Address by Angel Gurría, OECD Secretary-General, to Victoria University and the New Zealand Institute of International Affairs
30 July 2008, Wellington
Good afternoon. It is a pleasure to be here today at Victoria University on my visit to New Zealand as the Secretary-General of the OECD. I have been asked to address a difficult, but well-chosen topic this afternoon – the crisis that continues to unfold in global financial markets.
Everyone is asking where the global financial crisis will turn next, what it will mean and what to do about it. Probably the biggest problem is uncertainty, for policy makers and for individuals. Policy makers who must manage the crisis are facing a long series of risks that involve delicate trade-offs. What they do – and how the markets react, will make a difference. At the same time, citizens and consumers are wondering how far the turbulence will go and what it will mean for their investments and their credit, their homes, and ultimately their ability to make decisions and plan for the future.
My remarks will focus on the origins of the financial crisis, how it is being managed and further steps need to be taken. I will conclude with some comments on the outlook for the global economy more generally.
Where did the global financial crisis start?
There are no doubt many causes – and many consequences: high levels of market liquidity, low global interest rates, low cost of capital, and very low yields on safe investments.
Faced with strong investor demand for higher yielding assets, banks saw an opportunity to expand mortgage lending and then to repackage and sell the underlying credit risk as securities with different levels of risk and return – what is referred to as "securitisation" – the packaging of loans into securities.
In fact, we have seen a remarkable expansion of credit, especially in the United States, in parallel with a dramatic rise in securitised mortgages, especially after 2004.
What went wrong?
It is important to recall that financial innovation has been a source of strength, contributing to lower costs of capital, wider access to credit and more choices for investors.
But the rapid growth in securitised mortgages created some perverse effects. One result of securitisation was that in many cases loaning institutions no longer felt the consequences if the loans were not repaid. This allowed relaxation of the criteria for making loans.
This gave access to credit – and to home ownership – to a new group of borrowers, but opened opportunities for fraud. Many of the new borrowers did not understand their loans or have enough income to make the payments, especially those with adjustable rate mortgages, and regulators did not sufficient capacity to follow these developments.
On the investing side, securities products were extremely complex. Investors did almost no due diligence of their own, but relied on credit ratings. Unfortunately these ratings often gave a misleading picture of the quality of the underlying loans and the securities. Another important shortcoming was that the banks had set up structures to acquire and hold loans which depended entirely on continued access to short-term funding.
The crisis itself was triggered last summer, when the market saw higher-than-expected defaults on US subprime residential mortgages. Investors suddenly realised they were in a much riskier world than they had thought. Markets froze. The short-term funding for securities dried up and their prices plunged. And because no one knew which banks held the damaged assets, even lending between banks stopped. There was no more liquidity to help markets function. While the subprime mortgage problem is largely limited to the United States, the repackaging practices I mentioned a moment ago were international, so banks outside the US, especially in Europe, were also drawn in.
How did policy makers manage the crisis?
Central banks acted quickly and decisively when the liquidity crisis broke. The major central banks stepped in to lend (or provide liquidity) to banks under more flexible conditions. In a radical move, the Federal Reserve opened for the first time a lending facility for investment banks.
US authorities also took action in the mortgage market, by helping borrowers and lenders adjust the terms of loans. And just a few weeks ago they proposed to lend directly to the institutions supporting the US mortgage market.
While some might criticise these moves as giving impunity to the investment banks, or even encouraging irresponsible behaviour – what we call moral hazard – these central bank actions have been crucial in preventing an acceleration of liquidity problems in core money markets. In fact, owners of the banks have lost badly. And though the situation remains fragile, these markets have now stabilised.
Attention is now shifting from liquidity to solvency issues. There is an obvious problem of solvency in the household sector. There are already about 3.5 million US households with negative equity in their homes. If house prices continue to fall, the number of potentially defaulting households – and losses to financial institutions – will rise further.
Other than households, banks have been the most visibly affected. In April 2008, the OECD estimated that total losses related to residential mortgage backed securities would be about US dollars 400 billion, mainly to banks in the US and Europe.
These losses represent a tremendous drain on capital to the banking system. Banks have responded by raising capital – though there are differences across regions. US banks and investment houses have raised almost as much capital as their reported losses and write-downs, while European banks are lagging. Asian banks lost much less and have recapitalised. Despite efforts, current capital in many parts of the world is not enough to allow bank balance sheets to grow.
What have we learned?
The crisis shows that OECD and other countries must do some "hard thinking". In parallel with a period of strong economic growth, financial markets and financial innovation have delivered impressive benefits over the past decade. But it is now clear that the dangers and pitfalls were ignored. We obviously need to make the financial system more robust. But fine-tuning policies in a globalised world is not an easy task.
In April, the Financial Stability Forum – which brings together regulators and central bankers from the major financial centres as well as international institutions, including the OECD – identified the major problems that contributed to the crisis and the measures to address them. Over the coming months, it will give new guidance on addressing weaknesses in the international framework for supervising financial institutions (Basel II), including the regulatory oversight for managing risk -- an area that has proved seriously deficient.
These government actions can address some of the shortcomings revealed by the market crisis. But the key actors in the markets have to improve their performance.
The financial institutions themselves have a lot of work to do. Not all banks were affected by the crisis in the same way. A number of major banks saw the risk of subprime as early as 2006 and took steps to control and to manage those risks. Others failed to do so. This suggests a corporate governance failure, raising questions that the OECD is starting to examine.
Improved financial education is also essential so that consumers and investors will make more informed decisions and not only protect themselves, but also help to improve how markets function. The OECD launched a major international programme on financial education five years ago. After assessing the issues, we are making recommendations to help policymakers design and implement effective financial education programmes. Our most recent work has focussed on financial education in the area of credit.
The global economy
The other pressing issue now, of course, is how best to sustain economic growth. And this challenge has been made more complicated by rising inflation, reflecting high commodity prices.
The immediate danger today is that the financial crisis will have a strong impact on the real economy. Two weeks ago, Ben Bernanke, the Chairman of the US Federal Reserve, was reported to have said that he is "less concerned about the possibility of widespread bank failures than about the prospect that banks would cut back on lending to the economy". Bank failures get the headlines – but the real danger is less easy to see: that banks will not lend. This would have dire repercussions on the real economy.
To keep the economies moving, bank lending must expand. We have seen that lending standards to both households and business have been tightening and costs of borrowing are going up.
In these circumstances, the authorities might wish to ease monetary conditions to limit the impact of the financial turmoil – as your central bank did just a few days ago. But inflation is also a concern. Policy decisions will hinge on judgements about whether the rise in commodity prices will spill over into the broader economy and into wages, and whether the slowdown will be deeper than most of us are now forecasting. There is no one-size-fits-all – the policy requirements will vary from country to country.
So far, in major OECD economies, core inflation and wages remain under control. But some measures of inflation expectations have risen. At the same time, the depth of the slowdown is unusually difficult to predict. In our most recent Economic Outlook, we projected a significant slowing in the OECD area, but no recession, even in the United States. I would be the first to admit, however, the large uncertainties surrounding such projections.
Although it is too early for me to speculate on our next projections, I believe that decisive financial reform and careful macroeconomic management will keep the slowdown fairly mild, and we can expect to return to more normal financial market conditions and economic growth prospects in the course of next year.
I have underlined the strains facing the global economy and the uncertainties facing policymakers and ordinary citizens. Both are large. But the financial crisis will be resolved in time, as financial institutions recognise their weak assets and recapitalise, and as house prices stabilise and begin to rise again.
The subprime lending crisis and the subsequent credit squeeze have uncovered areas of vulnerability all over the world. We have seen that almost every problem today becomes everybody’s problem, regardless of its origins. The subprime lending crisis is not a US problem, SARS is not an Asian problem, and melting ice is not an Arctic affair. Global problems call for global answers.
Policy dialogue is all the more important today, and that is why the OECD is proudly responding to the call to become a hub of dialogue for global issues. We are working with OECD and non-OECD partners to address the regulatory challenges of new developments in the financial markets. For only with international co-operation will we be able to build mutual trust and keep our markets open and growing.