FINCANCIAL SYSTEMS, FUNCTIONS AND SYSTEMIC RISKS

Lecture 14

GENERAL SYSTEMS OF CORPORATE GOVERNANCEModel 1. Shareholder value

Model 2. Stakeholder value

Equity Market

Board

BusinessEmployees Creditors

CustomersState

Suppliers

Salary

Labour

Credit

Interest rate

Tax, fees

Laws, directives, enforcement

Payment

InputsGoods, services

Payment

Monitoring

Other shareholders Annual reports

Long-term active shareholders, consultation, board representation

Institutional passive s.h.

Voting power

Dividens

  Model for shareholder value

Model for stakeholder value

Priority Profit before responsibility

Responsibility, then profit

View on organisation

Instrumental Cooperation, a set of contracts

Objective of organisation

To serve the interest of the shareholders

To serve the interests of all partners involved in the business activity

Measure of success

Stock price and dividends

Content among all interest groups

Largest issue Getting management to act in the interest of the shareholders

To balance between various interest groups

Execution of corporate control

Independent external actors with shares

Representation of various interest groups

Acting of interest groups

Instrument (means) Target and instrument

Utility in society

To achieve economic efficiency by focusing on self-interest

To achieve economic gains by focusing on cooperation

Social respons-ibility

Individual matter, not an organisational (firm) issue

Both an individual and organisational issue

FINANCIAL SYSTEMS

Market-based systemControl-oriented system

FINANCIAL SYSTEMSMarket-based (US, UK)

Control-oriented (Europa, Asia)

Ownership and control

Dispersed ownership Controlling

blocks

Protection for minority shareholders

Strong Weak

Board Potentially independent

Close to controlling owner

Management Strong independence

Close to contr. owner

Bank relationships

Arm-lengths distance, no ownership

Close, possibly ownership

Management incentives

Central, strong Less central, somet. weak

Capital structure

Low debt/equity High debt/equity

Market for control

Hostile takeovers

Less hostile takeovers

SIX FUNCTIONS OF A FINANCIAL SYSTEMA. Providing ways of clearing and setting

payments to facilitate the exchange of goods, services and assets.

B. Providing a mechanism for the pooling of funds to undertake large-scale enterprise or for the subdividing of shares in enterprises to facilitate diversification.

C. Providing ways to transfer economic resources through time, across geographic regions, and among industries.

MORE FUNCTIONS…

A. Providing ways to manage uncertainty and control risk.

B. Providing price information that helps coordinate decentralized decision-making in various sectors of the economy.

C. Providing ways to deal with the incentive problems when one party to a financial transaction has information that the other party does not have, or when one party is an agent for another.

2004199819951978

2007 19641992 19581987 1994 19511979 1991 19491974 1976 19461973 1972 1941 20061962 1969 1940 19971961 1967 1935 19891957 1965 1933 19851956 1960 1928 1980

1990 1955 1953 1927 19751970 2001 1948 1945 1926 1971 20051966 2000 1947 1944 1925 1963 20031939 1984 1937 1943 1924 1950 19961932 1977 1923 1942 1918 1934 1982 1959 1993

2002 1921 1952 1922 1938 1910 1916 1968 1936 1988 19991931 1920 1930 1913 1929 1907 1915 1954 1911 1986 1983

2008 1914 1919 1908 1903 1912 1904 1906 1917 1909 1981 1905-51-40% -31-40% -21-30% -11-20% -0-10% +0-10% +11-20% +21-30% +31-40% +41-50% +51-60% +61%-

65 % positive yearsBest decades:

40-, 80- and 90th

35 % negative yearsWorst decades:

30-, 70- and 00th

2008 worst year ever: -42 %

SYSTEMIC RISK, FOCUS ON NEGATIVE EXTERNALITIES

Systemic risk is something that is built up before a crash. It signifies the danger of the system-wide contagion of the crisis.

Systemic risk is the very spread of financial fragility and financial distress within the system of finance.

System risk can be defined as negative externalities occurring when one actor takes a risk that causes a further risk for others in the financial system.

FOCUS ON LIQUIDITY RISK

A demand for central bank money and other liquid and safe investments exceeding supply.

A rapid reduction in the loan volume built up during the boom.

A situation where a borrower has previously been able to borrow without difficulty, now can not borrow at all, regardless of condition.

CONTINUING…

A forced sale of assets when liquidity is tight, which in turn further lowers the price of assets - the bubble burst.

A rapid decrease in the value of bank assets, leading to uncertainty about the value of the bank, bank runs and ultimately to the insolvency and bankruptcy of many banks.

EX POST EXPLANATION TO SYSTEMIC RISK

A systemic risk is the risk or probability of a collapse of the entire financial system as opposed to problems in its parts.

The systemic risk is indicated by the different elements in the system moving together, and that the correlation between different assets increases.

FOCUS ON FINANCIAL INSTABILITY (MINSKY)

The financial institutions and the functioning of the market change both as a result of market forces and because of practices and legislation. For this reason, the development of various financial variables will differ over a long phase of expansion in relation to the experience of the average business cycle.

The changes in the financial structure over a long period of growth allows the financial panic which then erupts.

CONTINUING…

An element in the development of a financially unstable financial system is a marked increase in total assets relative to income and capital.

Disturbances in the financial system are caused both by the system's own characteristics and the errors that people make. Once a strong reaction set in on the financial markets, after a long expansion, the shortcomings of its institutions quickly become apparent.

Bubble burst

Debt crisis and new structure

Increasing

demand

Financial muscles

Institu-tional clash

Idle capital

Debt accumula-

tion

Banking Crisis Cycle

WHAT HAVE WE LEARN TODAY?