GSB | Chicago: Risk, Regulation, Recession: Around the World in 80 Minutes

WITH THE STATE OF THE GLOBAL ECONOMY making headlines daily, we at GSB Chicago thought it would be enlightening to hear what GSB faculty members have to say about risk management, the Asian economy, and the U.S.’s ability to resist recession. In October, George Constantinides, Anil Kashyap, and Randall Kroszner gathered over lunch in Rosenwald Hall to debate the issues. What follows are excerpts from their discussion.

GSB Chicago: Most economists characterize the U.S. stock market’s recent volatility as a response to the economic crisis in Russia. Is it time to exercise greater control over investments?

KASHYAP: No.

CONSTANTINIDES: Are you referring to control of hedge funds and portfolio managers or control of the institutions that lend to hedge funds, like banks? It is true that the economic crises in Russia and in the countries of Southeast Asia have increased the volatility of the U.S. and international stock markets and derivatives markets. But by imposing capital controls, the countries in crisis neither help their economies nor dampen the market volatility.

KROSZNER: I don’t understand how trying to slow down the international movement of funds would help at all. I think it would increase the problems–the reason these countries have enjoyed such rapid growth over the last three decades has been due to foreign inflows of capital. With capital controls, they’re simply not going to grow as quickly.

KASHYAP: The problem in Russia wasn’t hedge funds, the problem is that they can’t collect taxes, they can’t enforce contracts, things are massively corrupt. And there’s nothing we can do on the outside that’s going to help that very much, unless maybe we dedicate some funding to try and improve the situation and have the IMF [International Monetary Fund] ride in there and say, “OK, you guys have got to get your court system up, and we’re going to subsidize honest judges.” Investors have to have the ability to pull their money out on short notice if they can’t be guaranteed the right to enforce contracts in the courts.

KROSZNER: And it’s the discipline of the capital markets that is exactly what helps the politics in these countries. If the governments won’t have rule of law and won’t enforce contracts, then they will be cut off from the markets. Then they’re not going to be able to grow, but the people want economic growth.

GSB Chicago: Should there be greater control of hedge funds?

KASHYAP: Consenting adults should be able to do whatever they choose. The problems come when the government comes in after the fact and decides that it’s going to rescue people and save them from their own stupidity. With Long-Term Capital Management, the crime was the Fed[eral Reserve] not saying unambiguously, “Warren Buffett’s put some money on the table, you guys go work something out.” But that’s got nothing to do with hedge funds, that’s got to do with just terrible decision making at the Fed.

Greenspan dissembled in the worst possible way. For him to say, “We shouldn’t regulate hedge funds because those are private activities, and we don’t really have any scope over it,” and then to undercut that by the Fed’s own actions was incredibly hypocritical. On the other hand, if he really thought there was a systemic problem, the Fed had the authority, still has the authority, to intervene directly. But they would have had to make the case convincingly, and they would have had to explain to the public exactly what the consequences would be. Instead, they took this unbelievably poor hybrid action of a bailout.

CONSTANTINIDES: I am against greater control of hedge funds. In any case, the issue is moot because hedge funds can evade U.S. government controls by operating from overseas.

Let me clarify something regarding the government’s role regarding Long-Term Capital Management. When we say “bailout,” it was a bailout not by the government but by the lending banks. Government money was not involved, it was the banks’. The government did coerce the banks to reverse their earlier mistakes in being so free to lend without proper collateral and without credit checks.

KASHYAP: Fair enough, but what business does the government have doing that? There ought to be an overarching principle that if there’s private money available to solve the problem, the government has the ethical, moral, and I would have hoped legal obligation to get out of the way and let the market work.

What signal does this send? If you get into trouble you can count on the government to coerce somebody else to help you or maybe help you directly. It also discourages people from keeping track of what’s going on, on the chance that hey, maybe they can swoop in and buy up a bargain.

KROSZNER: In the old days, before we had the Fed, we had J. P. Morgan, the Warren Buffett of his day. He had the money and the ability to call people into his office and say, “We’ve got to work something out here.” During the bank panics, that’s what he would do. He’d get people together and say, “We’ve got to save this bank because it’s good for us in general.”

Warren Buffett is not a philanthropist, he’s someone who has liquidity, he has the funds to go in when there’s trouble and say, “Well maybe I can make money here.” The markets have always done that, will always do that, except of course, as Anil [Kashyap] said, when the government intervenes the Warren Buffets and J. P. Morgans of the world may not want to do that anymore because after doing the due diligence to find out whether the investment’s worthwhile, they make an offer, and the government says, “Well, it’s not a good enough offer, we’ll put pressure on someone else to make a better offer.”

CONSTANTINIDES: I do not favor more regulation of the banks; however, the government should pay a little more attention to the banks and make sure that the banks understand their exposure to credit risk. I think that, in this respect, banks failed in their role.

KASHYAP: The market risk calculation that the big banks are supposed to be engaging in is supposed to provision for this. In principle, the regulations are there, we just have to enforce them.

CONSTANTINIDES: Are you referring to the Basle capital requirements? Those would not be adequate to address this problem.

KASHYAP: Right, those are designed for credit risk, but as of January this year there’s a set of laws in place that are intended to deal with so-called market risk.

CONSTANTINIDES: And they apply this set of models generally called VaR, Value-at-Risk, and I think what happened shows that the VaR approach, as commonly applied, is totally inadequate to take into account the rare events that occur. Looking at the time series of the fluctuations and their correlations, it was all conditional on the rare event not having occurred, so that by construction you are not building in the possibility of these rare events happening. Markets that normally appear uncorrelated, like Brazil and Russia, become correlated when the big event hits. The models themselves are blind to some of these correlations. This kind of cascading effect can lead to serious problems.

So the idea of banks having a well thought-out, well organized procedure of looking at their overall risk exposure is definitely a step in the right direction, but I would say that the banks are at the very early stage in developing systems that would be effective enough to address the kind of problems rare events present. In addition, whether the VaR model is or is not adequate, we have to plug in accurate inputs. Banks were lending, say, $200 million, and did not even know what their risk exposure was because they never asked.

We agree, if I may propose this, that banks are not undercapitalized, and a regulation to increase capital requirements is not the issue, but prodding banks to think harder about their risk management models is. There is evidence already that banks are beginning to ask their existing clients about their overall risk exposure.

KASHYAP: I disagree. I think at some level they are undercapitalized because would they not have the federal guarantee, they would be capitalized at levels like other financial services.

KROSZNER: Like finance companies, which have double the capital levels of even the relatively high capital levels banks have now. Finance companies don’t have government guarantees, they get involved in very similar sets of activities to banks making lots of short-term loans to consumers and business and investing in all different types of activities, but the market forces them to hold much higher capital.

KASHYAP: Even if banks had perfect risk management models, part of the reason they get away with the capital levels they do is this view that the government is there to help them. The more we can encourage them to mimic the guys who don’t have the government guarantees, the better.

KROSZNER: You can either try to take away the guarantees, which aren’t really credible, because people always figure that you will bail out the big boys, which is probably true, or you can approach it from the other side and say, “Well, if you are going to get this benefit from the government, then there’s going to be some cost. You’re going to have to make sure not to expose taxpayers to too much risk.”

GSB Chicago: Can anything the U.S. does–like the Fed’s rate cuts–have an impact on the global situation or prevent us from getting sucked into a global economic crisis?

KASHYAP: I think those are two rather different questions. On the one hand, can the Fed do anything to help Russia? Probably not. Can the Fed stop a recession from happening in the U.S.? Yes.

The question is, Can a recession in Russia spread to the U.S.? I think anybody’s got to conclude the answer is, Not easily. Japan’s been in the dumps for seven years, Southeast Asia has been crushed for a year, Russia’s gone down the drain, they’re going to have a hyperinflation, and the U.S. just keeps rolling along.

We have a tendency to give the Fed so much influence over things, maybe it’s psychological; we want to feel like somebody’s in control, but there are real limits to how far the Fed can go on these matters. They can’t do very much to clean up the Thai banking system, they can’t even control the Japanese, who have the money to do something sensible, so I don’t think that by wiggling around the Fed funds rate you’re going to get very far fixing the rest of these countries’ problems.

CONSTANTINIDES: The Fed can help alleviate the irrational illiquidity in some markets, which is an overreaction to the economic crisis. We observe a big discrepancy between the yield of the 30-year bond and the yield of the 29-year bond. It is not a rational discrepancy. In terms of fundamentals, the two yields should be very similar because nobody can really forecast what will happen to interest rates between years 29 and 30. Yet there is a big difference. Everybody wants to hold something safe, so they want to hold the 30-year bond. This is an issue of illiquidity now that has nothing to do with credit risk.

KROSZNER: If we’re willing to consider some more radical solutions than those we’ve discussed, the Fed could very indirectly help out these other countries.

Many countries have taken a first step toward effectively adopting Alan Greenspan as their central banker by either pegging to the U.S. dollar or by setting up a currency board.

Now, the pegs don’t work very well, because they’re only as good as the domestic monetary policy is. They say we’re going to fix to the U.S. dollar at a certain rate, and if things work out properly, they would then follow the same policies as the U.S. follows. The Asian Tigers fell because they pegged to the U.S. dollar but didn’t pursue the same low inflation, low fiscal deficit policy that the U.S. was pursuing. When a number of Asian countries were starting to slow down about two or three years ago, they stepped on the gas pedal, trying to boost up their money supply growth rates. You then had this tension and inconsistency between the internal policy and the external policy. Once you get that, either you’re going to have to have a realignment with the exchange rates, done voluntarily, or it’s just going to burst. And we saw it burst.
A currency board is one way to adopt the U.S. policy in a more direct way. Hong Kong has been able to maintain its relationship with the U.S. dollar very well through the storms. But with a currency board, there’s always a chance to say, “Well, we’ll just switch back to the peso or the Hong Kong dollar.”

The surefire way to get the full benefit of Greenspan is to fully adopt him, not to have him as a foster child but as a member of the family. And how do you do that? You just eliminate the local currency and use U.S. dollars. Panama has done this. There’s no risk premium, because there’s no concern about the local currency versus the U.S. dollar currency–there’s only the other currency.

So in some sense we could prevent some of the problems we’ve seen if these countries were willing to fully give up control of their monetary policy and just use U.S. dollars directly. But that’s a very radical solution.

GSB Chicago: Is that likely to happen in any of these countries?

KASHYAP: If things get bad enough.

KROSZNER: Clearly Asia’s fallen apart, and Brazil is in deep trouble–they’re going to get together $30 billion, $60 billion, maybe $90 billion to try to save this highly overvalued exchange rate between the Brazilian real and the U.S. dollar. It doesn’t make any sense. It would be much better if they just said to heck with this charade and just adopt the U.S. policies directly.

KASHYAP: But no country wants to give up their sovereignty, being able to issue a picture of one of their dead leaders instead of one of ours. If you ask someone to do that, they’re going to reject it unless the situation is pretty horrible, and I don’t think we’ve gotten to that level of pain yet. Although Russia’s heading there pretty fast.

In fact, probably what the U.S. should do is stick to mostly domestic affairs. We don’t have a tremendously good record of being able to convince people to do what we want them to do, leaving aside whether or not we know what the right answer is.

GSB Chicago: The IMF is calling for greater disclosure and a culture of transparency, is that. . .

KASHYAP: IMF can start at its own borders by making its own actions transparent, but I agree with the principle. It’s more than transparency, it’s actually deregulating, saying that if a foreign financial institution wants to lend or collect deposits locally, it can do it without having to worry about being nationalized or being subject to arbitrary rules that domestic financial institutions aren’t subject to.

KROSZNER: Where domestic financial institutions have collapsed there are probably still good projects that could be financed if there were a solvent institution there to provide the financing. Many industrialists want credit but can’t get it from the local institutions. In many of these countries, local banks are subject to political whim. They are nothing more than fiscal arms of the state. Foreign banks can be a much more stable source of funds than local banks.

In the United States, we got rid of interstate barriers and have a much more stable system because money can flow from California and New York down to Texas when Texas banks get into trouble. The same thing could happen if foreign banks developed a large presence in countries like Malaysia and Korea.

GSB Chicago: You’re suggesting that the answer to the global economic crisis is to create a true global economy. What do we have now?

KROSZNER: A Frankenstein monster, a hybrid of the worst of some regulation and some market-oriented approaches. The worst of both worlds.

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					WITH THE STATE OF THE GLOBAL ECONOMY making headlines daily, we at GSB Chicago thought it would be enlightening to hear what GSB faculty members have to say about risk management, the Asian economy, and the U.S.’s ability to resist recession. In October, George Constantinides, Anil Kashyap, and Randall Kroszner gathered over lunch in Rosenwald Hall to debate the issues. What follows are excerpts from their discussion. *GSB Chicago:* Most economists characterize the U.S. stock market’s recent volatility as a response to the economic crisis in Russia. Is it time to exercise greater control over investments? KASHYAP: No. CONSTANTINIDES: Are you referring to control of hedge funds and portfolio managers or control of the institutions that lend to hedge funds, like banks? It is true that the economic crises in Russia and in the countries of Southeast Asia have increased the volatility of the U.S. and international stock markets and derivatives markets. But by imposing capital controls, the countries in crisis neither help their economies nor dampen the market volatility. KROSZNER: I don’t understand how trying to slow down the international movement of funds would help at all. I think it would increase the problems–the reason these countries have enjoyed such rapid growth over the last three decades has been due to foreign inflows of capital. With capital controls, they’re simply not going to grow as quickly. KASHYAP: The problem in Russia wasn’t hedge funds, the problem is that they can’t collect taxes, they can’t enforce contracts, things are massively corrupt. And there’s nothing we can do on the outside that’s going to help that very much, unless maybe we dedicate some funding to try and improve the situation and have the IMF [International Monetary Fund] ride in there and say, “OK, you guys have got to get your court system up, and we’re going to subsidize honest judges.” Investors have to have the ability to pull their money out on short notice if they can’t be guaranteed the right to enforce contracts in the courts. KROSZNER: And it’s the discipline of the capital markets that is exactly what helps the politics in these countries. If the governments won’t have rule of law and won’t enforce contracts, then they will be cut off from the markets. Then they’re not going to be able to grow, but the people want economic growth. *GSB Chicago:* Should there be greater control of hedge funds? KASHYAP: Consenting adults should be able to do whatever they choose. The problems come when the government comes in after the fact and decides that it’s going to rescue people and save them from their own stupidity. With Long-Term Capital Management, the crime was the Fed[eral Reserve] not saying unambiguously, “Warren Buffett’s put some money on the table, you guys go work something out.” But that’s got nothing to do with hedge funds, that’s got to do with just terrible decision making at the Fed. Greenspan dissembled in the worst possible way. For him to say, “We shouldn’t regulate hedge funds because those are private activities, and we don’t really have any scope over it,” and then to undercut that by the Fed’s own actions was incredibly hypocritical. On the other hand, if he really thought there was a systemic problem, the Fed had the authority, still has the authority, to intervene directly. But they would have had to make the case convincingly, and they would have had to explain to the public exactly what the consequences would be. Instead, they took this unbelievably poor hybrid action of a bailout. CONSTANTINIDES: I am against greater control of hedge funds. In any case, the issue is moot because hedge funds can evade U.S. government controls by operating from overseas. Let me clarify something regarding the government’s role regarding Long-Term Capital Management. When we say “bailout,” it was a bailout not by the government but by the lending banks. Government money was not involved, it was the banks’. The government did coerce the banks to reverse their earlier mistakes in being so free to lend without proper collateral and without credit checks. KASHYAP: Fair enough, but what business does the government have doing that? There ought to be an overarching principle that if there’s private money available to solve the problem, the government has the ethical, moral, and I would have hoped legal obligation to get out of the way and let the market work. What signal does this send? If you get into trouble you can count on the government to coerce somebody else to help you or maybe help you directly. It also discourages people from keeping track of what’s going on, on the chance that hey, maybe they can swoop in and buy up a bargain. KROSZNER: In the old days, before we had the Fed, we had J. P. Morgan, the Warren Buffett of his day. He had the money and the ability to call people into his office and say, “We’ve got to work something out here.” During the bank panics, that’s what he would do. He’d get people together and say, “We’ve got to save this bank because it’s good for us in general.” Warren Buffett is not a philanthropist, he’s someone who has liquidity, he has the funds to go in when there’s trouble and say, “Well maybe I can make money here.” The markets have always done that, will always do that, except of course, as Anil [Kashyap] said, when the government intervenes the Warren Buffets and J. P. Morgans of the world may not want to do that anymore because after doing the due diligence to find out whether the investment’s worthwhile, they make an offer, and the government says, “Well, it’s not a good enough offer, we’ll put pressure on someone else to make a better offer.” CONSTANTINIDES: I do not favor more regulation of the banks; however, the government should pay a little more attention to the banks and make sure that the banks understand their exposure to credit risk. I think that, in this respect, banks failed in their role. KASHYAP: The market risk calculation that the big banks are supposed to be engaging in is supposed to provision for this. In principle, the regulations are there, we just have to enforce them. CONSTANTINIDES: Are you referring to the Basle capital requirements? Those would not be adequate to address this problem. KASHYAP: Right, those are designed for credit risk, but as of January this year there’s a set of laws in place that are intended to deal with so-called market risk. CONSTANTINIDES: And they apply this set of models generally called VaR, Value-at-Risk, and I think what happened shows that the VaR approach, as commonly applied, is totally inadequate to take into account the rare events that occur. Looking at the time series of the fluctuations and their correlations, it was all conditional on the rare event not having occurred, so that by construction you are not building in the possibility of these rare events happening. Markets that normally appear uncorrelated, like Brazil and Russia, become correlated when the big event hits. The models themselves are blind to some of these correlations. This kind of cascading effect can lead to serious problems. So the idea of banks having a well thought-out, well organized procedure of looking at their overall risk exposure is definitely a step in the right direction, but I would say that the banks are at the very early stage in developing systems that would be effective enough to address the kind of problems rare events present. In addition, whether the VaR model is or is not adequate, we have to plug in accurate inputs. Banks were lending, say, $200 million, and did not even know what their risk exposure was because they never asked. We agree, if I may propose this, that banks are not undercapitalized, and a regulation to increase capital requirements is not the issue, but prodding banks to think harder about their risk management models is. There is evidence already that banks are beginning to ask their existing clients about their overall risk exposure. KASHYAP: I disagree. I think at some level they are undercapitalized because would they not have the federal guarantee, they would be capitalized at levels like other financial services. KROSZNER: Like finance companies, which have double the capital levels of even the relatively high capital levels banks have now. Finance companies don’t have government guarantees, they get involved in very similar sets of activities to banks making lots of short-term loans to consumers and business and investing in all different types of activities, but the market forces them to hold much higher capital. KASHYAP: Even if banks had perfect risk management models, part of the reason they get away with the capital levels they do is this view that the government is there to help them. The more we can encourage them to mimic the guys who don’t have the government guarantees, the better. KROSZNER: You can either try to take away the guarantees, which aren’t really credible, because people always figure that you will bail out the big boys, which is probably true, or you can approach it from the other side and say, “Well, if you are going to get this benefit from the government, then there’s going to be some cost. You’re going to have to make sure not to expose taxpayers to too much risk.” *GSB Chicago:* Can anything the U.S. does–like the Fed’s rate cuts–have an impact on the global situation or prevent us from getting sucked into a global economic crisis? KASHYAP: I think those are two rather different questions. On the one hand, can the Fed do anything to help Russia? Probably not. Can the Fed stop a recession from happening in the U.S.? Yes. The question is, Can a recession in Russia spread to the U.S.? I think anybody’s got to conclude the answer is, Not easily. Japan’s been in the dumps for seven years, Southeast Asia has been crushed for a year, Russia’s gone down the drain, they’re going to have a hyperinflation, and the U.S. just keeps rolling along. We have a tendency to give the Fed so much influence over things, maybe it’s psychological; we want to feel like somebody’s in control, but there are real limits to how far the Fed can go on these matters. They can’t do very much to clean up the Thai banking system, they can’t even control the Japanese, who have the money to do something sensible, so I don’t think that by wiggling around the Fed funds rate you’re going to get very far fixing the rest of these countries’ problems. CONSTANTINIDES: The Fed can help alleviate the irrational illiquidity in some markets, which is an overreaction to the economic crisis. We observe a big discrepancy between the yield of the 30-year bond and the yield of the 29-year bond. It is not a rational discrepancy. In terms of fundamentals, the two yields should be very similar because nobody can really forecast what will happen to interest rates between years 29 and 30. Yet there is a big difference. Everybody wants to hold something safe, so they want to hold the 30-year bond. This is an issue of illiquidity now that has nothing to do with credit risk. KROSZNER: If we’re willing to consider some more radical solutions than those we’ve discussed, the Fed could very indirectly help out these other countries. Many countries have taken a first step toward effectively adopting Alan Greenspan as their central banker by either pegging to the U.S. dollar or by setting up a currency board. Now, the pegs don’t work very well, because they’re only as good as the domestic monetary policy is. They say we’re going to fix to the U.S. dollar at a certain rate, and if things work out properly, they would then follow the same policies as the U.S. follows. The Asian Tigers fell because they pegged to the U.S. dollar but didn’t pursue the same low inflation, low fiscal deficit policy that the U.S. was pursuing. When a number of Asian countries were starting to slow down about two or three years ago, they stepped on the gas pedal, trying to boost up their money supply growth rates. You then had this tension and inconsistency between the internal policy and the external policy. Once you get that, either you’re going to have to have a realignment with the exchange rates, done voluntarily, or it’s just going to burst. And we saw it burst. A currency board is one way to adopt the U.S. policy in a more direct way. Hong Kong has been able to maintain its relationship with the U.S. dollar very well through the storms. But with a currency board, there’s always a chance to say, “Well, we’ll just switch back to the peso or the Hong Kong dollar.” The surefire way to get the full benefit of Greenspan is to fully adopt him, not to have him as a foster child but as a member of the family. And how do you do that? You just eliminate the local currency and use U.S. dollars. Panama has done this. There’s no risk premium, because there’s no concern about the local currency versus the U.S. dollar currency–there’s only the other currency. So in some sense we could prevent some of the problems we’ve seen if these countries were willing to fully give up control of their monetary policy and just use U.S. dollars directly. But that’s a very radical solution. *GSB Chicago:* Is that likely to happen in any of these countries? KASHYAP: If things get bad enough. KROSZNER: Clearly Asia’s fallen apart, and Brazil is in deep trouble–they’re going to get together $30 billion, $60 billion, maybe $90 billion to try to save this highly overvalued exchange rate between the Brazilian real and the U.S. dollar. It doesn’t make any sense. It would be much better if they just said to heck with this charade and just adopt the U.S. policies directly. KASHYAP: But no country wants to give up their sovereignty, being able to issue a picture of one of their dead leaders instead of one of ours. If you ask someone to do that, they’re going to reject it unless the situation is pretty horrible, and I don’t think we’ve gotten to that level of pain yet. Although Russia’s heading there pretty fast. In fact, probably what the U.S. should do is stick to mostly domestic affairs. We don’t have a tremendously good record of being able to convince people to do what we want them to do, leaving aside whether or not we know what the right answer is. *GSB Chicago:* The IMF is calling for greater disclosure and a culture of transparency, is that. . . KASHYAP: IMF can start at its own borders by making its own actions transparent, but I agree with the principle. It’s more than transparency, it’s actually deregulating, saying that if a foreign financial institution wants to lend or collect deposits locally, it can do it without having to worry about being nationalized or being subject to arbitrary rules that domestic financial institutions aren’t subject to. KROSZNER: Where domestic financial institutions have collapsed there are probably still good projects that could be financed if there were a solvent institution there to provide the financing. Many industrialists want credit but can’t get it from the local institutions. In many of these countries, local banks are subject to political whim. They are nothing more than fiscal arms of the state. Foreign banks can be a much more stable source of funds than local banks. In the United States, we got rid of interstate barriers and have a much more stable system because money can flow from California and New York down to Texas when Texas banks get into trouble. The same thing could happen if foreign banks developed a large presence in countries like Malaysia and Korea. *GSB Chicago:* You’re suggesting that the answer to the global economic crisis is to create a true global economy. What do we have now? KROSZNER: A Frankenstein monster, a hybrid of the worst of some regulation and some market-oriented approaches. The worst of both worlds.
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