Order Code RL34742
The U.S. Financial Crisis: The Global Dimension
with Implications for U.S. Policy
November 18, 2008
Dick K. Nanto, Coordinator,
Martin A. Weiss, James K. Jackson, Ben Dolven,
Wayne M. Morrison, and William H. Cooper
Foreign Affairs, Defense, and Trade Division
J. Michael Donnelly
Information Research Specialist
Knowledge Services Group
The U.S. Financial Crisis: The Global Dimension with
Implications for U.S. Policy
Summary
What began as a bursting of the U.S. housing market bubble and a rise in
foreclosures has ballooned into a global financial crisis. Some of the largest and
most venerable banks, investment houses, and insurance companies have either
declared bankruptcy or have had to be rescued financially. In October 2008, credit
flows froze, lender confidence dropped, and one after another the economies of
countries around the world dipped toward recession. The crisis exposed fundamental
weaknesses in financial systems worldwide, and despite coordinated easing of
monetary policy by governments and trillions of dollars in intervention by
governments and the International Monetary Fund, the crisis continues.
The process for coping with the crisis by countries across the globe has been
manifest in four basic phases. The first has been intervention to contain the
contagion and restore confidence in the system. This has required extraordinary
measures both in scope, cost, and extent of government reach. The second has been
coping with the secondary effects of the crisis, particularly the slowdown in
economic activity and flight of capital from countries in emerging markets and
elsewhere who have been affected by the crisis. The third phase of this process is to
make changes in the financial system to reduce risk and prevent future crises. In
order to give these proposals political backing, world leaders have called for
international meetings to address changes in policy, regulations, oversight, and
enforcement. Some are characterizing these meetings as Bretton Woods II. On
November 15, 2008, a G-20 leaders’ summit recommended several measures to be
implemented by participating countries by March 31, 2009. The fourth phase of the
process is dealing with political and social effects of the financial turmoil.
The role for Congress in this financial crisis is multifaceted. A major issue is
how to ensure the smooth and efficient functioning of financial markets to promote
the general well-being of the country while protecting taxpayer interests and
facilitating business operations without creating a moral hazard. In addition to
preventing future crises through legislative, oversight, and domestic regulatory
functions, Congress has been providing funds and ground rules for economic
stabilization packages and informing the public through hearings and other means.
The largest question may be how U.S. regulations should be changed, if necessary,
and how closely any changes are harmonized with international recommendations.
Other questions include: should the United States promote global regulatory
standards to be voluntarily adopted by countries or should a supranational regulatory
institution be created that would impose rules on international financial markets?
Where would enforcement authority reside; at the state, national, or international
level? Congress also plays a role in measures to reform international financial
institutions and in recapitalizing the International Monetary Fund. Also, should U.S.
policies be designed to restore confidence in and induce return to the normal
functioning of a self-correcting financial system or has the system, itself, become
inherently unstable?
This report will be updated periodically.
Contents
Recent Developments and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Global Financial Crisis and U.S. Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Origins, Contagion, and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The Downward Slide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Effects on Emerging Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Latin America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Argentina . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Russia and the Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Effects on Europe and the European Response . . . . . . . . . . . . . . . . . . . . . . . . . . 28
The “European Framework for Action” . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
The British Rescue Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Collapse of Iceland’s Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Impact on Asia and the Asian Response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Asian Reserves and Their Impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
National Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
South Korea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Other Countries’ Moves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
New Challenges and Policy in Managing Financial Risk . . . . . . . . . . . . . . . . . . 47
The Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Bretton Woods II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
G-20 Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
G-7 Meeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
The International Monetary Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Changes in U.S. Regulations and Regulatory Structure . . . . . . . . . . . 58
Selected Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Appendix A. British, U.S., and European Central Bank Operations
April-Mid-October 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Appendix B. Major Recent Actions and Events of the International
Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Appendix C. G-20 Declaration of November 15, 2008 . . . . . . . . . . . . . . . . . . . 75
List of Figures
Figure 1. Origins of the Financial Crisis:
The Rise and Fall of Risky Mortgage and Other Debt . . . . . . . . . . . . . . . . . 10
Figure 2. Selected Stock Market Indices for the United States,
U.K., Japan, and Russia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Figure 3. Exchange Rate Values for Selected Currencies
Relative to the U.S. Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Figure 4. Current Account Balances (as a percentage of GDP) . . . . . . . . . . . . . . 17
Figure 5. Global Foreign Exchange Reserves ($ Trillion) . . . . . . . . . . . . . . . . . . 18
Figure 6. Capital Flows to Latin America (in percent of GDP) . . . . . . . . . . . . . . 20
Figure 7. Capital Flows to Developing Asia (in percent of GDP) . . . . . . . . . . . . 20
Figure 8. Capital Flows to Central and Eastern Europe (in percent of GDP) . . . 21
Figure 9. Asian Current Account Balances are Mostly Healthy . . . . . . . . . . . . . 39
List of Tables
Table 1. Selected Government Financial Support Actions . . . . . . . . . . . . . . . . . 15
Table 2. Projections of Economic Growth in 2008 and 2009 and Price
Inflation in Selected Regions and Countries (in percent) . . . . . . . . . . . . . . 30
Table 3. Losses on Selected Financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Table 4. Problems, Targets of Policy, and Actions Taken or Possibly to
Take in Response to the Global Financial Crisis . . . . . . . . . . . . . . . . . . . . . 61
The U.S. Financial Crisis: The Global
Dimension with Implications for U.S. Policy
Recent Developments and Analysis1
November 15. At a summit of leaders from the G-20 nations (including the G-
8, the European Union, Australia and 10 major emerging economies), leaders agreed
to continue taking steps to stabilize the global financial system and improve the
international regulatory framework. The leaders’ announced action plan (intended to
be implemented by national regulators by March 31, 2009) included pledges to (1)
address weaknesses in accounting and disclosure standards for off-balance sheet
vehicles; (2) ensure that credit rating agencies meet the highest standards and avoid
conflicts of interest, provide greater disclosure to investors, and differentiate ratings
for complex products; (3) ensure that firms maintain adequate capital, and set out
strengthened capital requirements for banks’ structured credit and securitization
activities; (4) develop enhanced guidance to strengthen banks’ risk management
practices, and ensure that firms develop processes that look at whether they are
accumulating too much risk; (5) establish processes whereby national supervisors
who oversee globally active financial institutions meet together and share
information; and (6) expand the Financial Stability Forum to include a broader
membership of emerging economies.
***********
— The crisis in credit markets and the threat of bankruptcy by major financial
institutions appears to have eased somewhat, but what began as a financial crisis has
evolved into a global macroeconomic downturn. The Euro zone and Japan are
officially in recession, and although the U.S. economy has not been declared to be
in recession, many observers assert that one already has begun. According to the
IMF, activity in advanced economies is expected to contract by ¼ percent in 2009 —
the first annual contraction during the postwar period — and in emerging economies,
growth is projected to slow appreciably to 5%.
— The G-20 summit illustrated the growing complexity, interconnectedness,
and shifting balance of economic power in the world. China with its nearly $2 trillion
in foreign exchange reserves, along with a rising India, reassertive Russia, and
reformed Brazil all had seats at the table with the usual leaders from Europe, the
United States, and Japan. It wasn’t apparent that the developing world pushed for a
broadly different agenda from advanced nations. The financial crisis and its aftermath
has been remarkably indiscriminate. It has struck nearly all countries regardless of
political system or size and even those not exceptionally exposed to risky debt.
1 For a more complete list of major developments and actions, see Appendix B.
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The Global Financial Crisis and U.S. Interests2
What began as a bursting of the U.S. housing market bubble and a rise in
foreclosures has ballooned into a global financial and economic crisis. Some of the
largest and most venerable banks, investment houses, and insurance companies have
either declared bankruptcy or have had to be rescued financially. In October 2008,
credit flows froze, lender confidence dropped, and one after another the economies
of countries around the world dipped toward recession. The crisis exposed
fundamental weaknesses in financial systems worldwide, and despite coordinated
easing of monetary policy by governments and trillions of dollars in intervention by
central banks and governments, the crisis seems far from over.
This financial crisis which began in industrialized countries quickly entered a
second phase in which emerging market and other economies have been battered.
Investors have pulled capital from countries, even those with small levels of
perceived risk, and caused values of stocks and domestic currencies to plunge. Also,
slumping exports and commodity prices have added to the woes, pushing economies
world wide toward recession. The global crisis now seems to be played out on two
levels. The first is among the industrialized nations of the world where most of the
losses from subprime mortgage debt, excessive leveraging of investments, and
inadequate capital backing credit default swaps (insurance against defaults and
bankruptcy) have occurred. The second level of the crisis is among emerging market
and other economies who may be “innocent bystanders” to the crisis but who also
may have less resilient economic systems that can often be whipsawed by actions in
global markets. Most industrialized countries (except for Iceland) seem to able to
finance their own rescue packages by borrowing domestically and in international
capital markets, but emerging market economies may have insufficient sources of
capital and may have to turn to help from the International Monetary Fund (IMF) or
from capital surplus nations, such as Russia, Japan, and the European Union.
For the United States, the financial turmoil touches on the fundamental national
interest of protecting the economic security of Americans. It also is affecting the
United States in achieving national goals, such as stability, maintaining cooperative
relations with other nations, and supporting a financial infrastructure that allows for
the smooth functioning of the international economy. Reverberations from the
financial crisis, moreover, are not only being felt on Wall Street and Main Street but
are being manifest in world flows of exports and imports, rates of growth and
unemployment, and government revenues and expenditures. The rapidity with which
growth is slowing in countries seems to indicate that this global downturn is not a
just a phase in the usual cycle of business.
A single global financial market now seems to be an economic reality, and
financial troubles also affect the goods-and-services-producing sectors of the
economy. As the force of the effects of the global financial market are felt, popular
and congressional concern may grow. Is the system too complex to be controlled, or
is it an insider’s game at the expense of Main Street? Opposition to globalization
2 Prepared by Dick K. Nanto, Specialist in Industry and Trade, Foreign Affairs, Defense, and
Trade Division.
CRS-3
from various quarters may work to shape the debate over rewriting U.S. and
international financial rules.
The global financial crisis has brought home an important point: the United
States is still a major center of the financial world. Regional financial crises (such
as the Asian financial crisis, Japan’s banking crisis, or the Latin American debt crisis)
can occur without seriously infecting the rest of the global financial system. But
when the U.S. financial system stumbles, it may bring major parts of the rest of the
world down with it.3 The reason is that the United States is the main guarantor of the
international financial system, the provider of dollars widely used as currency
reserves and as an international medium of exchange, and a contributor to much of
the financial capital that sloshes around the world seeking higher yields. The rest of
the world may not appreciate it, but a financial crisis in the United States often takes
on a global hue. Emerging market economies, in particular, have not de-coupled
from the U.S. economy.
The process as it has played out in countries across the globe has been manifest
in four basic phases. The first phase has been intervention to stop the financial
bleeding, to coordinate interest rate cuts, and pursue actions to restart and restore
confidence in credit markets. This has involved decisive (and, in cases,
unprecedented) measures both in scope, cost, and extent of government reach.
Actions taken include the rescue of financial institutions considered to be “too big
to fail,” injections of capital, government takeovers of certain financial institutions,
government guarantees of bank deposits and money market funds, and government
facilitation of mergers and acquisitions. (See Tables 3 and 5.)
The second phase of this process is less innovative as countries cope with the
macroeconomic impact of the crisis on their economies, firms, and investors. Many
of these countries, particularly those with emerging markets, have been pulled down
by the ever widening flight of capital from risk and by falling exports and commodity
prices. Governments have turned to traditional monetary and fiscal policies to deal
with recessionary economic conditions, declining tax revenues, and rising
unemployment, and several have turned to funding from the International Monetary
Fund (IMF), World Bank, and capital surplus countries. The IMF and others are in
the process of providing financing packages for Iceland ($2.1 billion), Ukraine ($16.5
billion), Hungary ($25.1 billion), and Pakistan ($7.6 billion). Other countries, such
as Belarus, are in talks with the IMF. In addition, nations, both industrialized and
emerging, facing difficult economic conditions include some other countries of the
Former Soviet Union, Mexico, Argentina, South Korea, Indonesia, Spain, and Italy.
The third phase of the process — to decide what changes may be needed in the
financial system — is also underway. While monetary authorities battled the
financial conflagration and slowdown in economic growth, the question of what
changes are necessary to prevent future crises had been left primarily to observers
and academics. As the triage has been applied and the crisis has ebbed somewhat,
attention now has turned to long-term solutions to the problems. In order to give
3 See, for example, Friedman, George and Peter Zeihan. “The United States, Europe and
Bretton Woods II.” A Strafor Geopolitical Intelligence Report, October 20, 2008.
CRS-4
these proposals political backing, world leaders began a series of international
meetings to address changes in policy, regulations, oversight, and enforcement.
Some are characterizing these meetings as Bretton Woods II.4 The G-20 leaders’
Summit on Financial Markets and the World Economy that met on November 15,
2008, in Washington, DC, was the first of a series of summits to address these issues.
(See Appendix C.)
In this third phase, the immediate issues to be addressed by the United States
center on “fixing the system” and preventing future crises from occurring. Much of
this involves the technicalities of regulation and oversight of financial markets,
derivatives, and hedging activity, as well as standards for capital adequacy and a
schema for funding and conducting future financial interventions, if necessary. Some
of the short-term issues that have been raised (and are discussed later in this paper
or other CRS reports) include:
! weakness in fundamental underwriting principles,
! the build-up of massive risk concentrations in firms,
! the originate-to-distribute model of mortgage lending,
! insufficient bank liquidity and capital buffers,5
! no overall regulatory structure for banks, brokerages, insurance, and
futures,
! lack of a regulatory ties between macroeconomic variables and
prudential oversight, and
! how financial rescue packages should be structured.
For the United States, the fundamental issues may be the degree to which U.S.
laws and regulations are to be altered to conform to international norms and
standards and the degree to which the country is willing to cede authority to an
international watchdog and regulatory agency. What form should any new
international financial architecture take? Should the Bretton Woods system be
changed from one in which the United States is the buttress of the international
financial architecture to one in which the United States remains the buttress but its
financial markets are more “Europeanized” (more in accord with Europe’s practices)
and more constrained by the broader international financial order? Should the
international financial architecture be merely strengthened or include more control,
and if more controls, then by whom?6 What is the time frame for a new architecture
that may take years to materialize?
Some of these issues are being addressed by the President’s Working Group on
Financial Markets (consisting of the U.S. Treasury Secretary, Chairs of the Federal
Reserve Board, the Securities and Exchange Commission, and the Commodity
4 The Bretton Woods Agreements in 1944 established the basic rules for commercial and
financial relations among the world’s major industrial states and also established what has
become the World Bank and International Monetary Fund.
5 Wellink, Nout. “Responding to Uncertainty,” Remarks by the Chairman of the Basel
Committee on banking supervision at the International Conference of Banking Supervisors
2008, Brussels, September 24, 2008.
6 Friedman, George and Peter Zeihan. “The United States, Europe and Bretton Woods II.”
A Strafor Geopolitical Intelligence Report, October 20, 2008.
CRS-5
Futures Trading Commission. On the international side, the G-20 nations, the
Financial Stability Forum, and the Bank for International Settlements also are seeking
solutions.
The fourth phase of the process is dealing with political and social effects of the
financial turmoil. These are secondary effects that relate to the role of the United
States on the world stage, its leadership position relative to other countries, and the
political and social impact within countries affected by the crisis. For example,
European leaders (particularly British Prime Minister Gordon Brown, French
President Nicolas Sarkozy, and German Chancellor Angela Merkel) have been
playing a major role during the crisis, particularly in Europe, and have been
influential in crafting international policies to deal with adverse effects of the crisis
as well as proposing long-term solutions. The end-of-term status of President George
W. Bush may have contributed to this situation, but over the longer-run, will the
financial crisis work to diminish the influence of the United States and its dollar in
financial circles relative to Europe and its Euro/pound? This may occur in spite of
the “flight to safety” into dollar assets during the crisis. Dealing with the financial
crisis also may enable countries with rich currency reserves, such as China, Russia,
and Japan, to assume higher political profiles in world financial circles. The
inclusion of China, India, and Brazil in the G-20 Summit on Financial Markets and
the World Economy rather than just the G-7 or G-8 countries as originally proposed,
seems to indicate the growing influence of the non-industrialized nations in
addressing global financial issues.7
The effects of the crisis also may impede the ability of the United States to carry
out certain U.S. goals. For example, the financial crisis comes at time of global food
shortages and has been causing recessions in countries or at least their growth rates
to decline. As economic conditions in developing countries worsen, requests for
economic and humanitarian assistance are likely to increase. This coincides,
however, with a slowdown in government revenues and huge costs for financial
rescue packages that may reduce the U.S. ability to increase funding for aid or other
programs. Also, if China helps to finance the various rescue measures in the United
States, Washington may lose some leverage with Beijing in pursuing human and
labor rights, product safety, and other pertinent issues. The precipitous drop in the
price of oil, moreover, holds important implications for countries, such as Russia,
Mexico, Venezuela, and other petroleum exporters, who were counting on oil
revenues to continue to pour into their coffers to fund activities considered to be
essential to their interests. While moderating oil prices may be a positive
development for the U.S. consumer and for the U.S. balance of trade, it also may
affect the political stability of certain petroleum exporting countries. The
concomitant drop in prices of commodities such as rubber, copper ore, iron ore, beef,
7 The G-7 includes Canada, France, Germany, Italy, Japan, United Kingdom, and the United
States. The G-8 is the G-7 plus Russia. The G-20 adds Argentina, Australia, Brazil, China,
India, Indonesia, Mexico, Saudi Arabia, South Africa, South Korea, and Turkey.
CRS-6
rice, coffee, and tea also carries dire consequences for exporter countries in Africa,
Latin America, and Asia.8
The decline in oil prices may be particularly troubling in oil-dependent Yemen,
a country with a large population of unemployed young people and a history of
support for militant Islamic groups. Also, in Pakistan, a particular security problem
exacerbated by the financial crisis could be developing. Although the IMF and
Pakistan have agreed in principle to a $7.6 billion loan, the country faces serious
problems economic problems at a time when the country is dealing with challenges
from suspected al Qaeda and Taliban sympathizers in the country and a budget
shortfall that may curtail the ability of the government to continue its counterterror
operations.9
The role for Congress in this financial crisis is multifaceted. The overall issue
seems to be how to ensure the smooth and efficient functioning of financial markets
to promote the general well-being of the country while protecting taxpayer interests
and facilitating business operations without creating a moral hazard.10 In addition to
preventing future crises through legislative, oversight, and domestic regulatory
functions, Congress has been providing funds and ground rules for economic
stabilization packages and informing the public through hearings and other means.
Congress also plays a role in measures to reform the international financial system
and in recapitalizing international financial institutions such as the International
Monetary Fund.
Origins, Contagion, and Risk11
Financial crises of some kind occur sporadically virtually every decade and in
various locations around the world. Financial meltdowns have occurred in countries
ranging from Sweden to Argentina, from Russia to Korea, from the United Kingdom
8 Johnston, Tim. “Asia Nations Join to Prop Up Prices,” Washington Post, November 1,
2008, p. A10. “Record Fall in NZ Commodity Price Gauge,” The National Business Review,
November 5, 2008.
9 Joby Warrick, “Experts See Security Risks in Downturn, Global Financial Crisis May Fuel
Instability and Weaken U.S. Defenses,” Washington Post, November 15, 2008. P. A01.
Bokhari, Farhan, “Pakistan’s War On Terror Hits Roadblock, Global Economic Crisis
Prompts Military To Consider Spending Cutbacks,” CBS News (online version), Oct. 28,
2008.
10 A moral hazard is created if a government rescue of private companies encourages those
companies and others to engage in comparable risky behavior in the future, since the
perception arises that they will again be rescued if necessary and not have to carry the full
burden of their losses.
11 Prepared by Dick K. Nanto. See also, CRS Report RL34730, The Emergency Economic
Stabilization Act and Current Financial Turmoil: Issues and Analysis, by Baird Webel and
Edward V. Murphy.
CRS-7
to Indonesia, and from Japan to the United States.12 As one observer noted: as each
crisis arrives, policy makers express ritual shock, then proceed to break every rule in
the book. The alternative is unthinkable. When the worst is passed, participants
renounce crisis apostasy and pledge to hold firm next time.13
Each financial crisis is unique, yet each bears some resemblance to others. In
general, crises have been generated by factors such as an overshooting of markets,
excessive leveraging of debt, credit booms, miscalculations of risk, rapid outflows
of capital from a country, mismatches between asset types (e.g., short-term dollar
debt used to fund long-term local currency loans), unsustainable macroeconomic
policies, off-balance sheet operations by banks, inexperience with new financial
instruments, and deregulation without sufficient market monitoring and oversight.
As shown in Figure 1, the current crisis harkens back to the 1997-98 Asian
financial crisis in which Thailand, Indonesia, and South Korea had to borrow from
the International Monetary Fund to service their short-term foreign debt and to cope
with a dramatic drop in the values of their currency and deteriorating financial
condition.14 Determined not to be caught with insufficient foreign exchange reserves,
countries subsequently began to accumulate dollars, Euros, pounds, and yen in record
amounts. This was facilitated by the U.S. trade (current account) deficit.15 By mid-
2008, world currency reserves by governments had reached $4.4 trillion with China’s
reserves alone approaching $2 trillion, Japan’s nearly $1 trillion, Russia’s more than
$500 billion, and India, South Korea, and Brazil each with more than $200 billion.16
The accumulation of hard currency assets was so great in some countries that they
diverted some of their reserves into sovereign wealth funds that were to invest in
higher yielding assets than U.S. Treasury and other government securities.17
Following the Asian financial crisis, much of the world’s “hot money” began
to flow into high technology stocks. The so-called “dot-com boom” ended in the
spring of 2000 as the value of equities in many high-technology companies collapsed.
After the dot-com bust, more “hot investment capital” began to flow into
housing markets — not only in the United States but in other countries of the world.
At the same time, China and other countries invested much of their accumulations
12 For a review of past financial crises, see: Luc Laeven and Fabian Valencia. “Systemic
Banking Crises: A New Database,” International Monetary Fund Working Paper
WP/08/224, October 2008. 80p.
13 Gelpern, Anna. “Emergency Rules,” The Record (Bergen-Hackensack, NJ), September
26, 2008.
14 During the Asian financial crisis in 1997, the IMF, World Bank, Asian Development
Bank, the United States, and Japan provided financial support packages to Thailand ($17.2
billion), Indonesia ($42.3 billion), and South Korea ($58.2 billion).
15 From 2005-2007, the U.S. current account deficit (balance of trade, services, and
unilateral transfers) was a total of $2.2 trillion.
16 Reuters. Factbox — Global foreign exchange reserves. October 12, 2008.
17 See CRS Report RL34336, Sovereign Wealth Funds: Background and Policy Issues for
Congress, by Martin A. Weiss.
CRS-8
of foreign exchange into U.S. Treasury and other securities. While this helped to
keep U.S. interest rates low, it also tended to keep mortgage interest rates at lower
and attractive levels for prospective home buyers.18 This housing boom coincided
with greater popularity of the securitization of assets, particularly mortgage debt
(including subprime mortgages), into collateralized debt obligations (CDOs).19 A
problem was that the mortgage originators often were mortgage finance companies
whose main purpose was to write mortgages using funds provided by banks and other
financial institutions or borrowed. They were paid for each mortgage originated but
had no responsibility for loans gone bad. Of course, the incentive for them was to
maximize the number of loans concluded. This coincided with political pressures to
enable more Americans to buy homes, although it appears that Fannie Mae and
Freddie Mac were not directly complicit in the loosening of lending standards and the
rise of subprime mortgages.20
In order to cover the risk of defaults on mortgages, particularly subprime
mortgages, the holders of CDOs purchased credit default swaps21 (CDSs). These are
a type of insurance contract (a financial derivative) that lenders purchase against the
possibility of credit event (a default on a debt obligation, bankruptcy, restructuring,
or credit rating downgrade) associated with debt, a borrowing institution, or other
referenced entity. The purchaser of the CDS does not have to have a financial
interest in the referenced entity, so CDSs quickly became more of a speculative asset
than an insurance policy. As long as the credit events (defaults) never occurred,
18 See U.S. Joint Economic Committee, “Chinese FX Interventions Caused international
Imbalances, Contributed to U.S. Housing Bubble,” by Robert O’Quinn. March 2008.
19 For further analysis, see CRS Report RL34412, Averting Financial Crisis, by Mark
Jickling. U.S. Joint Economic Committee, “The U.S. Housing Bubble and the Global
Financial Crisis: Vulnerabilities of the Alternative Financial System,” by Robert O’Quinn.
June 2008.
20 Fannie Mae (Federal National Mortgage Association) is a government-sponsored
enterprise (GSE) chartered by Congress in 1968 as a private shareholder-owned company
with a mission to provide liquidity and stability to the U.S. housing and mortgage markets.
It operates in the U.S. secondary mortgage market and funds its mortgage investments
primarily by issuing debt securities in the domestic and international capital markets.
Freddie Mac (Federal Home Loan Mortgage Corp) is a stockholder-owned GSE chartered
by Congress in 1970 as a competitor to Fannie Mae. It also operates in the secondary
mortgage market. It purchases, guarantees, and securitizes mortgages to form
mortgage-backed securities. For an analysis of Fannie Mae and Freddie Mac’s role in the
subprime crisis, see David Goldstein and Kevin G. Hall, “Private sector loans, not Fannie
or Freddie, triggered crisis,” McClatchy Newspapers, October 12, 2008.
21 A credit default swap is a credit derivative contract in which one party (protection buyer)
pays a periodic fee to another party (protection seller) in return for compensation for default
(or similar credit event) by a reference entity. The reference entity is not a party to the
credit default swap. It is not necessary for the protection buyer to suffer an actual loss to
be eligible for compensation if a credit event occurs. The protection buyer gives up the risk
of default by the reference entity, and takes on the risk of simultaneous default by both the
protection seller and the reference credit. The protection seller takes on the default risk of
the reference entity, similar to the risk of a direct loan to the reference entity. See CRS
Report RS22932, Credit Default Swaps: Frequently Asked Questions, by Edward V.
Murphy.
CRS-9
issuers of CDSs could earn huge amounts in fees relative to their capital base (since
these were technically not insurance, they did not fall under insurance regulations
requiring sufficient capital to pay claims, although credit derivatives requiring
collateral became more and more common in recent years). The sellers of the CDSs
that protected against defaults often covered their risk by turning around and buying
CDSs that paid in case of default. As the risk of defaults rose, the cost of the CDS
protection rose. Investors, therefore, could arbitrage between the lower and higher
risk CDSs and generate large income streams with what was perceived to be minimal
risk.
In 2007, the notional value (face value of underlying assets) of credit default
swaps had reached $62 trillion, more than the combined gross domestic product of
the entire world ($54 trillion),22 although the actual amount at risk was only a fraction
of that amount. By July 2008, the notional value of CDSs had declined to $54.6
trillion and by October 2008 to an estimated $46.95 trillion.23 The system of CDSs
generated large profits for the companies involved until the default rate, particularly
on subprime mortgages, and the number of bankruptcies began to rise. Soon the
leverage that generated outsized profits began to generate outsized losses, and in
October 2008, the exposures became too great for companies such as AIG.
22 Notional value is the face value of bonds and loans on which participants have written
protection. World GDP is from World Bank. Development Indicators.
23 International Swaps and Derivatives Association, ISDA Applauds $25 Trn Reductions in
CDS Notionals, Industry Efforts to Improve CDS Operations. News Release, October 27,
2008.
CRS-10
Figure 1. Origins of the Financial Crisis:
The Rise and Fall of Risky Mortgage and Other Debt
1997-98 Asian
Prime mortgages
Financial Crisis
High Tech
sold to Fannie M ae
Petrodollars
Stock Bubble
Prim e and
Freddie Mac
subprime
accum ulate
Burst
& others
overseas
(3/2000)
m ortgages issued
Investors buy & sell
Asian & M id-East countries
$50 to $60 trillion in
increase foreign exchange
Fed lowers interest
M ortgages bundled and
credit default
holdings & invest in U.S.
rates. Housing
sold as collateralized
swaps (CDSs) as
stocks & other assets
boom starts
debt obligations (CDOs )
insurance
Problem :
Problem :
Mortgage & other
Problem:
No regulation
Too high ratings of
Securities sold to
The Rise of
CDSs backed
O f many m ortgage
m uch securitized
investors w orldwide
by other CDSs
Risky Debt
originators
debt
not capital
10/3/08
The Fall of
9/7/08
9/14/08
Default rate rises on
$100 billion
Bush signs
Merrill Lynch
bailout
Risky Debt
m ortgages (particularly
sold to Bank of
$700 billion
of Fannie Mae
America
s ub-prim e m ortgages) and
and Freddie Mac
Economic
other securities
Stabilization
plan
Housing bust
9/15/08
begins
9/16/08
Fed’ s $85
Lehman Bros.
billion
(late 2006)
CDOs carry
Bankrupt
Rescue of
AIG
undisclosed and
10/6-10/08
underpric ed risk
Interest rates
Crisis spreads
rise
To Europe, Asia
9/25/08
9-10/08
Economic growth
Washington
Citigroup &
G lobal stocks fall
Mutual bankr upt
rates slow
Wells Far go
Credit markets
AAA Ratings
C redit default swap
Rescued by
Bid for
JP Morgan
freeze up
Wachovia
downgraded on
issuers have
Subprime CDO s
insuffic ient capital
(7/2007)
to cover losses
CRS-11
Risk
The origins of the financial crisis point toward three developments that
increased risk in financial markets. The first was the originate-to-distribute model
for mortgages. The originator of mortgages passed them on to the provider of funds
or to a bundler who then securitized them and sold the collateralized debt obligation
to investors. This recycled funds back to the mortgage market and made mortgages
more available. However, the originator was not penalized, for example, for not
ensuring that the borrower was actually qualified for the loan, and the buyer of the
securitized debt had little detailed information about the underlying quality of the
loans. Investors depended heavily on ratings by credit agencies.
The second development was a rise of perverse incentives and complexity for
credit rating agencies. Credit rating firms received fees to rate securities based on
information provided by the issuing firm using their models for determining risk.
Credit raters, however, had little experience with credit default swaps at the
“systemic failure” tail of the probability distribution. The models seemed to work
under normal economic conditions but had not been tested in crisis conditions.
Credit rating agencies also may have advised clients on how to structure securities
in order to receive higher ratings. In addition, the large fees offered to credit rating
firms for providing credit ratings were difficult for them to refuse in spite of doubts
they might have had about the underlying quality of the securities. The perception
existed that if one credit rating agency did not do it, another would.
The third development was the blurring of lines between issuers of credit default
swaps and traditional insurers. In essence, financial entities were writing a type of
insurance contract without regard for insurance regulations and requirements for
capital adequacy (hence, the use of the term “credit default swaps” instead of “credit
default insurance”). Much risk was hedged rather than backed by sufficient capital
to pay claims in case of default. Under a systemic crisis, hedges also may fail.
However, although the CDS market was largely unregulated by government, more
than 850 institutions in 56 countries that deal in derivatives and swaps belong to the
ISDA (International Swaps and Derivatives Association). The ISDA members
subscribe to a master agreement and several protocols/amendments, some of which
require that in certain circumstances companies purchasing CDSs require
counterparties (sellers) to post collateral to back their exposures.24 The blurring of
boundaries among banks, brokerage houses, and insurance agencies also made
regulation and information gathering difficult. Regulation in the United States tends
to be functional with separate government agencies regulating and overseeing banks,
securities, insurance, and futures. There is no suprafinancial authority.
24 For information on the International Swaps and Derivatives Association, see
[http://www.isda.org]. In 2008, credit derivatives had collateralized exposure of 74%. See
ISDA, Margin Survey 2008. Collateral calls have been a major factor in the financial
difficulties of AIG insurance.
CRS-12
The Downward Slide
The plunge downward into the global financial crisis did not take long. It was
triggered by the bursting of the housing bubble and the ensuing subprime mortgage
crisis in the United States, but other conditions have contributed to the severity of the
situation. Banks, investment houses, and consumers carried large amounts of
leveraged debt. Certain countries incurred large deficits in international trade and
current accounts (particularly the United States), while other countries accumulated
large reserves of foreign exchange by running surpluses in those accounts. Investors
deployed “hot money” in world markets seeking higher rates of return. These were
joined by a huge run up in the price of commodities, rising interest rates to combat
the threat of inflation, a general slowdown in world economic growth rates, and
increased globalization that allowed for rapid communication, instant transfers of
funds, and information networks that fed a herd instinct. This brought greater
uncertainty and changed expectations into a world economy that for a half decade had
been enjoying relative stability.
An immediate indicator of the rapidity and spread of the financial crisis has been
in stock market values. As shown in Figure 2, as values on the U.S. market plunged,
those in other countries were swept down in the undertow. By mid-October 2008,
the stock indices for the United States, U.K., Japan, and Russia had fallen by half or
more relative to their levels on October 1, 2007.
Figure 2. Selected Stock Market Indices for the United States,
U.K., Japan, and Russia
Stock Market Indices (1 Oct 2007 = 100)
140
Severe
Global
Russian RTS
Contagion
!
120
!!!!!!!!!
!!
!!!!!!!!!!!!!
!
UK FTSE 100!!!!!!
100 !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!
!!!!!!!!!! !!!!!!!!!!!!!!!!
! ! !
!
!
!!!!!!!!!!!!!!!!!!!!
!!
!!!!!!!!!!!!!
80
!!!
! !!!!!
Dow Jones Industrials
!!!!!!!!
60
Japan’s Nikkei 225
!
! !!
!
!
!!!
40
!!
!
! ! !
Mild Global Contagion
!!!!
!!
20
ct-07 ov-07 ec-07
ar-08 pr-08 ay-08
ug-08 ep-08
ct-08
31-O 30-N 31-D 31-Jan-08
29-Feb-08
31-M
30-A 30-M 30-Jun-0831-Jul-08
29-A 30-S
31-O
Date
Data Source: Factiva database.
CRS-13
Declines in stock market values reflected huge changes in expectations and the
flight of capital from assets in countries deemed to have even small increases in risk.
Many investors, who not too long ago had heeded financial advisors who were
touting the long term returns from investing in the BRICs (Brazil, Russia, India, and
China),25 pulled their money out nearly as fast as they had put it in. Dramatic
declines in stock values coincided with new accounting rules that required financial
institutions holding stock as part of their capital base to value that stock according
to market values (mark-to-market). Suddenly, the capital base of banks shrank and
severely curtailed their ability to make more loans (counted as assets) and still remain
within required capital-asset ratios. Insurance companies too found their capital
reserves diminished right at the time they had to pay buyers of credit default swaps.
The rescue (establishment of a conservatorship) for Fannie Mae and Freddie Mac in
September 2008 potentially triggered credit default swap contracts with notional
value exceeding $1.2 trillion.
In addition, the rising rate of defaults and bankruptcies created the prospect that
equities would suddenly become valueless. The market price of stock in Freddie
Mac plummeted from $63 on October 8, 2007 to $0.88 on October 28, 2008. Hedge
funds, whose “rocket scientist” analysts claimed that they could make money whether
markets rose or fell, lost vast sums of money. The prospect that even the most
seemingly secure company could be bankrupt the next morning caused credit markets
to freeze. Lending is based on trust and confidence. Trust and confidence
evaporated as lenders reassessed lending practices and borrower risk.
One indicator of the trust among financial institutions is the Libor, the London
Inter-Bank Offered Rate. This is the interest rate banks charge for short-term loans
to each other. Although it is a composite of primarily European interest rates, it
forms the the basis for many financial contracts world wide including U.S. home
mortgages and student loans. During the worst of the financial crisis in October
2008, this rate had doubled from 2.5% to 5.1%, and for a few days much interbank
lending actually had stopped. The rise in the Libor came at a time when the U.S.
monetary authorities were lowering interest rates to stimulate lending. The difference
between interest on Treasury bills (three month) and on the Libor (three month) is
called the “Ted spread.” This spread averaged 0.25 percentage points from 2002 to
2006, but in October 2008 exceeded 4.5 percentage points. The greater the spread,
the greater the anxiety in the marketplace.26
Currency exchange rates serve both as a conduit of crisis conditions and an
indicator of the severity of the crisis. As the financial crisis hit, investors fled stocks
and debt instruments for the relative safety of cash — often held in the form of U.S.
Treasury or other government securities. That increased demand for dollars,
decreased the U.S. interest rate needed to attract investors, and caused a jump in
inflows of liquid capital into the United States. For those countries deemed to be
25 Thomas M. Anderson, “Best Ways to Invest in BRICs,” Kiplinger.com, October 18,
2007.
26 For these and other indicators of the crisis in credit, see [http://www.nytimes.com/
interactive/2008/10/08/business/economy/20081008-credit-chart-graphic.html].
CRS-14
vulnerable to the effects of the financial crisis, however, the effect was precisely the
opposite. Demand for their currencies fell and their interest rates rose.
Figure 3 shows indexes of the value of selected currencies relative to the dollar
for countries in which the effects of the financial crisis have been particularly severe.
For much of 2007 and 2008, the Euro and other European currencies, including the
Hungarian forint had been appreciating in value relative to the dollar. Then the crisis
broke. Other currencies, such as the Korean won, Pakistani rupee, and Icelandic
krona had been steadily weakening over the previous year and experienced sharp
declines as the crisis evolved.
For a country in crisis, a weak currency increases the local currency equivalents
of any debt denominated in dollars and exacerbates the difficulty of servicing that
debt. The greater burden of debt servicing usually has combined with a weakening
capital base of banks because of declines in stock market values to further add to the
financial woes of countries. National governments have had little choice but to take
fairly draconian measures to cope with the threat of financial collapse. As a last
resort, some have turned to the International Monetary Fund for assistance.
Figure 3. Exchange Rate Values for Selected Currencies
Relative to the U.S. Dollar
Currency Exchange Rates in Dollars (Oct 1, 2007 = 100)
140
Severe
Hungarian Forint
Global
Contagion
120
Euro
100
80
Icelandic Krona
60
Pakistani Rupees
South Korean Won
40
Mild Global Contagion
20
10/31/2007
11/30/2007
12/31/2007
1/31/2008
2/29/2008
3/31/2008
4/30/2008
5/30/2008
6/30/2008
7/31/2008
8/29/2008
9/30/2008
10/31/2008
Date
Data from PACIFIC Exchange Rate Service, University of British Columbia
Details of many of the actions by other countries to address the effects of the
financial crisis are outlined in the sections below dealing with geographical regions
and countries. Table 1 provides a summary of costs of major actions taken so far by
national governments.
CRS-15
Table 1. Selected Government Financial Support Actions
(in billions of U.S. dollars)
Bank
Injections
Purchases of
Other
Guarantees
Capital
Assets
United Kingdom
$450
$90
$349
United States
1,400
250
450
198
Austria
127
23
Belgium
7
4
France
62
400
Germany
600
190
Greece
23
8
Ireland
Banks’ wholesale debt
Netherlands
300
70
Portugal
30
Spain
150
75
Norway
60
Sweden
214
Switzerland
5
60
Canada
Banks’ wholesale debt
26
Denmark
Banks’ wholesale debt
Iceland
Nationalization of Glitner, Landsbanki, and Kaupthing Banks
Australia
Banks’ wholesale debt
7
South Korea
100
1
1
Total dollars
$5,269
711
1,357
1,357
Source: The Bank of England. Financial Stability Report, Oct 2008, p. 33.
Effects on Emerging Markets27
The global credit crunch that began in August 2007 has led to a financial crisis
in emerging market countries (see box) that is being viewed as greater in both scope
and effect than the East Asian financial crisis of 1997-98 or the Latin American debt
crisis of 2001-2002, although the impact on individual countries may have been
greater in previous crises. Of the emerging market countries, those in Central and
Eastern Europe appear, to date, to be the most impacted by the financial crisis.
The ability of emerging market countries to borrow from global capital markets
has allowed many countries to experience incredibly high growth rates. For example,
the Baltic countries of Latvia, Estonia, and Lithuania experienced annual economic
growth of nearly 10% in recent years. However, since this economic expansion was
predicated on the continued availability of access to foreign credit, they were highly
vulnerable to a financial crisis when credit lines dried up.
27 Prepared by Martin A. Weiss, Specialist in International Trade and Finance, Foreign
Affairs, Defense, and Trade Division.
CRS-16
What are Emerging Market Countries?
There is no uniform definition of the term “emerging markets.” Originally conceived in
the early 1980s, the term is used loosely to define a wide range of countries that have
undergone rapid economic change over the past two decades. Broadly speaking, the term
is used to distinguish these countries from the long-industrialized countries, on one hand,
and less-developed countries (such as those in Sub-Saharan Africa), on the other.
Emerging market countries are located primarily in Latin America, Central and Eastern
Europe, and Asia.
Since 1999, the finance ministers of many of these emerging market countries began
meeting with their peers from the industrialized countries under the aegis of the G-20, an
informal forum to discuss policy issues related to global macroeconomic stability. The
members of the G-20 are the European Union and 19 countries: Argentina, Australia,
Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia,
Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United
States.
For more information, see: “When are Emerging Markets no Longer Emerging?,
Knowledge@Wharton, available at [http://knowledge.wharton.upenn.edu/
article.cfm?articleid=1911] .
Of all emerging market countries, Central and Eastern Europe appear to be the
most vulnerable. On a wide variety of economic indicators, such as the total amount
of debt in the economy, the size of current account deficits, dependence on foreign
investment, and the level of indebtedness in the domestic banking sector, countries
such as Hungary, Ukraine, Bulgaria, Kazakhstan, Kyrgyzstan, Latvia, Estonia, and
Lithuania, rank among the highest of all emerging markets. Throughout the region,
the average current account deficit increased from 2% of GDP in 2000 to 9% in
2008. In some countries, however, the current account deficit is much higher.
Latvia’s estimated 2008 current account deficit is 22.9% of GDP and Bulgaria’s is
21.4%.28 The average deficit for the region was greater than 6% in 2008 (Figure 4).
28 Mark Scott, “Economic Problems Threaten Central and Eastern Europe,” BusinessWeek,
October 17, 2008.
CRS-17
Figure 4. Current Account Balances (as a percentage of GDP)
8
6
4
2
0
1
92
94
95
97
98
0
01
2
3
04
05
6
07
-21990 199
19
1993 19
19
1996 19
19
1999 200
20
200
200
20
20
200
20
-4
-6
-8
Latin America
Developing Asia
Central and Eastern Europe
Source: International Monetary Fund
Due to the impact of the financial crisis, several Central and Eastern European
countries have already sought emergency lending from the IMF to help finance their
balance of payments. On October 24, the IMF announced an initial agreement on a
$2.1 billion two-year loan with Iceland. On October 26, the IMF announced a $16.5
billion agreement with Ukraine. On October 28, the IMF announced a $15.7 billion
package for Hungary. On November 3, a staff-level agreement on an IMF loan was
reached with Kyrgyzstan.29
The quickness with which the crisis has impacted emerging market economies
has taken many analysts by surprise. Since the Asian financial crisis, many Asian
emerging market economies enacted a policy of foreign reserve accumulation as a
form of self-insurance in case they once again faced a “sudden stop” of capital flows
and the subsequent financial and balance of payments crises that result from a rapid
tightening of international credit flows.30 Two additional factors motivated emerging
market reserve accumulation. First, several countries have pursued an export-led
growth strategy targeted at the U.S. and other markets with which they have
generated trade surpluses.31 Second, a sharp rise in the price of commodities from
2004 to the first quarter of 2008 led many oil-exporting economies, and other
29 Information on ongoing IMF negotiations is available at [http://www.imf.org].
30 Reinhart, Carmen and Calvo, Guillermo (2000): When Capital Inflows Come to a Sudden
Stop: Consequences and Policy Options. Published in: in Peter Kenen and Alexandre
Swoboda, eds. Reforming the International Monetary and Financial System (Washington
DC: International Monetary Fund, 2000) (2000): pp. 175-201.
31 “New paradigm changes currency rules,” Oxford Analytica, January 17, 2008.
CRS-18
commodity-based exporters, to report very large current account surpluses. Figure
5 shows the rapid increase in foreign reserve accumulation among these countries.
These reserves provided a sense of financial security to EM countries. Some
countries, particularly China and certain oil exporters, also established sovereign
wealth funds that invested the foreign exchange reserves in assets that promised
higher yields.32
Figure 5. Global Foreign Exchange Reserves ($ Trillion)
$6
$5
$4
$3
$2
$1
$0
99
03
04
05
06
19
2000
2001
2002
20
20
20
20
2007
2008
Industrial countries
Emerging Market and Developing Countries
Source: IMF
While global trade and finance linkages between the emerging markets and the
industrialized countries have continued to deepen over the past decade, many analysts
believed that emerging markets had successfully “decoupled” their growth prospects
from those of industrialized countries. Proponents of the theory of decoupling argued
that emerging market countries, especially in Eastern Europe and Asia, have
successfully developed their own economies and intra-emerging market trade and
finance to such an extent that a slowdown in the United States or Europe would not
have as dramatic an impact as it did a decade ago. A report by two economists at the
IMF found some evidence of this theory. The authors divided 105 countries into
three groups: developed countries, emerging countries, and developing countries and
studied how economic growth was correlated among the groups between 1960 and
2005. The authors found that while economic growth was highly synchronized
between developed and developing countries, the impact of developed countries on
32 See: CRS Report RL34336, Sovereign Wealth Funds: Background and Policy Issues for
Congress by Martin A. Weiss.
CRS-19
emerging countries has decreased over time, especially during the past twenty years.
According to the authors:
In particular, [emerging market] countries have diversified their economies,
attained high growth rates and increasingly become important players in the
global economy. As a result, the nature of economic interactions between
[industrialized and emerging market] countries has evolved from one of
dependence to multidimensional interdependence.33
Despite efforts at self-insurance through reserve accumulation and evidence of
economic decoupling, the U.S. financial crisis, and the sharp contraction of credit and
global capital flows in October 2008 affected all emerging markets to a degree due
to their continued dependence on foreign capital flows. According to the Wall Street
Journal, in the month of October, Brazil, India, Mexico, and Russia drew down their
reserves by more than $75 billion, in attempt to protect their currencies from
depreciating further against a newly resurgent U.S. dollar.34
A key to understanding why emerging market countries have been so affected
by the crisis (especially Central and Eastern Europe) is their high dependence on
foreign capital flows to finance their economic growth (Figures 6-8). Even though
several emerging markets have been able to reduce net capital inflows by investing
overseas (through sovereign wealth funds) or by tightening the conditions for foreign
investment, the large amount of gross foreign capital flows into emerging markets
remained a key vulnerability for them. For countries such as those in Central and
Eastern Europe which have both high gross and net capital flows, vulnerability to
financial crisis is even higher.
Once the crisis occurred, it became much more difficult for emerging market
countries to continue to finance their foreign debt. According to Arvind
Subramanian, an economist at the Peterson Institute for International Economics, and
formerly an official at the IMF:
If domestic banks or corporations fund themselves in foreign currency, they need
to roll these over as the obligations related to gross flows fall due. In an
environment of across-the-board deleveraging and flight to safety, rolling over
is far from easy, and uncertainty about rolling over aggravates the loss in
confidence.35
33 Cigdem Akin and M. Ayhan Kose, “Changing Nature of North-South Linkages: Stylized
Facts and Explanations.” International Monetary Fund Working Paper 07/280. Available
at: [http://www.imf.org/external/pubs/ft/wp/2007/wp07280.pdf].
34 Joanna Slater and Jon Hilsenrath, “Currency-Price Swings Disrupt Global Markets ,” Wall
Street Journal, October 25, 2008.
35 Arvind Subramanian , “The Financial Crisis and Emerging Markets,” Peterson Institute
for International Economics, Realtime Economics Issue Watch, October 24, 2008.
CRS-20
Figure 6. Capital Flows to Latin America (in percent of GDP)
7
6
5
4
3
2
1
0
2
-1 90
93
94
97
98
01
02
05
06
19
1991 199
19
19
1995 1996 19
19
1999 2000 20
20
2003 2004 20
20
2007
Net capital flow s
Gross capital inflow s
Source: IMF
Figure 7. Capital Flows to Developing Asia (in percent of GDP)
12
10
8
6
4
2
0
92
96
00
03
-21990 1991 19
1993 1994 1995 19
1997 1998 1999 20
2001 2002 20
2004 2005 2006 2007
Net capital flow s
Gross capital inflow s
Source: IMF
CRS-21
Figure 8. Capital Flows to Central and Eastern Europe (in percent of
GDP)
14
12
10
8
6
4
2
0
-2 90
93
96
0
3
19
1991 1992 19
1994 1995 19
1997 1998 1999 200
2001 2002 200
2004 2005 2006 2007
-4
Net capital f low s
Gross capital inflow s
Source: IMF
As emerging markets have grown, Western financial institutions have increased
their investments in emerging markets. G-1036 financial institutions have a total of
$4.7 trillion of exposure to emerging markets with $1.6 trillion to Central and Eastern
Europe, $1.5 trillion to emerging Asia, and $1.0 trillion to Latin America. While
industrialized nation bank debt to emerging markets represents a relatively small
percentage (13%) of total cross-border bank lending ($36.9 trillion as of September
2008), this figure is disproportionately high for European financial institutions and
their lending to Central and Eastern Europe. For European and U.K. banks, cross-
border lending to emerging markets, primarily Central and Eastern Europe accounts
for between 21% and 24% of total lending. For U.S. and Japanese institutions, the
figures are closer to 4% and 5%.37 The heavy debt to Western financial institutions
greatly increased central and Eastern Europe’s vulnerability to contagion from the
financial crisis.
In addition to the immediate impact on growth from the cessation of available
credit, a downturn in industrialized countries will likely affect emerging market
countries through several other channels. As industrial economies contract, demand
for emerging market exports will slow down. This will have an impact on a range
of emerging and developing countries. For example, growth in larger economies
such as China and India will likely slow as their exports decrease. At the same time,
demand in China and India for raw natural resources (copper, oil, etc) from other
36 The Group of Ten is made up of eleven industrial countries (Belgium, Canada, France,
Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the
United States).
37 Stephen Jen and Spyros Andreopoulos, “Europe More Exposed to EM Bank Debt than the
U.S. or Japan,” Morgan Stanley Research Global, October 23, 2008.
CRS-22
developing countries will also decrease, thus depressing growth in commodity-
exporting countries.38
Slower economic growth in the industrialized countries may also impact less
developed countries through lower future levels of bilateral foreign assistance.
According to analysis by the Center for Global Development’s David Roodman,
foreign aid may drop precipitously over the next several years. His research finds
that after the Nordic crisis of 1991, Norway’s aid fell 10%, Sweden’s 17%, and
Finland’s 62%. In Japan, foreign aid fell 44% between 1990 and 1996, and has never
returned to pre-crisis assistance levels.39
Latin America40
Financial crises are not new to Latin America, but the current one has two
unusual dimensions. First, as substantiated earlier in this report, it originated in the
United States, with Latin America suffering shocks created by collapses in the U.S.
housing and credit markets, despite minimal exposure to the assets in question.
Second, it spread to Latin America in spite of recent strong economic growth and
policy improvements that have increased economic stability and reduced risk factors,
particularly in the financial sector.41 Although repercussions in individual countries
have varied based in part on their policy framework, investors have punished the
region as a whole, perhaps leery of its capacity to weather both financial contagion
and a potential global recession.
Latin American economies have grown briskly over the past five years, lending
credence to the recent idea that they may be “decoupling” from slower growing
developed economies, particularly the United States.42 Changes in domestic policy
that have led to macroeconomic stability, lower risk levels of sovereign debt, stronger
fiscal positions, and sounder banking regulation are seen by some as a key to Latin
America’s growth with stability. Others note, however, that Latin America’s recent
growth trend is easily explained by international economic fundamentals, questioning
the importance of the decoupling theory. The sharp rise in commodity prices,
supportive external financing conditions, and high levels of remittances contributed
greatly to the region’s improved economic welfare, reflecting gains from a strong
38 Dirk Willem te Velde, “The Global Financial Crisis and Developing Countries,” Overseas
Development Institute, October 2008.
39 David Roodman, “History Says Financial Crisis Will Suppress Aid,” Center for Global
Development, October 13, 2008.
40 Prepared by J. F. Hornbeck, Specialist in International Trade and Finance, Foreign
Affairs, Defense, and Trade Division.
41 United Nations. Economic Commission on Latin America and the Caribbean. Latin
America and the Caribbean in the World Economies, 2007. Trends 2008. Santiago:
October 2008. p. 28.
42 Decoupling generally refers to economic growth trends in one part of the world, usually
smaller emerging economies, becoming less dependent (correlated) with trends in other parts
of the world, usually developed economies. See: Rossi, Vanessa. Decoupling Debate will
Return: Emergers Dominate in Long Run. London: Chatham House, 2008. p. 5.
CRS-23
global economy. But all three trends began to reverse even before the financial crisis,
suggesting that Latin America remains very much tied to world markets and trends.43
Latin America is experiencing two levels of economic problems related to the
crisis. First order effects may be seen in the sudden volatility in the financial sector.
All major financial indicators fell sharply in the third quarter of 2008, as capital
sought safe haven in less risky assets, many of them, ironically, dollar denominated.
Currencies in many Latin American countries depreciated suddenly from flight to the
U.S. dollar, reflecting a lack of confidence in local currencies and portfolio
rebalancing, as well as the fall in commodity import revenue related to declining
global demand and terms of trade. In at least two countries, Mexico and Brazil, large
speculative derivative positions in the currency markets exacerbated the
depreciations, compounding losses. Stock indexes, on average, declined by over
40%, in response to the retreat from equity markets and changes in currency values.44
Debt markets followed in kind. Borrowing became more expensive, as seen in
widening bond spreads. Over the past year, bond spreads in the Emerging Market
Bond Index (EMBI) and corporate bond index for Latin America increased by over
600 basis points, half occurring in the fall of 2008. This trend suggests first, that
Latin America was already beginning to experience a slowdown prior to the financial
crisis, and second, that the crisis itself was a sudden shock to the region. Compared
to earlier financial crises when bond spreads on average rose by over 1,000 basis
points, Latin America’s stronger economic fundamentals and regulatory regimes
helped cushion many countries from a more severe reaction. The exceptions are
Argentina, Peru, and Venezuela, all of which share a heavy dependence on
commodity exports and weak economic policy frameworks. In each of these
countries, bond spreads have risen by well over 1,000 basis points, reflecting a deep
lack of confidence in their financial future.45
The second order effects related to the financial crisis are deteriorating
economic fundamentals, which could be a major long term problem for Latin
America. Financial indicators all point to a tightening of credit markets and sharp
rise in the cost of capital for Latin America, which may dampen investment. Falling
investment and consumption, declining trade surpluses, and deteriorating public
sector budgets all point to broader economic slowdown. Public sector borrowing is
expected to rise and budget constraints may reduce spending on social programs,
with a predictably disproportional effect on the poor. The magnitude of these trends
will vary by country, depending on economic fundamentals and policy choices, as
three examples discussed below illustrate.
Mexico. Mexico faces two problems: one short term, the other long-term, but
both tied to its dependence on the U.S. economy. The United States accounts for half
43 Ocampo, Jose Antonio. The Latin American Boom is Over. REG Monitor. November
2, 2008.
44 Latin American Newsletters. Latin American Economy and Business. London: October
2008. pp. 1-3.
45 International Monetary Fund. Regional Economic Outlook. Western Hemisphere:
Grappling with the Global Financial Crisis. Washington, D.C. October 2008. pp. 7-10.
CRS-24
of Mexico’s imports, 80% of its exports, and most of its foreign investment.
Therefore, Mexico, despite its relatively strong fiscal position and solid
macroeconomic fundamentals, has begun to suffer first from direct links to the U.S.
financial fallout, and second, from its vulnerability to a protracted U.S. recession.
In the short term, Mexico experienced a run on the peso, which was particularly
severe in October 2008. It fell at one point by 40% from its August 2008 high. This
was not due to exposure to U.S. mortgage-backed securities, but rather, the re-
balancing of investor portfolios away from emerging markets, and the fall in
commodity prices. The currency also suffered because Mexican firms had apparently
taken to heart the notion of “decoupling,” believing that the peso’s strength would
not be seriously challenged by the U.S. crisis. Many firms went beyond hedging in
the currency market and bet heavily on the future strength of the peso by taking large
derivative positions in the currency. As the peso began to depreciate, companies had
to unwind these large (off balance sheet) speculative positions, accelerating its fall.
One large firm had losses exceeding $1.4 billion and filed for bankruptcy, indicative
of the severity of the problem. The Mexican government responded by selling
billions of dollars of reserves and entering into an agreement with the U.S. Federal
Reserve for a new $30 billion currency swap arrangement.46
The swap arrangement is intended to undergird liquidity in the Mexican
financial system and ensure dollar financing for the large trade volume conducted
between the two countries. The long-term challenge to Mexico’s exports to the
United States will hinge on U.S. aggregate demand. Because Mexico has a poorly
diversified trade regime, the effects could be significant, and have already been
compounded by the fall in remittances from Mexican workers living in the United
States. In October 2008, remittances fell by over 12%, the largest year-over-year
decline since 1995, when records began. In the short-term, it will be important to
evaluate Mexico’s ability to counter the peso’s decline and maintain liquidity to
support both domestic financing and its trade with the United States. In the medium
term, the depth of Mexico’s economic slowdown in response to the U.S. recession
will be the most telling benchmark of its economic future.47
Brazil. Like Mexico, Brazil entered the financial crisis from a position of
macroeconomic and fiscal strength. The Brazilian government, nonetheless, found
itself in a similar position of having to sell billions of dollars to fight a rapidly
depreciating currency (the real), which fell at one point by over 35% from its August
high. The real has since regained 10% of its value, but volatility remains a concern.
Brazil also has a large currency derivative market, where speculative trades
contributed to the real’s decline, although to a lesser degree than in Mexico. Brazil
has over $200 billion in international reserves, a sound banking system, and an
experienced Central Bank staff that has taken decisive action to maintain liquidity in
46 Latin American Economy and Business, October 2008, p. 3 and the Wall Street Journal.
Mexico and Brazil Step In to Fight Currency Declines, October 24, 2008.
47 Latin American Newsletters. Latin American Mexico and NAFTA Report. London:
November 2008. p. 14.
CRS-25
the financial markets, suggesting the country stands a good chance of weathering
short-term repercussions of the global financial crisis, depending on its severity.48
In addition to injecting billions of dollars into the banking system, the
government of Brazil has taken many other measures to soften the effects of the
financial crisis. These include stricter accounting rules for derivatives, extension of
credit directly to firms from the National Development Bank (BNDES) and the
Central Bank, authorization for state-owned banks to purchase private banks,
exemption of foreign investment firms from the financial transaction tax, and
utilization of a new $30 billion currency swap arrangement as provided in an
agreement with the U.S. Federal Reserve.49
Despite such strong policy responses, Brazil’s stock market index tumbled by
half in 2008, investment in both public and private projects appears to be on hold and
projections of economic growth are being revised downward. Over half of Brazil’s
exports are commodities, suggesting its trade account will likely deteriorate, although
the depreciated real may offset some of this effect. Capital inflows are also expected
to slow, despite Brazil’s solid macroeconomic performance and its investment grade
rating. As with other countries, the extent to which global demand diminishes will
ultimately affect all these variables. Brazil has a large internal market and is well-
positioned on macroeconomic and fiscal fronts, which may soften effects of the
global financial crisis, depending, as with other countries, on the severity of the
recession.50
Argentina. Argentina, because of its economic and financial position at the
beginning of the crisis, is in poor shape to deal with the crisis compared to other
Latin American countries. Although it has experienced dramatic economic growth
since 2002, this reflects a rebound from the previous severe financial crisis begun in
December 2001. The other side of the story is Argentina’s litany of questionable
policy choices beginning with its 2002 historic sovereign debt default and failure to
renegotiate with Paris Club countries and private creditor holdouts. Others include
government interference in the supposedly independent government statistics office
(particularly with respect to inflation reporting), market intervention, adoption of
export taxes, and most recently, its move to nationalize private pension funds to
bolster public finances.51
The sum total of these policies characterize an economy that is isolated from
international capital markets, and prone to price distortions, continued debt buildup,
a high dependency on commodity exports, and inadequate levels of investment.
From an international perspective, Argentina entered the financial crisis with little
48 Global Insight. Brazil Real Depreciates 6.8% in One Day. October 23, 2008 and Canuto,
Otaviano. Emerging Markets and the Systemic Sudden Stop. RGE Monitor. November 12,
2008.
49 Brazil-U.S. Business Council. Brazil Bulletin. October 27, 2008.
50 Latin American Economy and Business, October 2008, pp. 8-10
51 Benson, Drew and Bill Farles. Argentine Bonds, Stocks Tumble on Pension Fund
Takeover Plan. Bloomberg. October 21, 2008.
CRS-26
credibility in its economic policies and hence is unlikely to obtain needed external
financial assistance, as have Mexico and Brazil from the United States. Argentina,
by all indications, is poorly situated to respond to crisis.
Argentina’s currency has not fallen significantly, largely due to strong
management of the exchange rate. In selling dollars to protect the peso’s value,
however, Argentina has so far used up over 15% of its one-time $54 billion in foreign
reserves, forced interest rates skyward, and made exports less competitive.52 Given
the importance of export taxes for revenue, public sector revenues are expected to fall
precipitously, a serious problem given Argentina’s fiscal situation was already far
more precarious than either Brazil’s or Mexico’s.
Risk assessment has been swift and punishing. Bond ratings have fallen and
yields on short-term public debt exceed 30%. The stock market has declined by over
60% since May 2008 and the interest rate spread on Argentina’s bonds rose by over
500 basis points for the year ending September 2008. Since then, they have increased
by an additional 1,700 basis points, reflecting Argentina’s high risk investment
profile and ostracization from the capital markets.53 Given Argentina’s large public
spending needs for the coming year, the high and growing cost of its debt, and its
inability to access international credit markets, it may become the first full scale
casualty in Latin America of the global financial crisis.
Russia and the Financial Crisis54
Russia tends to be in a category by itself. Although by some measures, it is an
emerging market, it also is highly industrialized. Until recently, Russia had been
experiencing impressive economic success. In 2008, however, Russia has faced a
triple threat with the financial crisis coinciding with a rapid decline in the price of oil
and the aftermath of the country’s military confrontation with Georgia over the
break-away areas of South Ossetia and Abkhazia. These events have exposed three
fundamental weaknesses in the Russian economy despite its success over the past
decade: substantial dependence on oil and gas sales for export revenues and
government revenues; rise in foreign and domestic investor concerns; and a weak
banking system.
The decline in world oil prices has hit Russia hard. In 2007, oil, natural gas, and
other fuels accounted for 65% of Russia’s export revenues.55 In addition, the Russian
government is dependent on taxes on oil and gas sales for more than half of its
revenues. Should the price of oil go below $60/barrel, the government budget would
52 Global Insight. Argentina: S&P Lowers Argentina’s Rating to B-. November 3, 2008
53 International Monetary Fund. Regional Economic Outlook. Western Hemisphere:
Grappling with the Global Financial Crisis. Washington, D.C. October 2008. p. 8.
54 Prepared by William H. Cooper, Specialist in International Trade and Finance, Foreign
Affairs, Defense, and Trade Division.
55 Economist Intelligence Unit.
CRS-27
go into deficit.56 Should the price drop to $30-$35/barrel, the Russian economy
would stop growing, according to one estimate.57
Another sign of financial trouble for Russia has been the rapid decline in stock
prices on Russian stock exchanges. (See Figure 2.) At the close of business on
October 1, 2008, the RTS index had lost 69.0% of its value from its peak reached on
May 19, 2008.58 (The decline was the largest since Russia experienced a financial
crisis in August 1998.) On September 16 alone, the RTS index lost 11.5% of its
value leading the government to close stock markets for two days. The overall drop
in equity prices was blamed on the loss of investor confidence in the wake of the
August 2008 conflict between Russia and Georgia but also because of the decline in
oil prices and as a result of the credit crisis that has affected markets throughout the
world. In addition, the ruble has been declining in nominal terms because foreign
investors have been pulling capital out of the market to shore up domestic reserves
putting downward pressure on the ruble.
Russia’s banking system remains immature, and high interest rates prevail.
Russian companies, therefore, have relied on foreign bank loans for financing rather
than equity-based financing or domestic bank loans. However, these foreign loans
were secured with company stocks as collateral. Because of the drop in stock values
and because of the overall tightening of credit availability, foreign banks have
declined to rollover loans.
The Russian government, led by President Medvedev and Prime Minister Putin,
has implemented several packages of measures to prop up the stock market and the
banks. The packages, valued at around $180 billion, are proportionally larger in terms
of GDP than the U.S. package that Congress approved in September 2008.59 In mid-
September, the government made available $44 billion in funds to Russia’s three
largest state-owned banks to boost lending and another $16 billion to the next 25
largest banks. It also lowered taxes on oil exports to reduce costs to oil companies
and made available $20 billion for the government to purchase equities on the stock
market. In late September, the government announced that an additional $50 billion
would be available to banks and Russian companies to pay off foreign debts coming
due by the end of the year. On October 7, 2008, the government announced another
package of $36.4 billion in credits to banks..60
56 Open Source Center. Government Bails Out Oil Companies Suffering From World
Financial Crisis. October 30, 2008.
57 Economist Intelligence Unit. Monthly Report — Russia. October 2008. p. 7.
58 RTS.
59 Ibid. 6-7.
60 Economist Intelligence Unit. Monthly Report — Russia. October 2008. p. 6
CRS-28
Effects on Europe and the European Response61
Financial markets in the United States and Europe have become highly
integrated as a result of cross-border investment by banks, securities brokers, and
other financial firms. As a result of this integration, economic and financial
developments that impact national economies are difficult to contain and are quickly
transmitted across national borders, as attested to by the financial crisis of 2008. As
financial firms react to a financial crisis in one area, their actions can spill over to
other areas as they withdraw assets from foreign markets to shore up their domestic
operations. Banks and financial firms in Europe have felt the repercussions of the
U.S. financial crisis as U.S. firms operating in Europe and as European firms
operating in the United States have adjusted their operations in response to the crisis.
Within Europe, national governments and private firms have taken noticeably
varied responses to the crisis, reflecting the unequal effects by country. While some
have preferred to address the crisis on a case-by-case basis, others have looked for
a systemic approach that could alter the drive within Europe toward greater economic
integration. Great Britain has proposed a plan to rescue distressed banks by acquiring
preferred stock temporarily. Iceland, on the other hand, has had to take over three of
its largest banks in an effort to save its financial sector and its economy from
collapse. The Icelandic experience raises important questions about how a nation can
protect its depositors from financial crisis elsewhere and about the level of financial
sector debt that is manageable without risking system-wide failure.
According to a recent report by the International Monetary Fund, many of the
factors that led to the financial crisis in the United States are driving a similar crisis
in Europe.62 Essentially, the causes were low interest rates, growing complexity in
mortgage securitization, and loosening in underwriting standards combined with
expanded linkages between national financial centers that spurred a broad expansion
in credit and economic growth. This rapid rate of growth pushed up the values of
equities, commodities, and such tangible assets as real estate. As the combination
of higher commodity higher prices, including the price of crude oil and housing, rose
to historically high levels, consumer budgets were pinched, and consumers began to
pare back on their expenditures. In July 2007, these factors combined to undermine
the perceived value of a range of financial instruments and other assets and increased
the perception of risk of financial instruments and the credit worthiness of a broad
range of financial firms.
As creditworthiness problems in the United States began surfacing in the
subprime mortgage market in July 2007, the risk perception in European credit
markets followed. The financial turmoil quickly spread to Europe, although
European mortgages initially remained unaffected by the collapse in mortgage prices
in the United States. Another factor in the spread of the financial turmoil to Europe
has been the linkages that have been formed between national credit markets and the
61 Prepared by James K. Jackson, Specialist in International Trade and Finance, Foreign
Affairs, Defense, and Trade Division.
62 Regional Economic Outlook: Europe, International Monetary Fund, April, 2008, p. 19-20.
CRS-29
role played by international investors who react to economic or financial shocks by
rebalancing their portfolios in assets and markets that otherwise would seem to be
unrelated. The rise in uncertainty and the drop in confidence that arose from this
rebalancing action undermined the confidence in major European banks and
disrupted the interbank market, with money center banks becoming unable to finance
large securities portfolios in wholesale markets. The increased international linkages
between financial institutions and the spread of complex financial instruments has
meant that financial institutions in Europe and elsewhere have come to rely more on
short-term liquidity lines, such as the interbank lending facility, for their day-to-day
operations. This has made them especially vulnerable to any drawback in the
interbank market.63
Recent IMF estimates indicate that economic growth in Europe is expected to
slow sharply in 2009, while the threat of inflation is expected to lessen, as indicated
in Table 2. Economic growth, as represented by the rate of increase in gross
domestic product (GDP) for the Euro area countries is projected to fall to 1.4% in
2009 from 3.9% in 2007. Iceland, which has been particularly hard hit by the
financial crisis, is expected to experience a negative rate of growth of -3.1% in 2009.
These estimates may be a bit too pessimistic given the sharp drop in the price of oil
and that of other commodities in September and October 2008, which likely would
help to improve the rate of economic growth.
63 Frank, Nathaniel, Brenda Gonzalez-Hermosillo, and Heiko Hesse, Transmission of
Liquidity Shocks: Evidence From the 2007 Subprime Crisis, IMF Working Paper
#WP/08/200, August 2008, the International Monetary Fund.
CRS-30
Table 2. Projections of Economic Growth in 2008 and 2009 and
Price Inflation in Selected Regions and Countries (in percent)
Real GDP Growth
CPI Inflation
2006
2007
2008
2009
2006
2007
2008
2009
Actual
Projected
Actual
Projected
United States
2.8
2
1.6
0.1
3.2
2.9
4.2
1.8
Europe
4.1
3.9
2.6
1.4
3.6
3.6
5.8
4.2
Advanced
economies
3.0
2.8
1.3
0.2
2.2
2.1
3.5
2.2
Emerging economies
7.0
6.5
5.7
4.3
7.5
7.5
11.5
9.2
European Union
3.3
3.1
1.7
0.6
2.3
2.4
3.9
2.4
Euro Area
2.8
2.6
1.3
0.2
2.2
2.1
3.5
1.9
Austria
3.4
3.1
2
0.8
1.7
2.2
3.5
2.5
France
2.2
2.2
0.8
0.2
1.9
1.6
3.4
1.6
Germany
3.0
2.5
1.8
0
1.8
2.3
2.9
1.4
Italy
1.8
1.5
-0.1
-0.2
2.2
2.0
3.4
1.9
Netherlands
3.4
3.5
2.3
1.0
1.7
1.9
2.9
2.8
Spain
3.9
3.7
1.4
-0.2
3.6
2.8
4.5
2.6
Other EU
Sweden
4.1
2.7
1.2
1.4
1.5
1.7
3.4
2.8
United Kingdom
2.8
3.0
1.0
-0.1
2.3
2.3
3.8
2.9
Non-EU Advanced
Iceland
4.4
4.9
0.3
-3.1
6.8
5.0
12.1
11.2
Norway
2.5
3.7
2.5
1.2
2.3
0.8
3.2
2.7
Switzerland
3.4
3.3
1.7
0.7
1.0
0.7
2.6
1.5
Source: World Economic Outlook, the International Monetary Fund, October 2008, p. 6.
As Table 3 indicates, the amount of losses that can be traced to the financial
crisis varies across countries. Not all have been affected to the same degree.
Mortgage markets vary starkly across Europe, depending on national laws and local
mortgage practices. In addition, mortgage financing laws were relaxed in some
markets, but not in all, to allow for refinancing of mortgages and to allow
homeowners to withdraw equity to use for other purposes. Such laws were eased in
Great Britain and Ireland where the financial crisis has had an especially heavy cost.
According to the Bank of England, the financial crisis has cost the British economy
more than $200 billion in lost assets, compared with nearly $1.6 trillion in the United
States. For the Euro area as a whole, the Bank of England estimated the losses to be
at $1.1 trillion.
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Table 3. Losses on Selected Financial assets
(in billions of U.S. dollars)
Outstanding
Losses as of
Losses as of
amounts
April 2008
October 2008
United Kingdom
Prime residential mortgage-backed
securities
$346.8
$14.7
$31.3
Non-conforming residential mortgage-
backed securities
70.1
3.9
13.8
Commercial mortgage-backed securities
59.3
5.5
7.9
Investment-grade corporate bonds
808.6
83.0
155.4
High-yield corporate bonds
26.9
5.3
11.8
Total
112.7
220.3
United States
Home equity loan asset-backed
securities (ABS)(c)
$757.0
$255.0
$309.9
Home equity loan ABS collateralised
debt obligations (CDOs)(c)(d)
421.0
236.0
277.0
Commercial mortgage-backed securities
700.0
79.8
97.2
Collateralised loan obligations
340.0
12.2
46.2
Investment-grade corporate bonds
3,308.0
79.7
600.1
High-yield corporate bonds
692.0
76
246.8
Total
738.8
1,577.0
Euro area
Residential mortgage-backed
securities(e)
$553.4
$30.7
$55.6
Commercial mortgage-backed
securities(e)
48.6
4.0
5.9
Collateralised loan obligations
147.3
9.7
32.6
Investment-grade corporate bonds
7613.3
405.8
919.3
High-yield corporate bonds
250.3
41.6
108.5
Total
492.1
1,122.0
Source: Financial Stability Report, October 2008, Bank of England, p. 14.
Note: Losses estimated as of mid-October 2008. $1.43 dollars per euro; 1.797 pounds per dollar.
Central banks in the United States, the Euro zone, the United Kingdom, Canada,
Sweden, and Switzerland staged a coordinated cut in interest rates on October 8,
2008, and announced they had agreed on a plan of action to address the ever-
widening financial crisis.64 The actions, however, did little to stem the wide-spread
concerns that were driving financial markets. Many Europeans were surprised at the
speed with which the financial crisis spread across national borders and the extent to
which it threatened to weaken economic growth in Europe. This crisis did not just
involve U.S. institutions. It has demonstrated the global economic and financial
linkages that tie national economies together in a way that may not have been
imagined even a decade ago. At the time, much of the substance of the European
64 Hilsenrath, Jon, Joellen Perry, and Sudeep Reddy, Central Banks Launch Coordinated
Attack; Emergency Rate Cuts Fail to Halt stock Slide; U.S. Treasury Considers Buying
Stakes in Banks as Direct Move to Shore Up Capital, the Wall Street Journal, October 8,
2008, p. A1.
CRS-32
plan was provided by the British Prime Minister Gordon Brown,65 who announced
a plan to provide guarantees and capital to shore up banks. Eventually, the basic
approach devised by the British arguably would influence actions taken by other
governments, including that of the United States.
On October 10, 2008, the G-7 finance ministers and central bankers,66 met in
Washington, DC, to provide a more coordinated approach to the crisis. At the Euro
area summit on October 12, 2008, Euro area countries along with the United
Kingdom urged all European governments to adopt a common set of principles to
address the financial crisis.67 The measures the nations supported are largely in line
with those adopted by the U.K. and include:
! Recapitalization: governments promised to provide funds to banks
that might be struggling to raise capital and pledged to pursue wide-
ranging restructuring of the leadership of those banks that are
turning to the government for capital.
! State ownership: governments indicated that they will buy shares in
the banks that are seeking recapitalization.
! Government debt guarantees: guarantees offered for any new debts,
including inter-bank loans, issued by the banks in the Euro zone
area.
! Improved regulations: the governments agreed to encourage
regulations to permit assets to be valued on their risk of default
instead of their current market price.
In addition to these measures, on October 16, 2008, European Union leaders
agreed to set up a crisis unit and to hold a monthly meeting to improve financial
oversight.68 Josse Manuel Durao Barroso, President of the European Commission,
urged the EU members to develop a “fully integrated solution” to address the global
financial crisis. While continuing to rely on the current method that has each EU
country develop and implement its own national regulations regarding supervision
over financial institutions, the European Council stressed the need to strengthen the
EU-wide supervision of the European financial sector. The EU statement urged the
development of a “coordinated supervision system at the European level.”69
65 Castle, Stephen, British Leader Wants Overhaul of Financial System, The New York
Times, October 16, 2008.
66 The G-7 consists of Canada, France, Germany, Italy, Japan, the United Kingdom, and the
United States.
67 Summit of the Euro Area Countries: Declaration on a Concerted European Action Plan
of the Euro Area Countries, European union, October 12, 2008.
68 EU Sets up Crisis Unit to Boost Financial Oversight, Thompson Financial News, October
16, 2008.
69 Ibid.
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European leaders, meeting prior to the November 15, 2008 G-20 economic
summit in Washington, DC, agreed that the task of preventing future financial crisis
should fall to the International Monetary Fund, but they could not agree on precisely
what that role should be.70 The leaders set a 100-day deadline to draw up reforms for
the international financial system. British Prime Minister Gordon Brown reportedly
urged other European leaders to back fiscal stimulus measure to support the
November 6, 2008 interest rate cuts by the European Central Bank, the Bank of
England, and other central banks. Reportedly, French Prime Minister Nicolas
Sarkozy argued that the role of the IMF and the World Bank needed to be rethought.
French and German officials have argued that the IMF should assume a larger role
in financial market regulation, acting as a global supervisor of regulators. Prime
Minister Sarkozy also argued that the IMF should “assess” the work of such
international bodies as the Bank of International Settlements. Other G-20 leaders,
however, reportedly have disagreed with this proposal, agreeing instead to make the
IMF “the pivot of a renewed international system,” working alongside other bodies.
Other Ministers also were apparently not enthusiastic toward a French proposal that
Europe should agree to a more formalized coordination of economic policy.
Appendix B outlines the main operations the Bank of England, U.S. Federal
Reserve, and the European Central Bank have taken to address the financial crisis.
Several agreements between the U.S. Federal Reserve and the European Central
Bank have expanded, and these three banking institutions have announced joint
lending operations and other measures to increase the availability of dollar funding.71
Other national governments have acted to stem the financial crisis and to protect
their national economies. For instance, Germany was the first to implement a
comprehensive rescue package, which could cost up to $750 billion. The German
package provided $600 billion in bank guarantees and as much as $150 billion in
state funds. Of the money being offered in state funds, $120 billion was to be
available for recapitalization, while $30 billion was to be a provision for the bank
guarantees.
France, which has been leading efforts to develop a coordinated European
response to the financial crisis, offered a package of measures that is expected to cost
over $500 billion. The French government is creating two state agencies that will
provide funds to where they are needed. One entity is to issue up to $480 billion in
guarantees on inter-bank lending issued before December 31, 2009, and valid for five
years. The other entity is to use a $60 billion fund to recapitalize struggling
companies by allowing the government to buy equity stakes.
Italy has not created a fund for its rescue plan, but the Italian government has
announced a package of measures, including Treasury guarantees for new bonds
issued by banks until December 31, 2009, and valid for five years. The guarantees
are to be supplied at market prices and require the approval of the Bank of Italy.
70 Hall, Ben, George Parker, and Nikki Tait, European Leaders Decide on Deadline for
Reform Blueprint, Financial Times, November 8, 2008, p. 7.
71 The Bank of England. Financial Stability Report, October 2008, p. 18.
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The “European Framework for Action”
On October 29, 2008, the European Commission released a “European
Framework for Action” as a way to coordinate the actions of the 27 member states
of the European Union to address the financial crisis.72 The EU also announced that
on November 16, 2008, the Commission will propose a more detailed plan that will
bring together short-term goals to address the current economic downturn with the
longer-term goals on growth and jobs in the Lisbon Strategy.73 The short-term plan
revolves around a three-part approach to an overall EU recovery action
plan/framework. The three parts to the EU framework are:
A new financial market architecture at the EU level. The basis of this
architecture involves implementing measures that member states have announced
as well as providing for (1) continued support for the financial system from the
European Central Bank and other central banks; (2) rapid and consistent
implementation of the bank rescue plan that has been established by the member
states; and (3) decisive measures that are designed to contain the crisis from
spreading to all of the member states.
Dealing with the impact on the real economy. The policy instruments member
states can use to address the expected rise in unemployment and decline in
economic growth as a second-round effect of the financial crisis are in the hands
of the individual member states. The EU can assist by adding short-term actions
to its structural reform agenda, while investing in the future through: (1)
increasing investment in R&D innovation and education; (2) promoting
flexicurity74 to protect and equip people rather than specific jobs; (3) freeing up
businesses to build markets at home and internationally; and (4) enhancing
competitiveness by promoting green technology, overcoming energy security
constraints, and achieving environmental goals. In addition, the Commission
will explore a wide range of ways in which EU members can increase their rate
of economic growth.
A global response to the financial crisis. The financial crisis has demonstrated
the growing interaction between the financial sector and the goods-and services-
producing sectors of economies. As a result, the crisis has raised questions
concerning global governance not only relative to the financial sector, but the
need to maintain open trade markets. The EU would like to use the November
15, 2008 multi-nation G-20 economic summit in Washington, DC, to promote a
series of measures to reform the global financial architecture. The Commission
argues that the measures should include (1) strengthening international
regulatory standards; (2) strengthen international coordination among financial
supervisors; (3) strengthening measures to monitor and coordinate
macroeconomic policies; and (4) developing the capacity to address financial
crises at the national regional and multilateral levels. Also, a financial
72 Communication From the Commission, From Financial Crisis to Recovery: A European
Framework for Action, European Commission, October 29, 2008.
73 The Lisbon Strategy was adopted by the EU member states at the Lisbon summit of the
European Union in March 2001 and then recast in 2005 based on a consensus among EU
member states to promote long-term economic growth and development in Europe.
74 The combination of labor market flexibility and security for workers.
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architecture plan should include three key principles: (1) efficiency; (2)
transparency and accountability; and (3) the inclusion of representation of key
emerging economies.
Within Europe, the British have been especially active in developing a plan to
address the credit market aspects of the crisis. The plan promoted by British Prime
Minister Gordon Brown involves having the central government acquire preferred
shares in distressed banks for a specified amount of time, rather than acquiring the
non-performing loans of the banks. This approach is being followed in some cases
by other countries.
The British Rescue Plan
On October 8, 2008, the British Government announced a $850 billion multi-
part plan to rescue its banking sector from the current financial crisis. Details of this
plan are presented here to illustrate the varied nature of the plan. The Stability and
Reconstruction Plan followed a day when British banks lost £17 billion on the
London Stock Exchange. The biggest loser was the Royal Bank of Scotland, whose
shares fell 39%, or £10 billion, of its value. In the downturn, other British banks lost
substantial amounts of their value, including the Halifax Bank of Scotland which was
in the process of being acquired by Lloyds TSB.
The British plan included four parts:
! A coordinated cut in key interest rates of 50 basis, or one-half of one
percent (0.5) between the Bank of England, the Federal Reserve, and
the European Central Bank.
! An announcement of an investment facility of $87 billion
implemented in two stages to acquire the Tier 1 capital, or preferred
stock, in “eligible” banks and building societies (financial
institutions that specialize on mortgage financing) in order to
recapitalize the firms. To qualify for the recapitalization plan, an
institution must be incorporated in the UK (including UK
subsidiaries of foreign institutions, which have a substantial business
in the UK and building societies). Tier 1 capital often is used as
measure of the asset strength of a financial institution.
! The British Government agreed to make available to those
institutions participating in the recapitalization scheme up to $436
billion in guarantees on new short- and medium-term debt to assist
in refinancing maturing funding obligations as they fall due for terms
up to three years.
! The British Government announced that it would make available
$352 billion through the Special Liquidity Scheme to improve
liquidity in the banking industry. The Special Liquidity Scheme was
launched by the Bank of England on April 21, 2008 to allow banks
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to temporarily swap their high-quality mortgage-backed and other
securities for UK Treasury bills.75
In addition to this four-part plan, the Bank of England announced on October
16, 2008, that it had developed three new proposals for its money market operations.
First, the establishment of operational standing facilities to address technical
problems and imbalances in the operation of money markets and payments facilities
but not provide financial support. Second, the establishment of a discount window
facility which will allow banks to borrow government bonds or, at the Bank’s
discretion, cash, against a wide range of eligible collateral to provide liquidity
insurance to commercial in stress. Third, a permanent open market for long-term
repurchase agreements (securities sold for cash with an agreement to repurchase the
securities at a specified time) against broader classes of collateral to offer banks
additional tools for managing their liquidity.76
The British plan was quickly implemented with the UK government taking a
controlling interest in the Royal Bank of Scotland (RBS) and Hallifax Bank of
Scotland. The move was prompted by news that RBS was seeking £20 billion from
the British government effectively giving the government a controlling 60% stake in
the bank, with £5 billion issued in preferred shares and £15 billion underwritten by
the government. The amount of capital that was raised was almost twice the market
value of RBS, which had lost 61% of its stock value by October 10, 2008. In
addition, market observers were speculating that HBOS was planning to ask the
government for £12 billion to facilitate the merger between HBOS and Lloyds TSB.
Collapse of Iceland’s Banking Sector
The failure of Iceland’s banks raises questions of bank supervision and crisis
management for governments in Europe and the United States. As Icelandic banks
began to default, Britain used an anti-terrorism law to seize the deposits of the banks
to prevent the banks from shifting funds from Britain to Iceland.77 This incident
raises questions about how national governments should address the issue of
supervising foreign financial firms operating within their borders and whether they
can prevent foreign-owned firms from withdrawing deposits in one market to offset
losses in another. In addition, the case of Iceland raises questions about the cost and
benefits of branch banking across national borders where banks can grow to be so
large that disruptions in the financial market can cause defaults that outstrip the
resources of national central banks to address.
On October 24, 2008, Iceland78 and the International Monetary Fund (IMF)
announced they had reached an initial agreement on a $2.1 billion two-year loan to
75 The Bank of England, Financial Stability Report, April 2008, p. 10.
76 Ibid., p. 31.
77 Benoit, Bertrand, Tom Braithwaaite, Jimmy Burns, Jean Eaglesham, et. al., Iceland and
UK clash on Crisis, Financial Times, October 10, 2008, p. 1.
78 This section relies heavily on, The Economy of Iceland, 2008, a publication of the Central
Bank of Iceland.
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finance trade and to help rescue Iceland’s major banks.79 The amount was about one-
third of the $6 billion that Iceland had originally requested. As part of the agreement,
Iceland has proposed a plan to restore confidence in its banking system, stabilize the
exchange rate, and improve the nation’s fiscal position. As part of that plan, Iceland’s
central bank raised its key interest rate by 6 percentage points to 18% on October 29,
2008, to attract foreign investors and to shore up its sagging currency.80 The IMF
loan needs approval of the IMF’s Executive Board. Immediately after the Executive
Board’s approval, Iceland would be able to draw $833 million. So far, Iceland’s
three major banks have collapsed, and Iceland has experienced a major devaluation
of its currency, the krona. A separate rescue package may include assistance from
Norway, Sweden, Denmark, and Japan. Still pending is a $5.5 billion loan that
Iceland is hoping to get from Russia.
Between October 7 and 9, 2008, Iceland’s Financial Supervisory Authority
(FSA), an independent state authority with responsibilities to regulate and supervise
Iceland’s credit, insurance, securities, and pension markets took control, without
actually nationalizing them, of three of Iceland’s largest banks: Landsbanki, Glitnir
Banki, and Kaupthing Bank prior to a scheduled vote by shareholders to accept a
government plan to purchase the shares of the banks in order to head off the collapse
of the banks. At the same time, Iceland suspended trading on its stock exchange for
two days.81 In part, the takeover also attempted to quell a sharp depreciation in the
exchange value of the Icelandic krona.
The demise of Iceland’s three largest banks is attributed to an array of events,
but primarily stems from decisions by the banks themselves. Some observers argued
that the collapse of Lehman Brothers set in motion the events that finally led to the
collapse of the banks,82 but this conclusion seems to be highly suspect. By the time
of the acknowledged start of the global financial crisis in mid-2007, Iceland’s central
bank and Iceland’s banks themselves had begun to recognize how vulnerable the
banks had become. In particular, officials in Iceland as well as financial observers
in Europe had begun to reassess the risks associated with various financial
instruments, and to raise questions about the asset strength of the banks and the asset
size of the banks relative to the size of Iceland’s economy. In addition, by late 2007
various organization had begun to recognize the imbalances that were becoming
apparent in Iceland’s economy and had forecast a slowdown in Iceland’s torrid pace
of economic growth for 2008 and 2009.
On October 15, 2008, the Central Bank of Iceland set up a temporary system of
daily currency auctions to facilitate international trade. Attempts by Iceland’s central
79 IMF and Iceland Outline $2.1 Billion Loan Plan, International Monetary Fund, October
24, 2008.
80 Iceland Raises Key Rate by 6 Percentage Points, The New York Times, October 29, 2008.
81 Wardell, Jane, Iceland’s Financial Crisis Escalates, BusinessWeek, October 9, 2008;
Pfanner, Eric, Meltdown of Iceland’s Financial system Quickens, The New York Times,
October 9, 2008.
82 Portes, Richard, The Shocking Errors Behind Iceland’s Meltdown, Financial Times,
October 13, 2008, p. 15.
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bank to support the value of the krona are at the heart of Iceland’s problems. Without
a viable currency, there was no way to support the banks, which have done the bulk
of their business in foreign markets. The financial crisis has also created problems
with Great Britain because hundreds of thousands of Britons hold accounts in online
branches of the Icelandic banks, and they fear those accounts will default. The
government of British Prime minister Gordon Brown has used powers granted under
anti-terrorism laws to freeze British assets of Landsbanki until the situation is
resolved.
Impact on Asia and the Asian Response83
Many Asian economies have been through wrenching financial crises in the past
10-15 years. Although most observers say the region’s economic fundamentals have
improved greatly in the past decade, this crisis provides a worrying sense of deja vu,
and an illustration that Asian policy changes in recent years — including Japan’s
slow but comprehensive banking reforms, Korea’s opening of its financial markets,
China’s dramatic economic transformation, and the enormous buildup of sovereign
reserves across the region — have not fully insulated (and, so far, cannot fully
insulate) Asian economies from global contagion.
To date, Asia has not suffered a large-scale bankruptcy or had to come to the
rescue of a major financial institution. With only a few exceptions — most notably
in South Korea — leverage within Asian financial systems is comparatively low, and
bank balance sheets were comparatively healthy at the outset of the crisis. Nearly all
East Asian nations run current account surpluses, a reversal from their state during
the Asian financial crisis of the late 1990s. These surpluses have been one reason for
the buildup of enormous government reserves in the region, including China’s $1.9
trillion and Japan’s $996 billion — the two largest reserve stockpiles in the world.
Such reserves give Asian governments resources to provide fiscal stimulus, inject
capital into their financial systems, and provide backstop guarantees for private
financial transactions where needed. So overall, Asian economies are much healthier
than they were before the Asian Financial Crisis of 1997-1998, when several Asian
countries burned through their limited reserves quickly trying to defend currencies
from speculative selling.
83 Prepared by Ben Dolven, Asia Section Research Manager, Foreign Affairs, Defense, and
Trade Division.
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Figure 9. Asian Current Account Balances are Mostly Healthy
Source: Merrill Lynch
Still, Asia has not been insulated. The initial stage of the crisis, which centered
around losses directly from subprime assets in the United States, has given way to a
broader global crisis marked by slowing economies and dried-up liquidity. Asia and
the United States are deeply linked in many ways, including trade (primarily Asian
exports to the United States), U.S. investments in the region, and financial linkages
that entwine Asian banks, companies and governments with U.S. markets and
financial institutions. As a result, even though Asian banks disclosed relatively low
direct exposures to failed institutions and toxic assets in the United States and
Europe, Asian economies appear caught in a second phase of the crisis. With
Western economies slowing and global investors short of cash and pulling back from
any markets deemed risky, Asian economies appear extremely vulnerable — and that
threatens deeper damage to Asian financial systems and then, in turn, to markets for
U.S. exports and investments.
The signs of distress in Asia are legion. Japan’s Nikkei-225 Index has lost half
its value over the course of 2008, exacerbated by a surge by the yen to its highest
level against the dollar since 1982. The yen’s strength (which analysts say is largely
the result of international investors forced to buy yen to square trading positions that
had taken advantage of low Japanese interest rates84) makes Japanese exports more
expensive and adds to the damage that slowing economies around the world are
already expected to inflict on Japan’s export-led economy. Japan entered a recession
in the July-September 2008 quarter, contracting for the second straight quarter.
Meanwhile, South Korea’s stock market and currency have plunged
precipitously, as South Korean companies have hoarded dollars because of
84 Crisis Deals New Blow to Japan, The Wall Street Journal, October 28, 2008.
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substantial dollar debts. Chinese GDP growth, while still strong, slowed from 10.4%
in the April-June quarter to 9.0% in the July-September period, raising concerns that
further slowing could raise unemployment. Such concerns prompted the government
to announce a $586 billion stimulus package in early November 2008, although the
measures included many policies that had previously been announced. Smaller
economies dependent on the financial and trading sectors, such as Hong Kong and
Singapore, have been hammered — Singapore is already in a recession, and Hong
Kong’s government has announced it will guarantee all the $773 billion in Hong
Kong bank deposits through 2010.
One of the most worrying developments in Asia is that Pakistan, already coping
with severe political instability, has been forced to seek emergency loans from the
IMF because of dwindling government reserves. This points to the limits of bilateral
solutions to the crisis: For much of October and early November, Pakistan reportedly
sought support from China, Saudi Arabia and other Middle Eastern states before
being forced to the IMF.85 On November 13, well into discussions with the IMF,
Pakistan officials announced they had received a $500 million aid package from
Beijing, far short of the $10 billion-$15 billion that Pakistani leaders say they need
over the next two years.86 Then on November 15, Pakistani and IMF officials
confirmed that Pakistan would receive $7.6 billion in emergency loans, including $4
billion immediately to avoid sovereign default. But this remains short of what
Pakistan says it needs.87
Throughout October, governments in Japan, South Korea, Hong Kong,
Singapore, Malaysia, Australia, New Zealand, Indonesia and elsewhere have been
forced into a range of moves to support domestic financial systems, pumping money
into financial markets, issuing guarantees for bank deposits, and providing fiscal
stimulus to keep growth strong and slow declines in local stock markets. In several
instances, including in Japan and South Korea, initial interventions failed to staunch
financial market declines, leading authorities to broaden their support moves as the
crisis deepened.
So in Asia, a belief that held sway in recent years that Asian economies were
starting to “decouple” from the United States and Europe, generating growth that
didn’t depend on the rest of the world, has given way to a realization that a crisis that
originated in the West can sweep up the region as well. Declines in Asian stock
markets are similar in scale to, or larger than, those in the U.S. and Europe, despite
the lack of bankruptcies and failed institutions in Asia. Throughout the crisis thus far,
Asian economies have experienced a so-called “flight to quality,” in which lenders
and investors have sought safe investments and moved out of those perceived as
risky. This has so far included the majority of Asia’s emerging economies. Some
85 Despite Ambivalence, Pakistan May Wrap Deal by Next Week, The Wall Street Journal,
October 28, 2008.
86 IMF ‘Has Six Days to Save Pakistan,’ Financial Times, October 28, 2008.
87 Pakistan Says it will Need Financing Beyond IMF Deal, The Wall Street Journal,
November 17, 2008
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economists, however, believe that Asia’s reserves and current account surpluses may
recover more strongly than other emerging markets once the crisis stabilizes.88
Asian Reserves and Their Impact
Some analysts argue that substantial Asian reserves could be one source of relief
for the global economy.89 Japan has contributed funding for the IMF support package
of Iceland, and on November 14, Prime Minister Taro Aso said Japan would lend the
IMF $100 billion to support further packages that might be needed before the IMF
increases its capital in 2009.90 Many wonder if China and other reserve-rich
developing nations will find ways to use those reserves to support financially-
strapped governments. As noted previously, Pakistan reportedly has approached
China and several Gulf states for such support.
One key question is whether Asian countries will seek to play a larger role in
setting multilateral moves to shore up regulation, and international support for
troubled countries. Five Asian countries — Japan, China, South Korea, India, and
Indonesia, were present at the G-20 summit. But Asian approaches to multilateral
regulation are still unclear. At an October 25-26 meeting of the Asia Europe Forum
(ASEM), Chinese Premier Wen Jiabao said China generally agrees with many
European governments which seek an expansion of multilateral regulations. “We
need financial innovation, but we need financial oversight even more,” Wen
reportedly told a press conference.91
Previous Asian attempts to play a leadership role have been unsuccessful. In
1998, in the midst of the Asian Financial Crisis, Japan and the Asian Development
Bank proposed the creation of an “Asian Monetary Fund” through which wealthier
Asian governments could support economies in financial distress. The proposal was
successfully opposed by the U.S. Treasury Department, which argued that it could
be a way for countries to bypass the conditions that the IMF demands of its borrowers
and go straight to “easier” sources of credit.
Two years later, in 2000, Finance Ministers from the ASEAN+3 nations (the 10
members of the Association of Southeast Asian Nations92, plus Japan, South Korea
and China) announced the Chiang Mai Initiative (CMI), whose primary measure was
to provide a swap mechanism that countries could tap to cover shortfalls of foreign
reserves. This was a less aggressive proposal than the Asian Monetary Fund.
88 See, for instance, Morgan Stanley report, “EM Currencies, No Differentiation in the Sell-
Off,” October 23, 2008.
89 See, for instance, Jeffrey Sachs, The Best Recipe for Avoiding a Global Recession,
Financial Times, October 27, 2008.
90 The moved was announced in a November 14 opinion piece by Japanese Prime Minister
Taro Aso, Restoring Financial Stability, printed in The Wall Street Journal.
91 Leaders of Europe and Asia Call for Joint Economic Action, New York Times, October
25, 2008.
92 ASEAN’s members are Indonesia, Singapore, Malaysia, Thailand, the Philippines, Brunei,
Vietnam, Cambodia, Laos and Burma (Myanmar).
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Although a small portion of the swap lines could be tapped in an emergency, most
could go through the IMF.93 On October 26, Japan, China, South Korea, and ASEAN
members agreed to start an $80 billion multilateral swap arrangement in 2009, which
would allow countries with substantial balance of payments problems to tap the
reserves of larger economies.
Asian leaders have sought to start other regional discussions. On October 22, a
Japanese government official floated the idea of a pan-Asian financial stability
forum, modeled after the Financial Stability Forum at the BIS, which was discussed
in May at a meeting of Finance Ministers from Japan, South Korea and China.94 This
followed a call from South Korean President Lee Myung-bak for another trilateral
meeting between the three countries’ finance ministers to brainstorm on regional
responses to the crisis.95 On November 15, finance ministers from Japan, South
Korea, and China agreed to consider boosting bilateral currency swap agreements
among the three countries.96
National Responses
So far, the national-level responses among Asian governments include the
following:
Japan. Japan was part of the early moves among major economies to flood
markets with liquidity, in the “crisis containment” part of the global response.
Alongside other major central banks, the Bank of Japan pumped tens of billions of
dollars into financial markets in late September and early October. It followed these
moves with an announcement on October 14 that it would offer an unlimited amount
of dollars to institutions operating in Japan, to ensure that Japanese interbank credit
markets continued to function. The BOJ did not lower interest rates in the crisis’s
early stages, but on October 31, it joined other global central banks, including the
U.S. Federal Reserve, by cutting a key short-term interest rate to 0.3%, from 0.5%.
For a time, Japan was considered relatively insulated, because of its well
capitalized banks, substantial reserves and current account surplus. Japan spent
nearly $440 billion between 1998 and 2003 to assist and recapitalize its banking
system, and most observers say Japan’s financial system emerged from the
experience fairly sound. Healthy capital positions helped Mitsubishi UFG Group,
Japan’s largest bank, and Nomura, the country’s largest brokerage, to buy pieces of
distressed U.S. investment banks as the crisis was deepening in October. Mitsubishi
93 For a fuller discussion of the Chiang Mai Initiative, see East Asian Cooperation, Institute
of International Economics, [http://www.iie.com/publications/chapters_preview/345/
3iie3381.pdf].
94 Japan, China, S.Korea Eye Financial Stability Forum, Reuters, October 20, 2008.
95 ROK President Proposes Finance Minster Talks With China., Japan Amid Market
Turmoil, Yonhap News Agency, October 3, 2008.
96 China, Korea, Japan to Mull Boosting Bilateral Currency Swaps, Bloomberg, November
15, 2008
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UFG bought 21% of Morgan Stanley for $9 billion, and Nomura purchased the
Asian, European and Middle Eastern operations of Lehman Brothers.
But as Western economies began to slow, Japan’s financial insulation thinned.
The Japanese economy is highly exposed to slowdowns in export markets,
particularly in the U.S. and Europe. The U.S. accounted for 20.1% of Japan’s
exports in 2007. Japan has sought to provide fiscal stimulus: The government
unveiled a $107 billion stimulus package in August, and on October 31, Prime
Minister Taro Aso announced a second set of stimulus measures, valued at another
$51.5 billion.
There have been signs of stress in the Japanese financial system in the weeks
following the Nomura and Mitsubishi UFG purchases. In October, Yamato
Insurance, a mid-sized insurance company, filed for bankruptcy, with $2.7 billion in
liabilities. Then, in late October, with share prices tumbling, the much larger
Mitsubishi UFG Group — which just two weeks earlier was sufficiently capitalized
that it had bought the Morgan Stanley stake — said it would raise as much as $10.7
billion to improve its capital base. Many analysts say smaller banks may need direct
help from the government. Japan’s two largest political parties, the ruling Liberal
Democratic Party and the main opposition Democratic Party of Japan, have agreed
on the need to re-authorize expired legislation that would allow the government to
purchase equity to support private banks, and Japanese media reports say this is
expected to be passed in December. This move would restart a program first
authorized in 2002 as part of the bank recapitalization process.
China.97 The extent of China’s exposure to the current global financial crisis,
in particular from the fallout of the U.S. sub-prime mortgage problem, is mixed but
is believed to be relatively small. China’s numerous restrictions on capital flows to
and from China limit the ability of individual Chinese citizens and many firms to
invest their savings overseas. Thus, the exposure of Chinese private sector firms and
individual investors to sub-prime U.S. mortgages is likely to be rather small. On the
other hand, the exposure of Chinese government entities, such as the State
Administration of Foreign Exchange, the China Investment Corporation (a $200
billion sovereign wealth fund created in 2007),98 state banks, and state owned
enterprises), may be more exposed and may have suffered losses from troubled U.S.
mortgage securities. The Chinese government generally does not release detailed
information on the holdings of its financial entities, although some of its banks have
reported on their supposed level of exposure to sub-prime U.S. mortgage securities.
Such entities have generally reported that their exposure to troubled sub-prime U.S.
mortgages has been minor relative to their total investments, that they have liquidated
97 The section on China was prepared by Wayne M. Morrison, Specialist in Asian Trade and
Finance, Foreign Affairs, Defense, and Trade Division.
98 For an overview of the China Investment Corporation, see CRS report RL34337, China’s
Sovereign Wealth Fund, by Michael F. Martin.
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such assets or have written off losses, and that they continue to earn high profit
margins.99
However, Chinese banks are not immune to financial problems. Several
indicators show that an economic slowdown has been occurring in China over the
past several months that could threaten stability within the banking system. For
example, the real estate market in several Chinese cities has exhibited signs of a
bubble that is bursting, including a slowdown in construction, falling prices and
growing levels of unoccupied buildings. This has increased pressure on the banks
to lower interest rates further to stabilize the market, but has raised concerns that
doing so could result in higher inflation. In addition, the value of China’s main stock
market index, the Shanghai Stock Exchange Composite Index, fell by 67.2% from
January 1 to October 27, 2008. Finally, China’s media reports that export orders
have declined sharply. More than half of China’s toy exporters shut down in the first
seven months of 2008, and toy exports from January to August 2008 were 20.8%
lower than they were during the same period in 2007.100 On November 3, 2008,
Chinese Premier Wen Jiabao warned that 2008 would be the “worst in recent times”
for China’s economic development. As a result, Chinese banks may face a new wave
of non-performing loans.
China’s official response to the global financial crisis initially was somewhat
limited. On September 27, 2008, Chinese Premier Wen Jiabao reportedly stated in
a speech that: “What we can do now is to maintain the steady and fast growth of the
national economy and ensure that no major fluctuations will happen. That will be our
greatest contribution to the world economy under the current circumstances.” 101 On
October 8, 2008, China’s central bank announced plans to cut interest rates and the
reserve-requirement ratio in order to help stimulate the economy. The announcement
coincided with announcements by the U.S. Federal Reserve and other central banks
of major economies around the world to lower their benchmark interest rates,
although, neither China’s central bank or the media stated that these measures were
taken in conjunction with the other major central banks. On October 21, 2008,
China’s State Council announced it was considering implementing a new economic
stimulus package, which would include an acceleration of construction projects, new
export tax rebates, a reduction in the housing transaction tax, increased agriculture
subsidies, and expanding lending to small and medium enterprises.102 On November
4, 2008, China’s media reported that Chinese President Hu Jintao would attend the
G-20 summit on the financial crisis in Washington, DC, on November 15.
On November 9, 2008, however, the Chinese government announced it would
implement a two-year $586 billion stimulus package, mainly dedicated to
99 China’s holdings of Fannie Mae and Freddie Mac securities are likely to be more
substantial, but less risky (compared to other sub-prime securities), especially after these
two institutions were placed in conservatorship by the Federal Government in September
2008.
100 Global Insight, Country Intelligence Analysis, China, October 20, 2008.
101 Chinaview, September 27, 2008.
102 Global Insight, Country Intelligence Analysis, China, October 20, 2008.
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infrastructure projects. The package would finance programs in 10 major areas,
including affordable housing, rural infrastructure, water, electricity, transport, the
environment, technological innovation and rebuilding areas hit by disasters
(especially, areas that were hit by the May 12, 2998 earthquake).103
Analysts debate what role China might play in responding to the global financial
crisis, given its nearly $2 trillion in foreign exchange reserves. Some have speculated
that China could use some of these reserves to shore up financial institutions around
the world, particularly in the United States. Others have contended that China would,
in order to help stabilize its largest export market (the United States), use its reserves
to purchase some of the large amount of U.S. debt securities that are expected to be
issued to help fund the hundreds of billions of dollars that are expected to be spent
by the U.S. government to purchase troubled assets and stimulate the economy.104
On September 21, 2008, the White House indicated that President Bush had
called President Hu to discuss the global financial crisis and steps the United States
planned to take to address the crisis. An unnamed Chinese trade official reportedly
stated that “the purpose of that call was to ask for China’s help to deal with this
financial crisis by urging China to hold even more U.S. Treasury bonds and U.S.
assets.” The official was further quoted as saying that China recognized that it “has
a stake” in the health of the U.S. economy, both as a major market for Chinese
exports and in terms of preserving the value of U.S.-based assets held by China.” and
that a stabilized U.S. economy was in China’s own interest.105
On the other hand, there are a number of reasons why China might be reluctant
to boost significantly its purchases of U.S. assets. One concern would be whether
increased Chinese investments in the U.S. economy would produce long-term
economic benefits for China. Some Chinese investments in U.S. financial companies
have fared poorly, and Chinese officials might be reluctant to put additional money
into investments that were deemed to be too risky. Secondly, a sharp economic
slowdown in the Chinese economy would increase pressure to invest money at home
rather than overseas. Many analysts (including some in China) have questioned the
wisdom of China’s policy of investing a large level of foreign exchange reserves in
U.S. government securities, which offer a relative low rate of return, when China has
such huge development needs. China may also be reluctant to boost investment in
U.S. companies, due to concerns that doing so would be risky or could come under
unfavorable scrutiny by Congress.
South Korea. South Korea, Asia’s fourth largest economy, has been deeply
affected by the crisis, with both the South Korean stock market and the won tumbling
throughout October, sometimes precipitously. On October 28, the won reached its
lowest point since 1998, when South Korea was in the middle of its IMF support
package. Oxford Analytica estimates that foreign investors withdrew a net $25 billion
103 China Xinhua News Agency, November 12, 2008.
104 Such a move would help keep U.S. interest rates relatively low. If China decided not to
sharply increase its purchases of U.S. securities, U.S. interest rates could go up.
105 Inside U.S. Trade, China Trade Extra, September 24, 2008.
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from the Korean stock market between January and late September.106 Experts say
South Korean banks have large dollar-denominated debts, and therefore need to
protect their holdings of dollars. This has contributed to the won’s fall, and in early
October, President Lee Myung-bak invoked patriotism to encourage Korean banks
to stop hoarding dollars and buy won.107
The government announced a broad economic rescue package on October 19,
2008, promising to guarantee $100 billion in South Korean banks’ foreign-currency
debt and provide another $30 billion to directly support South Korean banks. (The
total amount was equivalent to 14% of the country’s GDP.) Struggling with its
plunging stock market and currency, President Lee’s government has also announced
policies in recent weeks to spend up to $9.2 billion to support real-estate developers
struggling with unsold apartments, and to provide further financial support to small
businesses. On October 27, Korea’s central bank cut its prime interest rate by 0.75
percentage points to 4.25%, the largest cut it has made since it began setting base
interest rates in 1999. It also said it was considering buying up to $6.9 billion in
bonds held by Korean banks to shore up their capital bases.108
South Korea has been an enormous economic success, and has bounced back
strongly from the Asian Financial Crisis that forced it to turn to the IMF for a $58
billion support package in December 2007. After contracting by 6.9% in 1998, South
Korea’s GDP bounced back by 9.5% and 8.5% in the ensuing two years. Since 2002,
GDP growth has been in the 3%-6% range. However, President Lee has said the
current situation is more severe than the 1997 crisis. Economically, South Korea is
an outlier within Asia. It is one of the few Asian countries that is running a current
account deficit ($12.6 billion in January-August 2008). Its banks are unusually
leveraged, with loan-deposit ratios of more than 130%, higher than that in the United
States and the EU, and the only East Asian country over 100%.109
Other Countries’ Moves. Governments around the region have been
affected by the crisis, and have issued a range of rescue measures to keep financial
markets functioning and shore up economic growth. Other moves include:
Australia, which had seen one of the largest jumps in housing prices in the
world in recent years, has seen property prices tumble, leading to a spike in bad loans
among Australian banks. Australia’s commodities-dependent economy has also been
hurt by declining commodities prices, and the Australian dollar has declined
substantially in recent weeks. In response, the government issued a full guarantee on
all bank deposits in early October, and added a $7 billion fiscal stimulus plan on
October 14.
106 SOUTH KOREA: Seoul Faces Growth and Liquidity Tests, Oxford Analytica, October
8, 2008.
107 Lee Warns Against Dollar Hoarding, Korea Times, October 8, 2008.
108 South Korea Cuts Key Interest Rate by 75 Basis Points, Reuters, October 27, 2008.
109 See Merrill Lynch, “Asia: Risks Rising”, October 3, 2008.
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On October 14, The Hong Kong Monetary Authority said it would provide
government backing for all of the $773 billion in Hong Kong bank deposits through
2010 as government assistance for banks in Europe and the United States put
pressure on Asian regulators to follow suit even though Asian banks tended to be
better capitalized. The authority also said that it was prepared to provide capital to
the 23 locally incorporated banks if they needed it, following the examples of the
United States and Britain.
Many countries have seen trade volumes fall — both because of slowing global
demand but also because domestic banks have been wary of issuing trade finance.
India’s central bank, the Reserve Bank of India, announced emergency measures on
November 15 to support Indian banks who issue letters of credit for Indian exporters.
The central bank more than doubled the level of funds it makes available for banks
to refinance export credits at favorable rates.110 The availability of trade finance has
become a regional problem that further threatens export-led Asian economies, as
evidenced by a call from the Asian Development Bank on November 16 for Asian
banks to unfreeze credit to borrowers seeking to continue doing business.111
New Challenges and Policy in Managing Financial
Risk112
The Challenges
So far, the actions of the United States and other nations in coping with the
global financial crisis have been primarily to contain the contagion, minimize losses
to society, restore confidence in financial institutions and instruments, and lubricate
the wheels of the system in order for it to return to full operation. There is
considerable uncertainty, however, over whether the worst of the crisis has passed,
how nations will cope with second phase of the crisis (global recession and the
spread of the crisis to emerging markets), and whether the current crisis is an
aberration that can be fixed by tweaking the system, or whether it reflects systemic
problems that require major surgery. The challenges of the third phase still remain.
They arguably are to change regulatory structure and regulations and the global
financial architecture to ensure that future crises do not occur or, at least, to mitigate
their effects. The fourth phase is to cope with long-term political and social effects
of the financial crisis and ensuing slow down in economic growth.
On a more philosophical plane, the fundamental assumption that markets are
self correcting and that individuals pursuing their own financial interests like an
“invisible hand” tend also to promote the good of the global community has been
questioned. Will the losses of this financial crisis hurt investors and institutions
110 India Acts to Avert Liquidity Crunch, Financial Times, November 16, 2008.
111 Ibid.
112 Prepared by Dick K. Nanto, Specialist in Industry and Trade, Foreign Affairs, Defense,
and Trade Division.
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enough that the system will become more prudent in the future, or is further
regulation and oversight necessary to fill gaps in information and technical expertise
to compensate for faulty or incomplete methods of modeling risk, and to provide
more resilience in the system to offset human error? A related question is whether
there should be a system of controls on flows of capital during a financial crisis that
would be aimed at temporarily calming markets.
At the G-20 Summit on Financial Markets and the World Economy on
November 15, 2008, in Washington, DC, the leaders of these nations seem to have
concluded that major changes are needed in the global financial system. The G-20
recommendations imply that most saw the system as functional but major measures
were needed to reduce risk, to provide oversight, and to establish an early warning
system of impending financial crises. The G-20 leaders also agreed, however, that
“needed reforms will be successful only if they are grounded in a commitment to free
market principles, including the rule of law, respect for private property, open trade
and investment, competitive markets, and efficient, effectively-regulated financial
systems.” (See Appendix C and section of this report on the G-20.)
A related philosophical question for the United States deals with the nature of
capitalism. Should U.S. government ownership of stock in private corporations113
also provide Washington a voice in how the corporations are managed? What
conditions should be attached to large loans provided to corporations? A key dispute
in the Cold War was capitalism versus socialism. Should major companies in the
economy be owned by private investors and entrepreneurs or should they be national
assets owned and managed by the government? Should the main objective of large
companies be to maximize returns to shareholders, or should the government use its
investment in company shares to turn management objectives more toward
maximizing the national well being? Should limits, for example, be placed on
executive compensation in companies that receive government assistance? Also,
should the government be in the business of “picking winners and losers” in the
process that the economist Joseph Schumpeter described as creative destruction in
capitalism?114 Should the government “prop up companies” that should actually be
“destroyed” so that stronger and more innovative companies can emerge? Is there
really a company that is “too big to fail?” This question is being raised in
conjunction with proposals to provide loans to U.S. automobile makers.
For other nations of the world, what has become clear from the crisis is that
U.S. financial ailments can be highly contagious. Foreign financial institutions are
not immune to ill health in American banks, brokerage houses, and insurance
companies. The financial services industry links together investors and financial
institutions in disparate countries around the world. Investors seek higher risk-
adjusted returns in any market. For example, in the “carry trade,” investors borrow
113 Does not include government sponsored enterprises, such as Fannie Mae and Freddie
Mac.
114 Creative destruction is a term coined by Joseph Schumpeter to describe what he
considered the driving force of capitalism, a process of industrial innovation in which new
technologies and firms revolutionize the economy by incessantly destroying the existing
economic structure and creating a new one in the process.
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funds in a country with low interest rates (such as Japan and Switzerland) and invest
in higher yielding securities in another country (such as New Zealand, Australia, or
the United States). This trade has involved amounts estimated in the hundreds of
billions of dollars and has been a major factor in the appreciation of the yen in late
2008 as investors unwound yen carry trade positions.115 In financial markets,
moreover, innovations in one market quickly spread to another, and sellers in one
country often seek buyers in another. AIG insurance, for example, appears to have
been brought down primarily by its London office, an operation that engaged heavily
in credit default swaps.116 The revolution in communications, moreover, works both
ways. It allows for instant access to information and remote access to market
activity, but it also feeds the herd instinct and is susceptible to being used to spread
biased or incomplete information.
The linking of economies also transcends financial networks. Flows of
international trade both in goods and services are affected directly by macroeconomic
conditions in the countries involved. In the second phase of the financial crisis,
markets all over the world have been experiencing historic declines. Precipitous
drops in stock market values are being mirrored in currency and commodity markets.
Not only are world prices for petroleum and copper plummeting, but major exporting
countries and companies are facing weak markets for their industrial and consumer
products.
Given the international nature of financial markets, the rapid movement of
capital and information, and the secondary effects of financial problems on the
services-and-production side of the economy, there seems to be no international
architecture capable of coping with and preventing global crises from erupting. The
financial space above nations basically is anarchic with no supranational authority
with firm oversight, regulatory, and enforcement powers. There are international
norms and guidelines, but most are voluntary, and countries are slow to incorporate
them into domestic law. As such, the system operates largely on trust and confidence
and by hedging financial bets. The financial crisis has been a “wake-up call” for
investors who had confidence in, for example, credit ratings placed on securities by
credit rating agencies operating under what some have referred to as “perverse
incentives and conflicts of interest.” After such trusted AAA and AA ratings led to
investments of hundreds of billions of dollars in toxic securities, what will be
necessary to restore confidence in the system?
The G-20 Summit on Financial Markets and the World Economy took some
steps toward more international supervision of financial markets. The leaders agreed
that national financial supervisors should establish Colleges of Supervisors consisting
of national financial supervisory agencies that oversee globally active financial
institutions. These colleges of supervisors are to meet together to share information
and strengthen the surveillance of cross-border firms. In banking, for example, major
global banks would meet regularly with their supervisory college for comprehensive
115 Gabriele Galati, Alexandra Heath, and Patrick McGuire. “Evidence of Carry Trade
Activity,” BIS Quarterly Review, September 2007.
116 Morgenson, Gretchen, “Behind Insurer’s Crisis, Blind Eye to a Web of Risk,” The New
York Times (Internet edition), September 27, 2008.
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discussions of the firm’s activities and assessment of the risks it faces. The G-20
also recommended that the Financial Stability Forum be expanded to include broader
membership of emerging economies. (See Appendix C and section of this report on
the G-20.)
The crisis also has shown that the International Monetary Fund, the international
lender of last resort, has limited capital to cope with a large financial crisis that spans
both developed and emerging market countries. Its current $250 billion in usable
capital is dwarfed by the various rescue packages announced by national
governments. As the crisis has spread to smaller countries more within the purview
of IMF activities (Iceland, Hungary, Ukraine, and Pakistan), however, the IMF is
playing its traditional role in providing stabilization loan packages.
Another issue is the mismatch between regulators and those being regulated.
The policymakers can be divided between those of national governments and, to an
extent, those of international institutions, but the resulting policy implementation,
oversight, and regulation almost all rests in national governments (as well as sub-
national governments such as states for insurance regulation). Yet many of the
financial and other institutions that are the object of new oversight or regulatory
activity may themselves be international in presence. They tend to operate in all
major markets and congregate around world financial centers (i.e., London, New
York, Zurich, Hong Kong, Singapore, Tokyo, and Shanghai) where client portfolios
often are based and where institutions and qualified professionals exist to support
their activities. The major market for derivatives, for example, is London, even
though a sizable proportion of the derivatives, themselves, may be issued by U.S.
companies based on U.S. assets. A similar issue exists on the tangible product side
of the economy. Multinational producers of consumer and industrial goods can
transfer production among supply bases all over the world, but most manufacturing
is tied to capital equipment that is fixed in place. Financial transactions, in contrast,
can nominally occur anywhere. Unless regulations and constraints apply to other
markets as well, transactions can, for example, easily move from New York to
London, Zurich, or elsewhere. Could tighter regulations in the United States, for
example, induce transactions to move to London?
A related issue is the functional nature of U.S. regulation. Separate regulatory
agencies oversee each line of financial service: banking, insurance, securities, and
futures. Hence, no single regulator possesses all of the information and authority
necessary to monitor systemic risk or the potential that seemingly isolated events
could lead to broad dislocation and a financial crisis so widespread that it affects the
real economy. Also no single regulator can take coordinated action throughout the
financial system. Other countries have addressed their own versions of this problem.
The United Kingdom, for example, created a tripartite regulatory and oversight
system consisting of the Bank of England, the H.M. Treasury, and a Financial
Services Agency (a national regulatory agency for all financial services). Australia
and the Netherlands have created systems in which one financial regulatory agency
is responsible for prudential regulation of relevant financial institutions and a
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separate and distinct regulatory agency is responsible for business conduct and
consumer protection.117
Policy
In making policy changes, Congress faces several fundamental issues. First is
whether any long-term policies should be designed to restore confidence and induce
return to the normal functioning of a self-correcting system or whether the policies
should be directed at changing a system that may have become inherently unstable,
a system that every decade or so creates bubbles and then lurches into crisis. 118 For
example, in Congressional testimony on October 23, 2008, former Federal Reserve
Chairman Alan Greenspan stated that a “once-in-a-century credit tsunami”’ had
engulfed financial markets, and he conceded that his free-market ideology shunning
regulation was flawed.119 In a recent book, the financier George Soros stated that the
currently prevailing paradigm, that financial markets tend towards equilibrium, is
both false and misleading. He asserted that the world’s current financial troubles can
be largely attributed to the fact that the international financial system has been
developed on the basis of that flawed paradigm.120 Could this crisis mark the
beginning of the end of “free market capitalism?” On the other hand, the
International Monetary Fund has observed that market discipline still works and that
the focus of new regulations should not be on eliminating risk but on improving
market discipline and addressing the tendency of market participants to
underestimate the systemic effects of their collective actions.121
A second question deals with what level any new regulatory authority should
reside. Should it primarily be at the state, national, or international level? If the
authority is kept at the national level, how much power should an international
authority have? Should the major role of the IMF, for example, be informational,
advisory, and technical, or should it have enforcement authority? Should
enforcement be done through a dispute resolution process similar to that in the World
Trade Organization, or should the IMF or other international institution be ceded
oversight and regulatory authority by national governments?
Bretton Woods II. The second question above is central for those calling for
a new Bretton Woods conference. U.K. Prime Minister Gordon Brown called for
117 U.S. Department of the Treasury. The Department of the Treasury Blueprint for a
Modernized Financial Regulatory Structure. March 2008. 217 p.
118 For an analysis of bubbles, see: CRS Report RL33666, Asset Bubbles: Economic Effects
and Policy Options for the Federal Reserve, by Marc Labonte.
119 Lanman, Scott and Steve Matthews. “Greenspan Concedes to ‘Flaw’ in His Market
Ideology,” Bloomberg News Service, October 23, 2008.
120 Soros, George. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and
What it Means (PublicAffairs, 2008) p. i. Soros proposes a new paradigm that deals with
the relationship between thinking and reality and accounts for misconceptions and
misinterpretations.
121 International Monetary Fund. “The Recent Financial Turmoil — Initial Assessment,
Policy Lessons, and Implications for Fund Surveillance,” April 9, 2008.
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such a conference to have the specific objective of remaking the international
financial architecture.122 In the declaration of the G-20 Summit on Financial Markets
and the World Economy, world leaders stated:
We underscored that the Bretton Woods Institutions must be comprehensively
reformed so that they can more adequately reflect changing economic weights
in the world economy and be more responsive to future challenges. Emerging and
developing economies should have greater voice and representation in these
institutions. (See Appendix C.)
G-20 Meeting. On November 15, 2008, the G-20 Summit on Financial
Markets and the World Economy was held in Washington, DC. This was billed as
the first in a series of meetings to deal with the financial crisis, discuss efforts to
strengthen economic growth, and to lay the foundation to prevent future crises from
occurring. This summit included emerging market economies rather than the usual
G-7 or G-8 nations that periodically meet to discuss economic issues. It was not
apparent that the agenda of the emerging market economies differed greatly from that
of Europe, the United States, or Japan.
The G-20 is an informal forum that promotes open and constructive discussion
between industrial and emerging-market countries on key issues related to global
economic stability. The members include the finance ministers and central bankers
from the member nations. A G-20 leaders’ summit is a new development.
The G-20 Washington Declaration to address the current financial crisis was
both a laundry list of objectives and steps to be taken and a convergence of attitudes
by national leaders that concrete measures had to be implemented both to stabilize
national economies and to reform financial markets. The declaration established an
Action Plan that included high priority actions to be completed prior to March 31,
2009. Details are to be worked out by the G-20 finance ministers. The declaration
also called for a second G-20 summit no later than April 30, 2009.
The summit reportedly achieved five key objectives.123 The leaders:
! Reached a common understanding of the root causes of the global
crisis;
! Reviewed actions countries have taken and will take to address the
immediate crisis and strengthen growth;
! Agreed on common principles for reforming our financial markets;
! Launched an action plan to implement those principles and asked
ministers to develop further specific recommendations that will be
reviewed by leaders at a subsequent summit; and
! Reaffirmed their commitment to free market principles.
The leaders agreed that immediate steps could be taken or considered to restore
growth and support emerging market economies by:
122 Gerstenzang, James. “Bush will Meet with G-20 After Election,” Los Angeles Times,
October 23, 2008.
123 The declaration from the Summit is in Appendix C.
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! Continuing to take whatever further actions are necessary to stabilize
the financial system;
! Recognizing the importance of monetary policy support and using
fiscal measures, as appropriate;
! Providing liquidity to help unfreeze credit markets; and
! Ensuring that the International Monetary Fund (IMF), World Bank,
and other multilateral development banks (MDBs) have sufficient
resources to assist developing countries affected by the crisis, as well
as provide trade and infrastructure financing.
The leaders agreed on common principles to guide financial market reform:
! Strengthening transparency and accountability by enhancing required
disclosure on complex financial products; ensuring complete and
accurate disclosure by firms of their financial condition; and aligning
incentives to avoid excessive risk-taking.
! Enhancing sound regulation by ensuring strong oversight of credit
rating agencies; prudent risk management; and oversight or
regulation of all financial markets, products, and participants as
appropriate to their circumstances.
! Promoting integrity in financial markets by preventing market
manipulation and fraud, helping avoid conflicts of interest, and
protecting against use of the financial system to support terrorism,
drug trafficking, or other illegal activities.
! Reinforcing international cooperation by making national laws and
regulations more consistent and encouraging regulators to enhance
their coordination and cooperation across all segments of financial
markets.
! Reforming international financial institutions (IFIs) by modernizing
their governance and membership so that emerging market
economies and developing countries have greater voice and
representation, by working together to better identify vulnerabilities
and anticipate stresses, and by acting swiftly to play a key role in
crisis response.
The leaders approved an Action Plan that sets forth a comprehensive work plan
to implement these principles, and asked finance ministers to work to ensure that the
Action Plan is fully and vigorously implemented. The Plan includes immediate
actions to:
! Address weaknesses in accounting and disclosure standards for
off-balance sheet vehicles;
! Ensure that credit rating agencies meet the highest standards and
avoid conflicts of interest, provide greater disclosure to investors,
and differentiate ratings for complex products;
! Ensure that firms maintain adequate capital, and set out strengthened
capital requirements for banks’ structured credit and securitization
activities;
! Develop enhanced guidance to strengthen banks’ risk management
practices, and ensure that firms develop processes that look at
whether they are accumulating too much risk;
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! Establish processes whereby national supervisors who oversee
globally active financial institutions meet together and share
information; and
! Expand the Financial Stability Forum to include a broader
membership of emerging economies.
The leaders instructed finance ministers to make specific recommendations in
the following areas:
! Avoiding regulatory policies that exacerbate the ups and downs of
the business cycle;
! Reviewing and aligning global accounting standards, particularly for
complex securities in times of stress;
! Strengthening transparency of credit derivatives markets and
reducing their systemic risks;
! Reviewing incentives for risk-taking and innovation reflected in
compensation practices; and
! Reviewing the mandates, governance, and resource requirements of
the International Financial Institutions.
The leaders agreed that needed reforms will be successful only if they are
grounded in a commitment to free market principles, including the rule of law,
respect for private property, open trade and investment, competitive markets, and
efficient, effectively-regulated financial systems. The leaders further agreed to:
! Reject protectionism, which exacerbates rather than mitigates
financial and economic challenges;
! Strive to reach an agreement this year on modalities that leads to an
ambitious outcome to the Doha Round of World Trade Organization
negotiations;
! Refrain from imposing any new trade or investment barriers for the
next 12 months; and
! Reaffirm development assistance commitments and urge both
developed and emerging economies to undertake commitments
consistent with their capacities and roles in the global economy.
G-7 Meeting. On October 10, 2008, the G-7 finance ministers and central
bankers,124 met in Washington D.C. to try to provide a more coordinated approach
to the crisis. A statement released by the group stated that the G-7, “agrees today that
the current situation calls for urgent and exceptional action.” In addition, the Group
agreed to:
! Take decisive action and use all available tools to support
systematically important financial institutions and prevent their
failure.
124 The G-7 comprises Canada, France, Germany, Italy, Japan, the United Kingdom, and the
United States.
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! Take all necessary steps to unfreeze credit and money markets and
ensure that banks and other financial institutions have broad access
to liquidity and funding.
! Ensure that our banks and other major financial intermediaries, as
needed, can raise capital from public as well as private sources, in
sufficient amounts to re-establish confidence and permit them to
continue lending to households and businesses.
! Ensure that our respective national deposit insurance and guarantee
programs are robust and consistent so that our real depositors will
continue to have confidence in the safety of their deposits.
! Take action, where appropriate, to restart the secondary markets for
mortgages and other securitized assets. Accurate valuation and
transparent disclosure of assets and consistent implementation of
high quality accounting standards are necessary.125
The International Monetary Fund. Policy proposals for changes in the
international financial architecture have included a major role for the IMF. As a
lender of last resort, coordinator of financial assistance packages for countries,
monitor of macroeconomic conditions worldwide and within countries, and provider
of technical assistance, the IMF has played an important role during financial crises
whether international or confined to one member country.
The financial crisis has shown that the world could use a better early warning
system that can detect and do something about stresses and systemic problems
developing in world financial markets. It also may need some system of what is
being called a macro-prudential framework for assessing risks and promoting sound
policies. This would not only include the regulation and supervision of financial
instruments and institutions but also would incorporate cyclical and other
macroeconomic considerations as well as vulnerabilities from increased banking
concentration and inter-linkages between different parts of the financial system.126
In short, some institution could be charged with monitoring synergistic conditions
that arise because of interactions among individual financial institutions or their
macroeconomic setting.
However, the IMF’s current system of macroeconomic monitoring tends to
focus on the risks to currency stability, employment, inflation, government budgets,
and other macroeconomic variables. It does not deal directly with how
macroeconomic variables and potential synergisms and blurring of boundaries among
regulated entities affect prudential risk for insurance, banking, and brokerage houses.
125 G-7 Finance Ministers and Central Bank governors Plan of Action, press release HP-
1195, October 10, 2008, the United States Department of the Treasury.
126 Lipsky, John. “Global Prospects and Policies,” Speech by John Lipsky, First Deputy
Managing Director, International Monetary Fund, at the Securities Industries and Financial
Markets Association, New York, October 28, 2008. World Bank. “The Unfolding Crisis,
Implications for Financial Systems and Their Oversight,” October 28, 2008. p. 8.
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The Bank for International Settlements makes recommendations to countries on
measures to be undertaken (such as Basel II) to ensure banking stability and capital
adequacy, but the financial crisis has shown that the focus on capital adequacy has
been insufficient to ensure stability when a financial crisis becomes systemic and
involves brokerage houses and insurance companies as well as banks.
The International Monetary Fund127
The IMF was conceived in July 1944, when representatives of 45 governments
meeting in the town of Bretton Woods, New Hampshire, agreed on a framework for
international economic cooperation. The IMF came into existence in December 1945 and
now has membership of 185 countries.
The IMF performs three main activities:
! monitoring national, global, and regional economic and financial
developments and advising member countries on their economic
policies (surveillance);
! lending members hard currencies to support policy programs designed
to correct balance of payments problems; and
! offering technical assistance in its areas of expertise, as well as training
for government and central bank officials.
The financial crisis has created an opportunity for the IMF to reinvigorate itself
and possibly play a constructive role in resolving, or at the least mitigating, the
effects of the global downturn. It has been operating on two fronts: (1) through
immediate crisis management, primarily balance of payments support to emerging-
market and less-developed countries, and (2) contributing to long-term systemic
reform of the international financial system.128
IMF rules stipulate that countries are allowed to borrow up to three times their
quota129 over a three-year period, although this requirement has been breached on
several occasions in which the IMF has lent at much higher multiples of quota. In
response to the current financial crisis, the IMF has activated its Emergency
Financing Mechanism to speed the normal process for loans to crisis-afflicted
127 Prepared by Martin A. Weiss. For further information see: CRS Report RS22976, The
Global Financial Crisis: The Role of the International Monetary Fund (IMF), by Martin A.
Weiss.
128 See: CRS Report RS22976, The Global Financial Crisis: The Role of the International
Monetary Fund (IMF), by Martin A. Weiss.
129 Each member country of the IMF is assigned a quota, based broadly on its relative size
in the world economy. A member’s quota determines its maximum financial commitment
to the IMF and its voting power. The U.S. quota of about $58.2 billion is the largest.
CRS-57
countries. The emergency mechanism enables rapid approval (usually within 48-72
hours) of IMF lending once an agreement has been reached between the IMF and the
national government.
On October 28, 2008, the IMF, the European Union, and the World Bank
announced a joint financing package for Hungary totaling $25.1 billion to bolster its
economy. The IMF is to lend Hungary $15.7 billion, the EU $8.1 billion, and the
World Bank is to provide $1.3 billion. On October 24, the IMF announced an initial
agreement on a $2.1 billion two-year loan with Iceland. On October 26, the IMF
announced a $16.5 billion agreement with Ukraine, on November 3, an initial
agreement with Kyrgyzstan for a $60 million loan, and on November 16, an
agreement in principle with Pakistan on a $7.6 billion loan. Belarus has also been
in talks with the IMF. Other potential candidates that have been mentioned for IMF
loans include Serbia, Kazakhstan, Lithuania, Latvia, and Estonia.
The IMF also may use its Exogenous Shocks Facility (ESF) to provide
assistance to certain member countries. The ESF provides policy support and
financial assistance to low-income countries facing exogenous shocks, events that are
completely out of the national government’s control. These could include
commodity price changes (including oil and food), natural disasters, and conflicts and
crises in neighboring countries that disrupt trade. The ESF was modified in 2008 to
further increase the speed and flexibility of the IMF’s response. Through the ESF,
a country can immediately access up to 25% of its quota for each exogenous shock
and an additional 75% of quota in phased disbursements over one to two years.
On October 29, 2008, the IMF announced that it plans on creating a new three
month short-term lending facility aimed at middle income countries such as Mexico,
South Korea, and Brazil. The IMF plans to set aside $100 billion for the new Short-
Term Liquidity Facility (SLF). In a unprecedented departure from other IMF
programs, SLF loans will have no policy conditionality.130
The IMF is not alone in making available financial assistance to crisis-afflicted
countries. The International Finance Corporation (IFC), the private-sector lending
arm of the World Bank, has announced that it will launch a $3 billion fund to
capitalize small banks in poor countries that are battered by the financial crisis. The
Inter-American Development Bank (IDB) announced on October 10, 2008 that it will
offer a new $6 billion credit line to member governments as an increase to its
traditional lending activities. In addition to the IDB, the Andean Development
Corporation (CAF) announced a liquidity facility of $1.5 billion and the Latin
American Fund of Reserves (FLAR) has offered to make available $4.5 billion in
contingency lines. While these amounts may be insufficient should Brazil,
Argentina, or any other large Latin American country need a rescue package, they
could be very helpful for smaller countries such as those in the Caribbean and Central
America that are heavily dependent on tourism and property investments.
130 “IMF to Launch New Facility for Emerging Markets Hit by Crisis,” IMF Survey Online,
October 29, 2008.
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Changes in U.S. Regulations and Regulatory Structure. Aside from
the international financial architecture, a large question for Congress may be how
U.S. regulations might be changed and how closely any changes are harmonized with
international norms and standards. Related to that is whether U.S. oversight and
regulatory agencies, government sponsored enterprises, credit rating firms, or other
related institutions should be reformed, merged, their mandates changed, or
rechartered. (Many of these questions are addressed in separate CRS reports.)131
One early regulatory change was announced on November 14, 2008, by the
President’s Working Group on Financial Markets (Treasury, Securities and Exchange
Commission, Federal Reserve, and the Commodity Futures Trading Commission).
The Working Group is undertaking a series of initiatives to strengthen oversight and
the infrastructure of the over-the-counter derivatives market. This included the
development of credit default swap central counterparties — clearinghouses between
parties that own debt instruments and others willing to insure against defaults.132
As events have developed, policy proposals have been coming forth through the
legislative process and from the Administration, but other proposals are emerging
from recommendations by international organizations such as the IMF,133 Bank for
International Settlements,134 and Financial Stability Forum.135
The IMF has suggested various principles that could guide the scope and design
of measures aimed at restoring confidence in the international financial system. They
include:
! employ measures that are comprehensive, timely, clearly
communicated, and operationally transparent;
131 See, for example, CRS Report RL34730, The Emergency Economic Stabilization Act and
Current Financial Turmoil: Issues and Analysis, by Baird Webel and Edward V. Murphy.
CRS Report RL34412, Averting Financial Crisis, by Mark Jickling; CRS Report RL33775,
Alternative Mortgages: Causes and Policy Implications of Troubled Mortgage Resets in the
Subprime and Alt-A Markets, by Edward V. Murphy; CRS Report RL34657, Financial
Institution Insolvency: Federal Authority over Fannie Mae, Freddie Mac, and Depository
Institutions, by David H. Carpenter and M. Maureen Murphy; CRS Report RL34427,
Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte; CRS Report
RS22099, Regulation of Naked Short Selling, by Mark Jickling; and CRS Report RS22932,
Credit Default Swaps: Frequently Asked Questions, by Edward V. Murphy.
132 U.S. Treasury, “PWG Announces Initiatives to Strengthen OTC Derivatives Oversight
and Infrastructure,” Press Release HP-1271, November 14, 2008.
133 For analysis and recommendations by the International Monetary Fund, see: “Global
Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications
and Policy,” October 2008. 246 p.
134 For information on Basel II, see CRS Report RL34485, Basel II in the United States:
Progress Toward a Workable Framework, by Walter W. Eubanks.
135 For recommendations by the Financial Stability Forum, see: “Report of the Financial
Stability Forum on Enhancing Market and Institutional Resilience, Follow-up on
Implementation,” October 10, 2008. 39 p.
CRS-59
! aim for a consistent and coherent set of policies to stabilize the
global financial system across countries in order to maximize impact
while avoiding adverse effects on other countries;
! ensure rapid response on the basis of early detection of strains;
! assure that emergency government interventions are temporary and
taxpayer interests are protected; and
! pursue the medium-term objective of a more sound, competitive, and
efficient financial system.136
For the global banking industry, the Basel II framework from the Bank for
International Settlements actually has been on the table for some time awaiting full
implementation by countries of the world. Basel II is aimed at providing a more
risk-sensitive approach to financial market supervision by better aligning capital
charges with the underlying risk that banks take on. It is to help reduce the incentive
for banks to shift assets off their balance sheets, and it includes methodologies to
arrive at minimum capital requirements for credit risk, operational risk and market
risk; the supervisory review process, and market disclosure.137 On July 20, 2007, the
United States began implementing pertinent parts of Basel II.138 Some analysts assert
that the current financial crisis has already made Basel II obsolete and call for a Basel
III.139 One analyst considers the Basel capital rules to be an inappropriate basis for
an international arrangement among banking supervisors.140
On the regulatory level, the Financial Stability forum brings together the major
industrialized countries of the world, international financial institutions, and
international standards-setting organizations to recommend changes to financial and
accounting regulations to be adopted by member countries. It is a voluntary
136 International Monetary fund. “Global Financial Stability Report: Financial Stress and
Deleveraging, Macrofinancial Implications and Policy” (Summary version), October 2008.
pp. ix-x.
137 Board of Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision.
“Banking Agencies Reach Agreement on Basel II Implementation.” July 20, 2007.
138 For details on U.S. implementation, see: U.S. Federal Reserve, “Basel II Capital Accord,
Basel I Initiatives, and Other Basel-Related Matters.” [http://www.federalreserve.gov/
generalinfo/basel2/USImplementation.htm#Current]
139 See, for example, Caprio, Gerald, Jr., Ash Demirguc-Kunt, and Edward J. Kane, “The
2007 Meltdown in Structured Securitization: Searching for Lessons Not Scapegoats,” World
Bank Working Paper, September 5, 2008.
140 Tarullo, Daniel K. Banking on Basel, the Future of International Financial Regulation
(Peterson Institute for International Economics, 2008). p. 5.
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organization whose secretariat is at the Bank for International Settlements.141 The
recommendations of the Financial Stability Forum have dealt with the following:
! strengthened prudential oversight of capital, liquidity, and risk
management;
! enhancing transparency and valuation;
! changes in the role and uses of credit ratings;
! strengthening the authorities’ responsiveness to risks; and
! robust arrangements for dealing with stress in the financial system.142
These appear to be the areas for more work by international and national
organizations and institutions.
Policies to deal with the second phase of the financial crisis, the global
slowdown in economic growth and recessionary economic conditions, also have
come sharply into focus. While these actions tend to rely more on traditional
monetary and fiscal policies, there have been calls for more coordination of various
national economic stimulus packages in order to maximize their effect.143
Table 4 lists the major problems raised by the crisis, the targets of policy, and
the policies already being taken or possibly to take by various entities in response to
the global financial crisis. The long-term policies listed in the table essentially center
on issues of transparency, disclosure, risk management, creating buffers to make the
system more resilient, dealing with the secondary effects of the crisis, and the
interface between domestic and international financial institutions. The length and
breadth of the list indicates the extent that the financial crisis has required diverse and
draconian action. The number of policies or actions not yet taken and being
141 The Financial Stability Forum brings together senior representatives of national financial
authorities (e.g., central banks, supervisory authorities and treasury departments),
international financial institutions, international regulatory and supervisory groupings,
committees of central bank experts and the European Central Bank. The FSF is serviced by
a small secretariat housed at the Bank for International Settlements in Basel, Switzerland.
Members include Australia, Canada, France, Germany, Hong Kong, Italy, Japan,
Netherlands, Singapore, Switzerland, United Kingdom, United States (Treasury, Securities
& Exchange Commission, and the Federal Reserve System), International Monetary Fund,
World Bank, Bank for International Settlements, Organisation for Economic Co-operation
and Development, the Basel Committee on Banking Supervision, International Accounting
Standards Board, International Association of Insurance Supervisors, International
Organisation of Securities Commissions, Committee on Payment and Settlement Systems,
Committee on the Global Financial System, and the European Central Bank.
142 These are areas in which the Financial Stability Forum has made recommendations to the
G7 Finance Ministers and central bank Governors on October 10, 2008. See: “The Report
of the Financial Stability Forum on Enhancing Market and Institutional Resilience,” April
7, 2008, 74 p.
143 For a review of U.S. macroeconomic policy, see: CRS Report RL34349, Economic
Slowdown: Issues and Policies, by Jane G. Gravelle, Thomas L. Hungerford, Marc Labonte,
N. Eric Weiss, and Julie M. Whittaker.
CRS-61
considered indicate that policymakers may still have a long way to go to rebuild the
financial system that has been at the heart of the economic strength of the world.
Table 4. Problems, Targets of Policy, and Actions Taken or
Possibly to Take in Response to the Global Financial Crisis
Problem
Targets of Policy
Actions Taken or Possibly To Take
Containing the Contagion and Restoring Market Operations
Bankruptcy of
Financial
— Capital injection through loans or
financial institutions
institution,
stock purchases
Financial sector
— Takeover of company by
government or other company
— Allow to go bankrupt
Excess toxic debt
Capital base of
— Writeoff of debt by holding
debt holding
institution
institution
— Purchase of toxic debt by
government at a discount
— Ease mark-to-market accounting
requirements
Credit market freeze
Lending
— Coordinated lowering of interest
institutions
rates by central banks/Federal Reserve
— Guarantee short-term,
uncollateralized business lending
— Capital injection through loans or
stock purchases
Consumer runs on
Banks
— Guarantee bank deposits
deposits in banks and
Brokerage houses
— Guarantee money market accounts
money market funds
— Buy underlying money market
securities to cover redemptions
Declining stock
Investors
— Temporary ban on short sales of
markets
Short sellers
stock
— Government purchases of stock?
Global recession,
National
— Stimulative monetary and fiscal
rising unemployment,
governments
policies
decreasing tax
— Trade policy?
revenues, declining
— Support for unemployed?
exports
CRS-62
Problem
Targets of Policy
Actions Taken or Possibly To Take
Coping with Long-Term, Systemic Problems
Poor underwriting
Credit rating
— More transparency in factors
standards
agencies
behind credit ratings and better models
Overly high ratings of
Bundlers of
to assess risk?
collateralized debt
collateralized debt
— Regulation of credit rating
obligations by rating
obligations
agencies?
companies
Corporate
— Changes to the IOSCO Code of
Lack of transparency
leveraged lenders
Conduct for Credit Rating Agencies?
in ratings
— Strengthen oversight of lenders?
— Strengthen disclosure requirements
to make information more easily
accessible and usable?
Incentive distortions
Mortgage
— Require loan originators and
for originators of
originators
bundlers to provide initial and ongoing
mortgages (no penalty
Fannie
information on the quality and
for mortgage defaults)
Mae/Freddie Mac
performance of securitized assets?
All participants in
— Strengthened oversight of mortgage
the originate-to-
originators?
distribute chain
— Penalties for malfeasance by
originators?
Shortcomings in risk
Investors
— More prudent oversight of capital,
management practices
Regulatory
liquidity, and risk management?
Severe
agencies
— Raise capital requirements for
underestimation of
complex structured credit products?
risks in the tails of
— Strengthen authorities’
default distributions
responsiveness to risk?
— Set stricter capital and liquidity
buffers for financial institutions?
Banks had weak
Bank structured
— Strengthen accounting and
controls over off-
investment
regulatory practices?
balance sheet risks
vehicles
— Raise capital requirements for off-
Bank sponsored
balance sheet investment vehicles?
conduits
CRS-63
Problem
Targets of Policy
Actions Taken or Possibly To Take
Problems for International Policy
Lack of consistency
National
— Implement Basel II (Bank for
in regulations among
regulatory and
International Settlements’ capital and
nations and need for
oversight
other requirements for banks)
new regulations to
authorities
— Bretton Woods II agreement?
cope with new risks
Bank for
— New recommendations by
and exposures
International
Financial Stability Forum?
Settlements
— Establish an Asian or African
International
counterpart to the Financial Stability
Monetary Fund
Forum?
— Greater role for the International
Monetary Fund?
— Establish colleges of national
supervisors to oversee financial sectors
across boundaries (agreed to by G-20,
Nov. 15, 2008)
Countries unable to
IMF, Development
— IMF rescue packages
cope with financial
Banks
— Loans and swaps by capital surplus
crisis
National monetary
countries
authorities and
— Creation of long-term international
governments
liquidity pools to purchase assets?
Countries slow to
National monetary
— Increased IMF surveillance and
recognize emerging
and banking
consultations?
problems in financial
authorities
— Build more resilience into the
systems
Governments
system?
IMF
— Increase reporting requirements?
Regional
— Establish colleges of national
organizations
supervisors to oversee financial sectors
across national borders (agreed to by
G-20, Nov. 15, 2008)
Lack of political
National political
— International summit meetings
support to implement
leaders
— Bilateral and plurilateral meetings
changes in policy
and events
Source: Congressional Research Service.
Note: In the Actions to Take column, a “?” indicates that the action or policy has been proposed but
is still in development or not yet taken.
CRS-64
Selected Legislation
H.R. 1424 [110th] Emergency Economic Stabilization Act of 2008. A bill to provide
authority for the Federal Government to purchase and insure certain types of
troubled assets for the purposes of providing stability to and preventing
disruption in the economy and financial system and protecting taxpayers, to
amend the Internal Revenue Code of 1986 to provide incentives for energy
production and conservation, to extend certain expiring provisions, to provide
individual income tax relief, and for other purposes. (Kennedy, Patrick J.),
introduced 3/9/2007, P.L. 110-343 (10/3/2008). Note: H.R. 1424 is the vehicle
for the 2008 economic rescue legislation. Division A is the Emergency
Economic Stabilization Act of 2008; Division B is the Energy Improvement
and Extension Act of 2008; and Division C is the Tax Extenders and Alternative
Minimum Tax Relief Act of 2008.
H.R. 3221 [110th] Housing and Economic Recovery Act of 2008. (Pelosi),
introduced 7/30/2007. P.L. 110-289 (7/30/2008). For analysis, see CRS Report
RL34623, Housing and Economic Recovery Act of 2008, by N. Eric Weiss, et
al.
H.R. 3666 [110th] Foreclosure Prevention and Homeownership Protection Act
(Sutton), introduced 9/25/2007.
H.R. 3915 [110th] Mortgage Reform and Anti-Predatory Lending Act of 2007
(Miller, Brad), introduced 10/22/2007, passed House 11/15/2007, referred to
Senate 12/3/2007.
H.R. 6482 [110th] To direct the Securities and Exchange Commission to establish
both a process by which asset-backed instruments can be deemed eligible for
NRSRO ratings and an initial list of such eligible asset-backed instruments.
(Ackerman), introduced 7/14/2008.
H.R. 6230 [110th] Credit Rating Agency Transparency and Disclosure Act.
(McHenry), introduced 6/10/2008.
H.R. 7104 [110th] National Commission on Financial Collapse and Recovery Act
of 2008 (Porter, Jon C.), introduced 9/25/2008.
S. 2595 [110th] S.A.F.E. Mortgage Licensing Act of 2008, (Feinstein), introduced
2/6/2008.
S. 3652 [110th] Financial Market Investigation, Oversight, and Reform Act of 2008.
(Cantwell), introduced 9/29/2008.
S. 3677 [110th] Financial Crimes Accountability Act of 2008 (Snowe), introduced
10/1/2008.
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Appendix A. British, U.S., and European Central
Bank Operations April-Mid-October 2008
Co-ordinated
European
Bank of England
Federal Reserve
Central Bank
Central Bank
Announcements
May
Announced that
Expanded size of
Expansion of
expanded three-
Term Auction
agreements
Facility (TAF).
between Federal
month long-term
repos would be
Extended
Reserve and
collateral of Term
European Central
maintained in
June and July.
Securities
Bank.
Lending Facility
(TSLF).
July
Introduced 84-day Announced that it
TAF.
would conduct
Primary Dealer
operations under
Credit Facility
the 84-day TAF
(PDCF) and
to provide US
TSLF extended to
dollars to
January 2009.
European Central
Authorized the
Bank
auction of options
counterparties.
for primary
dealers to borrow
Announced that
Treasury
supplementary
securities from
three-month
the TSLF.
longer-term
refinancing
operations
(LTROs) would
be renewed in
August and
September.
Sept.
Announced that
Expanded
Announced six-
Expansion of
expanded three-
collateral of
month LTROs
agreement
month long-term
PDCF.
would be renewed between Federal
repos would be
Expanded size
in October, and
Reserve and
maintained in
and collateral of
three-month
European Central
September and
TSLF.
LTROs would be
Bank.
October.
Announced
renewed in
Establishment of
Announced long-
provision of loans
November and
swap agreements
term repo
to banks to
December.
between Federal
operations to be
finance purchase
Conducted
Reserve and the
held monthly.
of high quality
Special Term
Bank of England,
Extended
asset-backed
Refinancing
subsequently
drawndown
commercial paper
Operation.
expanded.
period for Special
from money
Bank of England
Liquidity Scheme
market mutual
and European
9SLS).
funds.
Central Bank, in
conjunction with
the Federal
CRS-66
Co-ordinated
European
Bank of England
Federal Reserve
Central Bank
Central Bank
Announcements
Reserve,
announced
operation to lend
U.S. dollars for
one week,
subsequently
extended to
scheduled weekly
operations.
Oct.
Extended
Announced
Increased size of
Announced
collateral for one-
payment of
six-month
schedules for
week U.S. dollar
interest on
supplementary
TAFs and
repos and for
required and
LTROs.
Forward TAFs for
three-month long-
excess reserve
Announced a
auctions of U.S.
term repos.
balances.
reduction in the
dollar liquidity
Extended
Increased size of
spread of standing during the fourth
collateral of all
TAFs.
facilities from
quarter.
extended-
Announced
200 basis points
collateral sterling
creation of the
to 100 basis
European Central
long-term repos,
Commercial
points around the
and Bank of
U.S. dollar repo
paper Funding
interest rate on
England
operations, and
Facility.
the main
announced
the SLS to
refinancing
tenders of U.S.
include bank-
operation.
dollar funding at
guaranteed debt
Introduced swap
7-day, 28-day, 84-
under the UK
agreements with
day maturities at
Government bank
the Swiss
fixed interest
debt guarantee
National Bank.
rates for full
scheme.
allotment. Swap
Announced
agreements
Operations
increased to
Standing
accommodate
Facilities and a
required level of
Discount Window
funding.
Facility, which
together replace
existing Standing
Facilities.
Source: Financial Stability Report, October 2008, the Bank of England. p. 18.
CRS-67
Appendix B. Major Recent Actions and Events of
the International Financial Crisis144
2008
November 15. At a G-20 (including the G-8, 10 major emerging economies,
Australia and the European Union) summit in Washington, the G-20 leaders agreed
to continue to take steps to stabilize the global financial system and improve the
international regulatory framework.
November 15. Japan announced that it would make $100 billion from its
foreign exchange reserves available to the IMF for loans to emerging market
economies. This was in addition to $2 billion that Japan is to invest in the World
Bank to help recapitalize banks in smaller, emerging market economies. Also, the
IMF and Pakistan agreed in principle on a $7.6 billion loan package aimed at
preventing the nation from defaulting on foreign debt and restoring investor
confidence.
November 14. The President’s Working Group on Financial Markets
(Treasury, Securities and Exchange Commission, Federal Reserve, and the
Commodity Futures Trading Commission) announced a series of initiatives to
strengthen oversight and the infrastructure of the over-the-counter derivatives market.
This included the development of credit default swap central counterparties —
clearinghouses between parties that own debt instruments and others willing to insure
against defaults.
November 13. The African Development bank conference on the financial
crisis ended with a pessimistic outlook for Sub-Saharan Africa, due to declines in
foreign capital, export markets and commodity-based exports.
November 13. Eurostat declared that Eurozone GDP declined by 0.2% in the
third quarter of 2008, as well as the second quarter. Since recession is defined as
two successive quarters of contracting GDP, this means that the Eurozone is
technically in recession.
November 12. United States Treasury Secretary Paulson announced a
change in priorities for the US$700 billion Troubled Asset Relief Program (TARP)
approved by Congress in early October. The first priority remains to provide direct
equity infusions to the financial sector. Roughly US$250 billion has been allocated
to this sector. This scope was broadened to include non-banks, particularly insurance
companies such as AIG, which provide insurance for credit defaults. Paulson noted
that TARP would be used to purchase bank stock, not toxic assets. Paulson’s new
plan also would provide support for the asset-backed commercial paper market,
particularly securitized auto loans, credit card debt, and student loans. Between
August and November 2007 asset-backed commercial paper outstanding contracted
144 Prepared by J. Michael Donnelly, Information Research Specialist, Knowledge Services
Group.
CRS-68
by nearly US$400 billion. Paulson rejected suggestions that TARP funds be made
available to the U.S. auto industry.
November 12. The Central Bank of Russia raised key interest rates by 1%.
Swiss Economics Minister announced the Swiss government would inject 341
million Swiss Francs/US$286.6 million for economic stimulus. The State Bank of
Pakistan raised interest rates by 2%, to reduce inflation. It also injected 320 billion
rupees/US$4 billion into the Pakistan banking system.
November 11. IMF deferred their decision to approve US$2.1 billion loan
for Iceland. This was the third time the IMF board scheduled then failed to discuss
the Iceland proposal. The tentative Iceland package required Iceland to implement
economic stabilization. That economic stabilization was the required trigger for
implementation of EU loans to Iceland from Norway, Poland and Sweden. Iceland
is reportedly involved in disputes over deposit guarantees with British and Dutch
depositors in Icelandic banks.
November 10. The United States government announced further aid to
American International Group, AIG. AIG’s September $85 billion loan was
reduced to $60 billion; the government bought $40 billion of preferred AIG shares,
and $52.5 billion of AIG mortgage securities. The U.S. support of AIG increased
from September’s $85 billion to $150 billion.
November 7. Iceland’s President Grimsson reportedly offered the use of the
former U.S. Air Force base at Keflavik to Russia. The United States departed
Keflavik in 2006.
November 3. IMF announced agreement with Kyrgyzstan on arrangement
under the Exogenous Shocks Facility to provide at least U.S. $60 million. The
agreement requires the approval of the IMF Executive Board to become final.
November 9. G-20 meeting of finance ministers and central bank governors in
Sao Paulo, Brazil, concluded with a communique calling for increased role of
emerging economies in reform of Bretton Woods financial institutions, including the
World Bank and the International Monetary Fund.
November 9. China announced a 4 trillion Yuan/U.S. $587 billion domestic
stimulus package. primarily aimed at infrastructure, housing, agriculture, health
care, and social welfare spending. This program represents 16% of China’s 2007
GDP, and roughly equals total Chinese central and local government outlays in 2006.
November 8. Latvian government took over Parex Bank, the second-largest
bank in Latvia.
November 7. United States October employment report revealed a decline of
240,000 jobs in October, and September job losses revised from 159,000 to 284,000.
The U.S. unemployment rate rose from 6.1% to 6.5%, a 14-year high.
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November 7. Moody’s sovereign rating for Hungary is reduced from A2 to
A3. Despite IMF assistance, financial instability may require “severe
macroeconomic and financial adjustment.” Moody’s reduced its ratings of Latvia
from A3 to A2, before the Latvian statistical office announced Latvian GDP fell at
a 4.2% annual rate in the third quarter of 2008. Moody’s also announced an outlook
reduction for Estonia and Lithuania.
November 6. IMF approved SDR 10.5 billion/U.S. $15.7 billion Stand-By
Arrangement for Hungary. U.S. $6.3 billion is to be immediately available.
November 6. International Monetary Fund announced its updated World
Economic Outlook. Main findings include that “global activity is slowing quickly”,
and “prospects for global growth have deteriorated over the past month.” The IMF
now projects global GDP growth for 2009 at 2.2% , 3/4 of a percentage point lower
than projections announced in October, 2008. It projects U.S. GDP growth at 1.4%
in 2008 and -0.7% in 2009.
November 6. The European Central Bank, ECB, reduced its key interest
rate from 3.75% to 3.25%. In two months the ECB has reduced this rate from 4.25%
to 3.25%. The Danish Central Bank lowered its key lending rate from 5.5% to 5%.
The Czech National Bank reduced its interest rate from 3.5% to 2.75%. In South
Korea, the Bank of Korea reduced its key interest rate from 4.25% to 4%. During
October the Bank of Korea reduced its rate from 5.25% to 4.25%.
November 4. United States Institute of Supply Management’s manufacturing
index fell 4.6 points in October to 38.9, after previously falling in September. The
export orders component of the manufacturing index fell 11 points in October to 41,
following a drop of 5 points in September. 41 is the lowest level in this export index
in 20 years. Exports have been the strongest sector in U.S. manufacturing during the
past year.
November 4. Australia. Reserve Bank of Australia lowered its overnight cash
rate by 75 basis points to 5.25%, the lowest Australian rate since March 2005.
November 4. Indian Prime Minister Manmohan Singh established a Cabinet-
level committee to evaluate the effect of the financial crisis on India’s economy and
industries. This follows the November 2 Indian and Pakistani Central banks’
actions to boost liquidity. India cut its short-term lending rate by 50 basis points to
7.5% and reduced its cash reserve ratio by 100 basis points to 5.5%.
November 4. Chilean President Michelle Bachelet announced a U.S.$1.15
billion stimulus package to boost the housing market and channel credit into small
and medium businesses.
November 3. Russian Prime Minister Vladimir Putin reported measures to
support the real economy. The measures will include temporary preferences for
domestic producers for state procurement contracts, subsidizing interest rates for
loans intended to modernize production; and tariff protection for a number of
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industries such as automobiles and agriculture. The new policy aims to support
exporters.
October 31. Three of the six Gulf Cooperation Council, GCC, countries,
Bahrain, Kuwait and Saudi Arabian central banks reduced interest rates to
follow the actions of the U.S. Federal Reserve and other central banks.
October 31. Kazakhstan government will make capital injections into its top
four banks, Halyk Bank, Kazkommertsbank, Alliance Bank and BTA Bank.
October 31. The U.S. Commerce Department reported that consumer
spending fell 0.3% in September after remaining flat in the previous month. On a
year-to-year basis, spending was down 0.4%, the first such drop since the recession
of 1991. Consumer spending has not grown since June.
October 30. The U.S. Bureau of Economic Analysis reported that U.S. real
gross domestic product decreased 0.3 per cent in the third quarter of 2008 after
increasing 2.8 per cent in the second quarter of 2008.
October 29. The U.S. Federal Reserve lowered its target for the federal funds
rate 50 basis points to 1 per cent. It also approved a 50 basis point decrease in the
discount rate to 1.25 per cent. The Federal Reserve also announced establishment
of temporary reciprocal currency arrangements, or swap lines, with the Banco Central
do Brasil, the Banco de Mexico, the Bank of Korea, the Monetary Authority of
Singapore, and the Reserve Bank of New Zealand. Swap lines are designed to help
improve liquidity conditions in global financial markets.
October 29. IMF approved the creation of a Short-Term Liquidity Facility,
established to support countries with strong policies which face temporary liquidity
problems.
October 28. The IMF, the European Union, and the World Bank announced a
joint financing package for Hungary totaling $25.1 billion to bolster its economy.
The IMF is to lend Hungary $15.7 billion, the EU $8.1 billion, and the World Bank
$1.3 billion.
October 28. The U.S. Conference Board said that its consumer confidence
index has dropped to an all-time low, from 61.4 in September to 38 in October.
October 27. Iceland’s Kaupthing Bank became the first European borrower
to default on yen-denominated bonds issued in Japan (samurai bonds).
October 26. The IMF announced it is set to lend Ukraine $16.5 Billion.
October 24. IMF announced an outline agreement with Iceland to lend the
country $2.1 billion to support an economic recovery program to help it restore
confidence in its banking system and stabilize its currency.
October 23. President Bush called for the G-20 leaders to meet on November
15 in Washington, DC to deal with the global financial crisis.
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October 22. Pakistan sought help from the IMF to meet balance of payments
difficulties and to avoid a possible economic meltdown amid high fuel prices,
dwindling foreign investment and soaring militant violence.
G-20. The Group of 20 Finance Ministers and Central Bank Governors from
industrial and emerging-market countries is to meet in Sao Paulo, Brazil on
November 8-9, 2008, to discuss key issues related to global economic stability.
October 20. The Netherlands agreed to inject €10 billion ($13.4 billion) into
ING Groep NV, a global banking and insurance company. The investment is to take
the form of nonvoting preferred shares with no maturity date (ING can repay the
money on its own schedule and will have the right to buy the shares back at 150% of
the issue price or convert them into ordinary shares in three years). The government
is to take two seats on ING’s supervisory board; ING’s executive-board members are
to forgo 2008 bonuses; and ING said it would not pay a dividend for the rest of 2008.
October 20. Sweden proposed a financial stability plan, which includes a 1.5
trillion Swedish kronor ($206 billion) bank guarantee, to combat the impact of the
economic crisis.
October 20. The UN’s International Labor Organization projects that the
global financial crisis could add at least 20 million people to the world’s
unemployed, bringing the total to 210 million by the end of 2009.
October 19. South Korea announced that it would guarantee up to $100
billion in foreign debt held by its banks and would pump $30 billion more into its
banking sector.
October 18. President Bush, President Nicolas Sarkozy of France, and the
president of the European Commission issued a joint statement saying they agreed
to “reach out to other world leaders” to propose an international summit meeting
to be held soon after the U.S. presidential election, with the possibility of more
gatherings after that. The Europeans had been pressing for a meeting of the Group
of 8 industrialized nations, but President Bush went one step further, calling for a
broader global conference that would include “developed and developing nations”
— among them China and India.
October 17. The Swiss government said it would take a 9% stake ($5.36
billion) in UBS, one of the country’s leading banks, and set up a $60 billion fund to
absorb the bank’s troubled assets. UBS had already written off $40 billion of its $80
billion in “toxic American securities.” The Swiss central bank was to take over $31
billion of the bank’s American assets (much of it in the form of debt linked to
subprime and Alt-A mortgages, and securities linked to commercial real estate and
student loans).
October 15. The G8 leaders (Canada, France, Germany, Italy, Japan, Russia,
the United Kingdom and the United States, and the European Commission) stated
that they were united in their commitment to resolve the current crisis, strengthen
financial institutions, restore confidence in the financial system, and provide a sound
economic footing for citizens and businesses. They stated that changes to the
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regulatory and institutional regimes for the world’s financial sectors are needed and
that they look forward to a leaders’ meeting with key countries at an appropriate time
in the near future to adopt an agenda for reforms to meet the challenges of the 21st
century.
October 14. In coordination with European monetary authorities, the U.S.
Treasury, Federal Reserve, and Federal Deposit Insurance Corporation
announced a plan to invest up to $250 billion in preferred securities of nine major
U.S. banks (including Citigroup, Bank of America, Wells Fargo, Goldman Sachs
and JPMorgan Chase). The FDIC also became able to temporarily guarantee the
senior debt and deposits in non-interest bearing deposit transaction accounts (used
mainly by businesses for daily operations).145
October 13. U.K. Government provided $60 billion and took a 60% stake in
Royal Bank of Scotland and 40% in Lloyds TSB and HBOS.
October 12-13. Several European countries (Germany, France, Italy,
Austria, Netherlands, Portugal, Spain, and Norway) announced rescue plans for
their countries worth as much as $2.7 trillion. The plans were largely consistent with
a U.K. model that includes concerted action, recapitalization, state ownership,
government debt guarantees (the largest component of the plans), and improved
regulations.
October 8. In a coordinated effort, the U.S. Federal Reserve, the European
Central Bank, the Bank of England and the central banks of Canada and
Sweden all reduced primary lending rates by a half percentage point. Switzerland
also cut its benchmark rate, while the Bank of Japan endorsed the moves without
changing its rates. The Chinese central bank also reduced its key interest rate and
lowered bank reserve requirements. The Federal Reserve’s benchmark short-term
rate stood at 1.5% and the European Central Bank’s at 3.75%.
October 5. The German government moved to guarantee all private savings
accounts and arranged a bailouts for Hypo Real Estate, a German lender. A week
earlier, Fortis, a large banking and insurance company based in Belgium but active
across much of Europe, had received €11.2 billion ($8.2 billion) from the
governments of the Netherlands, Belgium and Luxembourg. On October 3, the
Dutch government seized its Dutch operations and on October 5, the Belgian
government helped to arrange for BNP-Paribas, the French bank, to take over what
was left of the company.
October 3. U.S. House of Representatives passes 110th Congress bill H.R.
1424, Financial Institutions Rescue bill, clearing it for Presidential signing or veto.
President signs bill into law, P.L. 110-343, the Emergency Economic Stabilization
Act of 2008, sometimes referred to as the Troubled Assets Relief Program, TARP.
The new bill’s title includes its purpose:
145 U.S. Treasury. “Joint Statement by Treasury, Federal Reserve and FDIC.” Press Release
HP-1206, October 14, 2008.
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“A bill to provide authority for the Federal Government to purchase and insure
certain types of troubled assets for the purposes of providing stability to and
preventing disruption in the economy and financial system and protecting
taxpayers...”
October 3. Britain’s Financial Services Authority said it had raised the amount
guaranteed in savings accounts to £50,000 ($88,390) from £35,000. Greece also
stated that it would guarantee savings accounts regardless of the amount.
October 3. Wells Fargo Bank announced a takeover of Wachovia Corp, the
fourth-largest U.S. bank. (Previously, Citibank had agreed to take over Wachovia.)
October 1. U.S. Senate passed H.R. 1424, amended, Financial Institutions
Rescue bill.
September/October. On September 30, Iceland’s government took a 75%
share of Glitnir, Iceland’s third-largest bank, by injecting €600 million ($850
million) into the bank. The following week, it took control of Landsbanki and soon
after placed Iceland’s largest bank, Kaupthing, into receivership as well.
September 26. Washington Mutual became the largest thrift failure with $307
billion in assets. JPMorgan Chase agreed to pay $1.9 billion for the banking
operations but did not take ownership of the holding company.
September 22. Ireland increased the statutory limit for the deposit guarantee
scheme for banks and building societies from €20,000 ($26,000) to €100,000
($130,000) per depositor per institution.
September 21. The Federal Reserve approved the transformation of Goldman
Sachs and Morgan Stanley into bank holding companies from investment banks in
order to increase oversight and allow them to access the Federal Reserve’s discount
(loan) window.
September 18. Treasury Secretary Paulson announced a $700 billion
economic stabilization proposal that would allow the government to buy toxic
assets from the nation’s biggest banks, a move aimed at shoring up balance sheets
and restoring confidence within the financial system. An amended bill to accomplish
this was passed by Congress on October 3.
September 16. The Federal Reserve came to the assistance of American
International Group, AIG, an insurance giant on the verge of failure because of its
exposure to exotic securities known as credit default swaps, in an $85 billion deal
(later increased to $123 billion).
September 15. Lehman Brothers bankruptcy at $639 billion is the largest in
the history of the United States.
September 14. Bank of America said it will buy Merrill Lynch for $50
billion.
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September 7. U.S. Treasury announced that it was taking over Fannie Mae
and Freddie Mac, two government-sponsored enterprises that bought securitized
mortgage debt.
August 12. According to Bloomberg, losses at the top 100 banks in the world
from the U.S. subprime crisis and the ensuing credit crunch exceeded $500 billion
as writedowns spread to more asset types.
May 4. Finance ministers of 13 Asian nations agreed to set up a foreign
exchange pool of at least $80 billion to be used in the event of another regional
financial crisis. China, Japan and South Korea are to provide 80% of the funds
with the rest coming from the 10 members of ASEAN.
March. The Federal Reserve staved off a Bear Stearns bankruptcy by
assuming $30 billion in liabilities and engineering a sale of Bear Sterns to
JPMorgan Chase for a price that was less than the worth of Bear’s Manhattan office
building.
February 17. The British government decided to “temporarily” nationalize the
struggling housing lender, Northern Rock. A previous government loan of $47
billion had proven ineffective in helping the company to recover.
January. Swiss banking giant UBS reported more than $18 billion in
writedowns due to exposure to U.S. real estate market. Bank of America acquired
Countrywide Financial, the largest mortgage lender in the United States.
2007
July/August. German banks with bad investments in U.S. real estate are
caught up in the evolving crisis, These include IKB Deutsche Industriebank,
Sachsen LB (Saxony State Bank) and BayernLB (Bavaria State Bank).
July 18. Two battered hedge funds worth an estimated $1.5 billion at the end
of 2006 were almost entirely worthless. They had been managed by Bear Stearns
and were invested heavily in subprime mortgages.
July 12. The Federal Deposit Insurance Corp. took control of the $32 billion
IndyMac Bank (Pasadena, CA) in what regulators called the second-largest bank
failure in U.S. history.
March/April. New Century Financial corporation stopped making new loans
as the practice of giving high risk mortgage loans to people with bad credit histories
becomes a problem. The International Monetary Fund warned of risks to global
financial markets from weakened US home mortgage market.
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Appendix C. G-20 Declaration of November 15,
2008
DECLARATION OF THE SUMMIT ON FINANCIAL
MARKETS AND THE WORLD ECONOMY
1. We, the Leaders of the Group of Twenty, held an initial meeting in Washington
on November 15, 2008, amid serious challenges to the world economy and financial
markets. We are determined to enhance our cooperation and work together to restore
global growth and achieve needed reforms in the world’s financial systems.
2. Over the past months our countries have taken urgent and exceptional measures
to support the global economy and stabilize financial markets. These efforts must
continue. At the same time, we must lay the foundation for reform to help to ensure
that a global crisis, such as this one, does not happen again. Our work will be guided
by a shared belief that market principles, open trade and investment regimes, and
effectively regulated financial markets foster the dynamism, innovation, and
entrepreneurship that are essential for economic growth, employment, and poverty
reduction.
ROOT CAUSES OF THE CURRENT CRISIS
3. During a period of strong global growth, growing capital flows, and prolonged
stability earlier this decade, market participants sought higher yields without an
adequate appreciation of the risks and failed to exercise proper due diligence. At the
same time, weak underwriting standards, unsound risk management practices,
increasingly complex and opaque financial products, and consequent excessive
leverage combined to create vulnerabilities in the system. Policy-makers, regulators
and supervisors, in some advanced countries, did not adequately appreciate and
address the risks building up in financial markets, keep pace with financial
innovation, or take into account the systemic ramifications of domestic regulatory
actions.
4. Major underlying factors to the current situation were, among others, inconsistent
and insufficiently coordinated macroeconomic policies, inadequate structural
reforms, which led to unsustainable global macroeconomic outcomes. These
developments, together, contributed to excesses and ultimately resulted in severe
market disruption.
ACTIONS TAKEN AND TO BE TAKEN
5. We have taken strong and significant actions to date to stimulate our economies,
provide liquidity, strengthen the capital of financial institutions, protect savings and
deposits, address regulatory deficiencies, unfreeze credit markets, and are working
to ensure that international financial institutions (IFIs) can provide critical support
for the global economy.
6. But more needs to be done to stabilize financial markets and support economic
growth. Economic momentum is slowing substantially in major economies and the
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global outlook has weakened. Many emerging market economies, which helped
sustain the world economy this decade, are still experiencing good growth but
increasingly are being adversely impacted by the worldwide slowdown.
7. Against this background of deteriorating economic conditions worldwide, we
agreed that a broader policy response is needed, based on closer macroeconomic
cooperation, to restore growth, avoid negative spillovers and support emerging
market economies and developing countries. As immediate steps to achieve these
objectives, as well as to address longer-term challenges, we will:
! Continue our vigorous efforts and take whatever further actions are
necessary to stabilize the financial system.
! Recognize the importance of monetary policy support, as deemed
appropriate to domestic conditions.
! Use fiscal measures to stimulate domestic demand to rapid effect, as
appropriate, while maintaining a policy framework conducive to
fiscal sustainability.
! Help emerging and developing economies gain access to finance in
current difficult financial conditions, including through liquidity
facilities and program support. We stress the International Monetary
Fund’s (IMF) important role in crisis response, welcome its new
short-term liquidity facility, and urge the ongoing review of its
instruments and facilities to ensure flexibility.
! Encourage the World Bank and other multilateral development
banks (MDBs) to use their full capacity in support of their
development agenda, and we welcome the recent introduction of
new facilities by the World Bank in the areas of infrastructure and
trade finance.
! Ensure that the IMF, World Bank and other MDBs have sufficient
resources to continue playing their role in overcoming the crisis.
COMMON PRINCIPLES FOR REFORM OF FINANCIAL MARKETS
8. In addition to the actions taken above, we will implement reforms that will
strengthen financial markets and regulatory regimes so as to avoid future crises.
Regulation is first and foremost the responsibility of national regulators who
constitute the first line of defense against market instability. However, our financial
markets are global in scope, therefore, intensified international cooperation among
regulators and strengthening of international standards, where necessary, and their
consistent implementation is necessary to protect against adverse cross-border,
regional and global developments affecting international financial stability.
Regulators must ensure that their actions support market discipline, avoid potentially
adverse impacts on other countries, including regulatory arbitrage, and support
competition, dynamism and innovation in the marketplace. Financial institutions
must also bear their responsibility for the turmoil and should do their part to
overcome it including by recognizing losses, improving disclosure and strengthening
their governance and risk management practices.
9. We commit to implementing policies consistent with the following common
principles for reform.
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! Strengthening Transparency and Accountability: We will strengthen
financial market transparency, including by enhancing required
disclosure on complex financial products and ensuring complete and
accurate disclosure by firms of their financial conditions. Incentives
should be aligned to avoid excessive risk-taking.
! Enhancing Sound Regulation: We pledge to strengthen our
regulatory regimes, prudential oversight, and risk management, and
ensure that all financial markets, products and participants are
regulated or subject to oversight, as appropriate to their
circumstances. We will exercise strong oversight over credit rating
agencies, consistent with the agreed and strengthened international
code of conduct. We will also make regulatory regimes more
effective over the economic cycle, while ensuring that regulation is
efficient, does not stifle innovation, and encourages expanded trade
in financial products and services. We commit to transparent
assessments of our national regulatory systems.
! Promoting Integrity in Financial Markets: We commit to protect the
integrity of the world’s financial markets by bolstering investor and
consumer protection, avoiding conflicts of interest, preventing
illegal market manipulation, fraudulent activities and abuse, and
protecting against illicit finance risks arising from non-cooperative
jurisdictions. We will also promote information sharing, including
with respect to jurisdictions that have yet to commit to international
standards with respect to bank secrecy and transparency.
! Reinforcing International Cooperation: We call upon our national
and regional regulators to formulate their regulations and other
measures in a consistent manner. Regulators should enhance their
coordination and cooperation across all segments of financial
markets, including with respect to cross-border capital flows.
Regulators and other relevant authorities as a matter of priority
should strengthen cooperation on crisis prevention, management,
and resolution.
! Reforming International Financial Institutions: We are committed to
advancing the reform of the Bretton Woods Institutions so that they
can more adequately reflect changing economic weights in the world
economy in order to increase their legitimacy and effectiveness. In
this respect, emerging and developing economies, including the
poorest countries, should have greater voice and representation. The
Financial Stability Forum (FSF) must expand urgently to a broader
membership of emerging economies, and other major standard
setting bodies should promptly review their membership. The IMF,
in collaboration with the expanded FSF and other bodies, should
work to better identify vulnerabilities, anticipate potential stresses,
and act swiftly to play a key role in crisis response.
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TASKING OF MINISTERS AND EXPERTS
10. We are committed to taking rapid action to implement these principles. We
instruct our Finance Ministers, as coordinated by their 2009 G-20 leadership (Brazil,
UK, Republic of Korea), to initiate processes and a timeline to do so. An initial list
of specific measures is set forth in the attached Action Plan, including high priority
actions to be completed prior to March 31, 2009.
In consultation with other economies and existing bodies, drawing upon the
recommendations of such eminent independent experts as they may appoint, we
request our Finance Ministers to formulate additional recommendations, including
in the following specific areas:
! Mitigating against pro-cyclicality in regulatory policy;
! Reviewing and aligning global accounting standards, particularly for
complex securities in times of stress;
! Strengthening the resilience and transparency of credit derivatives
markets and reducing their systemic risks, including by improving
the infrastructure of over-the-counter markets;
! Reviewing compensation practices as they relate to incentives for
risk taking and innovation;
! Reviewing the mandates, governance, and resource requirements of
the IFIs; and
! Defining the scope of systemically important institutions and
determining their appropriate regulation or oversight.
11. In view of the role of the G-20 in financial systems reform, we will meet again
by April 30, 2009, to review the implementation of the principles and decisions
agreed today.
COMMITMENT TO AN OPEN GLOBAL ECONOMY
12. We recognize that these reforms will only be successful if grounded in a
commitment to free market principles, including the rule of law, respect for private
property, open trade and investment, competitive markets, and efficient, effectively
regulated financial systems. These principles are essential to economic growth and
prosperity and have lifted millions out of poverty, and have significantly raised the
global standard of living. Recognizing the necessity to improve financial sector
regulation, we must avoid over-regulation that would hamper economic growth and
exacerbate the contraction of capital flows, including to developing countries.
13. We underscore the critical importance of rejecting protectionism and not turning
inward in times of financial uncertainty. In this regard, within the next 12 months, we
will refrain from raising new barriers to investment or to trade in goods and services,
imposing new export restrictions, or implementing World Trade Organization
(WTO) inconsistent measures to stimulate exports. Further, we shall strive to reach
agreement this year on modalities that leads to a successful conclusion to the WTO’s
Doha Development Agenda with an ambitious and balanced outcome. We instruct
our Trade Ministers to achieve this objective and stand ready to assist directly, as
necessary. We also agree that our countries have the largest stake in the global
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trading system and therefore each must make the positive contributions necessary to
achieve such an outcome.
14. We are mindful of the impact of the current crisis on developing countries,
particularly the most vulnerable. We reaffirm the importance of the Millennium
Development Goals, the development assistance commitments we have made, and
urge both developed and emerging economies to undertake commitments consistent
with their capacities and roles in the global economy. In this regard, we reaffirm the
development principles agreed at the 2002 United Nations Conference on Financing
for Development in Monterrey, Mexico, which emphasized country ownership and
mobilizing all sources of financing for development.
15. We remain committed to addressing other critical challenges such as energy
security and climate change, food security, the rule of law, and the fight against
terrorism, poverty and disease.
16. As we move forward, we are confident that through continued partnership,
cooperation, and multilateralism, we will overcome the challenges before us and
restore stability and prosperity to the world economy.
ACTION PLAN TO IMPLEMENT PRINCIPLES FOR REFORM
This Action Plan sets forth a comprehensive work plan to implement the five agreed
principles for reform. Our finance ministers will work to ensure that the taskings set
forth in this Action Plan are fully and vigorously implemented. They are responsible
for the development and implementation of these recommendations drawing on the
ongoing work of relevant bodies, including the International Monetary Fund (IMF),
an expanded Financial Stability Forum (FSF), and standard setting bodies.
Strengthening Transparency and Accountability
Immediate Actions by March 31, 2009
! The key global accounting standards bodies should work to enhance
guidance for valuation of securities, also taking into account the
valuation of complex, illiquid products, especially during times of
stress.
! Accounting standard setters should significantly advance their work
to address weaknesses in accounting and disclosure standards for
off-balance sheet vehicles.
! Regulators and accounting standard setters should enhance the
required disclosure of complex financial instruments by firms to
market participants.
! With a view toward promoting financial stability, the governance of
the international accounting standard setting body should be further
enhanced, including by undertaking a review of its membership, in
particular in order to ensure transparency, accountability, and an
appropriate relationship between this independent body and the
relevant authorities.
! Private sector bodies that have already developed best practices for
private pools of capital and/or hedge funds should bring forward
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proposals for a set of unified best practices. Finance Ministers
should assess the adequacy of these proposals, drawing upon the
analysis of regulators, the expanded FSF, and other relevant bodies.
Medium-term actions
! The key global accounting standards bodies should work intensively
toward the objective of creating a single high-quality global
standard.
! Regulators, supervisors, and accounting standard setters, as
appropriate, should work with each other and the private sector on
an ongoing basis to ensure consistent application and enforcement
of high-quality accounting standards.
! Financial institutions should provide enhanced risk disclosures in
their reporting and disclose all losses on an ongoing basis, consistent
with international best practice, as appropriate. Regulators should
work to ensure that a financial institution’ financial statements
include a complete, accurate, and timely picture of the firm’s
activities (including off-balance sheet activities) and are reported on
a consistent and regular basis.
Enhancing Sound Regulation
Regulatory Regimes
Immediate Actions by March 31, 2009
! The IMF, expanded FSF, and other regulators and bodies should
develop recommendations to mitigate pro-cyclicality, including the
review of how valuation and leverage, bank capital, executive
compensation, and provisioning practices may exacerbate cyclical
trends.
Medium-term actions
! To the extent countries or regions have not already done so, each
country or region pledges to review and report on the structure and
principles of its regulatory system to ensure it is compatible with a
modern and increasingly globalized financial system. To this end, all
G-20 members commit to undertake a Financial Sector Assessment
Program (FSAP) report and support the transparent assessments of
countries’ national regulatory systems.
! The appropriate bodies should review the differentiated nature of
regulation in the banking, securities, and insurance sectors and
provide a report outlining the issue and making recommendations on
needed improvements. A review of the scope of financial regulation,
with a special emphasis on institutions, instruments, and markets
that are currently unregulated, along with ensuring that all
systemically-important institutions are appropriately regulated,
should also be undertaken.
! National and regional authorities should review resolution regimes
and bankruptcy laws in light of recent experience to ensure that they
permit an orderly wind-down of large complex cross-border
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financial institutions. * Definitions of capital should be harmonized
in order to achieve consistent measures of capital and capital
adequacy.
Prudential Oversight
Immediate Actions by March 31, 2009
! Regulators should take steps to ensure that credit rating agencies
meet the highest standards of the international organization of
securities regulators and that they avoid conflicts of interest, provide
greater disclosure to investors and to issuers, and differentiate
ratings for complex products. This will help ensure that credit rating
agencies have the right incentives and appropriate oversight to
enable them to perform their important role in providing unbiased
information and assessments to markets.
! The international organization of securities regulators should review
credit rating agencies’ adoption of the standards and mechanisms for
monitoring compliance.
! Authorities should ensure that financial institutions maintain
adequate capital in amounts necessary to sustain confidence.
International standard setters should set out strengthened capital
requirements for banks’ structured credit and securitization
activities.
! Supervisors and regulators, building on the imminent launch of
central counterparty services for credit default swaps (CDS) in some
countries, should: speed efforts to reduce the systemic risks of CDS
and over-the-counter (OTC) derivatives transactions; insist that
market participants support exchange traded or electronic trading
platforms for CDS contracts; expand OTC derivatives market
transparency; and ensure that the infrastructure for OTC derivatives
can support growing volumes.
Medium-term actions
! Credit Ratings Agencies that provide public ratings should be
registered.
! Supervisors and central banks should develop robust and
internationally consistent approaches for liquidity supervision of,
and central bank liquidity operations for, cross-border banks.
Risk Management
Immediate Actions by March 31, 2009
! Regulators should develop enhanced guidance to strengthen banks’
risk management practices, in line with international best practices,
and should encourage financial firms to reexamine their internal
controls and implement strengthened policies for sound risk
management.
! Regulators should develop and implement procedures to ensure that
financial firms implement policies to better manage liquidity risk,
including by creating strong liquidity cushions.
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! Supervisors should ensure that financial firms develop processes that
provide for timely and comprehensive measurement of risk
concentrations and large counterparty risk positions across products
and geographies.
! Firms should reassess their risk management models to guard
against stress and report to supervisors on their efforts.
! The Basel Committee should study the need for and help develop
firms’ new stress testing models, as appropriate.
! Financial institutions should have clear internal incentives to
promote stability, and action needs to be taken, through voluntary
effort or regulatory action, to avoid compensation schemes which
reward excessive short-term returns or risk taking.
! Banks should exercise effective risk management and due diligence
over structured products and securitization.
Medium -term actions
! International standard setting bodies, working with a broad range of
economies and other appropriate bodies, should ensure that
regulatory policy makers are aware and able to respond rapidly to
evolution and innovation in financial markets and products.
! Authorities should monitor substantial changes in asset prices and
their implications for the macroeconomy and the financial system.
Promoting Integrity in Financial Markets
Immediate Actions by March 31, 2009
! Our national and regional authorities should work together to
enhance regulatory cooperation between jurisdictions on a regional
and international level.
! National and regional authorities should work to promote
information sharing about domestic and cross-border threats to
market stability and ensure that national (or regional, where
applicable) legal provisions are adequate to address these threats.
! National and regional authorities should also review business
conduct rules to protect markets and investors, especially against
market manipulation and fraud and strengthen their cross-border
cooperation to protect the international financial system from illicit
actors. In case of misconduct, there should be an appropriate
sanctions regime.
Medium-term actions
! National and regional authorities should implement national and
international measures that protect the global financial system from
uncooperative and non-transparent jurisdictions that pose risks of
illicit financial activity.
! The Financial Action Task Force should continue its important work
against money laundering and terrorist financing, and we support the
efforts of the World Bank - UN Stolen Asset Recovery (StAR)
Initiative.
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! Tax authorities, drawing upon the work of relevant bodies such as
the Organization for Economic Cooperation and Development
(OECD), should continue efforts to promote tax information
exchange. Lack of transparency and a failure to exchange tax
information should be vigorously addressed.
Reinforcing International Cooperation
Immediate Actions by March 31, 2009
! Supervisors should collaborate to establish supervisory colleges for
all major cross-border financial institutions, as part of efforts to
strengthen the surveillance of cross-border firms. Major global banks
should meet regularly with their supervisory college for
comprehensive discussions of the firm’s activities and assessment of
the risks it faces.
! Regulators should take all steps necessary to strengthen cross-border
crisis management arrangements, including on cooperation and
communication with each other and with appropriate authorities, and
develop comprehensive contact lists and conduct simulation
exercises, as appropriate.
Medium -term actions
! Authorities, drawing especially on the work of regulators, should
collect information on areas where convergence in regulatory
practices such as accounting standards, auditing, and deposit
insurance is making progress, is in need of accelerated progress, or
where there may be potential for progress.
! Authorities should ensure that temporary measures to restore
stability and confidence have minimal distortions and are unwound
in a timely, well-sequenced and coordinated manner.
Reforming International Financial Institutions
Immediate Actions by March 31, 2009
! The FSF should expand to a broader membership of emerging
economies.
! The IMF, with its focus on surveillance, and the expanded FSF, with
its focus on standard setting, should strengthen their collaboration,
enhancing efforts to better integrate regulatory and supervisory
responses into the macro-prudential policy framework and conduct
early warning exercises.
! The IMF, given its universal membership and core macro-financial
expertise, should, in close coordination with the FSF and others, take
a leading role in drawing lessons from the current crisis, consistent
with its mandate.
! We should review the adequacy of the resources of the IMF, the
World Bank Group and other multilateral development banks and
stand ready to increase them where necessary. The IFIs should also
continue to review and adapt their lending instruments to adequately
CRS-84
meet their members’ needs and revise their lending role in the light
of the ongoing financial crisis.
! We should explore ways to restore emerging and developing
countries’ access to credit and resume private capital flows which
are critical for sustainable growth and development, including
ongoing infrastructure investment.
! In cases where severe market disruptions have limited access to the
necessary financing for counter-cyclical fiscal policies, multilateral
development banks must ensure arrangements are in place to
support, as needed, those countries with a good track record and
sound policies.
Medium-term actions
! We underscored that the Bretton Woods Institutions must be
comprehensively reformed so that they can more adequately reflect
changing economic weights in the world economy and be more
responsive to future challenges. Emerging and developing
economies should have greater voice and representation in these
institutions.
! The IMF should conduct vigorous and even-handed surveillance
reviews of all countries, as well as giving greater attention to their
financial sectors and better integrating the reviews with the joint
IMF/World Bank financial sector assessment programs. On this
basis, the role of the IMF in providing macro-financial policy advice
would be strengthened.
! Advanced economies, the IMF, and other international organizations
should provide capacity-building programs for emerging market
economies and developing countries on the formulation and the
implementation of new major regulations, consistent with
international standards.
Source: [http://www.whitehouse.gov/news/releases/2008/11/20081115-1.html].