The current financial crisis was not an independent force, but originated from the distortions and incentives created by past policy actions compromising the credit system

At a recent Reserve Bank of Australia conference on the current financial turmoil, this paper explained the current financial crisis as being caused at two levels: (a) by global macro policies affecting liquidity, and (b) by a very poor regulatory framework that, far from acting as a second line of defence, actually contributed to the crisis in important ways.

The policies affecting liquidity created a situation like a dam overfilled with flooding water. Interest rates at one per cent in the United States and zero per cent in Japan, China's fixed exchange rate, the accumulation of reserves in Sovereign Wealth Funds, all helped to fill the liquidity reservoir to overflowing.
The overflow got the asset bubbles and excess leverage under way. But the faults in the dam - namely the regulatory system - started from about 2004 to direct the water more forcefully into some very specific areas: mortgage securitisation and off-balance sheet activity. The pressure became so great that the dam finally broke, and the damage has already been enormous.

The table below shows the veritable explosion in residential mortgage-backed securities (RMBS) after 2004. As this class of assets was in the vortex of the crisis, any theory of causality must explain why it happened then and not at some other time.

Many of the reforms now under way focus on securitisation, credit rating agencies, poor risk modelling and underwriting standards, as well as corporate governance lapses, among others.

Time-specific catalysts
But for the most part these are only aspects of the financial system that accommodated a new banking business model in its drive to benefit from the incentives that had been created over time, and were unleashed by time-specific catalysts.

In 2004 four time-specific factors came into play:

(i) the Bush Administration 'American Dream' zero equity mortgage proposals became operative, helping low-income families to obtain mortgages;

(ii) the then regulator of Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight (OFHEO), imposed greater capital requirements and balance sheet controls on those two government-sponsored mortgage securitisation monoliths, opening the way for banks to move in on their 'patch' with plenty of low-income mortgages coming on-stream;

(iii) the Basel II accord on international bank regulation was published and opened an arbitrage opportunity for banks that caused them to accelerate off-balance-sheet activity;

(iv) the SEC agreed to allow investment banks (IBs) voluntarily to benefit from regulation changes to manage their risk using capital calculations under the 'consolidated supervised entities program'. (Prior to 2004 broker dealers were supervised by stringent rules allowing a 15:1 debt to net equity ratio. Under the new scheme investment banks could agree voluntarily to SEC consolidated oversight (not just broker dealer activities), but with less stringent rules that allowed them to increase their leverage ratio towards 40:1 in some cases.)

The combination of these four changes in 2004 caused the banks to accelerate off-balance sheet mortgage securitisation as a key avenue to drive the revenue and the share price of banks.

When OFHEO imposed greater capital requirements and balance sheet controls on Fannie and Freddie, banks that had been selling mortgages to them faced revenue gaps and an interruption to their earnings.

Their solution was to create their own Fannie and Freddie look-alikes: the structured investment vehicles (SIVs) and collateralised debt obligation (CDOs). This new surge of RMBS caused by the Fannie-Freddie regulator was picked up much too late by bank regulators to take effective action.

The business model for banks moved towards an equity culture, with a focus on faster share price growth and earnings expansion during the 1990s. The previous model, based on balance sheets and old-fashioned spreads on loans, was not conducive to banks becoming 'growth stocks'.

So, the strategy switched more towards activity based on trading income and fees via securitisation, which enabled banks to grow earnings while at the same time economising on capital by 'gaming' the Basel system.

Seen this way, the 'originate-to-distribute' model and the securitisation process is not about risk spreading; rather it is a key part of the process to drive revenue, the return on capital and the share price higher.

In order for executives and sales at all levels to capture the benefits of this business model, compensation, too, had to evolve.

Bonuses based on up-front revenue generation rose relative to salary, and substantial option and employee share participation schemes became the norm. This was argued to be in shareholders' interest - the common philosophy being that: "if you pay peanuts you get monkeys".

This business model based on securitisation was most easily executed by an IB - so integral to the process of securitisation and capital market sales.

In Europe universal banks such as UBS and Deutsche Bank already had this advantage (a part of the point being made by US lobbyists with respect to: the Glass-Steagall Act; the SEC rules for IBs that were too restrictive compared to Europe; and the competitive 'unfairness' of the FDIC Act of 1991 that required US banks to adhere to a leverage ratio).

For these reasons US banks and/or IBs strongly supported and lobbied the US authorities first to remove Glass-Steagall in 1999, move to new SEC rules in 2004; and to adopt Basel II as soon as possible.

When Basel II was published in 2004, banks were informed that the capital weight given to mortgages would fall from 50 per cent (under Basel I) to 35 per cent under the simplified Basel II, and to as little as 15-20 per cent depending on whether and how a bank would use the sophisticated internal ratings-based (IRB) version.

A lower capital weight raises the return on capital for a given mortgage asset, and the corollary of this is that greater concentration in low-capital-weighted mortgages improves the overall bank return.

One of the 'gob-smacking' assumptions of basic capital regulation under the Basel system is something called 'portfolio invariance'. In simple terms, the riskiness of an asset like a mortgage is independent of how much of the asset is added to the portfolio.

Banks appear to have believed this, judging by the way they responded to the arbitrage opportunity that arose in the transition from Basel I to II. If mortgage securitisation could be accelerated and pushed into off-balance sheet vehicles, banks could raise the return on capital right away without waiting for the new regime.

It would be quite rational to do this to the point where the proportion of on-balance sheet mortgages (with a 50 per cent capital weight) and off-balance sheet mortgages (with a zero capital weight) equated the (higher) return likely to emerge for a Basel II mortgage (where capital weightings would apply regardless of whether assets were on or off the balance sheet). Citi was a perfect example of this phenomenon.

In the period in which Basel II was anticipated and arbitraged (as in the Citi example) and the Fannie and Freddie controls were in play, banks were able to accelerate RMBS using lower-quality mortgages (and supported by 'American Dream' policies) by some $1.3 trillion (about Dh4.8 trillion). Much of the problems now known as the 'sub-prime crisis' can be traced to these securities.

The incentives created by these factors proved to be too strong a temptation for the bank business model to ignore.

Most of the early disasters in the crisis occurred where investment banks were involved - either separately or as a part of a diversified financial institution: Bear Stearns, Merrill Lynch, Lehmans, Citi, UBS and AIG (via its investment bank subsidiary AIG Financial Products that had CDS losses on a massive scale), were all prominent in this respect.

The push to keep fee income from securitisation of (low-capital-charge) mortgages as a key source of earnings growth necessitated moving further and further into low-quality mortgages, and the issuance of RMBS based on them, that would prove increasingly 'toxic' in the levered vehicles and bank balance sheets into which they were thrust.

Other countries' (such as Switzerland's, Germany's and the UK's) investment banks took up similar activities - often to keep market share, or because the incentive to improve returns by gaming the Basel process was too strong.

But many countries would be drawn into the crisis in other ways as their banks expanded off-balance-sheet activity, rapidly expanded use of wholesale funding to anticipate more profitable mortgages under Basel II (as in the case of Northern Rock), invested in the products created, copied strategies in efforts to hold market share, or became involved as counterparties with banks at risk (for example in credit default swap transactions).

Liquidity problems, whereby bank liabilities were not matched to the duration of their assets as they grew mortgage products with Basel II anticipation in mind, are well illustrated by Northern Rock in the UK.

Mortgages products had been made so attractive by IRB adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by deposits.

Northern Rock grew assets at a rate of over 25 per cent per annum in the few years preceding the collapse, funded by borrowing heavily in wholesale markets and concentrating assets in mortgage products (75 per cent of assets) which would reduce their capital requirement as their Basel II application came into force.

UBS management saw Citi and others rapidly growing their fixed-income business in investment banking through securitisation. An external consultant pointed out that of all the businesses, fixed-income was the area where the UBS investment bank lagged the three leading competitors the most.

The three biggest players in fixed-income revenue in 2005 and 2006 were Goldman Sachs, Citigroup, and Deutsche Bank. Their numbers were presented by the UBS head of Fixed Income in March 2007 as the 'gap' that had to be closed.

UBS developed a 'me-too' strategy - a 'growth-at-any-cost' mentality - at exactly the wrong time from a macro-prudential risk perspective.

This is classic investment banking - from the Latin American Debt crisis to sub-prime, the modern bankers continue a long tradition. Market share, revenue gaps and beating the key competition is the topic of every morning meeting at all levels in the bank, and for senior management it can be a question of holding your job.

The corporate governance and risk control functions in many firms will adjust to accommodate strategy when an equity culture is mixed in with a banking credit culture. In UBS departing top risk managers were replaced by people from a sales background (consistent with growth) not a risk management background.

The transition to Basel II, and the strategy to cope with problems such as the Fannie and Freddie mortgage-buying halt and the use of lower-quality mortgages to fill the gap, placed the survival of banks at risk. The boardroom in many cases was found wanting.

This article is an abbreviated version of a paper appearing in the OECD publication Financial Market Trends, 2008.

The authors are respectively Deputy Director of the OECD Directorate for Financial and Enterprise Affairs, Senior Research Fellow at Groupe d'Economie Mondiale de Sciences Po, Paris, and Financial Markets Analyst in the Financial Affairs Division of the OECD Directorate for Financial and Enterprise Affairs. The views are those of the authors and do not necessarily reflect those of the OECD.