Financial Intermediation and the Post-Crisis Financial System Hyun - PowerPoint PPT Presentation

Financial Intermediation and the Post-Crisis Financial System Hyun Song Shin 8 th BIS Annual Conference Basel, June 25-26, 2009

Outline • Lessons on financial system architecture from global financial crisis • Implications for – Size of financial sector relative to real economy – Securitization – Financial regulation – Accounting standards – Monetary policy

Stylized Financial System ultimate ultimate borrowers claim holders Households Households Pension funds Insurance companies Non- financial firms direct credit Rest of world govt Treasury & municipal bonds corporate bonds

Stylized Financial System ultimate ultimate borrowers claim holders equity Households Banking Households intermediated (intermediary) Pension funds credit sector debt claims Insurance mortgages companies deposits corporate Non- financial paper credit… financial MBS, ABS… firms direct credit Rest of world govt Treasury & municipal bonds corporate bonds

US Financial Intermediaries Total Assets (2007Q2) 18.0 16.0 GSE 3.2 14.0 GSE 12.0 Mortgage Pools $ Trillion 10.0 4.5 Commercial Banks 8.0 Finance Co. 1.9 10.1 6.0 Broker Dealers 2.9 4.0 ABS Issuers Savings Inst. 2.0 4.1 1.9 Credit Unions 0.8 0.0 Market-Based Bank-Based

Holding of US Home Mortgages by Type of Financial Institution 4.5 4.5 Agency and GSE mortgage pools 4.0 4.0 ABS issuers 3.5 Savings institutions 3.5 GSEs 3.0 3.0 $ Trillion Credit unions 2.5 2.5 Commercial banks 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 1980Q1 1982Q1 1984Q1 1986Q1 1988Q1 1990Q1 1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1

Market-Based and Bank-Based Holding $ Trillion 0 1 2 3 4 5 6 7 1980Q1 1982Q1 Bank-based Market-based of Home Mortgages 1984Q1 1986Q1 1988Q1 1990Q1 1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 0 1 2 3 4 5 6 7

households Short Intermediation Chain deposits mortgage bank mortgage households

Long Intermediation Chain households households MMF shares mortgage money market fund mortgage pool Short-term MBS paper ABS Repo ABS issuer commercial bank securities firm

What Are the Advantages of the Long Intermediation Chain? • “Securitization enables dispersion of credit risk” • “Long chains promote more efficient maturity transformation” – “Households want short, liquid claims” – “Shadow banking system gives them what they want”

But Evidence in this Crisis Points the Other Way • Securitization has concentrated risks in leveraged sector • Biggest growth in short-term debt was between financial intermediaries • Financial intermediaries have become more intertwined – “CoVaR” Adrian and Brunnermeier (2009)

Exposure to Subprime Total reported sub-prime Percent of reported exposure (US$bn) exposure Investment Banks 75 5% Commercial Banks 418 31% GSEs 112 8% Hedge Funds 291 21% Insurance Companies 319 23% Finance Companies 95 7% Mutual and Pension Funds 57 4% Leveraged Sector 896 66% Unleveraged Sector 472 34% Total 1,368 100% Source: Greenlaw, Hatzius, Kashyap and Shin (2008)

Apr 29 2009 2.37 Jan 7 2009 Jun 25 2008 Overnight repos, Financial CP and M2 Aug 8 2007 Dec 12 2007 Mar 19 2008 (weekly, July 6 1994 as base date) May 30 2007 Nov 15 2006 May 3 2006 Oct 19 2005 Apr 6 2005 Sep 22 2004 Mar 10 2004 Aug 27 2003 Feb 12 2003 Jul 31 2002 Jan 16 2002 Jul 4 2001 Dec 20 2000 Jun 7 2000 Nov 17 1999 Overnight repo Financial CP May 5 1999 Oct 21 1998 Apr 8 1998 M2 Sep 24 1997 Mar 12 1997 Aug 28 1996 Feb 14 1996 Aug 2 1995 Jan 18 1995 Jul 6 1994 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Source: Adrian and Shin (2009) 20% 30% 40% 50% 60% 70% 80% 90% u 4 1 9 9 0 J l a n 3 0 1 9 9 1 J A u g 2 8 1 9 9 1 M a 2 5 1 9 9 2 r as Fraction of M2 (weekly) O 2 1 1 9 9 2 c t M Repos and Financial CP a y 1 9 1 9 9 3 D e c 1 5 1 9 9 3 J u 1 3 1 9 9 4 l F e b 8 1 9 9 5 S e p 6 1 9 9 5 A p 3 1 9 9 6 r O c 3 0 1 9 9 6 t M a 2 8 1 9 9 7 y D Aug 12 1998 e 2 4 1 9 9 7 c u 2 2 1 9 9 8 J l F e b 1 7 1 9 9 9 S e p 1 5 1 9 9 9 A p 1 2 2 0 0 0 r N o 8 2 0 0 0 v Sep 12 2001 u n 6 2 0 0 1 J a n 2 2 0 0 2 J u 3 1 2 0 0 2 J l F e b 2 6 2 0 0 3 S e p 2 4 2 0 0 3 A p 2 1 2 0 0 4 r N o 1 7 2 0 0 4 v u n 1 5 2 0 0 5 J a n 1 1 2 0 0 6 J A u g 9 2 0 0 6 M a 7 2 0 0 7 r Aug 8 2007 O c 3 2 0 0 7 t Apr 29 2009 A p 3 0 2 0 0 8 r N o v 2 6 2 0 0 8 Sep 10 2008

US Institutions’ CoVaR IMF Co-Risk Measures (March 2008) Source: IMF GFSR (April 2009)

Multi-layered Financial System Source: Haldane (2009)

Global Interconnectedness Source: Haldane (2009)

Relative Size of Intermediary Sector

Total Assets of Four Sectors [March 1954 =1] 900 800 700 Non-financial corporate 600 Households 500 Security Broker 400 Dealers Commercial 300 Banks 200 100 0 1954Q1 1956Q3 1959Q1 1961Q3 1964Q1 1966Q3 1969Q1 1971Q3 1974Q1 1976Q3 1979Q1 1981Q3 1984Q1 1986Q3 1989Q1 1991Q3 1994Q1 1996Q3 1999Q1 2001Q3 2004Q1 2006Q3 (Source: Federal Reserve, Flow of Funds)

Total Assets (Log Scale) [March 1954 =1] 1000 Non-financial corporate 100 Households Security Broker Dealers 10 Commercial 1980Q1 Banks 1 1954Q1 1957Q1 1960Q1 1963Q1 1966Q1 1969Q1 1972Q1 1975Q1 1978Q1 1981Q1 1984Q1 1987Q1 1990Q1 1993Q1 1996Q1 1999Q1 2002Q1 2005Q1 2008Q1 (Source: Federal Reserve, Flow of Funds)

Procyclical Leverage of Five US Investment Banks 20 Total Asset Growth (% Quarterly) 10 2008-1 2007-3 0 2007-4 -10 1998-4 -20 -20 -10 0 10 20 Leverage Growth (% Quarterly) Source: Adrian and Shin (2007)

US Primary Dealer Mean Leverage 26 6/30/1987 9/30/1998 12/30/2007 22 Leverage 18 14 3/30/2009 10 1986 1989 1992 1995 1998 2001 2004 2007

All Primary Dealer Mean Leverage All Primary Dealers - Through 2008Q4 40 3/30/2008 35 30 Leverage 25 20 15 1986 1989 1992 1995 1998 2001 2004 2007

Non-U.S. Residential New Issuance of Asset Backed Securities Commercial Real Student Loans Home Equity Credit Cards (Subprime) Mortgages Estate Autos Other in Previous Three Months Sep-08 Mar-08 Sep-07 Mar-07 Sep-06 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 Mar-03 Sep-02 Mar-02 Sep-01 Mar-01 Source: JP Morgan Sep-00 Mar-00 350 300 250 200 150 100 50 0 $ Billions

Biggest Damage is Done in Contractions ultimate ultimate borrowers claim holders Households Households Pension funds Banking (intermediary) Insurance companies sector Non- financial firms Rest of world govt

But Seeds of Crises Are Sown in Expansions ultimate ultimate borrowers claim holders Households Households Pension funds Banking (intermediary) Insurance companies sector Non- financial firms Rest of world govt

How To Moderate Balance Sheet Boom/Bust Cycles?

Individual Bank Balance Sheet Assets Liabilities Liabilities to non-banks Loans to firms, (e.g. deposits) households Liabilities to other banks Claims on other banks Equity Individual bank

Balance Sheet for Banking Sector Assets Liabilities Total debt liabilities Total lending to to non-banks ultimate borrowers (firms, households Total equity govt) Slow moving: Banking sector increases in line with household wealth

Aggregate Balance Sheet Identity   n n n        y e z 1 e i i i i i    i 1 i 1 i 1 Total lending to Total debt liabilities Total equity of ultimate borrowers To non-banks intermediaries

Booms • Higher leverage of financial intermediaries • Larger balance sheets of intermediaries • Greater intertwining of intermediaries – Longer chains – Maturity mismatch to sustain longer chains

Architectural Analogy • Adding extra capacity (more rooms) to a house when constrained by limited footprint – The only way is to build up (like a Manhattan skyscraper) – Except that Manhattan skyscraper is planned ahead, as a coherent whole – Better analogy is adding extra floors to a building without anticipating future floors on top

Sutyagin House in Archangel

Busts • Deleveraging • Shrinking balance sheets • Unraveling of interbank lending – Runs – Retrenchment

Northern Rock Northern Rock

Jun-07 Dec-06 Jun-06 Dec-05 Composition of Northern Rock's Liabilities Jun-05 Dec-04 Jun-04 Dec-03 (June 1998 - June 2007) Jun-03 Dec-02 Jun-02 Dec-01 Jun-01 Securitized notes Other Liabilities Retail Deposits Dec-00 Jun-00 Equity Dec-99 Jun-99 Dec-98 Jun-98 120 100 80 60 40 20 0 Billion pounds

Dec-07 Jun-07 Dec-06 Jun-06 Dec-05 Jun-05 Northern Rock's Leverage Dec-04 June 1998 - December 2007 Jun-04 Leverage on shareholder equity Dec-03 Leverage on common equity Jun-03 Leverage on total equity Dec-02 Jun-02 Dec-01 Jun-01 Dec-00 Jun-00 Dec-99 Jun-99 Dec-98 Jun-98 90 80 70 60 50 40 30 20 10