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

Global Financial and Eurozone Reform: Five questions on a common theme Adair Turner Riksbank Stockholm, 18 February 2013

Five questions on a common theme  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? 1

Measures of increasing financial intensity US debt as a % of GDP by Global issuance of asset-backed 300% 300% 300% 300% borrower type securities 250% 250% 250% 250% 200% 200% 200% 200% 150% 150% 150% 150% 100% 100% 100% 100% 50% 50% 50% 50% 10% 10% 10% 10% 1929 1929 1929 1929 1935 1935 1935 1935 1941 1941 1941 1941 1947 1947 1947 1947 1953 1953 1953 1953 1959 1959 1959 1959 1965 1965 1971 1971 1971 1971 1977 1977 1977 1977 1983 1983 1983 1983 1990 1990 1990 1990 1996 1996 1996 1996 2002 2002 2002 2002 2007 2007 2007 2007 Growth of interest rate derivatives FX Trading values & world GDP 450 1,100 values, 1987-2009 1977-2007 400 1,000 350 900 300 800 250 700 $Tr 200 600 $bn 500 150 400 100 300 50 200 0 100 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 0 1977 1982 1987 1992 1997 2002 2007 OTC interest rate contracts, notional amount outstanding Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn 2

Share of the financial industry in US GDP 9 8 7 6 5 4 3 2 Source: Philippon, T (2008), The 1 Evolution of the US Financial Industry from 1860 to 2007: 0 Theory and Evidence. (As referenced by Andrew Haldane in 50 70 90 10 30 50 70 90 1850 1870 1890 1910 1930 1950 1970 1990 The Future of Finance, LSE Report, 2010) 3

Market perception of private credit risk Non-investment grade Average CDS of major corporate bond spreads financial firms 1400 1.2% 1200 Option-adjusted spread 1.0% 1000 CDS-SENIOR 0.8% 800 0.6% 600 0.4% 400 0.2% 200 0.0% Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 0 2002 2003 2004 2005 2006 2007 2008 Average CDS-SENIOR Global, non-financial corporates BB-rated 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 : Merrill Lynch Source : Moody’s KMV, FSA calculations 4

NASDAQ index: 1990 – 2002 Source : Datastream 5

Three drivers of financial instability  Debt contracts create specific risks Real economy leverage,  Unregulated bank credit and private credit creation dynamics, and money creation is inherently unstable credit/asset price cycles are crucial macro-economic  Lending secured against real assets can variables, and phenomena be strongly pro-cyclical 6 6

Observed payout distributions for debt and equity Debt payouts Equity payouts Observed in good times 100% Full distribution continuously observed Not observed in good times 100% of principal and due interest 7

Credit and asset price cycles: the upswing Increased credit extended Increased borrower Increased lender Increased asset demand for credit supply of credit prices Expectation of future asset price increases Favourable assessments of credit risk Low credit losses: high bank profits • Confidence reinforced • Increased capital base 8

Leverage in real and financial sectors 600% UK debt as a % GDP by borrower type 500% (1987-2007), Debt Liabilities on B/S Corporate 400% Household 300% 200% Financial 100% 0% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 USA debt as a % GDP by borrower type (1929-2007) 1987 1987 300% Corporate 250% 200% Household 150% 100% 50% Financial 10% 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007 Source : Oliver Wyman 9

Private non-financial corporate deposits and loans: 1964 – 2009 40% Securitisations and loan transfers Deposits Loans 35% 30% 25% % of GDP 20% 15% 10% 5% 0% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 10

Household deposits and loans: 1964 – 2009 100% Securitisations and loan transfers 90% 80% 70% % of GDP 60% 50% 40% 30% 20% 10% 0% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Source: Bank of England, Tables A4.3, A4.1 11

Financial deepening: the pre-crisis consensus  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 12

Private credit to GDP ratio and growth Source: S. Cecchetti, BIS Working Paper No. 381 "Reassessing the impact of finance and growth" 13 13

Long-term trends in bank capital & liquidity ratios Capital ratios for US and UK banks Sterling liquid assets % of total assets Broad ratio (b) % UK 30 (all currencies) Reserve ratio (c) Narrow ratio (d) US 35 25 30 20 25 20 15 15 10 10 5 5 0 0 1968 1975 1982 1989 1996 2003 2010 1880 1900 1920 1940 1960 1980 2000 Source: US: Berger, A. Herring, R and Szegö, G (1995) and FDIC. Source : Bank of England and Bank calculations. UK: Sheppard, D.K (1971), BBA and Bank of England calculations. 14

Five questions on a common theme  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? 15

Single currency and single market completion “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 16

Eurozone current account deficits % of GDP 2000-2008 0 -2 -4 -6 Greee Ireland -8 % Portugal -10 Spain -12 -14 -16 2000 2001 2002 2003 2004 2005 2006 2007 2008 Year Source : International Monetary Fund, World Economic Outlook Database, October 2012 17

Eurozone government bond spreads 10 year benchmark spreads to German bunds 10 8 6 % 4 2 0 -2 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 Source: Bloomberg Note: Bloomberg doesn't quote a 10Y benchmark for Ireland and so 9Y has been used instead. 18

Credit extension and house prices House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007 250 120 100 200 Index: 2000 = 100 80 % GDP 150 60 100 40 50 20 0 0 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 US UK Spain Ireland Spain US UK Ireland Source : BEA; ONS; ECB Source : Ministry of Housing (Spain), S&P (US), DCLG 19

110% -30% -10% 10% 30% 50% 70% 90% 10% 20% 30% 40% 50% 60% 70% 80% 90% 0% Jan-02 Jan-02 Jul-02 (% of 2007 GDP) Decomposition of cumulative capital inflows Jun-02 PRIVATE INFLOWS Nov-02 Jan-03 Apr-03 Jul-03 SPAIN Sep-03 PROGRAMME Disb. PRIVATE INFLOWS Jan-04 Feb-04 Jul-04 Jul-04 Dec-04 Jan-05 May-05 Jul-05 Oct-05 Jan-06 GREECE Mar-06 Jul-06 Aug-06 Jan-07 TARGET Liab. Jan-07 Jun-07 Jul-07 Nov-07 Jan-08 Apr-08 Jul-08 Sep-08 TOTAL INFLOWS TARGET Liab. Jan-09 Feb-09 Jul-09 Jul-09 Dec-09 Jan-10 May-10 TOTAL INFLOWS Jul-10 Oct-10 Jan-11 Mar-11 Aug-11 Jul-11 Jan-12 Jan-12 Jun-12 Jul-12 -70% -50% -30% -10% 10% 30% 50% 70% 90% 10% 20% 30% 40% 50% 60% 70% 80% 90% 0% 2002Q1 Jan-02 2002Q3 Jun-02 PRIVATE INFLOWS 2003Q1 Nov-02 Apr-03 2003Q3 Sep-03 2004Q1 Feb-04 PROGRAMME Disb. PRIVATE INFLOWS 2004Q3 Jul-04 PORTUGAL 2005Q1 Dec-04 May-05 2005Q3 Oct-05 2006Q1 Mar-06 2006Q3 IRELAND Aug-06 TARGET Liab. 2007Q1 Jan-07 2007Q3 Jun-07 Nov-07 2008Q1 Apr-08 2008Q3 Sep-08 2009Q1 TOTAL INFLOWS TARGET Liab. Feb-09 2009Q3 Jul-09 2010Q1 Dec-09 TOTAL INFLOWS May-10 2010Q3 Oct-10 2011Q1 Mar-11 2011Q3 Aug-11 2012Q1 Jan-12 2012Q3 Jun-12

Cross border capital flows: Hierarchy of economic value Foreign direct investment Increasing stability Equity portfolio flows Debt portfolio flows Long-term bank lending Short-term bank lending See: Committee on the Global Financial System: Report of the Working Group on Capital Flows to Emerging Market Economies, BIS, 2009 21