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Way back in 2000, the Per Jacobsson Foundation organized
a panel discussion on "Strengthening the Resilience
of Financial Systems" at the Lucerene Culture and Convention
Center in Switzerland, in which Arminio Fraga, Governor
of the Central Bank of Brazil, made a set of very interesting
observations. First and foremost is: "If one looks
back at the history of international debt crisis, certain
regularities emerge." To prove his point he cited a
few instances: one, the Latin American debt crisis of the
1980s—too much borrowing to finance government budget
deficits; two, Mexico crisis of the 1990s—too much
borrowing to finance consumption; and three, the more recent
Asian crisis—too much borrowing to finance investment,
whereunder, somewhere along the line all these countries
ended up with the problem of weak balance sheets—too
much of short-term debt, which he termed stock stories,
rather than flow stories. He proposed two reasons for such
weak balance sheets: one, weak macroeconomic regimes; and
two, a weak banking environment and a weak corporate governance
environment. Then he went on to proclaim that even if we
"succeed in strengthening macroeconomic regimes, banking
structures, and capital markets, crisis will always happen"
because "markets adjust their risk- taking to the riskiness
of the environment." For instance, when the overall
business conditions are deemed safer, more leverage will
become the business norm.
Ironically, these remarks that Arminio Fraga made, keeping
in view the financial instability noticed in developing
economies, now appear to be well applicable to the credit
crisis emanating from the US home loans, particularly the
failure of century-old investment banks of the Wall Street.
Looking at the failure of Bear Stearns, Lehman Brothers,
and Merrill Lynch, one wonders if the long period of rapid
growth, low inflation, low interest rates, and macroeconomic
stability made these so-called specialized investment banks,
which claim to have had sophisticated risk-management techniques,
to take more risk with little or no awareness thereof. Weak
regulation, which is often ascribed to the developing world
as a ground for their financial failures, appears to have
drowned the icons of the American capitalism in the form
of too much reliance on free markets, which simply encouraged
free play with securitization, off-balance sheet financing,
and what not in the name of innovation. All this led to
`over-leveraging'—to stratospheric heights—that
has ironically transformed the stability in the global financial
market into instability.
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