the future of finance · 2010. 7. 15. · wednesday 14 july 2010 iet savoy place the report and a...
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THE FUTURE OF FINANCE AND THE THEORY THAT UNDERPINS IT
THE FUTURE OF FINANCE
Wednesday 14 July 2010IET Savoy Place
The report and a video recording of the conference can be downloaded from our website: www.futureoffinance.org.uk
What do banks do? Why do credit booms and busts occur and what can public policy do about it?
Adair TurnerChairman, Financial Services Authority
THE FUTURE OF FINANCE
0
THE FUTURE OF FINANCE
Adair Turner
What do banks do: Why do credit booms and busts occur and
what can public policy do about it?
London 14TH July 2010
1
Measures of increasing financial intensity1
92
9
19
35
19
41
19
47
19
53
19
59
19
71
19
77
19
83
19
90
19
96
20
02
20
07
10%
50%
100%
150%
200%
250%
300%
19
29
19
35
19
41
19
47
19
53
19
59
19
65
19
71
19
77
19
83
19
90
19
96
20
02
20
07
10%
50%
100%
150%
200%
250%
300%
19
29
19
35
19
41
19
47
19
53
19
59
19
71
19
77
19
83
19
90
19
96
20
02
20
07
10%
50%
100%
150%
200%
250%
300%
19
29
19
35
19
41
19
47
19
53
19
59
19
65
19
71
19
77
19
83
19
90
19
96
20
02
20
07
10%
50%
100%
150%
200%
250%
300%
0
50
100
150
200
250
300
350
400
450
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
$T
r
OTC interest rate contracts, notional amount outstanding
0
100
200
300
400
500
600
700
800
900
1,000
1,100
19
77
19
82
19
87
19
92
19
97
20
02
20
07
$b
n
Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn
US debt as a % of GDP by
borrower type
Growth of interest rate
derivatives values, 1987-2009
FX Trading values & world GDP
1977-2007
Global issuance of asset-
backed securities
$T
rn
2
What went wrong: the obvious agenda
Credit rating inadequacies and conflict of interest
Poor incentives for good underwriting
Over-complexity and lack of transparency
Poorly understood embedded options
Far too low trading book capital requirements – massive capital arbitrage opportunities
CRA regulation
Skin-in-the-game retention rules
Disclosure requirements
Fundamental reform of trading book capital
Demand for simplicity and transparency
No future for complex variants, e.g. CPDOs, CDO2s
Regulatory Reform
Market Reaction
3
Financial System Functions
1. Payment services
2. Insurance services – pooling risks
3. Creation of markets – in FX and commodities
4. Financial intermediation between providers of funds and
users of funds
4
Linking fund providers with fund users
Households
Non-profit making
institutions
Businesses
Businesses
Governments
Non-profit making
institutions
Households
Providers Users
Intermediation
of unmatched
asset and
liability
contracts
Facilitation of “matched” direct investments, e.g.:
equities, bonds
5
Four transformation functions
Pooling of risks
Maturity transformation on balance sheet
Maturity transformation via market liquidity
Risk/return transformation via tranching
6
Five conclusions
All financial markets inherently susceptible to divergence from
equilibrium
Credit contracts create specific risks
Banks create specific risks
Different categories of credit perform very different economic functions
Credit finance for property is deeply pro-cyclical
Securitisation appears to remove risks
But created new ones
The 2007-2008 was so severe because of the interaction of the
inherent risks of banks, property loans and liquid traded markets
7
NASDAQ
Source: Datastream
0
1,000
2,000
3,000
4,000
5,000
6,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
8
0
100
200
300
400
500
600
20
02
20
02
20
02
20
03
20
03
20
03
20
04
20
04
20
04
20
05
20
05
20
05
20
06
20
06
20
06
20
07
20
07
20
07
20
08
20
08
20
08
20
09
Ba
sis
po
ints
Sources: Bloomberg, Merrill Lynch, Thomson Datastream and Bank of England calculations
Corporate bond spreads
9
Output loss in different categories of recession
19.8
13.8
5.4Recession not preceded
by financial stress
Preceded by
financial stress
- of which banking
related
Source: IMF World Economic Outlook, October 2008, Table 4.2
Cumulative output
Loss:% of GDP
19.8
13.8
5.4Recession not preceded
by financial stress
Preceded by
financial stress
- of which banking
related
Source: IMF World Economic Outlook, October 2008, Table 4.2
Cumulative output
Loss:% of GDP
10
Five conclusions
All financial markets inherently susceptible to divergence from
equilibrium
Credit contracts create specific risks
Banks create specific risks
Different categories of credit perform very different economic functions
Credit finance for property is deeply pro-cyclical
Securitisation appears to remove risks
But created new ones
The 2007-2008 was so severe because of the interaction of the
inherent risks of banks, property loans and liquid traded markets
11
Why credit contracts increase instability
Specificity of tenor
Specificity of nominal value
Rigidities of default and bankruptcy
Interaction with real asset values
12
Five conclusions
All financial markets inherently susceptible to divergence from
equilibrium
Credit contracts create specific risks
Banks create specific risks
Different categories of credit perform very different economic functions
Credit finance for property is deeply pro-cyclical
Securitisation appears to remove risks
But created new ones
The 2007-2008 was so severe because of the interaction of the
inherent risks of banks, property loans and liquid traded markets
13
Maturity transformation via bank intermediation
Providers
of funds
Users
of funds
Instant or short
term access
Medium to long
term maturity
Permanent funds
Immediately available
Medium to long term
maturity loans
Underpinned by• Private insurance• Central Bank L.O.L.R. functions
Equity
Debt
Depositors
Liquid assets
14
Risk-return transformation via bank intermediation:
“Tranching”
Providers
of funds
Users
of funds Liabilities Assets
Close to zero risk deposits
Moderately risky senior debt
High risk equity
Moderately risk
loansRiskier
subordinated debt
15
Savings mobilisation, credit extension and
economic growth
Much more cash exists out of banks in France and Germany
and in all non-banking countries than can be found in England
or Scotland, where banking is developed. But the cash is
not… attainable.
… the English money is “borrowable money”. Our people are
bolder in dealing with their money than any continental
nation,… and the mere fact their money is deposited in a bank
makes it attainable.
A place like Lombard Street, where in all but the rarest times
money can always be obtained on good security or upon
decent proposals of probable gain, is a luxury which no other
country has ever enjoyed … before.
Walter Bagehot, Lombard Street, Chapter 1
”
“
16
Five conclusions
All financial markets inherently susceptible to divergence from equilibrium
Credit contracts create specific risks
Banks create specific risks
Different categories of credit perform very different economic functions
Credit finance for property is deeply pro-cyclical
Securitisation appears to remove risks
But created new ones
The 2007-2008 was so severe because of the interaction of the
inherent risks of banks, property loans and liquid traded markets
17
Household and PNFC deposits and loans:
1964 – 2009
Source: Bank of England, Tables A4.3, A4.1
0%
20%
40%
60%
80%
100%
120%
140%
1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
% o
f G
DP
Securitisations Deposits Loans
18
The role of credit: the classic story
Borrowers
investing in
productive
assets Pri
ce o
f cre
dit
Quantity of investment undertaken
Pro
ject
1
Pro
ject
2
Pro
ject
3
Pro
ject
4
Pro
ject
5
Etc
.
Increase in cost of
funding resulting from
increased capital
requirements on banks
Pri
ce o
f cre
dit
Quantity of investment undertaken
Pro
ject
1
Pro
ject
2
Pro
ject
3
Pro
ject
4
Pro
ject
5
Etc
.
Increase in cost of
funding resulting from
increased capital
requirements on banks
Credit prices and productive
investment
Savers=
Depositors
Quantity of investment undertaken
19
What the UK banking system did: 1964
39
7
13
14
Liabilities Assets
Banks & Building Societies’ £ lending/deposits
Private non-financial sector as % of GDP
Household lending
Corporate lendingHousehold deposits
Corporate deposits
Source: Bank of England
20
Household and NPISH lending: 1964 – 2009
0%
10%
20%
30%
40%
50%
60%
70%
80%
1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009%
of
GD
P
Lending to unincorporated businesses Unsecured lending to households
Residential mortgage lending Other lending to household and NPISH
Source: Bank of England, Tables A4.3, A4.1 Source: Bank of England, Table A4.1
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
% o
f G
DP
Securitisations and loan transfers
Loans secured on dwellings
21
The economic function of residential mortgage debt
To limited extent helps finance new investment in housing stock
Primary function is to support life-cycle consumption smoothing/ intergenerational transfer of consumption resources
With scale determined by
Supply constraints and consumer preference drivers of income elasticity of demand
Circular relationship between credit supply and house prices
Balance varies by country
Possible to imagine economy with nil net new investment in housing stock but high and rising mortgage debt to GDP
22
Corporate loans by broad sector: 1987 – 2008
0%
5%
10%
15%
20%
25%
30%
35%
Q1
1987
Q1
1989
Q1
1991
Q1
1993
Q1
1995
Q1
1997
Q1
1999
Q1
2001
Q1
2003
Q1
2005
Q1
2007
Q1
2009
% o
f G
DP
Non-commmercial real estate PNFC lending Commercial real estate lending
Source: ONS, Finstats
Note: Part of the increase in real estate lending may be due to re-categorisation of corporate lending
following sale and lease-back of properties and PFI (public finance initiative) lending, but we do not
think these elements are large enough to change the overall picture. Break in series from Q1 2008
due to inclusion of building society data. Sterling borrowing only.
23
Drivers of commercial real estate lending
Partly driven by new productive investment
But with significant element of:
Leveraged purchase of existing assets
With strong tax incentive to maximise leverage
Often in expectation of medium term capital gain
And in some cases exploiting the put option of limited liability
24
Credit and asset price cycles
Expectation of
future asset price
increases
Increased credit
extended
Low credit losses: high
bank profits
• Confidence reinforced
• Increased capital base
Increased asset
prices
Increased lender
supply of credit
Favourable
assessments of
credit risk
Increased
borrower demand
for credit
25
Drivers and economic function of different
categories of debt
Unsecured personal
Residential mortgage
Commercial real estate
Leveraged buy-outs
Other corporate
Welfare enhancingeconomic function
Lifecycle consumption smoothing
Finance of productive investment
Drivers of private incentives to borrow
Expectations of asset appreciation
Tax deductability of interest and put option of limited liability
No in UK
Yes in US
26
Five conclusions
All financial markets inherently susceptible to divergence from
equilibrium
Credit contracts create specific risks
Banks create specific risks
Different categories of credit perform very different economic functions
Credit finance for property is deeply pro-cyclical
Securitisation appears to remove risks
But created new ones
The 2007-2008 was so severe because of the interaction of the
inherent risks of banks, property loans and liquid traded markets
27
Tranching via securitisation
Providers
of funds
Users
of funds
Investors
with a
range of
different
risk / return
preferences
Pool of assets or,
for instance,
average AA
quality
Securitisation
AAA
AA
BBB
Equity
28
Securitised credit as % of total category: US
1970 – 2009
Source: U.S. Flow of Funds
Private label Home Mortgage
0%
10%
20%
30%
40%
50%
60%
70%
19
70
Q1
19
73
Q1
19
76
Q1
19
79
Q1
19
82
Q1
19
85
Q1
19
88
Q1
19
91
Q1
19
94
Q1
19
97
Q1
20
00
Q1
20
03
Q1
20
06
Q1
20
09
Q1
Home Mtge total Home mtge GSES Commercial Mtge Consumer credit
Home
mortgages
Consumer
credit
Commercial
mortgage
29
Benefits of securitisation and credit (and other)
derivatives
Better management of bank risks: ability to diversify credit,
interest rate and currency risk
Market completion: tailoring of risk/return and liquidity to
precisely match investor preference
More stable system
Facilitating credit extension
30
Apparent advantages of securitisation versus bank credit
Assets held by end
investors not leveraged
intermediaries
Maturity transformation
via marketability not bank
balance sheets
Shadow bank maturity
transformation as risky
and prone to contagion
effects as bank based
Large share of credit
securities held in bank
trading books
Theory Practice
31
Credit derivatives “enhance the transparency of the
markets’ collective view of credit risks … [and thus] …
provide valuable information about broad credit conditions
and increasingly set the marginal price of credit.”
IMF Global Financial Stability Review, April 2006
32
Financial firms’ CDS and share prices
Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%D
ec 0
2
Apr
03
Aug 0
3
Dec 0
3
Apr
04
Aug 0
4
Dec 0
4
Apr
05
Aug 0
5
Dec 0
5
Apr
06
Aug 0
6
Dec 0
6
Apr
07
Aug 0
7
Dec 0
7
Apr
08
Aug 0
8
Dec 0
8
Avera
ge C
DS S
pre
ad in P
erc
ent
-
0.50
1.00
1.50
2.00
2.50
Mark
etC
ap Index
CDS SHARE-PRICE-ADJUSTED
Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford &
Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan
Stanley, National Australia Bank, Royal Bank of Scotland and UBS.
CDS series peaks at 6.54% in September 2008.
Source: Moody’s KMV, FSA Calculations
33
Credit and asset prices: with securitised credit and
mark-to-market accounting
Expectations of
future asset price
rises
Mark-to-market accounting generates
bank profits and capital increase
• High bonuses and motivational
reinforcement
• Increased capital for own account
trading or on balance sheet lending
Increased real asset
prices e.g. real estate
Favourable
assessments of
credit risk
Increased
price/reduced
spreads of credit
securities
Increased investor
demand for credit
securities at lower
spreads
Increased on balance
sheet lending at low
spreads
Increased new credit
extension at lower
spreads
34
Overall conclusion
The Risky Interaction
Maturity transforming
banks
Credit financed
asset price cycles
Specific risks of credit
contracts
Securitisation: inherent
instability of liquid traded markets
35
Radical structural reform responses
Fix “Too Big to Fail”
Separate commercial banking from investment banking
(Volcker)
Separate deposit taking from lending (Kay)
Abolish banks: 100% equity enhanced loan funds
(Kotlikoff)
36
Separating deposit taking from lending: John Kay
Equity
Debt
Depositors
Liquid assets
Loans
Debt
Equity
Non-insured
deposits
Loans
Retail
DepositsLiquid
Assets
Free-market lending bank
Risk-free deposit taker
37
Replace banks with loan funds (Larry Kotlikoff)
Close to zero
risk deposits
Liabilities Assets
Moderately
risky
loans
Moderately
risky senior
debt
Riskier
subordinated
debt
High risk
equity
Investments
bearing
capital
value
risk
Moderately
risky
loans
100% equity financed
loan funds
38
Two distinct issues
Long-term comparative
staticsTransitional dynamics
Would UK be better off in long-term
future (say 2025) with debt to GDP of
120%, 100%, 80%?
Given that UK today has debt to
GDP of 125%*, what is the optimal
path over (say) next 5 years?
Impact of credit on long-term
savings rate and efficiency of capital
allocation and thus long-term
productive potential of economy
Direct impact of credit on human
welfare (e.g. via life-cycle
consumption smoothing
Key issues Key issues
Impact of change in credit
extension on aggregate nominal
demand (directly and via asset
price and confidence effects) and
thus on path of GDP relative to
productive potential
* £M4 equivalent debt of non-financial corporates
39
UK Banks’ unweighted capital ratios
Perc
en
tag
e o
f ban
ks’ a
ssets
Source: Sheppard (1971), Billings & Capie (2007), BBA, Bank of England
What is the contribution of the financial sector: miracle or mirage?
Andrew HaldaneDirector of Financial Stability, Bank of England
THE FUTURE OF FINANCE
1
The Contribution of the Financial SectorMiracle or Mirage?
Simon Brennan
Andy Haldane
Vasileios Madouros
Bank of England
July 2010
2
Here’s a funny thing….• 2008 Q4
– Collapse of Lehman Brothers, AIG, ….
– Global banks equity prices fall 50%
– World GDP falls 6% (annualised)
– World trade falls 25% (annualised)
– ….second Great Depression?
3
Here’s a funny thing….• 2008 Q4
– Collapse of Lehman Brothers, AIG, ….
– Global banks equity prices fall 50%
– World GDP falls 6% (annualised)
– World trade falls 25% (annualised)
– ….second Great Depression?
– Largest rise in GVA of financial sector on record
– Largest rise in gross operating surplus of financial sector
on record
– Contribution of financial sector to GDP at a record high
• How do we square this circle?
Plan
• Measuring financial sector output
• Decomposing financial sector output –
“productivity miracle”
• Explaining returns to finance – “risk mirage”
• Disaggregating returns to banking
4
Three Eras of Finance
5
0
50
100
150
200
250
300
350
400
1855 1875 1895 1915 1935 1955 1975 1995
Financial Intermediation
Aggregate
1975=100
Chart 1 UK financial intermediation
and aggregrate real GVA
Sources: Feinstein (1972), Mitchell (1988), ONS and Bank calculations.
GVA: Aggregate
GVA: Financial
intermediation Difference (pp)
1856-1913 2.0 7.6 5.6
1914-1970 1.9 1.5 -0.4
1971-2008 2.4 3.8 1.4
1856-2008 2.1 4.4 2.3
So urces : Fe ins te in (1972), Mitche ll (1988), ONS and Bank ca lcula tio ns .
Table 1 Average annual growth rate of UK
financial intermediation
1856-2008 2.1 4.4 2.3
6
0
50
100
150
200
250
300
350
400
1855 1875 1895 1915 1935 1955 1975 1995
Financial Intermediation
Aggregate
1975=100
Chart 1 UK financial intermediation
and aggregrate real GVA
Sources: Feinstein (1972), Mitchell (1988), ONS and Bank calculations.
GVA: Aggregate
GVA: Financial
intermediation Difference (pp)
1856-1913 2.0 7.6 5.6
1914-1970 1.9 1.5 -0.4
1971-2008 2.4 3.8 1.4
1856-2008 2.1 4.4 2.3
So urces : Fe ins te in (1972), Mitche ll (1988), ONS and Bank ca lcula tio ns .
Table 1 Average annual growth rate of UK
financial intermediation
1856-1913 2.0 7.6 5.6
Three Eras of Finance
7
0
50
100
150
200
250
300
350
400
1855 1875 1895 1915 1935 1955 1975 1995
Financial Intermediation
Aggregate
1975=100
Chart 1 UK financial intermediation
and aggregrate real GVA
Sources: Feinstein (1972), Mitchell (1988), ONS and Bank calculations.
GVA: Aggregate
GVA: Financial
intermediation Difference (pp)
1856-1913 2.0 7.6 5.6
1914-1970 1.9 1.5 -0.4
1971-2008 2.4 3.8 1.4
1856-2008 2.1 4.4 2.3
So urces : Fe ins te in (1972), Mitche ll (1988), ONS and Bank ca lcula tio ns .
Table 1 Average annual growth rate of UK
financial intermediation
1914-1970 1.9 1.5 -0.4
Three Eras of Finance
8
0
50
100
150
200
250
300
350
400
1855 1875 1895 1915 1935 1955 1975 1995
Financial Intermediation
Aggregate
1975=100
Chart 1 UK financial intermediation
and aggregrate real GVA
Sources: Feinstein (1972), Mitchell (1988), ONS and Bank calculations.
GVA: Aggregate
GVA: Financial
intermediation Difference (pp)
1856-1913 2.0 7.6 5.6
1914-1970 1.9 1.5 -0.4
1971-2008 2.4 3.8 1.4
1856-2008 2.1 4.4 2.3
So urces : Fe ins te in (1972), Mitche ll (1988), ONS and Bank ca lcula tio ns .
Table 1 Average annual growth rate of UK
financial intermediation
1971-2008 2.4 3.8 1.4
Three Eras of Finance
9
4
2
0
2
4
6
8
10
12
14
16
18
48 58 68 78 88 98 08
Per cent
-
+
1948 2008
Chart 2 Gross operating surplus of
UK private financial corporations (%
of total)
Sources: ONS and Bank calculations.
0
1
2
3
4
5
6
7
8
9
50 70 90 10 30 50 70 90
Per cent
1850 1910
Chart 3 Share of the financial
industry in US GDP
Source: Philippon (2008).
Measuring Financial Sector Output
• Fees (overdraft, underwriting etc) – easy to measure
• Intermediation services – difficult to measure
FISIM (Financial Intermediation Services Indirectly Measured)
• FISIM on loans/deposits
(Loan rate – Reference rate) x Loan Amount
(Reference rate – Deposit rate) x Deposit Amount
• FISIM = roughly 50% of gross output of financial sector
10
Measuring Financial Sector Output
11
0
5
10
15
20
25
30
35
40
04 05 06 07 08 09
Other operating income
Net Spread Earnings
Fees and commissions
FISIM
£ billions
Char t 7 Value of gross output of the
UK banking sector
Source: Bank of England.
Problems with FISIM
• No adjustment for risk
• Eg, rise in expected losses
rise in bank spreads/margins
rise in FISIM
but underlying financial services greater?
• Helps explain 2008 Q4 paradox
• Risk-adjusting reference rates using market rates:
FISIM 60% lower between 2003-07
• Even then, assumes risk correctly priced by market…
• …which it wasn’t in run-up to crisis12
Decomposing Financial Sector Output
• Growth accounting framework
gF = αK gK + αL gL + s
where α k , α l = capital/labour share
s = Solow residual (TFP)
• Rising share of finance - factor inputs (gK, gL)?
- or productivity (s)?
13
Factor Shares in Finance
14
0
1
2
3
4
5
48 58 68 78 88 98 08
United States (a)
United Kingdom (b)
Per cent
1948 2008
Chart 8 Share of financial intermediation employment in UK
and US whole - economy employment
0
2
4
6
8
10
12
14
70 73 76 79 82 85 88 91 94 97 00 03
Per cent
Chart 9 UK financial sector physical capital (share of
total industry capital)
Solow Residual – “Productivity Miracle”
15
1 0 1 2 3
Health and social work
Financial intermediation
Wholesale / retail trade
Manufacturing
Real estate, renting, etc (22%)
(12%)
(11%)
(8%)
(7%)
- +
Chart 10
Annual TFP growth across the five largest UK
industries, average 2000-7
Per Cent
Chart 11 Differential in TFP growth between
financial intermediation and the whole economy
2
0
2
4
6
8
10
Spai
n
Irel
and
Bel
giu
m
Ital
y
UK
Aust
rali
a
Net
her
lands
Japan US
Fra
nce
Sw
eden
Ger
man
y
Aust
ria
1995-2007 2003-2007
PPer cent
-
+
Returns to Capital and Labour
16
0
20
40
60
80
100
120
140
87 92 97 02 07
Gross operating surplus
Compensation of employees
Gross value added£ billions, current prices
1987 2002
Chart 12 Returns to labour and capital in UK financial intermediation
Returns to Labour
17
0.1
0.0
0.1
0.2
0.3
0.4
0.5
10 25 40 55 70 85 00
'Excess' wage
-
+
1910 2000
Chart 15 Historical 'excess' wage in
the US financial sector(a)
Source: Philippon and Reshef (2009).
(a) Difference between the actual relative wage in finance and an
estimated benchmark series for the relative wage.
Chart 13 Average weekly earnings across UK
industries, 2007
0
200
400
600
800
1000
Fin
ance
Min
ing a
nd q
uar
ryin
g
Uti
liti
es (
a)
Const
ruct
ion
Tra
nsp
ort
, et
c (b
)
Publi
c ad
min
istr
atio
n
Man
ufa
cturi
ng
Rea
l es
tate
, et
c (c
)
Oth
er s
ervic
es
Hea
lth a
nd s
oci
al w
ork
Educa
tion
Dis
trib
uti
on, et
c (d
)
Agri
cult
ure
, et
c (e
)
£ per week
Returns to Capital
18
0
10
20
30
40
50
60
70
48 58 68 78 88 98 08
Whole economy
Financial Corporations
Return
1948 20081948 2008
Chart 16 Net operating surplus over
net capital stock in UK financial
intermediation and the whole
economy(a)
Sources: ONS and Bank calculations.(a) Gross operating surplus less capital consumption , divided by net
capital stock.
0
5
10
15
20
25
30
35
1921 1941 1961 1981 2001
μ = 7.0σ = 2.0
μ = 20.4σ = 6.9
Per cent
Chart 17 Return on equity in finance
Explaining “Excess” Returns
• Three pre-crisis balance sheet strategies
– Leverage
– Trading books
– Deep out-of-the-money options
• All three boosted reported returns on equity …
• …but not risk-adjusted returns on equity
19
Price: Book ratios for UK, US and European
institutions (a)(b)
20
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
European LCFIs
US LCFIs
Major UK banks (b)
Ratio
Sources: Bloomberg, Thomson Datastream and Bank calculations
(a) Chart shows the ratio of share price to book value per share. Simple averages of the
ratio in each peer group are used. The chart plots the three month rolling average.
(b) Excludes Nationwide and Britannia from Major UK Banks peer group
-2,000
0
2,000
4,000
6,000
8,000
10,000
12,000
1900 1917 1933 1950 1967 1983 2000
Per cent
Chart 6 Cumulative excess returns
from hedged bet placed in 1900
Sources: Global Financial Data and Bank calculations.
“Excess” Returns to Finance
Balance sheets balloon….
21
Chart 19 Size of the UK banking
system(a)
Sources: Sheppard (1971) and Bank of England.
(a) The definition of UK banking sector assets used in the series is
broader after 1966, but using a narrower definition
throughout gives the same growth profile.
0
100
200
300
400
500
600
80 98 16 34 52 70 88 6
Banking sector assets (per cent of GDP)
1880 1916 2006980
20
40
60
80
100
120
70 90 10 30 50 70 901870 1910
Per cent
2008
Chart 20 Size of the US banking
system relative to GDP, 1870-2008
Source: Schularick and Taylor (2009).
….driven by leverage….
22
0
5
10
15
20
25
30
35
40
45
50
99 00 01 02 03 04 05 06 07 08 09 10
US securities houses
US commerical banks
European LCFIs
Major UK banks
Ratio
Chart 24 Leverage at the LCFIs(a)
Sources: Bloomberg, published accounts and Bank calculations.(a) Leverage equals assets over total shareholders equity net of
minority interests.
Chart 23 Long-run capital ratios for
UK and US banks
0
5
10
15
20
25
1880 1900 1920 1940 1960 1980 2000
Per cent
United Kingdom
United States
….flattering returns
23
100
50
0
50
100
150
200
H2 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2
Gearing
Pre-tax return on equity
Pre-tax return on assets
Pre-tax pre-provision return on assets
Dec 2002 = 100
02 03 04 05 06 07 08
+
-
09
Chart 26 Major UK banks' pre-tax
return on equity(a)
Sources: Published accounts and Bank calculations.(a) Based on twelve-month trailing pre-tax revenues and average
shareholders equity.
Rising trading books
24
15
20
25
30
35
40
45
50
00 01 02 03 04 05 06 07 08 09
Total trading assets as a proportion of total assets
Total loans to customers as a proportion of total assets
Per cent
Chart 29 LCFIs' trading assets and
loans to customers as a proportion of
total assets(a)
Sources: Published accounts and Bank calculations.
(a) Incluides US commercial bank LCFIs, European LCFIs and UK
LCFIs.
Chart 30 LCFIs' ratios of total assets to
Tier 1 capital and trading assets to total
assets(a)(b)
0
10
20
30
40
50
60
70
80
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
Trading assets/Total assets
Total assets/Tier 1 capital
Credit SuisseBNP Paribas Societe Generale
HSBC
Deutsche Bank
Bank of America
RBS
UBS
Barclays
JPMorgan
Citigroup
….in structured products….
25
0
5
10
15
20
25
30
35
40
0
100
200
300
400
500
600
700
800
900
1000
00 01 02 03 04 05 06 07 08 09 10
Other ABS
CMBS
RMBS
Moore's Law (LHS)
US$ billionsMar.2000 = 1
Chart 32 Global issuance of asset-backed
securities(a)(b)
Source: Dealogic.
(a) 'Other ABS' includes auto, credit card and student loan ABS.
(b) Bars show publicly-placed issuance.
0.0
1.0
2.0
3.0
4.0
5.0
6.0
0
10
20
30
40
50
60
70
Dec.04 Dec.05 Dec.06 Dec.07 Dec.08 Dec.09
Outstanding amount of CDS (rhs)
Moore's Law (lhs)
US$ trillionsDec 2004 = 1
Chart 34 Growth of outstanding
notional amount of CDS vs. Moore's
Law
Sources: Bank for International Settlements and Bank calculations.
….where losses greatest
26
10
0
10
20
30
40
50
60
70
80
H2
07
H1
08
H2
08
H1
09
H2
09
H2
07
H1
08
H2
08
H1
09
H2
09
H2
07
H1
08
H2
08
H1
09
H2
09
Other (b)Credit valuation adjustments(c)Leveraged loansCommercial mortgage-backed securitiesResidential mortgage-backed securities
US$ billions
-
+
Major UK banks
European LCFIs
US LCFIs
Sources: Published accounts and Bank calculations.(a) Includes write-downs due to mark-to-market adjustments on trading
book positions where details are disclosed by firms.
(b) Other includes SIVs and other ABS write downs.
(c) On exposures to monolines and others.
Chart 31 Major UK banks' and LCFIs'
write-downs(a)
0
10
20
30
40
50
91 93 95 97 99 01 03 05 07
Upgrades
Downgrades
Per cent
Chart 33 Global structured finance
ratings changes(a)
Source: Fitch Ratings.
(a) Data compares beginning-of-the-year rating with end-of-the-year
rating. Does not count multiple rating actions throughout the year.
Disaggregating Returns
27
40
30
20
10
0
10
20
30
40
50
60
70
Total Investment bank Retail financial services
Card services Commercial banking
Treasury and securities services
Asset management
Per cent
-
+
Per cent
-
+
Q4 05 to Q1 10 Q4 05 to Q1 10 Q4 05 to Q1 10 Q4 05 to Q1 10 Q4 05 to Q1 10 Q4 05 to Q1 10 Q4 05 to Q1 10
Chart 36 JP Morgan Chase business segment return on equity, quarterly Q4 2005 – Q1
2010
Source: Pubilshed accounts.
Questions
• Why are retail financial services so profitable?
• And transaction/custodial services?
• Marginal cost pricing for retail financial services?
• Is 3-4% the marginal cost of M + A and advisory?
• Why is market-making so profitable?
28
Conclusion
• Second “Golden Era” of finance…productivity miracle?
• High returns to labour/finance…risk mirage?
• Lessons for public policy/investors:
– Better capturing risk in the National Accounts
– Better measuring risk-adjusted performance
– Risk-sensitive regulation and structural reform
29
Why financial markets are so inefficient and exploitative – and a suggested remedy
THE FUTURE OF FINANCE
Paul WoolleySenior Fellow, The Paul Woolley Centre for the Study of Capital Market Dysfunctionality, LSE
What mix of monetary policy and regulation is best for stabilising the economy?
Sushil WadhwaniCEO, Wadhwani Asset Management
THE FUTURE OF FINANCE
June 2009 (1.4)
WHAT MIX OF MONETARY POLICY AND REGULATION IS BEST FOR STABILISING THE ECONOMY?
Dr Sushil B. Wadhwani, CBE
(CEO, Wadhwani Asset Management and Visiting Professor of
the LSE and Cass Business School)
Presentation to the “Future of Finance” conference, July 14, 2010
Wadhwani Asset Management LLP
2Wadhwani Asset Management LLP
Introduction and Summary
1. After the crisis, many proposals for regulatory reform, but surprisingly little attention paid to how we
should reform the setting of monetary policy.
2. Attempts to exonerate monetary policy from a role in the crisis (e.g. Bernanke, Greenspan) are
unconvincing.
3. “Leaning against the wind” (LATW) monetary policy is important in its own right, and it is necessary
to coordinate this with macro-prudential policy. The proposed UK reform may be flawed.
3Wadhwani Asset Management LLP
Introduction and Summary
4. Risks/costs of regulatory reform:-
(i) Regulators made many mistakes before and during the crisis – so do not neglect the costs of
“regulator failure”
(ii) Historically, financial innovation has been important to growth
(iii) Some countries (e.g. China, India) need more financial liberalisation to make the world more
balanced.
5. Key Point:-
Keynes suggested we use macro stabilisation policy to deal with the instabilities associated with
capitalist economies while preserving the considerable microeconomic benefits of market-based
economies.
We need a better monetary and fiscal framework, we don’t need a lot of regulatory interference
that hurts economic growth and may not work anyway.
4Wadhwani Asset Management LLP
Monetary Policy
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Attitudes towards “LATW” Monetary Policy
� Vigorous debate between those who wanted to “Lean” e.g. (BIS, CGLW) or “Clean” (Greenspan,
Bernanke, Bean etc.)
� Since “mopping-up” appears to be failing, one would have expected a change of heart with regards
to LATW
� Bernanke/Kohn say no to LATW, should use regulatory policy instead
� Bank of England’s paper on “Macro-Prudential” tools was rather dismissive of the role of monetary
policy in reacting to financial imbalances
� Chancellor Osborne exonerates the Bank of England by saying that because the Bank of England
was mandated to focus on CPI, could not respond to asset prices – this is plain wrong!
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Attitudes towards “LATW” Monetary Policy
� Since the remit is to meet the inflation target at all times, it was the duty of the Bank of England to
respond to asset price misalignments as they were emerging to reduce the probability of a a
deviation from target later on (i.e. miss the inflation target a little in the near term to avoid a bigger
miss later on).
� Other central banks (e.g. Australia, Sweden) did this.
� Was explicitly discussed in the UK (opposed by most on the Monetary Policy Committee and HM
Treasury).
7Wadhwani Asset Management LLP
Monetary Policy versus Macro-Prudential Policy
UK proposes a FPC that might vary capital requirements over the cycle
� In principle, a good idea to have an extra instrument
� However, odd to separate the FPC from the Monetary Policy Committee
a) In theory, better to set two instruments simultaneously to hit two targets than to have specific
assignment
b) In Spain – dynamic provisioning did not prevent a housing market bubble as monetary policy was set
by the European Central Bank
8Wadhwani Asset Management LLP
Monetary Policy versus Macro-Prudential Policy
Regulatory Arbitrage
Less easy to avoid higher policy rates than higher capital requirements
Role of “Market Capital Requirements”
� In good times, markets “reward” banks who engage in regulatory arbitrage
� In bad times, markets might hold banks to higher capital norms than might be set by the FPC
� Therefore counter-cyclical capital requirements may be relatively ineffective (Diamond & Rajan)
9Wadhwani Asset Management LLP
Monetary Policy versus Macro-Prudential Policy
Time-varying capital requirements (TVCR) will need to be coordinated internationally (to prevent arbitrage)
– interest rates can be set autonomously
Setting TVCR requires detailed knowledge we do not have (at least we have experience of setting interest rates)
� e.g. in the recent debate about the new base capital and liquidity rules, estimates of the long-run effect of a 1% increase in capital requirements vary by a factor of 10!
� Significant disagreement about the shorter-run impact too
� BEQM has no role for bankruptcy and assumes Modigliani & Miller holds!
� Bank of England was wrong about the effects of securitisation (argued it made the global banking system safer as late as August 2007!) and that British banks were more than adequately capitalised (September 2007). Incidentally, the markets were quicker to scent difficulties than the Bank of England
10Wadhwani Asset Management LLP
Monetary Policy versus Macro-Prudential Policy
Effect on output
Common argument is that raising interest rates to deal with bubbles would eviscerate the rest of
the economy
� LATW monetary policy is not designed to prick the bubble, but improve macro stability (so unlikely to
create a recession), so one raises rates by the “optimal” amount to achieve this
� In any case, increasing capital requirements operates through changing the spread between the
lending rate and the central bank’s policy rate. Therefore, you get a significant impact on output and
inflation anyhow – no “free lunch” here
11Wadhwani Asset Management LLP
Monetary Policy versus Macro-Prudential Policy
Bank of England asserts that LATW monetary policy would de-anchor inflation expectations
� But, LATW monetary policy easy to explain
� Price-level targeting (Carney)
� Choice between de-anchoring inflation expectations now versus later in a Japan-style deflation
Bank of England asserts that TVCR can target financial imbalances directly without perturbing consumer prices
(because the Monetary Policy Committee takes care of the latter)
� Seems implausible – for example, suppose the FPC increase capital requirements ═› lending margins
═› inflation forecast to undershoot the target
═› Monetary Policy Committee lowers the policy rate. Here, the overall impact on the housing market not clear
� Davies and Green warn of “Push-me, Pull-you” policies
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Monetary Policy versus Macro-Prudential Policy
Many bubbles historically under
� Different regulatory structures
� Different types of banking systems (including narrow banks)
� Always likely to need macro-stabilisation policy (fiscal & monetary)
13Wadhwani Asset Management LLP
The role of monetary policy in the recent crisis
Disappointing that central bankers are not accepting responsibility
Bernanke’s ‘defence’:-
1) Interest rates were not “too-low” as per the Taylor rule with Bernanke’s preferred inputs
— But, LATW proponents always argued that the Taylor rule has a missing term!
— Interest rates were too low in terms of a ‘CGLW rule’
2) Low interest rates only played a ‘small’ role – instead, ‘exotic’ mortgages were the key explanation of the housing bubble (so, need better regulatory policy, not better monetary policy)
But:-
a) Conclusion based on ‘inadequate’ econometric models
b) House prices went up in countries without ‘exotic’ mortgages (e.g. Spain)
c) “Loose” monetary policy plus “Greenspan put” led to banks taking more risk and creating these “exotic” products (e.g. Diamond-Rajan, BIS)
14Wadhwani Asset Management LLP
The role of monetary policy in the recent crisis
Bernanke’s ‘defence’ continued:-
Attributes it to the global savings-glut hypothesis
- i.e. countries with higher capital inflows had greater house price appreciation
- Bernanke argues that since loose monetary policy reduced capital inflows, monetary policy cannot
have been important
However, Laibson & Mollerstrom (2010) argue that asset price bubbles drew in capital inflows and
as loose monetary policy led to a house price bubble, it may have increased capital inflows
15Wadhwani Asset Management LLP
Regulatory Reform
16Wadhwani Asset Management LLP
Yes the regulators made mistakes too
1) There were policymakers who wanted a change in the regulatory structure, but were ignored:-
e.g Heikensten (Governor of Riksbank)
2) Levine (2010) provides many examples to suggest
“The crisis did not just happen. Policymakers and regulators, along with private sector co-
conspirators, helped cause it”
Always a risk that we could replace “market failure” with “policymaker failure”
17Wadhwani Asset Management LLP
Lack of policymaker contrition a problem
Bank of England:-
(i) Nothing to deal with the emerging bubble pre-emptively
(ii) Response to the crisis was slow (monetary policy, Northern Rock)
� Main problem is the doctrine that financial markets were efficient
� In my time, there was a perception that the financial stability wing was being run down
Odd that:-
� Bank of England has not apologised
� Bank of England has been given more power without any evidence that they are willing to learn from
their mistakes
18Wadhwani Asset Management LLP
Reforming the financial sector may hurt growth
1) Not uncommon to blame financial innovation after financial crises:-
e.g. After the South Sea bubble burst in 1720, this was followed by a ban on joint stock companies!
(and the Barnard Act in 1734 banned option trading)
Not all post-crisis reform is sensible!
2) Historically, the financial sector has made a significant contribution to growth:-
(i) e.g. Sir John Hicks asserted that the critical ingredient that brought the Industrial Revolution to
eighteenth century England was capital market liquidity
19Wadhwani Asset Management LLP
The financial sector and growth
Academic Evidence
� King and Levine (1993) showed that the initial level of financial intermediation and its growth had
beneficial effects on growth over the 1960-89 period
� Rosseau & Sylla (2001) studied 17 countries over the 1850-1997 period with similar conclusions
� Jayaratne and Strahan (1996) showed that the US states who relaxed branch banking restrictions
did better
� Rajan and Zingales (1998) showed that industries that were naturally heavier users of external
finance grew faster in economies with better developed financial systems
20Wadhwani Asset Management LLP
The financial sector and growth
� Often argued that while financial innovation may have contributed in the past (e.g. the Industrial
Revolution) and might help less-developed countries, somehow, financial innovation over the last 30
years has not made a positive contribution
� Not obvious as to what the theoretical justification is
Academic Evidence:-
Greenwood et al (2010) argue that, over 1974-2004, 30% of US growth due to technological
improvement in financial intermediation. Also, Michalopoulos et al (2010) show how financial innovation
was important over the 1973-95 period
21Wadhwani Asset Management LLP
The financial sector and growth
The cross-country relationship between interest-rate spreads and capital to
output ratios
The cross-country relationship between interest-rate spreads and TFP
Figure 1 Figure 2
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The Chinese case
� Chinese current surplus shot up from around 1% - 1.5% of GDP early in the decade to around 11%
of GDP in 2007
� The increased saving which went hand-in-hand with the rise in the current account surplus was the
rise in gross corporate savings, which rose from around 15% of GDP in 2000 to about 26% of GDP
in 2007
23Wadhwani Asset Management LLP
� Standard theoretical model – with perfect capital markets and no tax distortions, the level of national savings should be unrelated to the savings of corporations
� In emerging markets outside Asia, this approximately holds, but does NOT hold in Asia (see Figure 3)
� Remember, in China, corporates are often “state-owned” or “local government-led”. Usually the state does not receive dividends, and large companies either reinvest their profits or simply accumulate assets
Impact of corporate saving on total private saving
Private and Corporate Savings (in percent of GDP)Figure 3
24Wadhwani Asset Management LLP
How might one either reduce corporate savings or their impact on overall savings in Asia?
1) Financial liberalisation:- With a more market-driven system, firms are less likely to need to retain earnings
(less reliance on self-financing). Although this has already improved, it takes several years. (IMF estimates
that achieving the average level of financial liberalisation in the G7 would reduce corporate savings by 5
percent of GDP)
2) Improvements in corporate governance:- This would reduce the tendency of corporates to hoard cash
– again, improvements have already occurred in recent years, but this takes time
25Wadhwani Asset Management LLP
Financial liberalisation and negative skewness
Tornell, Westermann and Martinez (2004) show that :-
(i) Financial liberalisation leads to a greater incidence of crises
(ii) But, financial liberalisation also leads to higher GDP growth
(iii) A positive link between GDP growth and the negative skewness of credit growth (which is a
correlate of crises)
Between 1980 and 2002, growth in GDP per capita:
India 114%
Thailand 162%
the latter had lending booms and crisis – the former has a tightly regulated financial sector
26Wadhwani Asset Management LLP
Conclusion
Key Conclusion:-
Macro policy (including both monetary and fiscal policy) needs to work towards delivering greater
macro and financial stability without resorting to micro-meddling that may hurt growth significantly
How should we regulate the financial sector?
Charles GoodhartEmeritus Professor of Banking & Finance, LSE
THE FUTURE OF FINANCE
1
Financial Regulation
By C.A.E. Goodhart
Financial Markets Group, London School of Economics
2
(A) Introduction
Regulation normally a pragmatic reaction to prior crisis, “We must not
let that happen again”, rather than based on any theory.
Basel I was a reaction to MAB 1982; and 8% target highest level
consistent with current bank practices in major countries.
Subsequent market risk analysis based on „building block approach‟.
Technically inferior to VaR. Intellectual capture.
Aim of regulation was to bring each bank up to risk control measures
of the „best‟.
Problems:
(i) VaR good for normal occasions, not for tail risk
(ii) Process focussed on individual bank (also stress tests), not
system as a whole.
3
(B) Why do we have bank regulation at all?
Not to control risk-taking, or behaviour, but three main
reasons, (monopoly control, asymmetric information, i.e.
customer protection and externalities).
(1) Asymmetric Information
Professionals have greater knowledge. Deposit
insurance, both to protect customers and to prevent risks.
But premia (or bank taxes/levies) not related to risk, so
risk shifting, (also shareholders with limited liability).
4
(2) Externalities
Amplified spirals: Procyclicality of Basel II, reinforced by
Mark-to-Market.
Social costs of bankruptcies:
1) Direct (legal/accounting) costs
2) Dislocation of markets
3) Loss of human capital (skills)
4) Uncertainty (plus ultimate loss) to creditors
5) Loss of access to funds of debtors/creditors
Retail deposit protection not enough (Lehman Bros).
5
(C) Enhanced Regulation
Any fool can make banks safer:-
1) more capital
2) less leverage
3) more liquidity
4) tighter margin controls
Why not just do it?
6
Table 1: Annual Summary Statistics by Period
Notes: Money denotes broad money. Loans denote total bank loans. Assets denote total
bank assets. The sample runs from 1870 to 2008. War and aftermath periods are
excluded (1914-19 and 1939-47), as is the post-WWI German crisis (1920-25). The 14
countries in the sample are the United States, Canada, Australia, Denmark, France,
Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden and the United Kingdom.
This has induced banks to respond in three main ways:-
i.To replace safe public sector debt by riskier private sector assets;
ii.To augment retail deposits by wholesale funding, with the latter often at a very short
maturity;
iii. To originate to distribute by securitising an increasing proportion of new lending.
All three mechanisms are going sharply into reverse.
Pre-World War 2 Post-World War 2
N Mean s.d. N mean s.d.
Δ log Money 729 0.0357 0.0566 825 0.0861 0.0552
Δ log Loans 638 0.0396 0.0880 825 0.1092 0.0738
Δ log Assets 594 0.0411 0.0648 825 0.1048 0.0678
Δ log Loans/Money 614 0.0011 0.0724 819 0.0219 0.0641
Δ log Assets/Money 562 0.0040 0.0449 817 0.0182 0.0595
7
D. Border Problems
(a) Between regulated and non-regulated.
The rain it raineth every day
upon the just and unjust fellow;
but more upon the just because
the unjust hath the just’s umbrella.
The umbrella being the opportunity to provide greater
returns and services. Can we calibrate regulation to
marginal addition to systemic risk? How measure
systemic risk?
8
(b) Between countries
A global financial system in a world of nation states.
Argument for a „level playing field‟, but cycles are not
similar across countries.
Solutions:
1) Make system less global; host country control
2) A single world legal basis for special resolution
regimes
9
(E) Towards a Solution
1. Think systemically. Relate regulation to systemic
risk.
2. Develop a ladder of sanctions
3. More transparency, CCPs for derivatives
4. Adopt „Living Wills‟, and face up to the legal
issues
THE FUTURE OF FINANCE AND THE THEORY THAT UNDERPINS IT
Howard DaviesDirector, London School of Economics
THE FUTURE OF FINANCE
Can we identify bubbles and stabilise the system?
Andrew SmithersFounder, Smithers & Co.
THE FUTURE OF FINANCE
SMITHERS & CO. LTD.
Andrew Smithers
Future of FinanceLondon 14th July 2010
www.smithers.co.uk [email protected]
Can We Identify Bubbles and
Stabilise the System?
Slide 1. Can We Identify Bubbles and Stabilise the
System?
• We want to avoid recurrent crises.
• To do this we must focus on asset prices.
• As well as the prices of goods and services.
Slide 2. The Great Moderation – The Light That
Failed.
• Assumptions, widely held in the past, are seldom held
today. These included:
1. Central banks could maintain low and stable
consumer price inflation through changes in short-
term interest rates.
2. If this were done, macroeconomic and financial
stability would follow.
3. Asset prices should not be the concern of central
bankers.
Slide 3. The Theories Behind The Assumptions.
• The Efficient Market Hypothesis.
• Easy clean up – asset price falls would not disrupt the
ability of central bankers to deal with ex-post problems.
• These assumptions were disputed by some of us, even
before the crisis.
• Their fall from fashion was, as usual, due to events rather
than successful advocacy.
Slide 4. The Emerging Consensus.
• Consumer price stability is not enough, but remains vital.
• Steps are needed to mitigate the risks of major recessions.
• As these often follow from asset bubbles and financial
crashes, the aim must be to prevent them or at least
mitigate their severity.
• This needs a new policy framework.
Slide 5. Possible Contributions To Crisis Mitigation.
1. Safer and smaller financial institutions - e.g. higher
equity ratios escalating with size.
2. Tax reform – e.g. removing tax subsidies for debt.
3. Legal reform – e.g. discouraging non-recourse property
lending.
4. Using macroeconomic policy to dampen asset and credit
bubbles – e.g. via interest rates or flexible equity ratios
for banks.
Slide 6. Dampening Asset and Credit Bubbles.
• This must be a concern of macroeconomic management.
• Those involved will have to decide on the danger signals.
• It is clear that they will need to monitor asset prices and
debt.
Slide 7. Why Asset Prices Matter.
• They affect savings and investment.
• They make borrowing easier and are both the result and
the cause of rising debt.
• They are an important transmission mechanism for
monetary policy.
• This breaks down when bubbles collapse.
Slide 8. Why The Stock Market Matters.
• Changes in its level affect demand in the real economy.
• One route is via savings (Slides 9 & 10).
• It is also a transmission mechanism for monetary policy
(Slide 11).
• But this breaks down in crashes.
• The risk of crashes can be assessed through the market’s
level (Slides 12, 13 & 14).
Slide 9. US: Pension Savings and the Stock Market.
0
1
2
3
4
5
6
7
8
9
1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
Data Sources: Z1 Table F.100, NIPA Table 2.1 & S&P 500 Index.
Pen
sio
n s
av
ing
s a
s %
of
dis
po
sab
le i
nco
me.
0
5
10
15
20
25
Dis
po
sab
le i
nco
me/S
&P
50
0.
Pension Savings as % of Disposable Income 12 Months Average
Disposable Income/S&P 500
Correlation
coefficient 0.64
Slide 10. US: Household "Discretionary Savings"
and Household Real Estate.
-2
-1
0
1
2
3
4
5
6
7
8
1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
Data Sources: Z1 Table B.100 & F.100 & NIPA Table 2.1.
Dis
creti
on
ary
sa
vin
gs
as
% o
f d
isp
osa
ble
inco
me (
12
mo
nth
s).
40
45
50
55
60
65
70
75
80
85
90
Dis
po
sab
le i
nco
me a
s %
of
ho
use
ho
ld
rea
l est
ate
(1
2 m
on
ths)
.
Discretionary Savings as % of Disposable Income
Disposable Income as % of Household Real Estate
Slide 11. US: Probability that Interest Rate Changes Affect Share
Price Changes.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 1 2 3 4 5
Time in years after change in interest rates.
Pro
ba
bil
ity
.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Source: Smithers & Co calculations.
Nominal Price
Real Price
Data 1871 - 2007
Slide 12. US: Stock Market Value (According to q and CAPE).
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Q1 2010
Data Sources: Z1 Table B.102 & Wright for q , Shiller for CAPE.
CA
PE
an
d q
to
th
eir
ow
n a
vera
ges
(lo
g n
um
bers)
.
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
CAPE to Its Own Average
q to Its Own Average.
Slide 13. UK & US: Real House Prices.
0
25
50
75
100
125
150
175
200
225
250
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Data Sources: Robert Shiller for US & C.H. Feinstein for UK.
Ra
tio
of
ho
use
pric
es/
co
nsu
mer p
ric
es
ba
se 1
90
0 =
10
0.
0
25
50
75
100
125
150
175
200
225
250
US house prices/consumer prices
UK house prices/ consumer prices
Slide 14. Risk Aversion Implied from Investment Grade Bonds.
0
25
50
75
100
125
150
175
200
225
250
1997 1998 1999 2000 2001 2002 2004 2005 2006 2007 2008 2009
Data Source: Bank of England updated.
Imp
lied
retu
rn
in
ba
sis
po
ints
.
0
25
50
75
100
125
150
175
200
225
250
Implied Return for Illiquidity
Mean
Slide 15. Conclusions.
• The emerging consensus is correct. Inflation targeting
alone is not enough.
• We must also mitigate asset and credit bubbles.
• This should be possible as we can observe them.
What framework is best for systemic, macroprudentialpolicy
Andrew LargeFormer Deputy Director, Bank of England
THE FUTURE OF FINANCE
11
Systemic [macroprudential] policy
Thoughts on delivery
Future of Finance
Andrew Large
July 2010
2
Introduction
Avoiding financial crises
• Put in context: this is NOT about
architecture
• It’s not about individual bank supervision
• It is about trying to identify/fix risks to
avoid financial crises
• New policy area for many jurisdictions
• Make four propositions: then a few
comments on issues
3
Proposition 1
Policy gap
• Existing relevant policy areas
– Monetary: low and stable inflation
– Microprudential [regulatory]: limiting individual
firm failure
– Fiscal
– Competition
• How to deal with aggregate risks: where is
systemic [macroprudential] policy???
4
Proposition 2
The plethora of microprudential
[regulatory] initiatives won’t do it
• Basel, FSB, G20, EU, – Capital and liquidity
– Structural / Volker rules
– tbtf / living wills
– AI, ratings
– Rem incentives
– Accounting standards…….
– Etc etc
• Where is the oversight?
• How well are they joined up? Who by?
5
Proposition 3
International issue: needs national
initiatives
• That's where implementation can take
place. Where the laws and fiscal
authority reside.
• Difficult to address, but don’t lets funk it!
6
Proposition 4
It’s relevant for all jurisdictions
• The main problems were in mature
economies
• Too much leverage/debt in US, UK,
elsewhere in EU
• Less problem in Canada, Australia, main
Asian countries: including China
• But the issues are generic
• And so are the lessons
7
Systemic stress
caused by what and whom?• Root cause
– Excessive broad leverage/borrowing/debt
• Indicators of systemic tension [‘bubbles and froth’]– Asset prices [equities; real estate]
– Credit spreads
– Maturity mismatch, inadequate liquidity buffers
– Other compromised risk areas
• Sparks can then cause crisis!– Random shocks [triggers are never obvious nor
predictable]
8
Leverage: who creates?
Who uses?
• Creators of leverage
– Banks/quasi banks
– Insurance/guarantees
– Products …embedded leverage
• Users of credit
– Consumers
– Companies
– Government
– Other financial institutions [incl hedge funds, private
equity]
9
How to dampen leverage
• Act on root cause: adjust the cost of
creating credit
• Direct restrictions on users unreliable:
– arbitrage
– squeezed balloon syndrome
10
Policy framework and deliveryIssues to consider
• Mandate/objectives
• Overarching authority
• Indicators and assessment
• Qualities to create legitimacy and success
• What sort of vehicle
• Instruments
– Direct and indirect
– Relationship with other policy areas [monetary policy
etc]
11
Policy framework and delivery 1
Mandate/objectives
• ‘secure and maintain financial stability’
• an overarching mandate
– review and assess the systemic conjuncture,
– identify actual or incipient threats to financial stability
– apply the direct policy instruments available to it
– recommend policy actions to be taken by other
relevant policymakers
• No targets……
12
Policy framework and delivery 2
Overarching authority
• Overarching oversight
– assess data;
– deliver response;
• Overarching authority
– authority to get implementation;
– global and national factors;
– multiple policy areas
13
Policy framework and delivery 3
Indicators and assessment
A lot of data!– imbalances;
– leverage; indebtedness sectors and whole economy
– asset managers exposures and dynamic:
– asset prices
– new products / securitisation
– arbitrage
– stress testing
– measures of uncertainty / confidence and risk appetite.
– multiple data sources. Macro, micro, market intelligence
– ….relevance is the key
14
Policy framework and delivery 4
Qualities to create
legitimacy and respect
• …politicians, bankers and credit users: they won’t like it! So: – Objectives politically set
– Operationally independent from political process
– Skill sets/working knowledge not available from one institution: needs CB, regulators, practitioners, academics
– Accountability to political process
– Transparency of process and decision
– Authority
– Dedicated resources
15
Policy framework and delivery 5
What sort of vehicle?
• Committee/ self standing/ department?
• Anchor with central bank?– Respect, independence
– Experience macro environment
– Operational activity/nerve centre
– Interface with political process
– Too much power?
– Emerging practice favours central banks: but with vital regulatory involvement
• Time dimension: – Steady state
– Role in triggers and crisis?
16
Policy framework and delivery 6
Instruments 1
• Own instrument
– Capital ratios [?promising candidate]
– Hierarchy macro/micro: Basel and RWA’s
• Relationship with other policy areas
– Recommendations/ comply or explain?
• Monetary policy
• Regulatory policy
– Givens/Aim-offs?
• Fiscal policy
• Competition
17
Policy framework and delivery 7
Instruments 2
Three tricky areas for ‘own’ instrument
– Policy context» behavioural expectations;
» ‘single policy area single instrument’
» governance of other policymakers;
» political pressure;
» squeezed balloons
– Calibration» Regularity of assessment
» Reaction function
– Discretionary/automatic?
18
Tough questions to debate…
• Feasibility/legitimacy to create an
executive reponsibility like monetary
policy?
• Impact on growth and welfare?
• Cost benefit equation?
• Two other points:
– Systemic and monetary policy interaction?
– Global vs national
19
Relationship with Monetary Policy
• Interest rates [monetary] and leverage/capital ratios [systemic] – Interaction
– Mutual expectations
– Equilibrium, but where?
• Combine or separate?– Sub-optimal implementation if two policy areas
– Experience and capabilities
– Accountability
– Assessment process: band vs binary
– Much to learn!
20
Global vs national
• Global markets need global oversight
• But no global government…….
• requires national level implementation
– Reliance on fiscal support
– Legitimacy
– Taxpayers and voters
21
Global vs national:
who does what?
• Global level:
– IMF, G20, Basel, FSB etc
– Three areas to develop• Peer group pressure to create national systemic
policy frameworks
• Standards setting for microprudential initiatives
• Data flow and help with co-ordination of policy
• National level:
– Create legitimate frameworks for delivery;
– consistency of approach
22
National level approach:
the UK as example• SPC alongside MPC?
• Membership: central bank; supervisor; practitioner; academic;
• Role of Treasury
• Appointments through political process
• Individual accountability
• Data: no barriers
• Decision Making: consensus and voting?
• Regularity of meetings ?quarterly
• Minutes and transparency
• Accountability for resourcing
23
Conclusion
• New policy area
• Difficult judgements
• Don’t avoid the issues
• Self confidence to attack them!
THE FUTURE OF FINANCEKEYNOTE ADDRESS
Rt Hon Dr Vince CableSecretary of State for Business, Innovation and Skills
THE FUTURE OF FINANCE
Should we have narrow banking?
John KayVisiting Professor, LSE
THE FUTURE OF FINANCE
Why and how should we regulate pay in the financial sector?
Martin WolfFinancial Times
THE FUTURE OF FINANCE
Why and how should we regulate
financial sector pay?Martin Wolf, Associate Editor & Chief
Economics Commentator, Financial Times
London School of Economics
London
14th July 2010
2
Regulating pay in the financial sector
“Simply stated, the bright new
financial system – for all its
talented participants, for all its
rich rewards – failed the test of
the market place.” Paul Volcker,
April 8th 2008
3
Regulating pay in the financial sector
• What are the problems?
• What are the solutions?
4
1. What is the problem with pay?
• First argument - inequality and fairness:
– Employees of financial institutions have shared in the rapidly
rising profits of financial institutions over the past few decades;
– The consequent rise in inequality undermines social cohesion
and worsens social tension;
– The sense of grievance is exacerbated by a strong and
understandable sense that the exceptional rewards are
“unfair” and reflect the extraction of various kinds of rent or
explicit and implicit insurance by taxpayers;
5
1. What is the problem with pay?
• Second argument – incentives:
– Financial sector booms and busts create gigantic losses for
society
– To the extent, that institutions take synchronized risks, they
increase the likelihood and severity of such crises
– Asymmetric information is pervasive. Thus, strategies with
zero expected excess returns in the long run may look
successful in the short run
6
1. What is the problem with pay?
– Shareholders, lack the capacity to monitor risks
– Worse, in highly leveraged limited liability companies, shareholders
also lack the interest to monitor such risks properly, since they enjoy
the upside, while their downside is capped at zero
– Not only shareholders, but also creditors, lack the interest to price the
risks being assumed, since they enjoy a high probability of rescue in
the event of failure: the core of “too big to fail”.
– Managers also have an incentive to bet the bank to the extent that
their interests are aligned with those of the shareholders.
– Since share options are a leveraged play on gains to shareholders,
they make management more prone to bet the bank than
shareholders
7
1. What is the problem with pay?
– Evidence suggests that even the management of failed
institutions have been able to cash out substantial winnings
before the collapse
– Finally, the combination of asymmetric information with the
complexity of such institutions makes it impossible for
regulators to monitor the risks
– The problem of remuneration is, therefore, an extreme version
of the deep problem in this sector: misalignment of incentives
between decision-makers inside the system and ultimate risk-
bearers, particularly the taxpayers and the wider public.
8
2. What is the solution to pay?
• So let us consider what might be done about these problems.
• First, pay levels and inequality. Logically, I can see three possible
solutions:
– First, instigate analysis of whether there is sufficient competition in
the industry and, if not, make decisions either to promote competition
or regulate returns in some segments of the businesses - desirable;
– Second, introduce direct controls over pay – a nightmare
– Third, change taxation – necessarily general
– Structural reforms that increase competition, shrink the size of the
sector, increase capital requirements, lower equity returns and
reduce risk-taking should also lower rewards.
9
2. What is the solution to pay?
• Second, incentives
– The fundamental question is how one might align incentives
between risk-takers and decision-makers or, if one cannot do
so, supervise risk taking.
– Broadly speaking, there are two strategies:
• Restructure the financial industry so that risk-taking parts will not
need public bail-outs and leave the monitoring of pay structures
to shareholders.
• Or accept that the public sector will always insure the financial
system and intervene in pay structures directly, on the grounds
that the regulator is representing the true risk-takers of last resort.
10
2. What is the solution to pay?
– On the first approach, the question is whether such
restructuring is possible. Two possibilities would be:
• Narrow banking, plus a credibly free-market credit system; and
• “Limited purpose banking” in which all risk-taking institutions
would work like mutual funds, with full pass-through of risk to the
ultimate owners of the funds.
– I am sceptical of the effectiveness of both of these
alternatives.
• On the first, I have long argued that there can never be a credibly
free-market credit system.
• On the second, I am unconvinced that it would be possible to
avoid intervening in a panic, since asset prices could still collapse
11
2. What is the solution to pay?
– On the second approach, making the best of an insured
system, I start with the following broad principles.
• The regulator, representing the public interest, is interested in the
soundness of the institutions under its supervision, not in
maximizing expected returns to shareholders.
• At a minimum, therefore, it wants the interests of decisions-
makers to be aligned with those of the people financing the
balance sheet as a whole
• The regulator should make it clear that it is the responsibility of
management and others charged with oversight of risk-
management to protect the balance sheet
12
2. What is the solution to pay?
– So how might these ideas be made effective, in practice?
• Regulators should establish the principle of personal liability
• They should also establish principles on which the relevant key
decision-makers would be identified.
• They should publish the criteria for determining personal liability.
• The liability should be for a substantial portion of total
remuneration, whether paid as bonuses or salary, with the portion
rising with the seniority of the decision maker
• The liability would be a cash amount, indexed to inflation
• The period over which such liability would continue should be
substantial. It should be long enough to establish the viability of
the strategies.
13
2. What is the solution to pay?
• Stock awards would be permitted, but stock options would be
precluded for such decision-makers. The sale of stock would be
prevented if it lowered the net worth of decision-makers (active or
retired) below their liabilities.
• The liability would be uninsurable.
• Regulators would have a say in the remuneration structures of
the non-key decision makers in the firm. The principle of claw-
back of remuneration, in the event of failure, would be part of
such discussion.
• Senior executives of failed financial firms would be barred from
subsequent employment in the industry for a substantial period of
time
14
3. Conclusion
• The question of pay is politically fraught and complex.
• Pay structures are not the principal cause of the crisis.
• Nevertheless, the level and structure of rewards is a big social and economic issue.
• The focus, for finance, is the structure of rewards and, above all, the alignment of incentives with risk-taking
• Alignment with the interests of shareholders is not enough
• Managers should be liable for the safety of the balance sheet as a whole
Will the politics of moral hazard sink us again?
Peter BooneExecutive Chair, Effective Intervention
THE FUTURE OF FINANCE
Will the Politics of Global Moral Hazard Sink Us Again?
Peter Boone Centre for Economic Performance, LSE
Effective Intervention, UKSalute Capital Management
(with Simon Johnson, M.I.T. & Peterson Institute)
Main thesis of our chapter
• Despite the “reforms” coming, our global financial system remains on a dangerous path– Moral hazard has gotten worse
• TBTF banks, countries, and much more
– We’ll have the same regulatory institutions, and even strong pressures to ease regulations, after all the coming reforms
• The “Race to the bottom” will soon be on again, and a greater crisis looms– E.g., capital requirements tighten now, looser to
follow– Effects of cycle + continued regulatory capture
A global system with many large, changing sources of moral hazard
• Too big to fail banks: US, Europe, Emerging markets – everyone except Kazakhstan
• Quasi sovereign and politically important companies
• Small/interconnected entities that can threaten contagion
• Regional partners: Abu Dhabi/Dubai World
• Euro zone members, EEA members
• IMF loan eligible nations ($1 trillion capital)
• Agency debt in the US
• Insurance guarantee associations
This list got a lot bigger in the last 24 months
At least 2.5 times North American + European GDP(US trillion dollars)
TBTF Banks
Quasi Soverign
Insurance
0
10
20
30
40
50
60
70
80
Insurance
IMF
Euro Zone
Interconnedted
Quasi Sov
TBTF Banks
Four examples of what goes wrong:
• Iceland
• Canada
• Ireland
• Euro zone
Iceland: a small island shocks global finance
Iceland external debt by borrower(2007 GDP is 1,301 bn kr)
European
Banks...
...US Investors...
...UK Depositors
Global finance is interconnected:
You can’t rely on goodwill when asking that each nation regulates itself well
Canada: Cute when small, but watch out when they get bigger
The magic bullet?
“We need to learn from those countries that evidently did it right. And leading that list is our neighbor to the north. Right now, Canada is a very important role model.” Paul Krugman
– Limited leverage, higher capital requirements, avoided securitization
– Five large banks that trade profits in return for strong regulation
Too big to fail in action
“Maybe not explicitly, but what are the chances that TD bank will not be bailed out if it did something stupid?”
Ed Clark, President and CEO Toronto Dominion Bank, on an investor roadshow selling TD preference shares, January 2009
Government mortgage guarantees
• The Canadian Mortgage and Housing Corporate Guarantees approximately 50% of bank issued mortgages, and almost all mortgages with >80% loan to value
• Makes for safe bank balance sheets, but, do taxpayers realize that they bear the risk of all of Canada’s most risky mortgages?
0
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6
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/12
/19
90
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/07
/19
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08
Tie
r o
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cap
ital
rat
io (
%)
Tier one capital Major Canadian Banks
Bank of Nova Scotia
Royal Bank of Canada
Canadian Imperial Bank of Commerce
Bank of Montreal
Oil and Commodities collapse
There is no magic bullet:
All types of regulatory systems failed because they all suffer deep incentive problems that can eventually cause a financial system to
blow-up
Ireland: Gaining access to cheap credit without a strong regulator
Ireland
• Prudent government with little debt
• Solid growth starting 1990s: “The Celtic Tiger”
• Things fall apart post 2000:
– Irish banks built debt from 1X to 3.75X GNP from 2000 to 2009
– The Euro zone gave creditors confidence they could lend with impunity
Irish Public Debt/GNP(2009-2015E, includes NAMA debt but not bank guarantees)
The “prudent sovereign” is
now bailing out all the failed
spending of the last decade! 79.4%
153.6%
172.4%185.7%
195.7% 200.5%
40.0%
60.0%
80.0%
100.0%
120.0%
140.0%
160.0%
180.0%
200.0%
220.0%
2009 2010 2011 2012 2013 2014
Access to capital will, from time to time, become easy. We must expect it will find its way to the nations most desiring, across the globe, to use
it but some of those will abuse it.
Will capital be better of worse allocated in the future?
Euro zone: sinking with its moral hazard issues?
Euro zone and why the Russians gave up on a ruble zone
• 15 CIS states, each with commercial banks and the ability to issue money
• 1992 was a free-for-all. Credit growth rose dramatically (Chechyna, Belarus and Ukraine especially)
Politics trumps prudency - we can’t rely on each other to regulate for the global good:
The euro zone was designed with deep flaws in place, and those flaws are now larger than
ever
Without Institutional change, why expect this round of re-regulation to last?
0
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6/1/
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12/1
/199
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12/1
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/200
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/200
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9/1/
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6/1/
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3/1/
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12/1
/200
7
9/1/
2008
6/1/
2009
Private sector Credit/GDP (%, RHS)just keeps growing....
Fed Funds Target rate (%, LHS)now near to zero....
TECH Bubble
Savings & Loan Crisis
LTCM Bailout
Sub PrimeBubble
The Global Doomsday Cycle
Risk taking, spending gets going
Regulation erodes with time, race to the bottom
Losses happen,
again
Fiscal and money bail
out the system
We tighten regulation promote prudency
Five Steps to End the Doomsday Cycle
1. An international treaty, similar to WTO, to lock in rules to help limit the “race to the bottom” and tie politicians hands
2. Cross-border macro-prudential supervision
3. Discourage debt
4. Let defaults happen
5. Depoliticize financial regulation
Few of our planned solutions to today’s crisis are different from our
solutions to past crises....
....the incentives remain for most the good reforms today to be
diluted and circumvented again in the future
THE FUTURE OF FINANCE AND THE THEORY THAT UNDERPINS IT
PANEL – WHERE DO WE GO FROM HERE?
THE FUTURE OF FINANCE