crises, however, will point to a very different fact. It is that the prob-
abilities of market rate-of-return outliers simply do not conform nicely to a strict Gaussian
assumption. Many of the adverse events which have mounted in number in recent years,
in terms of truly random and thus normally-distributed sets of occurrences would take
billions if not trillions of years in some cases to happen instead of the mere decades
between such misfortunate happenings. Not only are certain boom-bust dynamics at play,
other influences are also at work. Even in the most law-abiding countries and time periods,
the scope and proclivity for greed to prevail over probity, such as in the spate of corpo-
rate crimes prosecuted in the US and Europe (where there should be less excuse for
lapses in legal machinery than in emerging-market and frontier countries) just since the
turn of the millennium, serve to add fuel to the fires of financial market distress.
The lesson here should be that the new types of risk and uncertainties operating in
conjunction with finance (not only the result of innovative product but new institutions
and mechanisms as well) strongly argue in favour of finding a careful balance between
public sector and private sector involvement.
Along these lines, a practical suggestion might be for the regulators to insist on a trial
period of market testing for new high-octane financial instruments before they are offered
to the public or to institutions with an important fiduciary responsibility to vulnerable
segments of the population. Another would be to close the current regulatory gaps which
allow financial leverage in many cases to vastly exceed prudent levels. Yet another would
be to re-examine all the different ways that conflicts of interest within financial institu-
tions can emerge and the adequacy with how they are being resolved as the basis for
eliminating regulatory ‘blind spots’.
In this connection, although hedge funds have received much bad press in recent years,
as long as they continue to remain open only to investors who can be considered
‘consenting adults of means’ based on net-worth tests and other criteria, then the case to
subject them to strenuous regulation tends to lose cachet. This is from the viewpoint of
prioritising the role of government to that of saving the public from the criminally
unscrupulous and from systemic risk, instead of saving people from themselves.
On the other hand, to the extent that any type of institution opens its capital to the
general public or can threaten the financial system through the scale or scope of its
actions, such as in the case of LTCM, then arguments for subjecting them to regulation
become an entirely different matter. However, even in situations where the case for tighter
regulation is compelling, the focus should be more on governance and procedure than
one of subjecting institutions and investors to a proliferation of diktats of spurious preci-
sion.
Finally, an aspect of modern finance which tends to be overlooked and which needs to be
revisited from time to time in all countries (although in some more so than in others) is the
added exposure to boom and bust dynamics which societies are incurring as a consequence
213
of mortgaging our future. We have somehow heavily discounted if not outright ignored the
fact that the proliferation of goods and services we have achieved today in providing
consumers with an unprecedented abundance of choice and richer lifestyles is not the sole
product of the sweat and sacrifice of the past. Indeed, it has been accomplished increas-
ingly through financial innovation. In one respect this is good, as any economist will attest
to the power inherent in the time value of money (consumption today is preferred to consump-
tion tomorrow). Clearly, the advent of consumer finance, for example, produced an upward
quantum leap in standards of living worldwide. It did this by enabling people to enjoy the
benefits of housing and durable goods in their early years. This was in sharp contrast to
those societies in which major acquisitions could only be achieved through savings which
often deferred such benefits until late in life, if at all.
But to the extent that higher living standards have been achieved by exacerbating global
environmental, social and even geopolitical imbalances, as well as by increasingly financing
this consumption with assets incorporating promises to pay out of future wealth yet to be
created, we need to take a pause. Today’s escalating global financial depth coupled with
evidence of an increasing potential for massive disruption of many kinds – environmental,
social, geopolitical and economic – reveals new vulnerabilities and levels of risk. When
such risk ultimately crystallises, it will make its presence felt in various ways, not the least
of which (nor for that matter necessarily, the severest) will be new sources of distress in
financial markets. The question is: do we know what to do and will we have the resolve to
act accordingly?
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Annex 1
Treynor’s models of market bubbles1
Treynor model I
In Treynor’s simple market bubble model, he describes the conditions that would foster the
creation of a market bubble. He posits that three things are required. First, the view that
investors hold regarding market prospects in a risk-adjusted sense. Second their total wealth.
And third, how strongly they are prepared to bet, subject to their wealth constraint, on their
view of the market. He further groups the market population into two sub-populations –
optimists (bulls) and pessimists (bears). In this model, allowance is made for differences
between these two sub-groups in terms of their wealth, their market outlook and their hold-
ings of a presumed ‘composite market security’ but the entire population is assumed to
respond in like manner to the degree of error in the ‘forecast’ inherent in their market
outlook in a multiplicative way.
Assuming that K represents a ratio of trading aggressiveness relative to the variance of
the forecast error which applies to all, then bulls and bears are assumed to hold h1, and h2
in proportion to: (1) the difference between their respective expectations (P1 and P2) and
the actual price level, p as represented by a suitable market index; and (2) their respective
total wealth positions (W1 and W2). These relationships can be closed by the following
three equations:
h1 = W1·(P1 – p)·K
h2 = W2·(P2 – p)·K
h1 + h2 = 0
On examination, these equations suggest that h1 and h2 apply to changes in existing bull
and bear portfolios (that is, reflecting amounts available to trade and whether that amount
is to be bought or sold), since if any of the three terms in the first two equations (repre-
senting wealth, forecast error, and response intensity) were to be zero in either or both of
these equations, then the corresponding holding values would also necessarily be zero.
Furthermore, the third equation, representing the market constraint, means that the portfolio
change desired by one of the sub-groups (whether bulls or bears) is exactly matched by a
desired change of equal and opposite type (sign) in respect of the other group.
Given the aggregate wealth of the bulls (W1), market price expectations of the bulls
(P1), the aggregate wealth of the bears (W2), market price expectations of the bears (P2)
and the factor representing the degree of trading aggressivity (K) and solving the system
for the price of the market index (p), the amount held for trading by the bulls (h1) and the
amount held for trading by the bears (h2), we obtain:
215
Annex 1
冤冥
P1·W1 + P2·W2
W1 + W2
K·W1·W2·(P1 – P2)
X(W1,P1,W2,P2,K) := Find(p,h1,h2) factor →
W1 + W2
K·W1·W2·(P1 – P2)
W1 + W2
If we assume that new information is introduced which reaches all quickly and simultan-
eously (with no informational asymmetries) and further that all investor expectations are
homogeneous, then the new information will not cause any wealth transfer. This can be seen
by solving the same set of equations again but with the introduction of an additional impact
on price expectations in the form of Δ added in the same way to both the bulls’ expecta-
tions (P1) and the bears’ expectations (P2).
The new equations are:
h1' = W1·(P1 + Δ – p')·K

h2' = W2·(P2 + Δ – p')·K
h1' + h2' = 0
with the new endogenous variables all marked with a prime.

By solving the system with the new information, assumed to be available to all and
with homogenous expectations applying, we get:
冤冥
P1+Δ – P1·W2 – P2·W2
W1 + W2
K·W1·W2·(P1 – P2)
X'(W1,P1,W2,P2,K, Δ) := Find(p',h1',h2') simplify →
W1 + W2
K·W1·W2·(P1 – P2)
W1 + W2
for which it can be seen by subtracting the two sets of equations from one another
Δ
(X'(W1,P1,W2,P2,K, Δ) – X(W1,P1,W2,P2,K)) simplify → 0
0
冤冥
that p' = p + Δ, h1 = h1' and h2 = h2'. This is because with the new information intro-
duced as described, Δ cancels out (entering both bull and bear equations identically) and
thus it has no effect on the difference (P1-P2).
However, new information will transfer wealth from one sub group to the other propor-
tional to their respective holdings for trading (h1 and h2). These changes are represented
by the following equations:
216
Treynor ’s models of market bubbles
W1n = W1 + h1·Δ
W2n = W2 – h1·Δ
With the new wealth effects introduced, we calculate the new equilibrium for the bulls’ new
holding amount as a result of the increased wealth effect h1' and the negative of this amount
indicates the new amount (and type of trade) applicable to the bears.
W1n = W1 + h1·Δ
W2n = W2 – h1·Δ
h1' = W1n·W2n ·(P1 – P2)·K

W1 + W2
W1 + Δ·h1
Find(W1n,W2n,h1') simplify →
冤 W2 – Δ·h1
K·(P1 – P2)·(W1 + Δ·h1)·(W2 – Δ·h1)
W1 + W2
冥
Rearranging, we obtain an expression for the percentage by which bulls would be prepared
to add to their holding over the initial holding as a consequence of the increase in wealth
brought about by the introduction of new information.
冢冣
h1' – h1 P1 – P2
= ·(W2 – W1)· Δ·K
h1 W1 + W2
On inspection, the percentage increased holding is zero if either market price expectations
are identical for both bulls and bears or alternatively the total wealth of the bulls and the
bears is identical.
Financial markets can trend upward due entirely to a series of changes and expectations of
changes in market fundamentals. They can also trend upward purely as a consequence
of the formation of an asset price bubble. They can also trend upwards as a consequence of
both effects. The task of ascertaining the real causes for an upward trending market involves
testing for the formation of price bubbles. If markets are characterised by rational expecta-
tions and a random walk process, then factors explaining a relentless upward trending in a
market price index are based on market price determination as a result of both market funda-
mentals and the formation of a bubble. In other words, the current market price level is
determined by market fundamentals and expectations regarding the change in price formed
at that point in time. When prices are a function of inter alia their own rate of price change,
then price change expectations can describe a bubble which drives prices at a rate which is
independent of market fundamentals. One can expect to encounter indeterminacy of the price
level in looking for a new market equilibrium. This is because the current market price level
is a function of two unknown or endogenous variables – the current price and the current
expected rate of price change – while only one condition for market equilibrium exists. In
217
Annex 1
other words, a bubble describes that part of a series of price increases which is strictly the
result of self-fulfilling expectations. It is what is left after all the change attributable to infor-
mation has already been accounted for.
1
Treynor (2008).
218
Annex 2
Securitisation and the market for

structured finance products
In view of the growing importance of structured finance securities in global financial markets
and their potential to transmit distress when problems in the international financial system
occur, a brief treatment of the evolution of this asset class from relatively simple securi-
tisation structures to the complex structures of today is presented as a basis for understanding
the inherent benefits of this class of assets as well as its principal sources of risk.
Disintermediation was a popular term in finance in the 1970s. The term as applied tradi-
tionally, however, generally involved the simple idea of economic entities such as companies
going directly to the capital markets to raise debt or equity financing through the issuance
of their own securities. Disintermediation today is the basis for the development of the securi-
tisation market. Banks, as financial intermediaries, still play an important role in originating
the loans or assets which comprise the building blocks, the raw material if you will, for the
securitisation business. However, by packaging loans for securitisation they add a layer of
value by restructuring the risk-return-liquidity profile of financial obligations in ways which
best meet prevailing market appetite.
Definition of securitisation
‘Securitisation is the process of converting cash flows arising from underlying assets or
debts (receivables) due to the originator (the entity which created the receivables) into
smoothed repayment stream, thus enabling the originator to raise asset-backed finance through
a loan or an issue of debt securities – generically known as asset-backed finance securities
or ABS – which is limited recourse in nature to the credit of the receivables rather than
that of the originator as a whole, and with the finance being self-liquidating in nature.’1
Rationale for securitisation

Numerous reasons are cited for companies to undertake securitisation. Some of those more
frequently encountered are:2
• return on capital;
• balance sheet management;
• off-balance-sheet funding;
• funding diversification;
219
Annex 2
• bank liquidity;
• cost of funds;
• strategic profile;
• matched funding;
• tenor;
• transfer of risk; and
• systems.
Feasibility of securitisation
The reasons provided above as to why an institution might want to undertake a securitisa-
tion transaction or a series of them may be viewed as the determinants of ‘demand’ for
structured finance. This should only occur, however, if the economics of undertaking the
transaction(s) make sense. The economics of securitisation are driven by the ability to sepa-
rate and correctly price risk as well as the tight control of costs and risks. To drive the point
home, if virtually not everything then at least a wide array of assets can be securitised.
Whether or not this activity comprises a viable business is another matter. For example,
early attempts in many countries to securitise non-standard mortgage loans wound up being
prohibitive based on the costs of having to review in some detail each and every loan file
in depth. To the extent that these costs cannot be passed on to the senior tranche holders
(such as by offering lower yields on the tranches they are willing to hold), then the full
brunt is felt by the equity tranche which even if held by the institution sponsoring the securi-
tisation either means it is heavily discounted from the outset or is held on the basis of
erroneous value expectations. Problems of this nature have been encountered, for example,
in countries in which attempts have been made to securitise distressed assets and where
differences in degrees of distress and even quality of the information known about the under-
lying accounts was poor. In essence, the additional expenditure of both effort as well as
out-of-pocket expenses to realise value from such portfolios combine to make securitisation
a loss-producing exercise. It is not surprising then that in the early days of this industry,
mainly in the US, considerable care and effort was put into:
• standardisation of loan product not only in terms of loan characteristics and underwriting
practices but in terms of the nature of the underlying collateral as well;
• standardisation of ancillary services such as property appraisals and so on;
• ‘seasoning’ the loan product by ‘warehousing’ to weed out early the defective ones; and
• industry expenditure of billions of dollars on data capture and analysis.
Moreover, for securitisation as a business to thrive, it needs as preconditions the following

in place (repeated here as a sine qua non even though many of these aspects have been
previously listed as important elements of financial markets infrastructure).
• Modern and efficient lending laws which inter alia enforce rights and obligations in
connection with commercial indebtedness.
220
Securitisation and the market for structured finance products
• Modern laws for secured transactions which provide clarity regarding the rights and reme-
dies of all parties to the transaction as a basis for asset resolution in the event of payment
default.
• Laws pertaining to the trading of secured and unsecured loans which make explicit rights,
remedies and responsibilities in connection with assignments, novations, and transferring
collateral and the attached rights.
• A streamlined law of negotiable instruments which permits their creation, transfer
(including daily trading in them) and enforcement of rights attached to them without
undue administrative delay or cost.
• Laws pertaining to the creation, governance and regulation of special financing vehicles
(trusts, conduits, special purpose entities, structured investment vehicles and so on)
designed to isolate, manage and account for different categories of financial risk.
• Comprehensive accounting and auditing systems, including off-balance-sheet accounting,
which, inter alia, provide for necessary transparency in connection with the structuring
of securitised products and institutions and their evolving risk characteristics.
• A fair and equitable tax system which is conducive to securitisation while at the same
time ensuring that the economic effects of these activities are consistent with other social
and economic policy objectives.
• A strong business culture based on the rule of law and fair business practices (an ingre-
dient which has seen occasional lapses even in those countries which have been regarded
as the most advanced in this respect).
Early securitisations of residential mortgages, for example in the US, involved structures
with a single class of security. These only worked in the case of very high quality homoge-
nous home mortgage credits for example (which had usually been ‘seasoned’) to keep
front-end costs down. Eventually, securitisation structures used significant amounts of finan-
cial leverage (debt) in order to boost returns. To the extent that the mortgages pay an interest
rate above the overall costs of servicing the liabilities, the structure will be profitable. As
the market for securitisation obligations developed so too did the scope for differentiating
obligations in terms of types of risks and tenors. This resulted in collateralization structures
with large numbers of securities (called tranches) each of which with entitlement to different
types of claim against cash flows and asset values and thus consequently carrying differ-
entiated risk.
While it is technically feasible to issue securities associated with a securitisation differ-
entiated by their risk, return, and liquidity characteristics and then have all of those securities
held to their respective maturities by the initial holders, it is the prospect of dynamic price
discovery, which only secondary securities markets can provide, that permits maximum value
realisation based on differentiation from the perspective of the transaction sponsor. It was
the pre-existence of the formidable US bond market that gave the United States the uncon-
tested lead in development of the business side of structured finance products. This often
seems to be a fact that is lost on proponents of securitisation transactions in many emerging
market or frontier countries where a liquid market for even government securities has yet
to develop.
221
Annex 2
Types of securitisation and CDO

• Pass-through structures versus pay-through structures.
• Balance-sheet transactions versus arbitrage transactions.
• Cash versus synthetic versus hybrid.
• Cash flow versus market value.
• Offshoots.
Credit enhancement
Securitisation structures employ a variety of ways to manage risk and boost the credit-
worthiness of the notes issued in conjunction with the transaction or securitisation entity.
These generally fall into internal and external enhancements. Examples of internal enhance-
ments include:
• senior-subordinated structures;
• reserve funds (as either cash reserve funds or an excess servicing spread account);
• overcollateralisation; and
• shifting interest structure.
Internal enhancements can become quite complex and have the capacity to modify the cash
flows from securitisation structures in ways that are not always obvious even in the absence
of default.
Examples of external enhancement, which for the most part are in the form of third-
party guarantees, include:
• bond insurance;
• pool insurance;
• corporate or sponsor guarantees; and
• a letter of credit.
Unlike internal enhancements, external enhancements do not materially change the cash flow
characteristics of a securitisation structure, with the exception being when prepayment risk
materialises. What this means is that, with the exception of prepayment within the asset
pool, the investor receives the same expected amounts irrespective of whether or not defaults
occur. If defaults do not occur, then pay out to the investor will have been met by the antici-
pated cash flow generation of the asset pool. If defaults do occur, then pay out to the investor
will be covered by the external enhancement or third-party guarantees.
In looking to the future and the prospects for structured finance markets, enhancement
will continue to play an important role. However, it seems reasonable to predict that regu-
lators, rating agencies and industry participants will need to take a hard look at bringing
the relationship between how much of the value in a securitisation is intrinsic (derived from
the quality of the underlying assets and their cash flows relative to the costs of the trans-
action) and how much derived exclusively from enhancement (both internal and external).
222
Securitisation and the market for structured finance products
To the extent that much of the current sub-prime crisis can be attributed to this relationship
being allowed to become excessively distorted, focus will be required to bring it back to
some reasonable balance in the interests of renewing investor confidence in structured finance
products.
1
Deacon (2004).
2
Deacon (2004).
223
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00-DFM-Prelims-cpp:Layout 1 21/10/08 16:35 Page i

Distressed Financial Markets:

Distressed Financial Markets:

Tel: +44 (0)20 7779 8999 or USA 11 800 437 9997

Copyright © 2008 Euromoney Institutional Investor PLC

ISBN 978 1 84374 543 3

Typeset by Phoenix Photosetting, Chatham, Kent

Part 1 – The framework

1 Financial crises and their origins 3

2 Evolving characteristics of financial markets 17

3 Systemic liquidity and financial market distress 40

4 Financial risk management and liquidity risk 57

The symbiosis between risk markets and securities markets

Part 2 – Country cases and global trends

5 Country case histories of financial market distress 89

6 Financial globalisation – global trends and the new functions,

Part 3 – Lessons for policy-makers and portfolio managers

7 Lessons from financial crises for policy-makers 163

Thoughts on orthodox and heterodox economic policies 170

8 Lessons from financial crises for portfolio managers 193

Annex 1 Treynor’s models of market bubbles 215

About the author

• Chapter 7, while not in any way intended to be comprehensive in terms of treatment or

Financial crises and their origins

The South Sea bubble

Part I: The framework

The panic of 1907

Financial crises and their origins

The Wall Street crash of 1929 and the Great Depression

Part I: The framework

• the model of social organisation (Marxism versus capitalism);

Financial crises and their origins

• It was not preceded by commodity or industrial price inflation.

Thoughts on the causes of bubbles, panics and crashes

Part I: The framework

• self-reinforcing and perpetuating;

Are distressed financial markets always caused by bubbles?

What other causes can be responsible?

Financial crises and their origins

be triggered by adverse developments in sectors – domestically, internationally, or both –

What explains the formation and accretion of bubbles?

Part I: The framework

Financial crises and their origins

Who to blame – external or internal causes, crowds or

The role of macroeconomic policies as a cause of financial

Part I: The framework

Financial crises and their origins

The human element in financial markets

Part I: The framework

The problem with statistics and probabilities

Random walk and misleading probabilities

Financial crises and their origins

Part I: The framework

The institutional importance of a financial market perspective

Part I: The framework

The role of legal frameworks

Evolving characteristics of financial markets

• undertakings regarding information security standards and safeguards;

Part I: The framework

Evolving characteristics of financial markets

Part I: The framework

Intermediation and disintermediation – how banks and securities

Evolving characteristics of financial markets