1. 1 Lessons from the sub-prime crisis Kevin Davis Commonwealth Bank Chair of Finance, University of Melbourne Director, The Melbourne Centre for Financial Studies www.melbournecentre.com.au kevin.davis@melbournecentre.com.au November 2008

2. 2 Outline Origins of the Crisis Features of the Crisis Regulatory Responses Future Regulatory Responses

3. 3 Origins of the Crisis Financial engineering and financial products Liquidity creation and leverage “Shadow banking” & risk sharing and spreading Inadequate public information

4. 4 An Increasingly Complex Financial System Central Bank Banks & ADIs Investment Banks Managed Funds Hedge Funds Pension Funds Finance Cos. Insurance Cos. Private Equity

5. 5 Origins of the Crisis Financial engineering and financial products Liquidity creation and leverage “Shadow banking” & risk sharing and spreading Inadequate public information

6. 6

7. 7 Easy Credit – An Example Large Business Credit Spreads - Australia Source: RBA

8. 8 Origins of the Crisis Financial engineering and financial products Liquidity creation and leverage “Shadow banking” & risk sharing and spreading Inadequate public information

9. 9 An Interdependent Financial System Central Bank Banks & ADIs Investment Banks Managed Funds Hedge Funds Pension Funds Finance Cos. Insurance Cos. Private Equity

10. 10 Origins of the Crisis Financial engineering and financial products Liquidity creation and leverage “Shadow banking” & risk sharing and spreading Inadequate public information

11. 11 Public Information

12. 12 A simple explanation Ian Ramsay April 1, 2008 http://business.theage.com.au/opes-prime-who-understood/20080331-22qf.html Illustration: Michael Leunig

13. 13 Features of the Crisis Consumer sophistication Incentive structures Outsourcing due diligence Regulatory avoidance Inadequate risk management systems Excessive liquidity creation

14. 14 Features of the Crisis “Shadow banking sector” importance Deposit insurance inadequacy “Freezing” of funding and asset liquidity Liquidity support facility arrangements Inadequacy of risk based capital Globalization issues “Flight to quality” issues

15. 15 Regulatory Responses Protection of national banking systems Liquidity Creation/restoration Bail Outs Temporary regulations

16. 16 Regulatory Responses Protection of national banking systems Liquidity Creation/restoration Bail Outs Temporary regulations

17. 17 The Flight to Quality Effect Central Bank Banks & ADIs Investment Banks Managed Funds Hedge Funds Pension Funds Finance Cos. Insurance Cos. Private Equity

18. 18 Regulatory Responses Protection of national banking systems Liquidity Creation/restoration Bail Outs Temporary regulations

19. 19 Socializing the losses

20. 20 Regulatory Responses Protection of national banking systems Liquidity Creation/restoration Bail Outs Temporary regulations

21. 21

22. 22

23. 23

24. 24 A Fragile Financial System? Central Bank Banks & ADIs Investment Banks Managed Funds Hedge Funds Pension Funds Finance Cos. Insurance Cos. Private Equity

25. 25 Banking Crises: 1980-96

26. 26 Financial Crises since 1996 Asian crisis 1997 Russian crisis 1998 (& Long Term Capital Management) Brazil 1999 DotCom Bubble 2000 Argentina 2001 “since the collapse of Argentina in 2001, the international financial system has been an oasis of stability. Some believe this is merely good luck, and that the bad old days will return. They are wrong.” Andrew K. Rose 31 May 2007 CEPR Policy Insight No. 1, June 2007Andrew K. RoseCEPR Policy Insight No. 1, June 2007 http://www.voxeu.org/index.php?q=node/199 Subprime Crisis – June 2007 - ??

27. 27 Future Regulatory Issues Central Bank targets Macro-prudential policy Mark-to-market accounting Deposit Insurance “Too big/important to fail” Automatic recapitalization stabilizers

28. 28 Future Regulatory Issues Basel II Domain of Prudential Regulation Reporting and Information Requirements Promoting organized exchanges Transactions taxes and volatility

29. 29 Future Regulatory Issues Governance and agency problems Financial consumer protection Securitization structures Financial sector concentration

30. 30 Conclusion Was it inevitable – probably! Who’s to blame – enough for all to share!

31. 31

32. 32 Conclusion Was it inevitable – probably! Who’s to blame – enough for all to share! Will a depression result – probably not! Will similar financial crises recur – probably! Will the financial system be restructured –Needs to be, but vested interests are strong!