Archive for the '2008 Archives' Category

So far, an under-reported aspect of the current financial crisis is its geopolitical impact—but this is changing as investors and government policy-makers come to grips with the implications. For instance, in the latest edition of Foreign Affairs, Roger Altman argues that the crisis is a setback for the West (Europe/ U.S./Canada/Japan), an advance for China, neutral for India, and potentially destabilizing for other emerging economies such as Russia, Iran, and Venezuela. This is something for the business community to watch closely. Though the developed economies get more news coverage, the emerging countries are gaining attention as important players in the next phase of the crisis. Like children in a game of “snap the whip,” we must watch how well the emerging economies can hang on through the volatility of this crisis.

History shows that every financial crisis is associated with profound changes in the geopolitical landscape. At the start of the Great Depression, enactment of the infamous Smoot-Hawley tariff dampened global trade and carried to other countries what would likely have been only a bad recession in the U.S. The S&L Crisis of 1986-1989 helped to truncate George H.W. Bush’s service as President—in the memorable phrase of Bill Clinton’s 1992 campaign, “It’s the economy, stupid.” The “Tequila Crisis” in 1995 coincided with a return of populism throughout Latin America that persists to this day. The “Asian Flu” of 1997 launched the uprising of political resistance to the “Washington Consensus” that ultimately torpedoed the Doha Round of trade liberalization negotiations. In 1998, the crisis associated with the Russian bond default coincided with the decisive reversal of political liberalization in that country.

The Panic of 1907 spawned the U.S. Federal Reserve System, founded in 1913. But less well-known is its association with the Mexican Revolution of 1910. Historian Kevin Cahill wrote, “the U.S. depression crippled the Mexican economy. Generating widespread dissatisfaction with President Porfirio Diaz’s government, it thus was one of the factors that provoked the Maderistas and other revolutionaries to rebellion in 1910.” ^[1]

In 2008, the financial crisis had a major influence on the election of Barack Obama to the U.S. Presidency. Voters don’t like impoverishment and uncertainty. A wave of re-regulation and massive government spending seems likely. Fortunately, the resource base of the U.S. has been large enough to withstand the threat of the crisis (so far). And it looks like the big emerging economies of China, India, and Brazil will withstand it as well.

What about less well-endowed countries? The year ahead should make interesting watching, not least for the unexpected ways in which the financial crisis will affect them. Domestic stability is significantly dependent on inflows of cash. Many emerging economies are major exporters of natural resources; as commodities prices fall, so will their ability to finance domestic programs (an op-ed today urges us to think of Russia, Iran, and Venezuela). An article today notes that remittances are likely to decline in 2009—remittances are cash payments sent from migrant workers in developed countries to their kin in emerging countries. The flows of cash from remittances are so large that the stability of some countries depends on them. In the Philippines, for instance, remittances in 2007 accounted for $16 billion, or 11% of GDP.

Here are four emerging countries to watch as the financial crisis rolls on:

**Mexico: An important trading partner of the U.S. and source of major immigration-related concerns. The interests of the U.S. are served by a strong and stable neighbor. But in a recent article, Forbes magazine worries about a drift toward chaos, fueled by the U.S. recession, crime, corruption, and the free-fall in oil prices.

**Pakistan: The current crisis hit this country already in the throes of neighboring war and internal instability. In November, the country obtained an emergency loan from the IMF. Worsening financial conditions can only deepen the political crisis within the country, and indeed, the entire South Asian region.

**South Africa. The strongest democracy on the African continent, SA has been a voice of leadership within the region and of reconciliation from a colonial past. Yet the country struggles with poverty, high unemployment, refugees, xenophobia, HIV/AIDS, crime, corruption, and unstable neighbors (read: Zimbabwe). An economist at the world bank opines that SA’s reserves are adequate for now, but that currency volatility will threaten the economy.

**Latvia. Following the break-up of the Soviet Union in 1991, this country returned to a liberal economy and joined the European Union. Now, buffeted by the free markets, the country is struggling to stabilize. The central banks of Sweden and Denmark recently offered aid. With an ethnically-diverse population and a neighbor (Russia) that is reasserting its geopolitical influence, Latvia may have fewer degrees of freedom to maneuver.

The financial crisis “ain’t over ‘till it’s over.” Some economists are suggesting that a recovery will begin in the U.S. in two or three quarters. Many of the emerging economies are likely to lag behind that date; the notion that their economies are somehow “decoupled” from the crisis is false. More importantly, the economic metrics are merely a subset of what the thoughtful practitioner should watch. My argument here is that major financial crises are associated with important geopolitical change. The emerging economies are like the canary in the coal mine, giving some early indication of the likely impact of the current crisis.

1. Kevin Cahill, “The U.S. Bank Panic of 1907 and the Mexican Depression of 1908-1909” The Historian, 1998, page 795. [↩]

Forty years had passed since the Wolf had had his last encounter with the Three Little Pigs. Now, he was running a debt rating service, focused on collateralized mortgage obligations (CMOs). The Three Pigs were principals in a financial institution that traded and invested in CMOs. The first pig specialized in mortgages on houses of straw; the second in houses of sticks; and the third in houses built of bricks. Letting bygones be bygones, the Three Pigs decided to seek the opinion of the Wolf regarding the credit quality of a bundle of CMOs that were offered to them for investment. The Wolf came to their door at the appointed hour. The following conversation ensued:

Wolf: In my opinion, these CMOs merit the highest rating, AAA.

1st Pig: Is this just an opinion, or is there some factual basis to support it?

Wolf: Sure, I did some research. I asked some friends, who think well of the mortgage loan originators. The originators have sure been growing rapidly. And I looked at the general default rate on CMOs. I judge these CMOs to be similar to the general pool of CMOs, and the default rate on all CMOs isn’t very high. Finally, I did look at the terms of two or three of the mortgages in each CMO—they looked fine.

2^nd Pig: How do you know these CMOs aren’t AA-rated or lower? How do you tell the AAA’s apart from the others?

Wolf: You can pretty much tell just by looking at them. A top-rated CMO has a certain je ne sais quois. You know the very best quality when you see it.

3^rd Pig: What, then, does your debt rating system measure? What does it predict? And how do you know it predicts accurately?

Wolf: Well, I’ve been in this business forty years and I almost never have had a bad experience with an AAA-rated CMO. My ratings measure credit quality, which predicts default risk.

On the basis of this exchange, the credulous Three Little Pigs decided to invest in the bundle of CMOs, which the Wolf had rated AAA. But starting in 2006, the default rate on the mortgages contained within the CMOs skyrocketed. The successive write-offs on these CMOs ultimately caused the collapse of the Three Little Pigs’ financial institution. The Wolf inadvertently succeeded in blowing down their house, as he had vowed years earlier.

What went wrong? The credit ratings provided by the Wolf were flawed. First, they were not objective and transparent; the Wolf’s biases and frame of mind influenced the ratings. The Wolf offered no framework of analysis. The ratings could not be reproduced by an impartial judge; they were just opinions.

Second, the Wolf did say that he had looked at two or three of the mortgages underlying the CMOs. But he could not attest that his sample was representative of the population. Every CMO contains hundreds or thousands of mortgages—simply to examine a few of the mortgages could hardly give assurance of the nature of the whole pool of mortgages.

Third, the credit rating had no proof of validity. The Wolf’s bland assertion that he “almost never” had a problem with AAA-rated CMOs is no proof of the highest credit quality. What constitutes a “problem” or a “bad experience”? If his rating is an indication of default risk, what is the probability of default associated with an AAA rating? What measures prove the validity of his claim to high credit quality?

Finally, the Wolf’s credit ratings did not differentiate credit quality to a significant degree. In statistics, a difference is significant if it could not be due to some low chance, such as one random occurrence in 100. A good system of credit ratings should meaningfully explain the difference in default risk between rating categories. But the Wolf offered nothing other than “gut feel” for explaining that difference. He could not really assert that his AAA rating was significantly different from his other possible debt ratings.

I offer this story as a way to stimulate your thinking about what might characterize a “good” rating. We’ve read a lot about bad ratings in recent months. I have former students and friends at the rating agencies and know that they are earnest people who are inconsistent with my characterization of the Wolf. It distressed me to see the rating agencies at the epicenter of the current financial crisis, for having issued AAA ratings on CMOs that subsequently tanked. A year ago, Floyd Norris at the New York Times wrote, “Rating agency downgrades do not destroy markets for corporate bonds, simply because enough information is disseminated that other analysts can reach their own conclusions. But the securitization markets collapsed when it became clear the rating agencies had been overly optimistic. When a security goes from AAA to junk within a few weeks, it does not inspire confidence in the rating process. Every financial disaster deserves a scapegoat, because someone must be blamed when bad investments are made. Such scapegoats are seldom without fault, but their venality can easily be overstated. Equity analysts and corporate crooks took the blame after the technology bubble burst. This time it could be the credit rating agencies.” Sure enough, a subsequent investigation by the SEC turned up some juicy emails that impair our confidence in credit ratings: one note said, “Let’s hope we are all wealthy and retired by the time this house of cards falters.” So, the SEC imposed new rules on the agencies earlier this month.

What is the place of B-schools in all of this? My story and the recent news coverage about ratings certainly bespeak the importance of at least four virtues, which B-schools can help to instill:

** intellectual rigor around concepts such as objectivity, representativeness, validity, and significance;

**critical thinking—the frame of mind to check assumptions, logic, and conclusions;

**integrity, the ability to test processes and outcomes against deep values held by individuals, firms, and society.

**candor, the capacity to speak truth to power;

We’ve been here before. The rash of business scandals surfaced around the turn of the decade because of the absence of these and other virtues. B-schools responded then. As best I can tell, they are responding in like fashion to the current crisis.

It seems inevitable that the ratings industry will change: more regulation; more transparency; more independence; and payment by investors rather than issuers—all of these are under active discussion today. Certainly, the rating methodologies will come under intense scrutiny in the avalanche of litigation to come. At the conclusion of the fairy tale of The Three Little Pigs, the Wolf attempts to attack the pigs by climbing down the chimney of the 3^rd Little Pig; instead, he falls into a boiling cauldron in which he is cooked and thereafter eaten. This is rough justice, but no less than in the modern version, where the rating agencies land in a stew of government investigations and lawsuits that will last for years.

Posted by Robert Bruner at 12/28/2008 03:18:09 PM

“Common sense is what tells you that the world is flat.” — Bertrand Russell

What a difference a few weeks makes. When I visited East Asia two months ago, the sentiment was that the financial crisis was America’s problem and that Asia would motor on quite nicely despite America’s malaise. This view suggested that America’s financial distress was decoupled from the big growth engines in the world.

Last week, I visited Europe and South America and heard a very different message: like it or not, all countries have been dragged into this mess. The shock and apprehension Americans felt in September is now global. Iceland nearly defaulted on its external debt and was saved last week by an emergency loan from the IMF. Earlier this month, Korea negotiated a $30 billion currency swap with the U.S. Fed; the Fed cut similar deals with the central banks of Brazil, Mexico, and Singapore. Argentina has nationalized its private pensions, which many fear is a step toward using the pension assets of private citizens for political purposes. China has pledged a stimulus package of $584 billion to boost its growth. And the European Union, which had managed its financial affairs rather conservatively, seems to be ahead of other regions into recession.

The political fallout seems to be spreading globally as well. Like the Republicans who were sacked in the U.S. elections earlier this month, incumbents around the world find themselves on tottering seats of power. In countries as different as India, Israel, South Africa, Germany, and Spain, voters seem to be lining up for change. Following the recent G20 conference, the Financial Times published a survey among voters in Europe and the U.S. revealing a sharp negative swing in judgment of their governments’ response to the crisis. All financial crises have geopolitical consequences.

This is “contagion,” the spread of a shock from one country to the next. Such movement certainly seems consistent with the conventional wisdom that the world is “flat.” The thesis advanced by Thomas Friedman’s ubiquitous book is that information technology and free trade have eliminated frictions and leveled business differences across borders so that competition has evened out between established firms in developed countries and the upstart companies in emerging countries. In the U.S., we understand this well: offshoring, outsourcing, and the hollowing-out of American manufacturing testify to the global fluidity of business.

But hold on. The spread of the financial crisis offers some clues that the world is not as flat as Friedman argues. Not all countries are affected equally; nor can all countries fight the crisis equally. Size matters. Having a reserve currency (like the U.S.) matters. Having liquid reserves matters, in the form of savings and powerful sovereign wealth funds—this is a telling point in David Smick’s The World is Curved: Hidden Dangers to the Global Economy. Economic advantages are sprinkled unequally among nations and shape the exposure of countries to the crisis. These advantages include natural resources (Brazil and Australia), low manufacturing cost (China, Vietnam), low cost business process services (India), and special know-how in financial services (U.K., U.S., Singapore). The greater is the curvature of the world (the disparity among countries), the more difficult will be the challenge to coordinate a response to the crisis.

My colleague, Alan Beckenstein, gave an interview in New Zealand that emphasized the inherent instability of market economies. We have had bubbles in the past and will have them in the future. Given the connectivity of markets and communications, it seems likely that contagion will be a feature of the future busts as well. But the fact remains that countries such as New Zealand, China, India, and the U.S. respond to these crises in very different ways. Though globalization is a fact of life, it hardly seems that the flat world has arrived.

I have talked about the financial crisis using a metaphor that suggests the relevance of business topography; the metaphor is the game of pool: banks and countries are scattered like balls around the table. Then a shock occurs sending the white ball ricocheting around the system, destabilizing the balls and sending some into the pockets. In a flat world, the table would be flat and the balls would be of equal size. In a curvy world, the table is not flat and the balls are of uneven size and may not even be spherical. The crisis affects nations and companies differently.

The extent to which the world is flat has been on my mind lately—both with respect to the global financial crisis and to the globalization of management education. Your view of the global topography as flat or curved has huge implications for the way you organize businesses, plot strategy, use technology, brand products, hire talent, or just about anything. Fighting the global crisis is increasingly a matter of coordination among central banks and finance ministries. By now, I doubt that anyone questions the need for coordination. But how they coordinate is the key question—it should be tailored to the topography. Management education should adapt as well to the topography of global business. ^[1]

A recent book by Pankaj Ghemawat, Redefining Global Strategy: Crossing Borders in a World Where Differences Still Matter, offers some insights about globalization that are relevant to helping crisis fighters and management educators think about the curvature of the world. He argued that four factors produce a world that is curved.

• Cultural distance. The reality is that language and history dramatically affect the choice of business partners. Anglo-Saxon heritage, Romance languages, the Diaspora of Chinese and Hindus, and ethnic ties the world over have influenced trading patterns.
• Geographic distance. Your neighbor is more likely to be your major trading partner and your competitor—think of Canada and the U.S.
• Economic distance. The gulf between developed and developing economies induces wide disparities of business behavior. Economic distance is reflected in differences in the use of special know-how, advanced technology, infrastructure, and capital markets.
• Administrative distance. Legal, political, and tax systems, transparency, and respect for the rights of investors can generate distance among countries and markets.

Ghemawat marshals a range of measures to argue that business activity has not achieved the level of global integration as to justify the claim that the world is flat. He says the world is “semi-globalized”—maybe it is heading toward a flat competitive field, but the world has a long way to go. If you take Ghemawat’s view, then national and regional differences still really matter for fighting the global financial crisis, for setting business strategy, and for making a host of business decisions.

Management education is not devoid of concerns about whether the world is flat or curved. The topography of the world raises at least five big questions for management education:

1. For what do we prepare our students? Is it “anytime, anywhere” performance? This may be possible in a flat world. Those who believe in a very curvy world would argue that domain knowledge really matters—local or regional practices and customs.
2. What is the canon of ideas that we impart? Is there a canon? Perhaps the tools and concepts of business are not everywhere and equally applicable. Business schools certify their graduates as Master of Business Administration—is the mastery of ideas contingent on location?
3. Does leadership development depend on world topography? The stronger the localization, the greater the need for leadership development that is locally-oriented.
4. What is the language of business? The rise of English as the global commercial language during the post-World War II era is one of Thomas Friedman’s proofs of the flattening of the world. But surely Chinese and Spanish would qualify for major commercial languages as well, given the sheer size of populations that speak those languages.
5. How shall we teach management globally? Answers to the foregoing questions may suggest an answer to this final question. The discussion method of instruction, using case studies and other teaching materials, is consistent with certain cultural settings.

Answers to questions such as these are not straightforward. But one can connect several dots here. The difficulties of doing business across borders, coordinating the fight against the global financial crisis, and educating MBAs for a world of global competition all arise because of the persistence of local differences. Bertrand Russell’s comment, “Common sense is what tells you that the world is flat,” is ironic: he is challenging the reader to think beyond what common sense might suggest. We would be well-advised to do the same.

1. I’m chairing a task force on the globalization of management education for AACSB (Association for the Advancement of Collegiate Schools of Business). The task force has been charged with studying the current state of global business education and recommending actions to AACSB. The members represent management education on six continents. We want to elevate the achievement of business schools in producing graduates who are capable of succeeding in, and adapting within, a global business environment. Ideally, the findings of our study will enhance awareness of effective collaboration opportunities between business schools and accelerate adoption of, and innovation of, effective mechanisms that support the globalization of business education. Many business schools are entering unfamiliar territory (literally and figuratively) as they strive to serve as a global market, teach global perspectives, and engage in globally relevant research and outreach. [↩]

“I call that mind free which is not passively framed by outward circumstances, which is not swept away by the torrent of events, which is not the creature of accidental impulse, but which bends events to its own improvement, and acts from an inward spring, from immutable principles which it has deliberately espoused.” — William Ellery Channing

Here are two vignettes from the financial crisis:

**An applicant to Darden cornered me at a reception to tell me about his miserable job and the likelihood of a coming layoff. He is looking for a safe harbor for the next couple of years and thinks B-school will suffice. I told him to think some more. I said that we aim to admit not “safe harbor people,” but people who can be leaders, want to have a positive impact on the world and achieve great personal success—this means writing admission essays that tell us about one’s character, potential, and intentions, not just one’s history. This may not have been the reply he was looking for. Framing the future is hard; talking about the past is easy.

**Old acquaintances from the financial services industry tell me their anxieties about layoffs and disbelief of financial losses. They had so much more and now have so much less. They merit help. I have directed alums to Darden’s Alumni Career Services office, a best-in-class career counseling shop. Yet the before-and-after comparison for these friends is a showstopper. Like the applicant to Darden, these victims of the Panic of 2008 face a challenge about framing the future. Going from plenty to scarcity is a big leap. But to frame the future compared to the past overlooks the relevant choice, between various paths into the future. How you frame choices today is the big issue.

The wave of deleveraging sweeping the world will impose a dramatic reframing of expectations and choices about the future. People ask for my advice about such choices. Four ideas seem relevant:

1. Saying “enough”: setting reasonable limits on expectations. In his brand-new book, Enough, John Bogle, the iconic investment manager, rails against the excesses of the recent boom: too much leverage, exorbitant executive pay, managerial self-dealing, and outlandishly risky business behavior. The book is part of a recent stream of jeremiads. ^[1] But now is the right time to take such medicine. Bogle tells the story of two great writers of the 20^th Century, Kurt Vonnegut and Joseph Heller, who were at a lavish cocktail party at the house of a hedge fund manager on Long Island. Heller was the author of Catch-22, one of the best-selling novels of the century. Vonnegut was equally successful. Vonnegut turned to Heller and said, “This hedge fund manager makes more in one day than you made with all the royalties from Catch-22.” Heller replied, “Yes, but I have something he doesn’t…enough.” Saying “enough” is probably the first necessary step in a world of deleveraging. This isn’t the year to trade up to a bigger house, buy the flat-screen TV, pester the boss for a big raise promotion, or easily get a job at an investment bank. Be pragmatic. Deal with the limitations you face.
2. Benchmark the future against a variety of possible forward paths, not against the past. Last summer, I read Stumbling on Happiness by Daniel Gilbert—it was commended to me by my colleague, Alec Horniman. Gilbert is a psychologist and cites a lot of research suggesting that happiness is significantly a matter of framing the future. He notes that “the human being is the only animal that thinks about the future…Our brains were made for ‘nexting’.” The problem is that the brain plays tricks on us: mis-imagining the future is related to human functions of misremembering the past and misperceiving the present. Unhappy people fail to imagine effectively how things might turn out; they tend to project the present onto the future; and they fail to recognize that things will look different once they happen. His big idea is that “our inattention to these lapses influences the way we think about the future.” With all of this capacity to imagine, we make decisions as much by “pre-feeling” rather than by logic.
3. Recalibrate what “success” means to you. So much of the documentable excesses of the recent boom seem linked to definitions of professional success defined by money. This was a big mistake. Success as a manager can also be defined in terms of building a sustainable enterprise, serving others, inventing products and services that lift human welfare, and having a positive impact on the problems facing society. In Just Enough: Tools for Creating Success in Your Work and Life Laura Nash and Batten Fellow Howard Stevenson present the conclusions of in-depth interviews from numerous successful executives. They find that truly successful people frame career success much more broadly than stereotypes suggest. Real “success” consists of four elements: happiness, achievement, significance, and legacy. Success is more than winning; it is multidimensional; it is a moving target; it is sufficiency (just enough), not maximization; it is a lifetime process.
4. Find your “calling.” A couple of months ago, I wrote about the need to listen for a calling in order to make important career decisions. In Business as a Calling: Work and the Examined Life, Michael Novak advances the radical idea that business can be a “calling,” something more than just a job—this is a big idea, since it frames one’s work in terms of being in service to some ideal. Such framing is useful in times like these. Novak’s introductory chapter is entitled, “Plenty isn’t enough.” He writes, “Business is a demanding vocation, and one is not good at it just by being in it, or even by making piles of money. The bottom line of a calling is measured by pain, learning, and grace. Having a good year in financial terms is hard enough; having a good year in fulfilling one’s calling means passing tests that are a lot more rewarding…Doing anything as a calling—especially doing something quite difficult—is a lot more fulfilling than merely drifting.” ^[2]

As I connect the dots among my many conversations in the past couple of months, I conclude that (re)framing the future is the big task facing the average man or woman. The cycle of deleveraging imposed by this crisis will take years; the shape and extent of the adjustment this will require is impossible to predict. But as William Ellery Channing might have said, the challenge is not to let yourself be “passively framed” by the financial crisis, but rather to act from an “inward spring” in your engagement with these new circumstances.

Posted by Robert Bruner at 10/29/2008 03:04:05 PM

1. The jeremiad is an art form. For another example, see Lee Iacocca’s Where Have all the Leaders Gone? The jeremiad has morphed into blogs and media sound-bites. We were recently treated to Jack Welch’s outburst about GE’s CEO, Jeffrey Immelt. And the venerable Jimmy Carter has had plenty to say about his successors in the White House. [↩]
2. Novak, Business as a Calling, pages 14-15. [↩]

“I heard that Bank of East Asia was in trouble this morning but wasn’t so worried until I saw the queue. Something must have gone wrong.” ^[1]

These words express the essence of any financial crisis: the loss of confidence based on incomplete information and fearful inference. I spent much of this past week in Hong Kong and was treated to a mini-case example of financial crisis in the run that hit Bank of East Asia (BEA) here on Wednesday, the 24^th. This was the first run-on-the-bank in Hong Kong since 1997. This week’s story of BEA illustrates the origins of a panic and what it takes to stop one.

Here’s a sketch of the case. Bank of East Asia is Hong Kong’s fifth-biggest bank by assets, mainly serving a regional clientele. It issued a quarterly earnings report in early September that showed a profitable and moderately-growing firm. Then in mid-month, two events occurred that challenged the image of stability. Turmoil in the American financial markets—especially the failures of Lehman Brothers and AIG—spawned concerns about the exposure of Hong Kong Banks to the collateralized debt obligations of the American firms. ^[2] Also in mid-month, BEA issued a revision to its earnings report revealing that a rogue trader had accumulated losses of HK$93 million in equity derivatives that would reduce the latest quarter’s financial results.

On Monday, September 22^nd, rumors began to circulate regarding the solvency of BEA. These rumors gathered momentum on Tuesday in a slew of broadcast text messages from an anonymous source. One message said, “There is a run on the BEA—if you have money there, go get it quickly.” ^[3] Depositors showed up in large numbers on Tuesday afternoon at BEA’s branches. They expressed panic: “I just want the peace of mind when I go to sleep tonight. Nothing is safer than hard cash in my pocket…You know, this is a crazy time, banks are falling over…It’s not normal what is happening in the world. Who knows if what they are saying is true?…I just want my money. Everyone is queuing and so should I.” ^[4]

Management of BEA responded vigorously. First, they issued repeated public statements asserting the solvency of the bank and briefed the media on BEA’s financial condition. BEA’s CEO said, “I can confirm categorically these rumors are unfounded.” He shared data that showed BEA’s cash reserves were adequate to meet all withdrawals and capital adequacy ratio is twice as large as the required minimum. Second, they met all withdrawal requests and stayed open past normal closing time to do so. Third, they enlisted the help of the Hong Kong Monetary Authority who issued a statement confirming the solvency of BEA: “BEA’s capital adequacy and liquidity ratios are well above regulatory requirements.” ^[5] The Monetary Authority also flooded the Hong Kong banking system with liquidity, nearly HK$3.9 billion. Fourth, local tycoon Li Ka-shing (and BEA’s Chairman of the Board) purchased shares of BEA, not unlike Warren Buffett purchasing a stake in Goldman Sachs, Constellation Energy and so on. Also the bank’s executives cast votes of confidence in the troubled lender by buying stock. Finally the commercial crime bureau of the Hong Kong police department embarked on an investigation of the source of the rumors.

By Thursday, September 25^th, the bank run had ended. BEA announced that HK$2 billion in deposits had been withdrawn in the brief run—the withdrawal represented 0.67 percent of the bank’s total deposit base. On Saturday the 27^th, the police announced the arrest of an individual who allegedly issued the mass-mailed text messages.

What are we to make of this episode? It illustrates the drivers of financial crisis that Sean Carr and I outlined in our study of the Panic of 1907: complexity, few safety buffers, an economic shock, all of which produce a sharp change for the worse in expectations. The thread that knits these factors together is what economists call an “information asymmetry,” roughly, the situation where a decision-maker doesn’t have all the vital facts and someone else does. In this case, the better-informed people might exploit the poorly informed. ^[6] The poorly-informed people worry about this and begin to behave in ways that produce market panics. In an influential paper, Charles Calomiris, Gary Gorton suggested that bank runs could begin when some depositors observe negative information about the value of bank assets and withdraw their deposits. Then other depositors follow suit, being unable to discriminate perfectly between sound and unsound banks and observing a wave of withdrawals. A run begins. In a world of unequally distributed information, some depositors will find it costly to ascertain the solvency of their banks. Thus, runs might be a rational means of monitoring the performance of banks, a crude means of forcing the banks to reveal to depositors the adequacy of their assets and reserves. Calomiris and Gorton reasoned that if the information asymmetry theory were true, panics would be triggered by real asset shocks that cause the decline in collateral values underpinning bank loans. They found that bank panics originated following economic shocks and that typically the cause was a sudden decline in asset values. In particular, panics tend to follow sharp declines in the stock markets and tended to occur in the spring and the fall. They also reasoned that the resolution of a bank panic would be created by elimination of an important aspect of the information asymmetry: gaining clarity as to which banks were solvent and insolvent would stop the runs on solvent banks.

In contrast, bank runs could be triggered by random events that cause depositors to fear for the safety of their funds. In 1985, a panic hit a Hong Kong bank when a line extended out of the door of a nearby bakery and across the front of the bank. Depositors passing by simply feared for the solvency of the bank and began to withdraw their funds. This is the “stuff happens” theory of bank panics. ^[7]

Which theory, information asymmetry or stuff happens, better explains the history of bank panics? Empirical research lends support to the asymmetric information theory. Studies have affirmed the relationship between information asymmetry and panics, by looking at how deposit losses predict panics, the yield spreads between low- and high-risk bonds peak at the panic, and real declines in the stock market are greater in panic years than non-panic years. In the case of Hong Kong’s BEA, the issue of information asymmetry seems to square with the facts.

My only issue with the simple explanation offered by the theory of information asymmetry is that it seems to suggest a very simple solution to panics: flood the market with information. Yet as our study of the Panic of 1907 showed, simply offering evidence of solvency of banks isn’t enough. It takes some serious leadership to organize the intense kind of collective action that it takes to stem the emotional tide of a panic. Virtually every panic contains deeper lessons about shaping a vision, enlisting others, acting with integrity, reading the mood of a crowd, communicating very well, and showing a bias for action–all of these are the attributes we associate with effective leaders.

To quell a panic requires ample liquidity, injection of capital, transparency about the facts of the situation, and vigorous leadership to organize collective action and assert the common good. The financial system in Hong Kong may have been lucky. The system was at risk; rumors were swirling about other institutions as well; banks in nearby Macau experienced some runs. As we are seeing in the U.S. today and saw in 1907, financial panic usually does not end so quickly. This mini-case emphasizes the importance of quick and decisive action in fighting the bank run.

Posted by Robert Bruner at 09/28/2008 04:42:42 AM

1. Justine Lau and Tom Mitchell, “Malicious rumours spark run on Bank of East Asia” Financial Times September 25, 2008, page 1. [↩]
2. It turned out that BEA had outstanding exposures of HK$422.8 million to Lehman Brothers and HK$49.9 million to AIG. [↩]
3. Phyllis Tsang, “Panic sparked by electronic whispers,” South China Morning Post, September 25, 2008, page A3. [↩]
4. Barclay Crawford, Peter So, and Ambrose Leung, “Thousands waste hours in bank lines,” South China Morning Post, September 25, 2008, page A3. [↩]
5. “BEA and Monetary Authority’s Response” South China Morning Post September 25, 2008, page A3. [↩]
6. George Akerlof described this as the “lemons” problem in which the market for used cars features imperfect pricing. Michael Spence extended the insights drawing on the labor market. And Joseph Stiglitz focused on credit markets. Akerlof, Spence, and Stiglitz received the Nobel Prize in Economics in 2001 for their groundbreaking work. [↩]
7. In an influential paper published in 1983, two economists, Douglas Diamond and Phillip Dybvig suggested that bank panics are simply randomly occurring events. Bank runs occur when depositors fear that some kind of shock will force the bank into costly and time-consuming liquidation. To be last in line to withdraw deposited funds exposes the individual to the risk of loss. Therefore, a run is caused simply by the fear of random deposit withdrawals and the risk of being last in line. [↩]