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									Leverage, Maturity Transformation
and Financial Stability: Challenges
        Beyond Basel III


            Adair Turner
               Chairman
    Financial Services Authority


    CASS Business School, London
          16th March 2011
 Ideal equity ratios higher than Basel III

 TBTF: making banks „resolvable; necessary but not
  sufficient

 Markets as important as institutions; shadow banking as
  important as banks

 The fundamental issues
        Debt/equity balance
        How much maturity transformation

 Four implications

                                                       1
IMF estimates of public support costs in 2008-2009
financial crisis

       % of GDP

                                                                                            Net direct
                                Pledged                  Utilised               Recovery
                                                                                              cost

       Advanced
      economies                      6.2                     3.5                      0.8      2.8



       Emerging
      economies                      0.8                     0.3                       -       0.3




Source: IMF: A fair and substantial contribution by the financial sector, June 2010
                                                                                                         2
Growth in lending and nominal income:
UK 2005 – 2010


                   14
                                             Private debt stock (%YoY)
                   12
                   10
       % change year-on-year


                                                         Leverage increased
                               8                          through the boom
                               6
                               4                         Nominal GDP (%YoY)
                               2
                               0
                        -2
                        -4
                        -6
                                   Q1 2005

                                               Q3 2005

                                                         Q1 2006

                                                                   Q3 2006

                                                                             Q1 2007

                                                                                       Q3 2007

                                                                                                 Q1 2008

                                                                                                           Q3 2008

                                                                                                                     Q1 2009

                                                                                                                               Q3 2009

                                                                                                                                         Q1 2010

                                                                                                                                                   Q3 2010

                                                                                                                                                             Q1 2011

                                                                                                                                                                       Q3 2011

                                                                                                                                                                                 Q1 2012
                                                                                                                                                                                           3
Credit and asset price cycles

                              Increased credit
                                 extended




                            Increased
    Increased lender                                                 Increased asset
                        borrower demand
     supply of credit                                                     prices
                             for credit


                                         Expectation of
                                       future asset price
                                           increases

         Favourable
       assessments of
         credit risk
                                          Low credit losses: high
                                          bank profits
                                          • Confidence reinforced
                                          • Increased capital base
                                                                                       4
Minimum bank equity ratios: Basel II to Basel III


                                    Basel II              Basel III

   Total assets

                                      Risk                   Risk
                                    weighted               weighted
                                     assets                 assets
                    Estimated
                  riskiness, e.g.
                    SME 100%
                  Mortgages 15%



                                               Required
                                      2%
                                     2%         equity      7%


                                                                      5
Costs and benefits of higher bank equity capital

                                          Key insights from:


                                  David Miles et al: “Optimal Bank Capital”
 Costs:     Increased cost of
                                  Martin Hellwig et al: “Fallacies, Irrelevant
          credit intermediation
                                  Facts and Myths in the Discussion of Capital
                                  Regulation”

                 Vs
                                   Distinguish social from private costs
                                   Consider low probability extreme events
Benefits: Reduced likelihood
          of financial crises      Focus on total systems not specific
                                    institutions




                                                                              6
UK banks‟ leverage and real GDP growth


                                 5%                                                                              40
                                 4%                                                                              35
                                 3%                                                                              30
                                 2%
            Real GDP growth                                                                                      25
             (10 year m.a.)      1%
            Leverage (rhs)                                                                                       20
                                 0%
                                                                                                                 15
                                -1%
                                -2%                                                                              10

                                -3%                                                                              5
                                   1880          1900       1920        1940       1960        1980       2000

Source: David Miles, Jing Yang and Gilberto Marcheggiano, Optimal Bank Capital, External MPC Unit, Discussion
Paper No. 31                                                                                                          7
Mechanisms to increase loss absorption capacity
and market discipline
                               Capital surcharge
                               and/or sub debt     Resolvability &
                               convertibility      statutory bail-in



               Insured
              depositors

                                                    Resolution
             Non-insured                            procedures which
              depositors                            can rapidly
                                                    impose
           Interbank & other                        losses/conversion
             counterparties                         on all liabilities (to
                                                    extent required)
             Senior debt
             instruments

            Subordinated        Increase role of
           debt & Preferred     loss-absorbing
                stock           capital
              Common
               equity

                                                                             8
   Mechanisms to increase loss absorption capacity
   and market discipline
                    Capital
                    surcharge
                    and/or sub debt     Bail-inable senior           Resolvability &
                    convertibility      debt                         statutory bail-in

    Insured
   depositors

                                                                       Resolution
  Non-insured                                                          procedures which
   depositors                                                          can rapidly
                                                                       impose
Interbank & other                                                      losses/conversion
  counterparties                         Smooth resolution             on all liabilities (to
                                         without disruption            extent required)
  Senior debt
  instruments                                  OR
                     Increase role of    „Reserve army‟ of capital
 Subordinated        loss-absorbing      to cover extreme events
debt & Preferred     capital
     stock

   Common
    equity

                                                                                                9
Current initial investor base for UK bank senior debt




                                    Other banks
                                                25%




                             12%
                      Insurance                          50%
                                       12%            “Fund Manager”
                                     Other




Source: Broad estimates from firm information
                                                                       10
Frequency distribution of bank bond payouts

                                 Observed in good times
    100%




               Not observed in
                 good times




       0
                                   100% of principal
                                   and due interest
                                                          11
Financial firms‟ CDS and share prices
                                                        Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices
                                     1.2%                                                                                                                                                                              2.50
     Average CDS Spread in Percent




                                     1.0%
                                                                                                                                                                                                                       2.00




                                                                                                                                                                                                                              MarketCap Index
                                     0.8%
                                                                                                                                                                                                                       1.50

                                     0.6%

                                                                                                                                                                                                                       1.00
                                     0.4%


                                                                                                                                                                                                                       0.50
                                     0.2%



                                     0.0%                                                                                                                                                                              -
                                                              Aug 03




                                                                                         Aug 04




                                                                                                                    Aug 05




                                                                                                                                               Aug 06




                                                                                                                                                                          Aug 07




                                                                                                                                                                                                     Aug 08
                                            Dec 02




                                                                       Dec 03




                                                                                                  Dec 04




                                                                                                                             Dec 05




                                                                                                                                                        Dec 06




                                                                                                                                                                                   Dec 07




                                                                                                                                                                                                              Dec 08
                                                     Apr 03




                                                                                Apr 04




                                                                                                           Apr 05




                                                                                                                                      Apr 06




                                                                                                                                                                 Apr 07




                                                                                                                                                                                            Apr 08
                                                                                                           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.
Source: Moody‟s KMV, FSA Calculations                                                                               CDS series peaks at 6.54% in September 2008.                                                                                12
Development of the crisis: 2007 – 2008

     June 2007: Bear Stearns hedge funds impose redemption gates, sudden
                   increases in margin calls, drops in asset prices.

   August 2007: Major losses by „market neutral‟ hedge funds

 February 2008: Carlyle Capital and Peloton Hedge Funds closed

Autumn 2007 to Liquidity and solvency problems at off-balance sheet SIVs
     Mid 2008:
 Summer 2008: Stresses at MMMFs: Reserve Primary Fund „breaks the buck‟
     August to Liquidity run in repo and other secured funding markets
 October 2008:
   Late autumn Hedge fund deleveraging and asset sales exacerbate downward
          2008: spiral of asset values

                                                                             13
US financial sector assets

               Banks                              MMMFs
               GSE                                Agency and GSE- Mortgage Pools
               Issuers of ABS                     Finance Companies
     300%      Security Broker-Dealer             Funding Corporation


     250%


     200%


     150%


     100%


     50%


      0%
        1960   1965    1970    1975     1980   1985   1990   1995   2000   2005    2010
                                                                                          14
Traditional non-bank credit intermediation

                                •Leverage
                                •Maturity
                                 transformation


 Corporates        Banks
                                                   Corporates

                   •Insurance
                   •Pensions                       Households
                   •Other


 Households            Direct                      Government
                  Non-intermediated


                                •Not leveraged
                                •Little maturity
                                 transformation
                                                            15
Credit intermediation via the shadow banking system

                                      Hedge
                                      Funds
                     Investment
                      Banking /
                   Prime brokers

 Corporates
                                                          Corporates


                                         Securitisation   Households
                            SIVs &
                           Conduits

                MMMFs
                                                          Government
 Households


                               Multi-stage
                              leverage and
                                maturity
                             transformation                        16
 Credit intermediation via the shadow banking system

                                  Extensively
                            interconnected via repo
                                    market


                                   Hedge
                      Investment   Funds
                         banks
Corporates
                                                            Corporates
                  Banks


                                                            Households
                                           Securitisation
                             SIVs &
              MMMFs         Conduits
                                                            Government
Households



                                                                         17
Fundamental drivers of „shadow banking‟ activities



     Gorton &       Securitised bonds plus repo markets result
      Metrick       in “privately created money” (i.e.
                    apparently risk free immediate value claim)

                    Tranching of securitised bonds creates
     Gennaoili,
                    apparently risk free credit instruments
     Shleifer &
                    (equivalents of T-bonds but with additional
      Vishny
                    yield)


                    Deposit equivalents with immediate access
      MMMFs         and „certain‟ capital value but higher return



                                                                    18
 Financial engineering and financial alchemy


                     Financial System

                   Can                                          Corporates
                 • Pool and hedge some risks
                 • Repackage and redistribute risks
                                                                Households
Corporates
                 Cannot
                                                               Governments
                 • Make risks disappear


Households
                                                       Inherent real risks constrain potential
               Innovation, product complexity, and     mix of:
             interconnected system      collectively   • Certain / close to certain cash flows
                 impossible assessments of risk        (debt)
                                                       • Participation in uncertain cash flows
                                                       (equity)

                                                                                         19
           “We recognise the benefits of private supply of safe securities, but
           at least in some cases, such securities owe their very existence to
           neglected risks…



recent policy proposals, while desirable in terms of their intent to control
leverage and fire sales, do not go far enough.




         It is not just the leverage but the scale of financial innovation and of the
         creation of new claims itself, that might require regulatory attention”


                                               Gennaioli, Shleifer and Vishny, 2010
                                                                                   20
 Ideal equity ratios higher than Basel III

 TBTF: making banks „resolvable; necessary but not
  sufficient

 Markets as important as institutions; shadow banking as
  important as banks

 The fundamental issues
        Debt/equity balance
        How much maturity transformation

 Four implications

                                                       21
Rigidities and vulnerabilities of debt contracts


        Bankruptcy costs: non-smooth adjustment

        Fire-sale losses

        Need for continual roll-over

        Multiple equilibria depending on interest rate

        Credit and asset price cycles




                                                          22
     Source: Datastream
                                     0
                                         1000
                                                2000
                                                       3000
                                                              4000
                                                                     5000
                                                                            6000




                          02/01/95

                          02/07/95




                              1995
                                                                                   NASDAQ: 1995 – 2002




                          02/01/96

                          02/07/96



                              1996
                          02/01/97

                          02/07/97
                              1997

                          02/01/98
                          02/07/98
                              1998




                          02/01/99

                          02/07/99
                              1999




                          02/01/00

                          02/07/00
                              2000




                          02/01/01
                          02/07/01
                              2001




                          02/01/02

                          02/07/02
                              2002




23
Unstable risk assessments in debt claims


    Sovereign debt

           Borrowers/taxpayers: unstable awareness of Ricardian
            equivalence

           Lenders: „local thinking‟, unstable credit assessment, surges
            and sudden stops, multiple equilibria




                                                                            24
       Greek sovereign debt and cost of borrowing


Basis points                                                              % GDP
1000                                                                      150
                       Greek 10-year spread to bunds                                                                                                                   Forecast
                                                                                   Greek general government gross debt as % of GDP
                                                                          140
 800
                                                                          130
 600
                                                                          120

 400                                                                      110

                                                                          100
 200
                                                                           90

  0                                                                        80



                                                                                2000

                                                                                       2001

                                                                                              2002

                                                                                                     2003

                                                                                                            2004

                                                                                                                   2005

                                                                                                                          2006

                                                                                                                                 2007

                                                                                                                                        2008

                                                                                                                                               2009

                                                                                                                                                      2010

                                                                                                                                                             2011

                                                                                                                                                                    2012

                                                                                                                                                                           2013

                                                                                                                                                                                  2014
       2005



                2006



                              2007



                                        2008



                                                  2009



                                                          2010



                                                                   2011




                                                         Source:
         Source: Datastream                                                                                                             Source: IMF World Economic




                                                                                                                                                                      25
Unstable risk assessments in debt claims

    Sovereign debt

        Borrowers/taxpayers: unstable awareness of Ricardian
         equivalence
        Lenders: „local thinking‟, unstable credit assessment, surges and
         sudden stops, multiple equilibria



    Private debt

        Borrowers: unstable cycle driven by asset price expectations
        Lenders: „local thinking‟, unstable credit assessment, surges and
         sudden stops

                                                                             26
Maturity transformation

  Bank based           Liabilities Assets
                                     Liquid Assets

                       Deposits
          Corporates       &                         Corporates
                        short             Loans
                         term
                         debt                        Deposits

         Households                                  Government
                       Equity/debt
                         capital

  Market based

          Corporates                                 Corporates
                           Debt markets
                          Equity markets             Deposits

         Households                                  Government   27
Household deposits and loans: 1964 – 2009

                      100%

                      90%            Securitisations and loan transfers   Deposits   Loans
                      80%

                      70%

                      60%
           % of GDP




                      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
                                                                                                           28
  Holdings of US MMMF Shares by Sector
         100%

          90%

          80%

          70%
                                                                     Other
          60%                                                        Rest of the World
                                                                     Insurance Companies
          50%                                                        Pension Funds
                                                                     Funding Corps
          40%                                                        Non-Financial Business
                                                                     H'Hold
          30%

          20%

          10%

           0%
             1980          1985   1990   1995   2000   2005   2010
Source: US Flow of Funds
                                                                                    29
   Financial institutions, corporate bond and CP
   issuance
        Total issuances
                $ billion               768                2823                6410               16281

                    >10 years                                                    4%                  4%
                                        10%                   7%
                                                                                11%                 10%
                                                            19%
                   6-10 years           26%                                    22%                  24%

                                                            26%

                    1-5 years           28%

                                                                                63%                 61%
                                                            48%
                                        36%
                     <1 year


                                  1991-1994           1995-1999           2000-2004           2005-2010
Source: McKinsey Global Institute: Farewell to Cheap Capital? The Implications of long-term shifts in global investment and
saving“, December 2010                                                                                                        30
Three questions in maturity transformation


    How much is optimum

    The role of non-bank long term credit intermediation

    Should regulation recognise a capital versus liquidity trade-off?




                                                                         31
 A capital adequacy and liquidity trade-off?


             Liabilities   Assets                         Liabilities   Assets
                                    Liquid                              5        Liquid
                            10      assets                                       assets


  Debt of                                       Debt of
                                    Loans      average                           Loans of
 average                            of                                           average
maturity 6      95          90                 maturity       80        95
                                    average    1 month                           maturity
  months                            maturity                                     1 year
                                    1 year



                                                Equity        20
   Equity       5



                                    Which is riskier?
                                                                                   32
Four implications


   1. Equity capital surcharge for systemically important banks

   2. Macro-prudential oversight of continually mutating system

   3. Policy levers to lean against credit cycle

   4. Appropriate robustness of financial stability policies must
      reflect assessment of social value added of financial intensity
      and innovation




                                                                        33
Typical haircuts on term securities financing
% for prime counterparties

                                                        June 2007                       June 2009
                         Prime MBS:
                            AAA rated                           4                             10
                        AA and A rated                          8                            ~ 100
         Asset backed securities
                                                               10                              25
               Structured products                             10                            ~ 100
                             (AAA)
       Investment Grade Bonds
              AAA and AA rated                                  1                               8
               A and BBB rated                                  4                              10

    Source: CGFS Paper No. 36 The role of margin requirements and haircuts in pro-cyclicality, March 2010


                                                                                                            34
Four implications


   1. Equity capital surcharge for systemically important banks

   2. Macro-prudential oversight of continually mutating system

   3. Policy levers to lean against credit cycle

   4. Appropriate robustness of financial stability policies must
      reflect assessment of social value added of financial intensity
      and innovation




                                                                        35
Measures of increasing financial intensity

                                    US debt as a % of GDP by                                                                                                       Global issuance of asset-
300%
                                         borrower type                                                                                                                backed securities
250%

200%

150%

100%
 50%
 10%
                                                                             1971
                                                                      1965



                                                                                    1977

                                                                                            1983
                                                                                                     1990
                                                                                                                   1996
                                                             1959




                                                                                                                             2002
              1929
                     1935




                                                                                                                                    2007
                            1941
                                     1947

                                               1953




      450                                                                                                                                     1,100
                                                                                                                                              1,000
                                                                                                                                                               FX Trading values & world GDP
      400                             Growth of interest rate
                                                                                                                                                  900                    1977-2007
      350                          derivatives values, 1987-2009
      300                                                                                                                                         800
                                                                                                                                                  700
      250



                                                                                                                                           $Trn
$Tr




                                                                                                                                                  600


                                                                                                                                           $bn
      200
                                                                                                                                                  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

                                                                                                                                                                                                                                   36
 Share of the financial industry in US GDP




                                                                                                      %




Source: Andrew Haldane, What is the contribution of the financial sector: Miracle or mirage?, Chapter 2, The Future of
Banking, LSE Report 2010                                                                                                 37
Historical „excess‟ wage in the US financial sector




Source: Andrew Haldane, What is the contribution of the financial sector: Miracle or mirage?, Chapter 2, The Future of
Banking, LSE Report 2010
                                                                                                                         38

								
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