Global Financial and Eurozone Reform: Five questions on a common - - PowerPoint PPT Presentation

Global Financial and Eurozone Reform: Five questions on a common theme

Riksbank Stockholm, 18 February 2013

Adair Turner

Five questions on a common theme

1

 Are optimal capital ratios higher still than Basel III standards, and if so, what should we do about it?  Should macro-prudential regulators seek to constrain aggregate economy wide leverage and if so, how?  How much federalism is needed to make the Eurozone a sustainable and successful monetary union?  Are we too worried about fragmentation of global banking?  Should banks have the right to cross-border branching within the European Union?

Measures of increasing financial intensity

50 100 150 200 250 300 350 400 450 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 $Tr OTC interest rate contracts, notional amount outstanding

100 200 300 400 500 600 700 800 900 1,000 1,100 1977 1982 1987 1992 1997 2002 2007 $bn Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

2

Growth of interest rate derivatives values, 1987-2009 FX Trading values & world GDP 1977-2007 Global issuance of asset-backed securities

1929 1935 1941 1947 1953 1959 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300% 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300% 1929 1935 1941 1947 1953 1959 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300% 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300%

US debt as a % of GDP by borrower type

Share of the financial industry in US GDP

3

Source: Philippon, T (2008), The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

1 2 3 4 5 6 7 8 9 50 70 90 10 30 50 70 90

1850 1870 1890 1910 1930 1950 1970 1990

4

Market perception of private credit risk

Source: Merrill Lynch

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

Non-investment grade corporate bond spreads

Average CDS of major financial firms

200 400 600 800 1000 1200 1400 2002 2003 2004 2005 2006 2007 2008 Option-adjusted spread Global, non-financial corporates BB-rated

0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 CDS-SENIOR Average CDS-SENIOR

NASDAQ index: 1990 – 2002

5

Source: Datastream

6 6

Three drivers of financial instability

Debt contracts create specific risks Unregulated bank credit and private money creation is inherently unstable Lending secured against real assets can be strongly pro-cyclical

Real economy leverage, credit creation dynamics, and credit/asset price cycles are crucial macro-economic variables, and phenomena

7

Observed payout distributions for debt and equity

Debt payouts Equity payouts

100% of principal and due interest

Full distribution continuously observed Observed in good times

100%

Not observed in good times

Credit and asset price cycles: the upswing

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 8

9

Leverage in real and financial sectors

Source: Oliver Wyman

UK debt as a % GDP by borrower type (1987-2007), Debt Liabilities on B/S

Household Corporate Financial

USA debt as a % GDP by borrower type (1929-2007)

Household Corporate Financial

1987 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007 10% 50% 100% 150% 200% 250% 300% 1987

0% 100% 200% 300% 400% 500% 600% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Private non-financial corporate deposits and loans: 1964 – 2009

10

0% 5% 10% 15% 20% 25% 30% 35% 40% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% of GDP

Securitisations and loan transfers Deposits Loans

11

Household deposits and loans: 1964 – 2009

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% of GDP

Securitisations and loan transfers

Source: Bank of England, Tables A4.3, A4.1

Financial deepening: the pre-crisis consensus

12

 Neutral:

“We assumed we could ignore the details of the financial system” (Olivier Blanchard, October 2012) The dominant new Keynesian model of monetary economics “lacks an account of financial intermediation, so that money, credit and banking play no meaningful role” (Mervyn King, October 2012)

 Welcome:

Axiomatically beneficial since reflects more complete markets and contracts between rational private agents

13 13

Private credit to GDP ratio and growth

Source: S. Cecchetti, BIS Working Paper No. 381 "Reassessing the impact

• f finance and growth"

Long-term trends in bank capital & liquidity ratios

14 Sterling liquid assets

Source: US: Berger, A. Herring, R and Szegö, G (1995) and FDIC. UK: Sheppard, D.K (1971), BBA and Bank of England calculations. Source: Bank of England and Bank calculations.

Capital ratios for US and UK banks

5 10 15 20 25 30 1880 1900 1920 1940 1960 1980 2000 UK US 5 10 15 20 25 30 35 1968 1975 1982 1989 1996 2003 2010 Broad ratio (b) Reserve ratio (c) Narrow ratio (d) % of total assets (all currencies) %

Five questions on a common theme

15

 How much federalism is needed to make the Eurozone a sustainable and successful monetary union?  Are we too worried about fragmentation of global banking?  Should banks have the right to cross-border branching within the European Union?  Are optimal capital ratios higher still than Basel III standards, and if so, what should we do about it?  Should macro-prudential regulators seek to constrain aggregate economy wide leverage and if so, how?

Single currency and single market completion

16

“A major effect of EMU is that balance of payments constraints with disappear […] private markets will finance all viable borrowing, and savings and investment balances will no longer be constraints at the national level”

One Market, One Money, European Commission, 1990

Eurozone current account deficits

17

Source: International Monetary Fund, World Economic Outlook Database, October 2012

• 16
• 14
• 12
• 10
• 8
• 6
• 4
• 2

2000 2001 2002 2003 2004 2005 2006 2007 2008 % Year Greee Ireland Portugal Spain

% of GDP 2000-2008

Eurozone government bond spreads

18

Source: Bloomberg

10 year benchmark spreads to German bunds

Note: Bloomberg doesn't quote a 10Y benchmark for Ireland and so 9Y has been used instead.

• 2

2 4 6 8 10 Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 % Italy Portugal Spain Greece Ireland

19

Credit extension and house prices

House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007

Source: BEA; ONS; ECB

20 40 60 80 100 120 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 % GDP US UK Spain Ireland 50 100 150 200 250 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Index: 2000 = 100 Spain US UK Ireland

Source: Ministry of Housing (Spain), S&P (US), DCLG

Decomposition of cumulative capital inflows

(% of 2007 GDP)

SPAIN PORTUGAL IRELAND GREECE

• 30%
• 10%

10% 30% 50% 70% 90% 110%

Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 PRIVATE INFLOWS TARGET Liab. PROGRAMME Disb. TOTAL INFLOWS

• 70%
• 50%
• 30%
• 10%

10% 30% 50% 70% 90% 2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 PRIVATE INFLOWS TARGET Liab. PROGRAMME Disb. TOTAL INFLOWS

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Jan-02 Jun-02 Nov-02 Apr-03 Sep-03 Feb-04 Jul-04 Dec-04 May-05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12

PRIVATE INFLOWS TARGET Liab. TOTAL INFLOWS

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Jan-02 Jun-02 Nov-02 Apr-03 Sep-03 Feb-04 Jul-04 Dec-04 May-05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12

PRIVATE INFLOWS TARGET Liab. TOTAL INFLOWS

Cross border capital flows: Hierarchy of economic value

21

Foreign direct investment Equity portfolio flows Debt portfolio flows Long-term bank lending Short-term bank lending

Increasing stability

See: Committee on the Global Financial System: Report of the Working Group on Capital Flows to Emerging Market Economies, BIS, 2009

Total cross-border capital inflows: 1980–2011

22

Loans and deposits Bonds Equity Foreign direct investment

2005 2000 1995 1990 2007 2011 12 10 8 6 4 2

• 2
• 4

5.8 2.0 11.7 4.9 4.8 5 5 13 15 7 21 % Global GDP

Source: Future of Long-term Finance, Group of Thirty Report, MGI, December 2012

USD trillions, constant 2011 exchange rates

Coefficient of variation of inward cross-border flows by maturity

23

Source: Future of Long-term Finance, Group of Thirty Report, MGI, December 2012

Long maturity Short maturity FDI Equity Bonds Long-term bank claims Short-term bank claims Emerging Markets Developed Markets

Five questions on a common theme

24

 How much federalism is needed to make the Eurozone a sustainable and successful monetary union?  Are we too worried about fragmentation of global banking?  Should banks have the right to cross-border branching within the European Union?  Are optimal capital ratios higher still than Basel III standards, and if so, what should we do about it?  Should macro-prudential regulators seek to constrain aggregate economy wide leverage and if so, how?

Required steps to Eurozone long-term viability

25

 Banking union – including ability to recapitalising with

“federal” resources

 “Federal level” deposit insurance  Eurobonds – held as banking systems safe liquid

assets

 Significant but still limited (e.g. 5% of GDP) federal fiscal budget – and associated automatic

stabilisers

Cutting the sovereign/bank solvency link

 Macro–prudential levers deployable at national level?

Five questions on a common theme

26

 How much federalism is needed to make the Eurozone a sustainable and successful monetary union?  Are we too worried about fragmentation of global banking?  Should banks have the right to cross-border branching within the European Union?  Are optimal capital ratios higher still than Basel III standards, and if so, what should we do about it?  Should macro-prudential regulators seek to constrain aggregate economy wide leverage and if so, how?