On 15 October, the Mannheim Centre for European Economic Research (ZEW) and the accounting firm Ernst & Young jointly organised a conference on the recent financial crisis. In his opening speech, Professor Anil Kashyap from the University of Chicago provided valuable insights into the causes and consequences of the subprime mortgage crisis in the United States. Based on his calculations, Professor Kashyap expects subprime-related losses to amount to approximately 500 billion US dollars. These estimates are, however, associated with a number of uncertainties. Not without a trace of irony, he pointed out that the US financial sector has a particular talent for turning defaulting subprime loans into securitised credit exposures with the highest AAA credit rating.

In his speech, Kashyap explained that, within the framework of active risk management, most banks have eliminated a great number of risk-bearing assets over the course of the crisis as a result of their high debt-to-equity ratio.  This development has in turn led to a further drop in prices, creating a vicious circle. The only way to put an end to this vicious circle, explained Kashyap, is through considerable increases in equity capital. This could in turn contribute to a sustainable reduction in the debt-to-equity ratio.

Professor Kashyap went on to explain that the injection of government capital into private banks did, in fact, provide the necessary support to financial institutions, as it has strengthened their equity capital base. This measure would, however, have been more productive if the government had recapitalised only those banks that were in distress, rather than practically the entire sector. The way in which governments participated in the financing of banks through partial nationalisation or support schemes has recently been the subject of controversial debate in Europe.

In the second speech, Franceso Papadia, head of the unit “Market Operations” of the European Central Bank (ECB), shed light on the measures the ECB implemented over the course of the crisis. He explained, for instance, how the ECB ensured the liquidity of banks during the financial crisis. During his speech, he also referred to the spread between the interbank rate and the rate set by the ECB that had been widening for the past few weeks. This development, explained Papadia, reflects market tensions as well as a distrust among financial institutions. He also emphasised that since cooperation between EU and US banks has virtually ceased, the ECB is currently also providing liquidity for European banks in the form of US Dollars.

High risk propensity among banks

In the third keynote speech, Professor Michael Heise, chief economist at Allianz SE, focused on the causes and consequences of the financial crisis from a European perspective. According to Heise, one of the most important reasons for the disastrous banking crisis was the high risk propensity of banks. This is partly due to the relatively low profit margins in traditional banking services and partly due to the substantial gains in the US real estate market and the securitised loans. Heise provided further reasons for the crisis; namely inaccurate ratings, uninformed buyers who invested in those credit derivatives, and the risky behaviour of private households in the US.

According to Heise, it was foreseeable that the first domino, namely the exaggerated enthusiasm in the real estate and mortgage market, would fall. The consequences of the financial crisis, however, took the world by surprise.

Heise predicts that the equity requirements of banks, which ensure that the risks arising from loans are sufficiently covered, are likely to increase in the future.  In his speech, he also called for the introduction of international supervision of banks. The crisis, explained Heise, has highlighted that the systemic problems in the banking sector have an impact on the world as a whole and can therefore only be addressed through the joint efforts of the international community. Furthermore, Heise considers it likely that we will see the introduction of supervisory authorities for rating agencies and hedge funds in the near future.

The fact that Heise believes that we are about to leave the worst stage of the crisis behind us, was met with particular interest from the conference participants. By contrast, Kashayp assumes that both Europe and the United States are likely to experience at least two more quarters of weak economic performance.

The lectures given by the economists were followed by a lively debate with the conference participants. Among other things, the participants were particularly interested in the question of whether market evaluations in accounting (market-to-market) should be made more flexible, since they have intensified the financial crisis.

Dr. Michael Schröder, schroeder@zew.de

Date

24.11.2008

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