ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

A+| A| A-

Causes, Cures and Myths

Our sights must be set on moderating the recurring cycle of financial crises and our solutions must go beyond the instruments, institutions or individuals of the day. Blaming offshore financial centres or the complexity of derivatives for the current problems misses the point. This article proposes counter-cyclical capital charges to push banks to develop incentive packages that are more encouraging of longer-term behaviour and a valuation method based on the relative maturity of an intermediary's funding. What the latter will do is allow any institution in a liquidity crisis to set up its own internal "bad bank" mechanism so long as it has sufficient long-term funding to support it.


Causes, Cures and Myths

Avinash D Persaud

Our sights must be set on moderating the recurring cycle of financial crises and our solutions must go beyond the instruments, institutions or individuals of the day. Blaming offshore financial centres or the complexity of derivatives for the current problems misses the point. This article proposes counter-cyclical capital charges to push banks to develop incentive packages that are more encouraging of longer-term behaviour and a valuation method based on the relative maturity of an intermediary’s funding. What the latter will do is allow any institution in a liquidity crisis to set up its own internal “bad bank” mechanism so long as it has sufficient long-term funding to support it.

The introductory section and the later section on “mark-to-funding” borrow heavily from my contributions to the 2009 Geneva Report on the Fundamental Principles of Financial Regulation, co-authored with Markus Brunnermeier of Princeton, Andrew Crockett, formerly of the BIS and Bank of England, Charles Goodhart of the London School of Economics, and Hyun Shin of Princeton University.

Avinash D Persaud ( is with Intelligence Capital, London.

Economic & Political Weekly

march 28, 2009 vol xliv no 13

What Went Wrong

he crisis which was triggered by the US sub-prime mortgage market in early 2007 and then spread broadly and deeply was not the world’s first banking crisis. It was probably the 85th. We can draw a few important implications from this observation. If an event with widespread and severe economic and social consequences keeps on repeating itself, the onus is surely on the authorities to change something. Sackings and show trials of bankers in front of the United States (US) Congress, United Kingdom (UK) parliamentary committees or elsewhere provide some schadenfreude; but are unlikely to change much for long. When a regulatory mechanism has failed to mitigate boom/bust cycles, simply spreading its basic structure across more institutions, instruments and countries is unlikely to be a successful strategy and could make matters worse. Moreover, a type of crisis that repeats itself cannot easily be put down to new derivative instruments. If we set our sights on moderating the r ecurring cycle of financial crises, our solutions must go beyond the instruments, institutions or individuals of the day.

The prevention of crises in the banking system is more important than in the case of other industries. The externalities from an individual bank failure both to other banks and thence to the wider economy are greater, primarily because banks lend to banks and liquidity of all banks depends on a general air of confidence. Given these externalities, the regulation of banks must do more than instil best practice among bankers, or converge regulatory capital to the capital a prudential bank would otherwise hold. One of the key purposes of bank regulation should be to internalise the wider, social, costs of potential bank failures. This may be achieved in the way we set capital adequacy requirements—though I suspect there may be better ways. But tackling systemic risks is more than setting capital adequacy ratios higher than otherwise.

The current approach to systemic regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks, and other highly leveraged financial intermediaries can behave in a way that collectively undermines the system. Selling an asset when the price of risk increases is a prudent response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing institutions to take yet further steps to r ectify the situation. It is, in part, the response of the banks themselves to such pressures that leads to generalised declines in asset prices, enhanced correlations and rising volatility in asset m arkets. Systemic regulation must therefore consider sources of

march 28, 2009 vol xliv no 13


systemic risk such as behaviour, and not just a static view of b alance sheets.

Through a number of avenues, some regulatory, some not, though often in the name of risk-sensitivity, sophistication and modernity, the impact of current market prices on behaviour has intensified. These avenues include mark-to-market valuation of assets, regulatory approved market-based measures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models, and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices. Crashes follow booms and in the boom, pricebased measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increase.

Market discipline encourages financial institutions to respond to these three related developments by some combination of

(i) expanding their balance sheets to take advantage of the fixed costs of banking franchises and regulation, (ii) trying to lower the cost of funding by using short-term funding from the money m arkets, and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets. When the boom ends, and asset prices fall and short-term funding to institutions with impaired and uncertain assets or high leverage dries up, leading to forced sales of assets which drives up their measured risk, the boom turns to bust. The s tarting point of correcting financial regulation is addressing the boom. We shall turn to regulatory solutions in a moment but in the meantime, let us turn to the urban myths of the causes of crisis.

Two Urban Myths: Tax Havens and Derivatives

Despite all this, political leaders in the US, Germany, France, the UK and elsewhere have responded by calling for a closure of offshore financial centres and the banning of complex derivatives. Offshore financial centres have been presented as the drug d ealers of modern finance and pushers of instability. As discussed above, the origins of this crisis are a failure of regulatory p hilosophy in the US, Europe and elsewhere. It would have

o ccurred were there no offshore financial centres. The attack on offshore centres is a politically seductive distraction from the thorny task of making regulation better in large developed c ountries and will end up being a discriminatory attack on small developing countries with little voice. We shall turn to d erivatives in a moment but for now let us consider the case against tax havens.

One of the first institutions to fail in this crisis was Northern Rock, a very British bank where supervisors appeared to overlook the niggling detail that funding long-term mortgages of over 100% of the value of homes in a mature boom, with short-term deposits and money market funds, is highly risky. A German s avings institution, IKB, was next. Regulators did nothing about the exponential growth of mortgage-related financial derivatives, not because they were hidden in offshore financial centres

– they had the discretionary powers to raise bank capital charges for any additional risks they perceived – but because they thought that this was an example of safe financial innovation that was banking the under-banked and diversifying risk.

Economic & Political Weekly

march 28, 2009 vol xliv no 13

Admitting that the crisis was a failure of domestic regulation implies that those in power were out to lunch as the largest financial crash was brewing. It is easier to blame tax-dodging foreigners. But let us be real. The largest centres of boastfully light regulation and light taxes for non-residents were London, Luxembourg, Dublin, the Channel Islands, Gibraltar, Monaco and many other locations in the European backyard. Yet some G-7 leaders would rather play to the gallery by stepping on countries that cannot respond – small developing countries. You can see why international cooperation is struggling to secure legitimacy when the same countries that mucked up their own regulation, plunging the world into crisis, appoint themselves judge and jury of what is good, bad and ugly elsewhere.

There are at least three ways in which the current attack on offshore financial centres is illegitimate. First, it flies against the notion of tax sovereignty. Europeans prize this internally, but do not want others to have it. Why should developing countries that have difficulties in administering direct taxes, and so rely more on land and consumption taxes, not have low income taxes? And remove tax competition and you remove one discipline on countries otherwise tempted to engage in expensive wars or overgenerous government bailouts.

Second, the idea of offshore financial centres is that they offer low tax because taxes are paid before money reaches them and after it leaves them. Imagine a company that builds and sells cars in the UK, Turkey and Japan. If the holding company is based in an offshore financial centre, corporation taxes on earnings will be paid in the British, Turkish and Japanese subsidiaries before they arrive in the holding company. Taxes on dividends are then paid by the shareholders when they repatriate their dividends home – wherever that may be. The offshore centre acts as a “way station” that facilitates complex international trade and investment flows. There are no taxes or low taxes in the “way station” because the money is in transit. Taxes are paid at the beginning and at the end of the journey, just not along the way.

The potential for abuse is whether the way station becomes a hiding spot, either to reduce taxes at the end of the journey, or to launder criminal money. The problem is not the tax rate but Swiss-style bank secrecy. The solution is what Bermuda, B arbados, Jersey and other responsible offshore financial centres do, which is to have information agreements that allow tax authorities to share information. The presence of standardised tax i nformation agreements applicable to all countries would be an objective measure of responsibility.

Of the 192 members of the United Nations (UN), 56 countries and a further 100 dependent territories have populations of less than 1.5 million. Smallness brings its own challenges and vulnerabilites. International finance is one of their few comparative a dvantages: it can be scaled up without more land and labour. Many have developed genuine world-class expertise in international financial services such as Bermuda, Luxembourg and Guernsey. The current financial crisis suggests that large states have a comparative disadvantage in global finance. They do not need global finance to prosper, but global finance distorts their economy and politics. There are more than a few small states that need to improve the quality of their regulation, but so too for


large states. European and US governments should refocus r egulation on all financial activities that take place in their jurisdiction, making them less vulnerable to the quality of regulation in Iceland or elsewhere, should agree to broad principles internationally and should sign common information agreements across all the jurisdictions their banks deal with.


Everyone is now getting into the game of blaming “complex derivative instruments” on the crisis. There are a couple of things to bear in mind. First, financial instruments do not have original sin. It all depends on how they are used. You can do a lot of damage with simple cash instruments like a mortgage if they are used in the wrong way. Second, everything that happened in this crisis was incentivised to happen by regulation. Dwell on that point for a little – it is important. Capital adequacy requirements incentivised banks to sell off their loan book to non-regulated institutions. By mapping credit ratings to risk weightings, regulators incentivised banks to create packages of risky loans and combine them in such a diversified way that portfolio effects improved the credit rating without lowering the yield. Complexity was a direct result of this attempt to enhance credit ratings and lower risk weights.

Complex credit derivatives were endogenous to bank regulation and not an exogenous “shock” that we can legislate away. Moreover, back to the issue of boom and falling perceptions of risk, if market participants had not found mortgage-related credit instruments that they felt they had made safe or had become safe, they would have found something else. The environment – where the perceptions of falling risks met rising risk appetite as interest rates remained low – was a breeding ground for risk.

Two Solutions: Counter-Cyclical Capital and Amended Accounting

Micro-prudential regulation concerns itself with factors that a ffect the stability of individual institutions. Macro-prudential regulation concerns itself with factors that affect the stability of the financial system as a whole. The nature of the regulation a pplied to an individual financial institution should depend c rucially on how “systemic” its activities are. This, in turn, is r elated, inter alia, to its size, degree of leverage and interconnectedness with the rest of the system. Large, leveraged i nstitutions with plenty of interconnections should face a tough combination of micro and macro-prudential regulation. Small, unleveraged, unconnected institutions should face modest forms of micro-prudential regulation.

A critical component of macro-prudential regulation must be to act as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the subsequent collapse. This countervailing force has to be as much rule-based as possible. Supervisors have plenty of discretion, but their ability to utilise it is limited by the general short-sighted desire to prolong a boom and by bankers pleading for equality of treatment. In a boom, lending, leverage and r eliance on short-term liquidity become mutually reinforcing and excessive. To counter this, I have proposed with Charles Goodhart counter-cyclical capital charges. Regulators should increase the existing capital adequacy requirements (based on an assessment of inherent risks) by two multiples. The first is related to above average growth of credit expansion and leverage. Regulators should agree on the degree of bank asset growth and leverage that is consistent with the long-run target for nominal gross domestic product (GDP), so that the multiple on capital charges rises the more credit expansion exceeds this target. The purpose of this capital charge is not to eliminate the economic cycle – something which would be unrealistically ambitious – but to e nsure that in a boom, when risk measures are suggesting banks can safely leverage or lend more, banks are putting aside an i ncreasing amount of capital which can then be released when the boom ends and asset prices fall back.

The second multiple on capital charges should be related to the mismatch in the maturity of assets and liabilities. One of the significant lessons of the Crash of 2007-08 is that the risk of an asset is largely determined by the maturity of its funding. Our proposed adjustment to mark-to-market accounting discussed below should provide a further incentive to reduce maturity mismatch. Northern Rock and other casualties of the crash might well have survived with the same assets, if the average maturity of their funding had been longer. When regulators make little distinction how assets are funded, there is a tendency for financial institutions to rely on cheaper, short-term funding, which increases systemic fragility. If short-term funding of long-term assets carries a capital cost – because it weighs on systemic stability – it will moderate banks’ reliance on systemically adverse short-term funding and encourage them to seek longer-term funding.

A combination of these charges should push banks to develop incentive packages that are more encouraging of longer-term b ehaviour. A little more is required on this front, though we do not share the zeal of some for governments to be involved in the m icro-decisions of private firms.


There are two principal methods for valuing an asset. The first is its current market valuation, or an estimate of what that might be. The second is the present value of the (estimated) future cash flows from that asset. Normally arbitrage in the market forces these two alternative methods of valuation into close alignment; but sometimes liquidity risks, and other causes of market dysfunctionality, make these two alternative approaches diverge, occasionally sharply so, as in the case of mortgage-backed assets in the current crisis. It is my thesis that the choice of valuation methods in such cases should be based on the relative maturity of the intermediary’s funding.

In order to illustrate the case most simply, assume that there are two financial institutions, A and B. Both hold a single identical asset, whose market value has fallen well below the present value of future expected cash flows. Institution A has financed this asset on the basis of a long duration liability (where the durations of asset and liability are exactly matched), whereas institution B has financed the same asset on the basis of a short-dated (one period) liability which needs to be rolled over each period. If the assets in both institutions (A and B) are valued equally at the

march 28, 2009 vol xliv no 13


latest market price, both will appear to be insolvent. This is unfair to institution A, which has no need to sell the asset, and can ride out the liquidity (market) crisis, garnering the cash flows in due course. If, on the other hand, the assets in both institutions are valued at the present value of expected cash flows, both may appear to be sound, but this too is incorrect, since the liquidity crisis means that institution B may either not be able to roll over its funding needs at all, or only at a much higher rate of interest. Institution B really is insolvent. Clearly there is a major difference in their solvency, depending on their relative funding positions, and the accounting methods ought to reflect this.

Apart from those who would deny that market prices can ever move away from the fundamentals of the present value (PV) of expected future cash flows, the above analysis should not be controversial. The problem that many see with mark-to-funding, instead, is practical. The above example was purposefully simplified with each institution having just one asset financed by one liability. In practice, banks and other financial institutions have n assets financed by j different forms of funding, where both n and j are large numbers. It is not possible normally to say that a particular liability finances a particular asset; instead all liabilities go into a common pot to finance all assets. On this view, although the objectives of mark-to-funding may be praiseworthy, it cannot be done in practice.

I think that this objection can be met. There are cases where particular assets and liabilities can be directly related, covered bonds and German pfandbriefe being examples. Moreover, occasions when PVs and market prices diverge significantly are likely to be quite rare. In practice our proposal would allow an institution, when such a divergence did occur, to “carve out” the assets to which this applied, and to select which liabilities it chose from its portfolio to support those assets. Suppose that the chosen liabilities had as long a duration as the assets, then the valuation would be PV; if half as long, then the valuation would be half PV and half market price.

In a sense what this proposal does is to allow any institution in a liquidity crisis to set up its own internal “bad bank” mechanism so long as it has sufficient long-term funding to support that. The need for such a mechanism should only be occasional, but a b enefit of doing this is that it should provide an additional i ncentive for banks to seek out additional longer term funding in normal times.

Such a carve out could be operated flexibly with no limit on the use of assets or liabilities assigned to it, which could vary over time. Recall that the exercise would only come into operation when the PV of expected cash flows was significantly greater than the current market value of the assets involved. But such a mechanism might have been very beneficial to such banks and other financial institutions and vehicles as had a sufficiency of longer dated liabilities in the recent crisis.

In Conclusion: Some Political Economy

Liberals tend to think that the solution to a global financial crisis is a global financial regulator. Conceptually this has many attractions. But there are two fundamental problems with this. First, emerging market regulators tend to be cut from the same cloth as

Economic & Political Weekly

march 28, 2009 vol xliv no 13

global regulators and from my experience of working with emerging as well as developed country regulators, it is far from clear that the content of regulation would have been any better if it had been more democratic. Liberals tend to assume that it must be better because it is more democratic. However much I would like to believe that, it goes against my experience. In general, emerging market regulators were no more counter-cyclical than developed country regulators and no less captured by their banking systems. Similarly, liberals tend to think there is something called “regulation” and when things go wrong it is because we did not “regulate” it sufficiently. But there is also something called bad regulation. This crisis occurred in highly regulated institutions. Stretching bad regulation across more countries and more institutions is not going to make things better.

Second, power does not like to be shared. Any agreement that appears to give developing countries a large say in how developed countries regulate their financial institutions will be bypassed by the developed countries. The only agreements that will stick are those that will be dominated by developed countries, which do not have the interests of developing countries in mind. And these interests can be quite different than for developed countries. In developing countries, for instance, financial inclusion and capital account management are important challenges that spill over into financial regulation. I am not being pessimistic about power, just realistic. The General Assembly of the UN is democratic; so the real power is at the Security Council, which is not. The World Trade Organisation has a more democratic g overnance structure than the World Bank and International Monetary Fund (IMF); which is why it has been usurped by A merica’s free trade agreements and Europe’s economic partnership agreements, which are bilateral and flout the most-favoured n ation principle.

In the light of these problems, I have become less keen on g lobal solutions and feel that there is much we can do to improve regulation at the local level – counter-cyclical regulation being critical. So we should raise the weight of “host” country r egulation over international “home” country influences by r equiring local financial institutions to be subsidiaries. And we should continue to strive for international agreements on broad principles and reporting standards such as mark-tofunding value accounting.

Style Sheet for Authors

While preparing their articles for submission, contributors are requested to follow EPW’s style sheet.

The style sheet is posted on EPW’s web site at

It will help immensely for faster processing and error-free editing if writers follow the guidelines in style sheet, especially with regard to citation and preparation of references.

Dear Reader,

To continue reading, become a subscriber.

Explore our attractive subscription offers.

Click here

Back to Top