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Ritsumeikan Asia Pacific University

Accounting & Finance Department

Internship Report

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Bank Al-Maghrib Economics and International Relations Director

Monetary Studies Department

1 The two slogans used in the cover above are under the sole intellectual property of the Ritsumeikan Asia Pacific University and Bank Al-Maghrib respectively.

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i. Acknowledgement My gratefulness goes to my parents who have unreservedly been the greatest supporter of me. Without their unconditional love, encouragement and backup, I would not be the person writing those words.

I would like first and foremost express my respect and sincere gratitude to Dr. SUZUKI Yasushi –my supervisor, who haven’t spared no efforts in assisting with what I need in the scope of what he can. His constructive criticism and substantial suggestions were played always considerable role in improving my academic performances. Mr. HOSSAINI and Mr. AL-ALAMI at the director who have showed sincere cooperativeness and extreme professionalism.

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ii. Table of Contents

i. Acknowledgement…………………………………………………..02

ii. Table of Content……………………………………………………03

iii. List of Abbreviations……………………………………….……..04

iv. Abstract……………………………………………………………..05

1. Background of the global financial crisis……………………….06

1.1. Financial deregulation in the United States……………...06

1.2. Excessive leveraged financial institutions……………..….07

1.3. Financial innovation………………………………………….07

1.4. Conflict of interest…………………………………………….08

1.5. Impact on world economy…………………………………….08

2. Pre-crisis central banking policy instruments…………………10

2.1. Interest rates…………………………………………………..11

2.2. Conventional monetary policy tools………………………..11

3. Post-crisis central banking policy instruments………………..11

3.1. Seventeenth century writings on crisis contexts………….11

4. Conclusion…………………………………………………………..17

v. Bibliography………………………………………………………...18

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iii. List of Abbreviations BAM Bank Al-Maghrib CCP Central Counterparty Clearing House CDG Deposit and Management Fund of Morocco CFTC Commodity Futures Trading Commission CPC Cash Processing Centers CPSS Committee On Payment and Settlement Systems CSA Central Settlement Account DMCA Deregulation and Monetary Control Act ECB European Central Bank FDI Foreign Direct Investment FED Federal Reserve Bank FIFO First-In, First-Out FMI Financial Market Infrastructure GCC Gulf Cooperation Council GDP Gross Domestic Product IMF International Monetary Fund MENA Middle East and North Africa NEC National Economic Council OICV International Organization of Securities Commissions PER Price-Earnings Ratio RBI Reserve Bank of India SMES Small and Medium-Sized Enterprises TB Treasury Bonds VA Value Added VAT Value Added Tax VSES Very Small Enterprises VSMES Very Small, Small and Medium Sized Enterprises WBG World Bank Group

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iv. Abstract Purpose – This report seeks to analyze the central banks’ monetary policy decision-making prior and post 21st century’s global financial crisis. Orthodoxly, the central banking model features several conventional instruments used to control the money supply and maintain price stability. A sustained path of financial deregulation since the 1980s in the United States led to a burst by subprime mortgages Ponzi-scheme, causing the deepest financial crisis since the great depression. Design/methodology/approach – We will try to reach the purpose above by analogously looking at central banks’ decisions concerning the prongs of monetary and fiscal policy, before and after the financial crisis. We will review the balance sheets of major world central banks namely the ECB, the Fed and the BoJ from one side, and Findings – The global financial crisis has proved that there is a huge space for improvement in the central banking practice. One of the main challenges of the crisis is an effective formulation and management of the monetary policy expectations. Without effective management of expectations and creating an adequate pace for rational decision-making, it is impossible to reach objectives of the Central Banks. Practical implications – This work will provide an understanding framework about the turmoil that started in summer 2007, when central banks worldwide stepped in to provide additional liquidity to financial markets. It appeared that conventional measures could still do the job which means that easing monetary policy by simply lowering official interest rates would not have been enough. Keywords – Monetary policy, financial crisis, conventional & unconventional instruments. JEL classifications – E52, E58, E59 and G01. Paper type – field research report.

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1. Background of the global financial crisis 1.1. The history of financial deregulation in the United States

The current financial crisis that have burst in the United States is not the result of today, it resulted from a series of accumulated measures that began by deregulation since the 1980s. Those measures featured actions that would grant the banking system an ideal environment to grow massively and make enormous gains. Since the time of A. Greenspan, chairman of the Federal Reserve, financial deregulation started by passing the DMCA, an act to facilitate the implementation of monetary policy, to provide for the gradual elimination of all limitations on the rates of interest which are payable on deposits and accounts, and to authorize interest-bearing transaction accounts, and for other purposes. Although this act gave greater control of the Fed over non-member banks, it allowed institutions to charge any loan interest rates they chose, allowed banks to merge and removed the power of the Glass–Steagall act to use regulation Q against a maximum interests’ rates for any deposit accounts.

Figure 1. Timeline of financial deregulation key events

Source: Sherman, 2009.

1980 • Complete phase-out of interest rate ceilings on deposit accounts

1982• Allowing commercial lending, providing for a new account to compete with

money market funds

1994 • Eliminating previous restrictions on interstate banking and branching

1996• Reinterpretation of Glass-Steagall Act allowing banks holding companies

to earn up to 25% revevenues in Investment Banking.

1999• Complete repeal of Glass-Steagall Act.• L. Summers endorsing the Gramm-Leach-Bliley act

2000• Preventing the CFTC from regulating most OTC derivative contracts:

Futures, CDS and Options

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In this context, it is important to highlight that at the time of independence, all states set maximum limits for loan interest rates at no more than 8 percent per annum. After independence, the Uniform Small Loan Law, passed in 1916, permitted regulated lenders to charge between 24 and 42 percent interest per annum (Peterson & Christopher, 2008) allowing many businesses to operate profitably in the small loan market. Among the key events cited in the timeline above, the act passed in 2000 about which Dr. L. Summers2 explicitly stated “the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.” 3 , has removed the separation between investment and commercial banks. On April 18, 2010, in an interview on ABC's "This Week" program, former president Clinton said that Dr. Summers was wrong in the advice he gave him not to regulate derivatives.

1.2. Excessive leveraged financial institutions Leverage is considered to be the second root of the global financial crisis after deregulation. It is the practice of borrowing money to make an investment. Usually leverage is at the center of all banking crises, it is a practice embedding borrowed funds in off-balance-sheets instruments such as derivatives which were unregulated. There is no clear-cut accounting mechanism for leverage, a fact that makes it complex for legislators to define in law regulated practices of leverage. That aside, imposing higher capital requirements described in the Basel III Accord, is the only solution.

1.3. Financial innovation

2 Larry H. Summers, former president of Harvard University, 71st secretary of Treasury and current director of the National Economic Council. 3 Statement on July 30, 1998, by Dr. Summers, then deputy secretary of the Treasury testifying before the U.S. Congress.

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The 3rd pivotal root of the current global financial crisis is the financial innovation that spread across the world since the 1990s following the end of the cold war. Scientists have dedicated their efforts in order to create and innovate new financial models/products4 that would be more profitable and risk sharing. Not to forget the recent innovations in technology, risk transfer, debt restructuring and credit & equity generation. In this context, it is important to highlight the controversial debate stating if the financial innovation have made financial markets riskier or not. A notorious paper published by (R. Raghuram, 2005) –then chief economist at the IMF, and presented at the 2005 annual meeting of the Jackson Hole symposium have concluded that it does not.

1.4. Conflict of interest It has been observed how several policy and decision making figures, have been influenced by wall street beginning the 21st century. L. H. Summers, T. Geithner, Mishkin and others who have been previous “old school” bankers have received enormous amounts of bonuses from investment banks in the hope of a less regulated financial market. I will conclude this section with the quote of Philippe Angelides, chairman of the Financial Crisis Inquiry Commission, following investigations on the global financial crisis. “We conclude first and foremost that the crisis was avoidable”.

1.5. Impact on world economy As shown in the Figure 2. below, and following the collapse of Lehman Brothers the GDP growth rate in the Euro area has proven to be negative beginning the 4th quarter of 2008. The Euro area GDP have contracted significantly reached unrecorded low levels of -5%.

4 OTC and exchange-traded derivatives (Swaps, options, forwards)

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Figure 2A. Annual GDP growth rates in the Euro area, 1996-2012

Source: ECB, 2012. Figure 2B. Annual Inflation rate in the Euro area, 1991-2012

Source: ECB, 2012. Adding up a peak in high inflation, measured by the harmonized consumer price inflation index (HICP) triggered by an oil price shock in 2008, inflation

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rates came down rapidly during the short recession in the overall Euro area. However, worries of a major deflationary development which occurred in 2009. Inflation accelerated afterwards peaked at the end of 2011 and is approaching the 2 percent target range of the ECB again. But since inflation is decelerating in the whole Euro area in 2009 and the economy is falling into recession a more expansionary monetary policy would suffice. What makes the situation more complicated are the internal imbalances of the Euro area countries. Furthermore, monetary policy has exhausted its possibilities to drive down the nominal interest rate. It needs to provide more stimuli beyond the liquidity trap boundary. In this context (G. Erber, 2012) argues that the ECB could have conducted its monetary policy under a homogenous economic framework condition following the Taylor-Rule-approach to monetary policy (J. Taylor, 1993).

2. Pre-crisis central banking policy instruments Extending a standard New Keynesian model both to incorporate

heterogeneity in spending opportunities along with two sources of (potentially time-varying) credit spreads and to allow a role for the central bank’s balance sheet in determining equilibrium. We use the model made by the Federal Reserve in the United States (Cúrdia & Woodford, 2009) to investigate the implications of imperfect financial intermediation for familiar monetary policy prescriptions and to consider additional dimensions of central bank policy―variations in the size and composition of the central bank’s balance sheet as well as payment of interest on reserves―alongside the traditional question of the proper operating target for an overnight policy rate.

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2.1. Interest rates In our model, the central bank’s liabilities consist of the reserves Mt (which also constitute the monetary base), on which it pays interest at the rate im . These liabilities in turn fund the central bank’s holdings of government debt, and any lending by the central bank to type b households. We let Lcb denote the real quantity of lending by the central bank to the private sector; the central bank’s holdings of government debt are then given by the residual mt − Lcb. We can treat mt (or Mt) and Lcb t as the bank’s choice variables, subject to the constraints

0 ≤ Lcb ≤ mt. (Equation 1) It is also necessary that the central bank’s choices of these two variables satisfy the bound

mt < Lcb + bg (Equation 2) where bg is the total outstanding real public debt, so that a positive quantity of public debt remains in the portfolios of households.

Figure 3. Central Bank roles & policy tools Table 1

Conventional Monetary policy tools Prudential policy tools - Focus on prices; - Indirect approach to influencing financial conditions and asset prices; - Direct influence on the very short-term interbank market only.

- Policy interest rate - Reserve requirements

- Capital requirements - Liquidity requirements

Source: Hannoun, 2010. 3. Post-crisis central banking policy instruments 3.1. Seventeenth century writings on crisis contexts

During a panel discussion with B. Bernanke at the Hutching Center for monetary policy, Brookings Institute in 2014, Bernanke stated that bailouts during the 2008 financial crisis were consistent with Walter

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Bagehot5's rules for a lender of last resort. This central banking critical functionality, was consistent with what the Fed and the ECB have undertaken when lending “unlimited amounts to solvent institutions against good collateral at a penalty rate” (W. Bagehot, 1873). (J. Muellbauer, 2008) is the first one to give the name of unorthodox monetary policies to monetary activities initiated by the ECB and the Bank of England following the near collapse of the world financial system upon the default of Lehman Brothers. Until that time orthodox monetary policies, i.e. interest rate policies, were the key instrument to guide the liquidity provision of money markets and maintain price stability (inflation level). After the central banks already lowered key interest rates rapidly close to zero (reaching the lower zero-bound) and money markets still not recovered from the shock monetary policy was considered to ineffective and have become stuck in the liquidity trap. However, Demand for liquidity still stayed at extraordinary high levels even if the price of money (cost of capital) has decreased to near zero. Uncertainty about future developments of the still unfolding crisis triggered a money hoarding previously unseen. What makes is hard for conventional monetary policy instruments to work effectively is that monetary policy has exhausted its possibilities to drive down the nominal interest rate. It needs to provide more stimuli beyond the liquidity trap boundary/zero lower bound. Similar challenges prevailed for the US Fed and the Bank of England (Pollin, 2012). We can group these alternative monetary policy instruments into three broad categories6: first, alternative monetary and macro-prudential tools aimed at offsetting the financial implications of capital inflow (Table 3A). Second, balance sheet policies other than foreign exchange intervention (Table 3B). Third, fiscal and quasi-fiscal measures to offset the domestic consequences of foreign

5 British economist in the 1860s. 6 categorization by Bank of International Settlements

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exchange intervention. The table 2 below summarizes what we have been discussing above:

Figure 4. Central Bank roles & policy tools

Table 2

Unconventional Central Bank balance sheet tools

Intervention in domestic financial markets

Intervention in Forex Market

- Focus shifted from prices to quantities; - Direct market intervention

- Term interbank market - Sovereign bond market - Credit markets (Corporate and covered bonds, ABS) - Mortgage markets

- FX intervention - Reserve accumulation - Currency swap arrangements

Source: Hannoun, 2010. As a result, central banks’ balance sheets in advanced economies have expanded significantly, with a notable lengthening of asset duration (see figure 5 below):

Figure 5. Consolidated balance sheet of the Euro area, 2005-2015

Gold and gold receivables Lending to euro area credit institutions related to monetary

policy operations Securities of euro area residents Source: ECB, 2016.

Bala

nce

(EU

R m

illio

ns)

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We can clearly see that the element represented in purple (securities of euro area residents denominated in euro) has been expanding substantially since 2008. During the period 2008-2015, the euro securities account has known an increase with 60%. In the emerging market economies, the size of the central bank balance sheet has already expanded considerably before the crisis as many central banks has build-up foreign reserves in what might be considered a long-standing form of unconventional policies. Since the start of 2007, the role of the central bank has changed considerable from a financial institution with narrow focus of a mandate with the goal of achieving price stability/growth or price stability/full employment to maintaining a key presence in the financial system. Against this background, the following table presents a summary of selected EMEs central banks’ decisions dealing with exogenous shocks on their domestic financial systems over the past three years.

Figure 6. Alternative monetary policy and macro-prudential tools Table 3A

Policy tools Objectives/Effects Changes in reserve requirements

Brazil - (3 December 2010): Reserve requirements on time deposits increased from 15% to 20%.

Russia - (15 January–17 September 2008): Required reserve ratio on credit institutions’ liabilities to nonresident banks in local and foreign currencies was gradually raised from 3.5% to 8.5%; required reserve ratio on liabilities to individuals and on credit institutions’ other liabilities raised from 3% to 5.5%, and from 3.5% to 6%, respectively. (18 September 2008–30 April 2009): All required reserve ratios were gradually cut to 0.5%. (Since May 1, 2009): Required reserve ratios were gradually raised, with the most recent increase on 1 February 2011 (increase in reserve requirements on non-resident companies to 3.5%

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from 2.5%, and of other reserve requirements by 50 basis points to 3.0% India - Between 26 December 2006 and 10 October 2008 the cash reserve ratio was gradually increased from 5% to 9%. Between 13 October 2008 and 19 January 2009, the ratio was cut in several steps back to 5%, and stayed at that level until 12 February 2010. It was subsequently raised in three steps back to 6%.

Sterilization of the domestic liquidity implications of capital inflows.

Saudi Arabia - (2007–09): Changes in the required reserve requirements.

Contain the rapid growth of bank credit.

Source: Bank of International Settlements, 2010.

Table 3B Policy tools Objectives/Effects

Real estate market measures / Limits on credit growth Brazil - (20 October 2009): 2% tax on capital inflows to equities and fixed income public securities issued domestically (October 2010): Tax on fixed income instruments issued domestically raised to 6%.

India - (November 2010): Introduced a LTV ceiling of 80% and increased risk weights for mortgage loans over INR 7.5 million to 125%.

China - (April 2010): Lowered LTV ceiling from 80% to 70% for the first home buyers of apartments over 90 m2, lowered the LTV ceiling to 50% and set the minimum mortgage rate at 110% of the base rate for second home buyers; in certain areas, suspended mortgages on third homes and mortgage loans to non-local residents. (September 2010): Suspended all mortgages on third homes and mortgage loans to non-local residents; lowered the LTV ceiling to 70% for all first home buyers. (January 2011): For mortgages of second homes, lowered the LTV cap to 40% and set the minimum

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Turkey (2008) - Removing obstacles on domestic foreign currency loans.

Shifting a portion of external debt to Turkey and hence preventing exaggeration of external debt shock. Shift in foreign currency borrowing from Turkish banks’ foreign branches or affiliates to borrowing from domestic banks.

Source: Bank of International Settlements, 2010.

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4. Conclusion The pre-crisis situation around the monetary policy is another proof

that the monetary policy framework is inadequate to address its new growing crucial role. Certainly, we cannot claim that all distortions during the crisis are generated from the monetary policy. However, it is true that there are a number of challenges and lessons from the crisis and the significant part of them are related to the monetary policy (S. Naghdaliyev, 2011). Rules in the central banking are changing very rapidly. The recent global crisis proved that the scale of mistakes in the monetary (also financial stability) policy is capable to paralyze the entire economy. Historically, the fiscal policy dominance as the major driver of the economy makes concession to the monetary policy. The effects on the private demand, as the main sustainable source of the economic development, the monetary policy actions gain a clear priority over the fiscal policy. However, at the same time the global economic crisis surfaced fundamental weakness of the financial framework, where monetary policy is a common variable. Some scholars ponder that the crisis stemmed from expansionary monetary policy of the Federal Reserve after 2001. The scale of results and the post-crisis

challenges highlight important growing role of the monetary policy. After the global crisis, even the fiscal policy guidelines are formed considering effects of the failures occurred because of the inefficient monetary policy. In a response to the crisis, the government budgets have provided substantial support for the aggregate demand. In the process, fiscal balances deteriorated, government liabilities expanded, and risks of the future losses escalated.

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iv. Bibliography Sherman, M. (2009, July). A Short History of Financial Deregulation in the United States. Center for Economic and Policy Research, 1 2 (1), 2nd ser., 2-15. Peterson, Christopher L., “Usury Law, Payday Loans, and Statutory Sleight of Hand: An Empirical Analysis of American Credit Pricing Limits,” Minnesota Law Review, vol. 92, no. 4, April 2008. R. Raghuram. (2005) “Has Financial Development Made the World Riskier?”, 2005, Proceedings of the Jackson Hole Conference organized by the Kansas City Fed. Bagehot, W. (1873), Lombard Street, a Description of the Money Market. London: Kegan Paul. Rpt., London: John Murray, 1920. J., Muellbauer. (2008), Time for unorthodox monetary policy VOX, November 27, 2008. Institute for New Economic Thinking, Oxford Martin School. Pollin, R. (2012), The Great U.S. Liquidity Trap of 2009-11: Are we stuck pushing on strings? PERI-WP 284, University of Massachusetts-Amherst, June 2012, submitted to Review of Keynesian Economics. H. Hannoun, “The expanding role of central banks since the crisis: what are the limits?” Speech at the Conference on the 150th Anniversary of the Central Bank of the Russian Federation, Moscow, 18 June 2010. Taylor, J. B. (1993), Discretion versus Policy Rules in Practice, in: Carnegie-Rochester Conference Series on Public Policy, Vol. 39, p. 195-214. Erber, G. (2012), What is unorthodox monetary policy? in: German Economic Research Institute, p. 2-23. V. Cúrdia & M.Woodford (2009) Conventional and Unconventional Monetary Policy Federal Reserve Bank of New York Staff Reports, no. 404 November 2009.

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S. Naghdaliyev, Central Banks’ Communication in the Post-crisis (2011), The Harriman Institute Columbia University New York May 2011.