Financial crisis are crisis in confidence
Economic crisis have multiple causes. They may occur following a sudden shortage in a key resource. For instance, in 1973 the Organization of Arab Petroleum Exporting Countries declared an oil embargo in response to the United States involvement in the Arabo-Israeli Yup Kippur War. A recession and a rise in the unemployment rate soon followed as factories ran out of the fuel necessary for production and transportation.
Economic crisis may also be caused by a sovereign default. When governments are unable to honor their debt, they either formally decide not to pay creditors or they devalue their currency by printing truckloads of money that they use to pay back their obligations. Either way, they find it impossible to maintain their programs and build projects as creditors refuse to write new loans at a loss. This sudden retreat of government leads to lay-offs and to decreases in output since firms and workers who depend on their contracts lose a major consumer and employer.
Finally, economic crisis may follow a financial crisis. To put it in the simplest term, a financial crisis is an episode when lenders loose their ability to predict borrowers' likelihood to repay their obligations. To minimize the risk of writing bad loans, banks refuse to lend until this information becomes known. The latest crisis originated from investors' sudden refusal to finance mortgages because they did not know which ones were "toxic", and was followed by a precipitous fall in economic output as the U.S economy shrank at 8% per year and shed over 800,000 jobs per month.
At first glance, it would seem that firms would produce the same amount of goods and services and employ the same number of workers because they have access to the same tools, but the availability of input has little influence on the decision on how much to produce. It only sets the maximum amount of goods and services that firms can make. When deciding how much to produce, firms only take into account customers' demand for their output and their ability to finance their purchases. If they lose their confidence at predicting customers' demand and their capacity to pay, firms will produce less by putting machines offline and laying-off workers until this information becomes known.
Governments implement policies to spur confidence
Lending slows significantly during financial crisis because lenders lose confidence in borrowers' ability to honor their obligations. This has very real consequences in the economy since, in response, firms also decrease production because they do not know if their customers or suppliers will be able to secure the loans required to stay in business.
To resolve financial crisis, governments have to ensure that important transactions continue to take place. Its most potent tool is to guarantee Systematically Important but Compromised Contracts (SICC). These are contracts that would seriously damage the economy if they are not honored.
Safeguarding household deposits
Banks only keep in their vaults a small percentage of money from savings and checking accounts. Although banks commit to providing the balance of depositors' accounts on demand, under current regulation they are allowed to lend out 97% of those funds to finance mortgages and business loans. Since banks have so little liquidity on hand, they would be forced to close and depositors would lose all their savings if more than 3% of clients demand their money simultaneously.
The likelihood of SICC Deposits increases during economic crisis as depositors who lose their jobs or access to credit are forced to draw on their account for funds. If enough money is retrieved from a bank, it could fail causing all its clients to lose their money. In turn, panicked households that are clients of other banks would also draw their money out to put it under the proverbial mattress. This catastrophic run on banks would cause the collapse of the banking system, and an eventual depression, as business will not know where to turn to finance projects and consumer will be unable to borrow to finance their spending.
The most common tool used by governments to back SICC Deposits is an explicit deposit insurance system. In fact, as of January 2014 it was implemented in 113 jurisdictions. Deposit insurance is a government guarantee that it will pay depositors when banks are unable to do so. If the insurance is credible, in the darkest moments of financial crisis, households will keep their deposits in the bank and banks will use those funds to continue lending.
Safeguarding the contracts of financial firms
There can be runs on any financial contract. Much like households need to post their house to obtain a mortgage, large financial institutions also need to post a collateral to obtain financing.
For instance, life insurance companies are required by law to maintain a combination of cash, bonds and stocks equal to the value of the policies of their clients. When borrowing funds from large lenders, banks also need to post a collateral. If they are unable to honor their obligations, lenders and policyholders will be paid back with the proceeds of the sale of the collateral.
During financial crisis, the value of that collateral, which are typically stocks or bonds, falls with the overall market. Borrowers, who are contractually forced to maintain a certain level of collateral, sell them and their price falls further. They sell it for cash and high quality government bonds, whose values remain constant. However, during financial crisis there are few private buyers, and they require a hefty discount because they expect further depreciation. If the government does not step in to buy these assets, much like a run on banks when depositors try to retrieve their funds as quickly as possible, the value of financial assets falls precipitously as borrowers try to sell them as quickly as possible.
The most recent example of such a run is the 2008 financial crisis. Banks traditionally lend money to finance mortgages against a monthly payment from homeowners. In the years preceding the crisis, banks as always gave out mortgages, but instead of keeping it on their books, they sold the future flow of payments as mortgage backed bonds, freeing up funds to lend again.
These bonds were in high demand, thus expensive, because they provided a steady cashflow and were backed by houses whose value nearly tripled between 1996-2006. This meant that even if a home owner defaulted on his mortgage, by then the value of the house would have risen by so much as to allow investors to recoup all of their money.
Insurance companies, banks, non-financial firms and even governments bought those mortgage backed bonds and posted them as collateral when borrowing. When the value of houses started to fall in 2007, the value of the mortgage backed bonds gradually decreased. Borrowers who had to maintain a fixed level of collateral, sold the bonds before it decreased, putting further pressure on prices.
By March 2008, large banks like Bear Stearns who were heavily invested in mortgage backed bonds were in great difficulty and required government assistance. Finally, in October 2008 when one of the largest investment bank, Lehman Brother, suddenly fell, the whole financial system was on the brink of collapse as everyone was trying to sell their assets for cash.
Since private buyers required large discounts to purchase these SICC Bonds, to maintain their value and prevent a fire sale, the government bought non-performing bonds from banks, insurance companies, pension funds, hedge funds... who wanted to get rid of them. In fact, the first measure passed by congress following the 2008 market collapse was the Troubled Asset Relief Program (TARP), which authorized the government to "insure or purchase up to $700 billion in troubled assets". This amount was further increased to a commitment of $12.2 trillion and since then $2.5 trillion was spent on purchasing SICCs and non-SICCs.
Although it stabilized financial markets, the funds did not restore confidence. Financial institutions, instead of lending out proceeds from of the sale of these troubled assets to the government, kept it as cash which carries much less risk. For instance, the cash and cash-equivalent reserves of deposit taking banks in excess of what is required by regulators grew from $40 billion in 2007 to $2.7 trillion in September 2014.
Safeguarding the contract of non-financial firms
Sever economic downturn follows financial crisis because dependence on loans is staggering. In the U.S. for instance, customer debt in July 2014, excluding mortgages, stood at $3.2 trillion or $27,200 per household. Business debt, excluding the financial sector, was even greater at $11.7 trillion.
The amount of debt firms carry is so great because they use it as a bridge to cover cost until they collect money from their customers. In industries which use inputs from a wide range of suppliers, such as the automobile sector, this reliance on debt financing makes companies dependent on the ability of their peers to secure loans.
If the maker of brakes halts production because it is unable to secure new loans, car manufacturers will stop their activities and will not buy mufflers until they can find new brakes. To preempt this possibility, if the muffler manufacturer expects that just one supplier will be in financial turmoil, it will halt production so it does not accumulate excess parts.
In 2008, non-financial firms such as car manufacturers had access to TARP funding because the government believed that temporary stoppage in production from SICC Suppliers could leave enough workers unemployed to cause a systematically important downturn.
How to strike the right balance
Financial crisis cause a loss of confidence in every type of contract, but protecting them is very expensive because taxpayers become counterparties in large contracts which are by definition losing money. By not letting problematic contracts fail, governments also ignore the source of the crisis resulting in the accumulation of issues, and even greater guarantees and purchases to resolve the next one.
Therefore, in order to minimize cost and to maintain the stability of the financial sector, policy makers should only focus on protecting contracts whose failure can cause widespread damage.
The economy is composed of imperfect people who fail to predict their future economic situation and who write flawed contracts. As a result, cycles of booms and busts are bound to happen. Fortunately, busts are usually not systematically significant.
Just as the economy does not unravel when the local autoshop closes, there have been large falls in stock prices and major bankruptcy that barely registered in economic accounts. It would cost an incredible amount of taxpayers' money to prevent unimportant failures, money that has to be repaid through austerity measures, increased taxes and reduced programs. These periodic busts are also essential for getting rid of problematic contracts. Giving a blanket protection allows hidden problems to accumulate and eventually blow up into systematic crisis.
However, due to political pressure these small busts are often dampened by policy makers' concerns that their constituents may suffer loses. For instance, Alan Greenspan, the Federal Reserve Chairman who oversaw the pre-recession boom, prided himself on reducing market volatility by intervening whenever the price of bond, stocks and houses decreased.
He notably injected liquidity in the market during the dot-com bust to support stock prices, but most importantly he moved mountains to maintain high house prices in the early to mid 2000's. Analysts now think that this policy aggravated the 2008 crisis since the financial system was not given the chance to rework contracts governing mortgages and mortgage back bonds while problems were still minor.
During crisis that can take down whole financial systems, it is essential to intervene to protect SICCs. However, not all contracts are systematically important and have to be guaranteed. Analysts have criticized the government for buying financial institutions' troubled assets, during the 2008 crisis, no matter their systematic importance and at full cost, when restricting purchases and imposing a discount would be cheaper.
As a result of this blanket transfer, taxpayers have been burdened with a massive bailout bill, whereas benefits may be short lived as studies have shown that the bailouts have further weakened the financial system by not ridding it of problematic contracts.
Policy makers must remember that contracts, not the institutions or executives who wrote them, that are systematically important and have to be protected. They must also remember that by definition, buyers must be willing to pay for the services a systematically important contract provides.
A good analogy would be a business owners who owns an autoshop and an ice cream parlor. Due to unforeseen climatic events, she is forced to close the ice cream parlor, declare bankruptcy, and lose all her assets including the autoshop. Of course, the government will not compensate her for the lost investment nor her clients for the cost of finding a new autoshop or ice cream parlor. However, if it is the only autoshop in town and the local economy depends on it, the government may take temporary ownership of the business until it can find someone to take over the repair contracts.
Similarly, there is no such thing as a financial institution that is too big to fail but there are SICCs which are too important to renegade. During financial crisis, unforeseen structural changes may cause one of those business lines to suddenly become unprofitable and compromise the survival of lucrative systematically important contracts (i.e. deposits, mortgages...).
The probability of compromising systematically important contracts due to weak business lines have been magnified since the repeal of the Glass-Steagall Act in 1999. This act forbade commercial banks, which undertook low risk operations such as writing mortgages or taking deposits, from engaging in high risk investment banking activities. Ever since its repeal, banks' investments divisions have taken relatively risky positions in the stocks, bonds and derivatives markets.
If problems in a division causes a bank to fail, the government should let the stockholders fail, take temporary ownership of the bank, get rid of the problematic lines of business, and become counterparties in SICCs until it finds a buyer willing to take over these profitable contracts. This solution was successfully implemented with South Africa's largest lender African Bank Investment and Portugal's Espirito Santo. These countries had no choice but to take over these banks because they could not borrow enough money to buy back their troubled assets. Taxpayers also benefited from this policy because they were not burdened with a massive bailout bill.
This solution is not only fair, since it treats the financial and non-financial sector similarly, but essential to promote financial stability. If creditors expect the government's protection when their counterparty defaults, they will be unwilling to monitor their behavior or to select prudent counterparties. On the flip side, much like a losing poker player who receives a loan to play another hand, the debtor who receives a temporary government loan or even free money will take even riskier decisions because there are no downside.
This article does not define SICCs as they should be analyzed on a case by case basis. It is also by no means a road map on how to solve the economic downturn associated with financial crisis. I have absolutely no clue how to resolve this conundrum.
This is simply a framework on how to mitigate the panic and loss of confidence that financial crisis bring. However, a policy that focuses on only protecting Systematically Important but Compromised Contracts, will not only reduce the risk of further major crisis, but will also save taxpayers trillions of dollars, money that can be used to address unemployment, infrastructure, and other economic issues.
By Kasole Nyembo