ECONS528 FINANCIAL MARKETS, GOVERNANCE AND REGULATION

CHAPTER II – PART I: THE TRANSFORMATION OF FINANCIAL

MARKETS

Pierre Francotte2015-16

2

READING

• McKinsey (2014), « Global Flows in a Digital Age » (April), available on Mc Kinsey’s website (section MGI). McK (2014)

• McKinsey (2013), « Financial Globalization: Retreat or Reset? » (March). McK (2013-1).

• Mc Kinsey (2012), « How EU banks can navigate a regulatory squeeze » (July). McK (2012-1)

• Mc Kinsey (2012), « The Triple Transformation: achieving a sustainable business model » (October). McK (2012-2)

• Chapter 9, Mishkin et al.• Inquiry Report: National Commission on the Causes of the

Financial Crisis in the US, The Financial Crisis Inquiry Report, (2011), edited by Public Affairs, NY.

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CONTENTS

I. The transformation of financial marketsA. Main causesB. How the markets have evolved

II. The evolution of the traditional banking modelA. The traditional banking modelB. Profitability has been eroding over the last 30 yearsC. Prompting banks to diversify their activitiesD. Contributing to the advent and magnitude of the 2007 crisisE. Emergence of Shadow Banking

Annex - Sizing up the financial markets

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INTRODUCTION

• Financial markets have undergone profound changes since the 1980s, and in particular in the last two decades.

• To understand why and how financial regulation has evolved (and will need to adapt further), it is important to review:– the magnitude of these changes (See Annex)– the underlying forces that prompted them (Section I)– the impact that they have had on the traditional

business models of banks (Section II).

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I. THE TRANSFORMATION OF FINANCIAL MARKETS

A. Main causesB. How the markets have evolved

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A. Main causes

• The main primary drivers for change have been– trade and services liberalisation,– technology advances, and – a regulatory environment that accommodated

change,• Which brought – more competition in the financial system and – new (skewed) financial incentives for both financial

institutions and managers, • In turn generating more changes.

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Liberalisation

• Trade and financial services have been progressively liberalised across industrialised countries and, increasingly, emerging markets.

• It encouraged foreign investment by financial institutions offering services:– locally through branches or subsidiaries, or– on a remote basis, especially within the EU

(European passport).

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Technology advances

• Like in other industries, technology advances have revolutionised the ability:– to obtain, store and analyse information, – to communicate with clients, and – to process transactions.

• All this at massively lower costs:• facilitating entry by new players in several segments of

the financial industry and • blurring lines between different segments.

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Accommodative regulatory context

• Regulators accommodated and sometimes encouraged the evolution of the financial industry as long as this evolution produced mostly benefits – lower costs, – better services to ultimate clients.

• The 2007 financial crisis and the 2011 sovereign debt crisis triggered a rethink of this approach, because the hidden costs abruptly and massively materialised.

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Competition in the financial system

• Competitive pressures built up progressively thanks to the other drivers for change (internationalisation, technology improvements).

• Regulators accommodated increased competition as a way of improving service quality and reduce costs for clients.

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Financial incentives

• Profits of financial firms started to grow at greater pace than GDP.

• Financial compensation of bank managers started to deviate upwards from other industries’ benchmarks.

• General short term focus (not only financial sector)

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Compensation: financial vs non-financial sector

• Source: US Inquiry Report

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Banks’ profitsSource: CityUK Research Ctr.

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B. How the markets evolved

• Between 1980 and 2010, the financial markets have become: – Bigger– More international– More complex– Increasingly concentrated

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Bigger

• By practically all yardsticks, financial markets volumes have grown until 2010 by about:– a factor of 2 in 2000-10 (with sometimes a

correction at the time of the crisis), and – a factor of 4 in 1990-2010 years.

• Financial markets have also grown compared to GDP over the 2000 decade by:– a factor of 1.3 (e.g., for global financial assets

stock) Source: Mc Kinsey

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Summary Table (2000-10) Annex

Aggregate Size (2010) Growth rate (2000-2010)

Stock

Global Financial Stock $ 212 trillion X 2

Securities $ 175 trillion X 2.6

Derivatives $ 623 trillion X 6

Banks’ assets $ 96 trillion (top 1,000 banks) (2009) X 2.5

Bank deposits $ 54 trillion X 1.8

Transactions

Forex $ 4 trillion/day

Securities $ 8 trillion/day (incomplete)

Derivatives $ 5.5 trillion/day (incomplete)

Profits $ 0.8 trillion (2008) X 2.5 (2000-08)

Global GDP Growth X 1.9

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Bigger – inflexion in 1980s Annex

• The trend is even more apparent over the very long term, showing that the acceleration of financial markets growth can be traced to around 1980, and even earlier.

• Financial assets in the US grew twice as much in the last 30 years as it had in the previous 80 years:– 1900-1980: from 101% to 194% of GDP– 1980-2008: 194% to 392% of GDP. Source: Mc Kinsey

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Comparison with selected GDPs Annex

. Area/Country

GDP$ trillion

World 69.99

US 15.09

Eurozone 13.07

Belgium 0.51

Source:World Bank (2011) Financial data vs GDP ...

0

50

100

150

200

250

70

15 13

212

96

54

World GDPUS GDPEurozone GDPFinancial StockBanks' assetsBank deposits

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More international

• Financial markets have progressively become more international:– investors have diversified their portfolio to foreign assets

(demand side), and– financial services have been offered by foreign

institutions (offer side). • Main causes:– growth of international trade after WW II, which

increased faster than GDP,– expansion first by US banks and then by European and

Japanese banks beyond their mature markets.

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More international - Cont’d

– reduced barriers to banking by foreign firms, both in industrialised markets and in emerging markets,

– in Europe, • freedom of banking services on a remote basis

(European passport) and • launch of EUR

– fundamental shift of investment patterns from domestic markets to pan-European sectoral approach.

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But globalisation has stalled with the crisis

• The trend towards internationalisation of financial markets was reversed in 2008, as cross-border capital flows dropped by 83% in a single year, dropping further in 2009:– interbank lending dried up completely after

Lehman– bank lending to non-banks, foreign direct

investment and repatriation of assets by investors also dropped sharply.

• Cross border flows have not yet recovered.

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Cross-border finance flows crashed after the crisis Annex

Cross-Border Financial Flows in USD trillion, Source Mc Kinsey0

2

4

6

8

10

12

14

0.51

4

7.3

8.6

12

2.41.8

5.95.3

3.9

19801990200020052006200720082009201020112012

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Banks’ domestic focus

• Banks have refocused their activities domestically:– foreign activities more risky and less core– pressure for banks to lend to domestic economy.

• Healthy recalibration, as much of the growing international activity had been financed through excessive leverage, but …

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Banks’ domestic focus – cont’d

• … it carries risks as well:– less foreign expertise and competition will lead

to higher cost of financing and possibly unmet demand for worthy projects (especially in Emerging Markets).

– low profitability of mature domestic markets could prompt strategically risky spiral of shrinkage.

– Could lead to consolidation in domestic markets, reducing competition.

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More complex

• Financial innovation and, as a result, complexity, have increased in last 30 years.

• Creating more complex financial institutions:– bank conglomerates running several different business

lines, and looking for economies of scale and scope and for cross-selling opportunities, and

– emergence of new financial institutions (hedge funds) and investors (e.g., private equity, SWF).

• And more complex financial instruments, such as:– derivatives, – structured products.

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More complex – cont’d

• Re-regulation since 2008 has forced certain parts of the financial sector, mainly banks, to reduce complexity to some extent:– Some products banned or restricted• Especially if to be sold to retail investors

– Capital costs of complex/risky products increased• But the financial sector as a whole has not

become materially less complex– Shifts of business to non-bank providers.

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…and more concentrated Annex

• Across all regions, the number of banks has reduced through consolidation.

• Of the 1,000 world’s largest banks:– the top 10 hold 26% of total assets (14% in 1999)– the top 25 hold 40% of total assets– the smallest 950 hold 38% (51% in 1999).

• In US, 10 largest financial US commercial banks held 55% of the industry’s assets in 2005, more than double the 1990 level. Source: Inquiry Report

• In Europe, there is even greater concentration than in the US in some countries, and yet there is room for further consolidation.

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Affecting the traditional banking model

• This transformation of the financial markets has had a major impact on the traditional banking model, – creating strains that contributed to the financial

crisis, and – raising questions about the future shape of the

banking industry.

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II. THE EVOLUTION OF THE TRADITIONAL BANKING MODEL

A. The traditional banking modelB. Profitability has been eroding over the last 30 yearsC. Prompting banks to diversify their activitiesD. Contributing to the advent and magnitude of the

2007 crisis

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Introduction

• Commercial banks’ traditional model is:– to make loans to range of economic agents– using cash deposits of their clients.

• Banks’ profits from these traditional banking activities have been shrinking for many years.

• Prompting them to diversify activities.• Boosting their profitability, – but in part through greater leverage and risk-taking, – which contributed to the 2007-10 crisis.

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A. The traditional banking model

• Banks' traditional financial intermediation role has been:– to receive demand and other deposits from clients

(typically short term borrowing), and – to use this funding to make loans to economic agents

(typically longer term lending).• Making a profit:– on the margin between the interest paid and the

interest received (“Net Interest Income” – NII), and– on fees for side services (“fee-based” business).

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Historically a profitable business

• Because:– few competitors for cash deposits or lending• banks were the main source of financing to the

economic agents

– regulatory framework was favourable to banks for these activities • while constraining banks to conduct other activities –

quid pro quo.

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Regulatory protection

• Banks could fund themselves very cheaply, as laws typically imposed that:– demand deposits could not to be remunerated (free

funding for banks), and/or– interest rates on term deposits were capped (e.g.,

Regulation Q in the US)• Regulation was limiting competitors to banks in their

cash collecting and/or lending activities:– deposit guarantee schemes only for bank deposits, – separation of commercial and merchant banking (Glass

Steagall in US and equivalent laws in Europe).

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…compensating for regulatory constraints

• This protection was a quid pro quo for regulatory constraints on the conduct of their business, such as: – limitations on ability to carry out other financial

activities,– variety of regulatory requirements on risk

management, and– consumer protection measures limiting profits.

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B. Profitability has been eroding over the last 35 years

• Better information and improvements in technology to disseminate and analyse information progressively reduced information asymmetry, – encouraging direct financing (bank lending

disintermediation).• Competitive pressures from non-banks,• Pressure from clients demanding better services

and better remuneration of their cash deposits.

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Competition for core banking services

• Banks have come under increased competitive pressure from non-banks on their core functions– Collecting cash through deposits– Lending to households, corporates and government.

• The process accelerated in the 1970s when inflation reached very high levels, eroding the value of cash deposits which were poorly (or not) remunerated by banks.

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Competition for cash collection and lending

• Example of alternative to cash deposits:– Money market mutual funds.

• Examples of alternative to bank lending:– Commercial paper issued by high quality

corporate issuers– Junk bonds issued by poor credit quality

corporate issuers– Repos (repurchase agreements) between broker-

dealers and cash-rich corporates.

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Money Market Fund competes with bank deposits Annex

• Developed in US by fund managers in the 1970s.• Mutual fund that is unsecured (i.e., no

collateral) but issued by quality fund sponsors and invested in safe, short term assets:

• not subject to Reg. Q (cap on interest paid by banks on demand deposit ) or to reserve requirements,

• no capital fluctuation, backed by issuer parent, and• works like bank accounts (cheques in US).

• Assets in MMF in US grew from $3bn in 1977 to $2.3 trillion in 2009.

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Commercial Paper competes with bank lending Annex

• Short term bonds issued mostly by large corporates and financial institutions (e.g., broker dealers) with good credit quality– Form of direct financing

• Unsecured (no collateral), but issuers generally considered good quality.

• Cheaper source of financing for issuers than borrowing from banks.

• CP market in US rose from $125bn in 1980 to $1.6 tr in 2000.

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Causing banks to look for other funding than deposits

• New competition pushed banks to look for other funding than bank deposits.– borrowing from markets and other banks to fund

their business, including loans to customers,– for instance, in the UK, in 2008, 40% of customer

loans was funded through wholesale money markets, much of it from foreign sources.

Source: The CityUK Research Centre

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Non-bank financing caught up with banks’ financing Annex

. Example: the US.

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Leading to an erosion of market share for banks Annex

• In the US:– Banks market share in lending to non-financial

firms:• 60% in 1970 • 32% in 2008.

– Banks funding through interest-free cash deposits:• 60% in 1960 • 6% in 2008. Source: Mishkin et al

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And of NIE share in their income

• In the traditional banking business, banks’ predominant source of income is net interest income (NII).

• With diversification, an increasing share of income is derived from other sources:– fee and commission-based activities, and– profit from financial operations.

• Share of NII dropped from about 80% in the mid-1980s to 60% in the mid-2000. Source: OECD, ECB

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As shown by Loan-Deposit Margin Annex

• LDM is metric commonly used to assess banks’s ability to generate NIE:– difference between interest rates on loans and

interest rates on deposits– steadily declining for many years:• LDM of EU banks has dropped sharply– from 3.5% in 2003– to 2.8% in 2008 Source: ECB

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C. Prompting banks to diversify their activities

• Banks diversified their activities:– offering a broader range of services,– expanding internationally,– increasing their size through M&A.

• Sought regulatory changes to allow them to engage in securities activities:– relaxation of Glass Steagall in the 1980s until full repeal in

1999/same in Europe.• Looked for more remunerative activities to compensate for

very low interest rates (since 2000’s)– lower lending standards– risky investments in search for yield (e.g., sub-primes).

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A few examples of diversification of services

• Securitisation • New types of loans, including more risky loans (e.g.,

commercial real estate, M&A financing),• Underwriting and trading of securities,• Custody, settlement, collateral management and

corporate action management of securities, valuations of portfolio, etc,

• Servicing hedge fund (prime brokerage), including extension of credit,

• Running hedge funds and private equity firms internally.

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Boosting profits Annex

Pre-tax profits of the world top 1,000 banks more than doubled between 2000-08 to about $800bn, (before tumbling to $125bn as a result of the crisis in 2009) Source: CityUK Research Ctr.

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But also leverage

• Banks’ debt grew at a faster pace than GDP (and than other debt) between 2000-08

• Leverage ratio (asset to equity) of large banks was on average 30– top 20 global banks increased from 20 in 2000 to

24 in 2007 and to 30 in 2008. – actually 50, after adjustments? Source: Haldane (2010)

• Some large banks had a ratio of 60 in 2008.

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But also leverage – Cont’d Annex

• Accelerating in the 2000s:– Bonds issued by financial institutions grew by

$23 trillion in decade before crisis. Source: McKinsey

– In US alone, debt of the financial sector grew from $3 trillion in 1978 to $36 trillion in 2007• doubling as a share of GDP. Source: Inquiry Report

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Leverage and leverage ratio

• Leverage is expressed in terms of debt vs equity, but two different ways to present it.

• Ratio is often presented as debt/equity– Bank with debt that is 33 times size of its equity has

« leverage of 33 »• Basle III rules express leverage ratio has equity/debt

– Regulatory ratio set at minimum 3% means that equity must be no less than 3% of bank debt

– which means debt cannot exceed 33 times size of equity.• Leverage of 33 is same as leverage ratio of 3%.

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D. Contributing to the 2007 crisis

• Evolution of banking was major contributor:– Unbridled securitisation in the US

• led to the subprime crisis and to overvalued assets (« originate and distribute » model turned into « originate and dump”)

– High leverage • made banks’ balance sheets too vulnerable to unexpectedly

serious shocks

– Excessive reliance on short term funding • exacerbated the effects of the liquidity crunch in 2007,

especially when value of collateral assets was in doubt.

– Focus on short term profits• Encouraged by managers’ compensation policies

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Revenue constraints

• Banking revenues will be structurally constrained in next decade by:– regulation (capital, liquidity and leverage ratios), – deleveraging.

• Will remain very dependent on:– level of interest rates, – especially as new regulation prohibits, or

increases the cost of, some non-interest related sources of business.

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Impact of regulations on EU banks’ RoE

• Regulations have a significant impact on RoE, in particular Basle III. Source: McKinsey (2012-1)

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Bank’s RoE

• RoE of banks in Europe have not been covering their cost of capital. Source: McKinsey 2012-2

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Banking revenues vs. GDP

Banking revenues are now expected to grow at same pace as GDP, like other industries. Source: Mc Kinsey (2013-1)

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ANNEX – SIZING UP THE FINANCIAL MARKETS

A. Preliminary considerations on measuringthe size of financial markets.

B. Selected key aggregate data

NB: a billion (bn) is a thousand million, a trillion (tr) is a thousand billion.

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A. Preliminary considerations

• There are a number of measures of the size of the financial markets and/or of individual components:– global stock of financing (equity and debt outstandings),– global private wealth invested,– size of securities and derivatives markets and activity,– forex activity,– global cross-border capital flows, – profit and/or revenue figures, etc

• However, none of these measures gives a complete picture on its own and it is by adding the information from the various pieces that the puzzle emerges.

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Using available public sector sources

• Various studies are published on periodical or ad hoc basis, providing a vast amount of data on financial markets and activity.

• Some of the key public sector sources are:– the Bank of International Settlements (BIS)– the International Monetary Fund (IMF)– the European Central Bank (ECB)– national central banks – the European Commission

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As well as private sector sources

• In addition, various consulting firms, think tanks, trade associations, financial firms, and lobbying groups produce their own data aggregations and/or analyses.

• While these must sometimes be taken with caution because some of these firms have commercial or political rationales to present conclusions in a way that serves their clients’ interests, several of these are thoughtful and well documented.

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B. Selected key aggregate data

• A few selected aggregate data are reviewed, with graphs in Annex (providing sources).

• Additional data, with graphs and notes, are provided in Annex. You do not need to know them by heart - they are for reference purposes.

• Some of these data will be analysed in greater details in subsequent chapters.

NB: the sources of the data differ and may use different methodologies, sometimes making reconciliation difficult.

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Global Financial Stock: $225 trillion (Q2 2012)

• Captures all external financing:– equity (capital raising), and– debt (leverage), including both bonds and loans.

• Q2 2012: $225 trillion. Source: McKinsey (2013-1)

• Financial stock in 2010:– doubled in the previous 10 years, and – quadrupled in the previous 20 years.

• But has stagnated since 2007.

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Shift in composition since the crisis

2007 2012 Q2 In USD trillion

Source: Mc Kinsey (2013-1)

0

50

100

150

200

250

64 50

32 47

39 428 1113 13

5062

Non-Securitised LoansSecuritised LoansCorporate BondsFinancial BondsGovernment BondsEquity

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Financial Depth: 312%

• Financial depth is the size of the capital markets in terms of GDP.

• Grew massively between 1990 and 2007 and has dropped since.

• Is globally still 312% (Q2 2012), but with large discrepencies between regions:– 408% in advanced economies– 157% in emerging markets Source Mc Kinsey 2013-1

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Financial Depth - regions

Financial depth (% of GDP) 2012 Q2 Source: Mc Kinsey (2013-1)

0

50

100

150

200

250

300

350

400

450

500 463 453

369

226

408

157

USJapanWestern EuropeChinaAdvanced countriesEmerging Markets

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Financial Stock and Financial Depth evolution

Financial Stock in USD trillion Financial Depth (%GDP) Source McKinsey (2013 -

1)

0

50

100

150

200

250

300

350

400

1256

263

119

310

206

355

225

312

19801990200020072012 Q2

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Private investors’ global assets: $123 trillion (2011)

• Captures the total private wealth of individuals that needs to be invested:– is only a fraction of total assets to be invested

(excludes assets of corporates, governments, pension funds, etc).

• $123 trillion at end 2011 Source: BCG 2012

• Doubled over 2000-10.

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Global Bank Assets: $112 trillion (2012)

• Measure of size of banks’ balance sheets:

• Increased by 2.5x in 2000-10.

Top regions In $tr – 1,000 largest banksSource: The Banker Database 2013

EU 30,716

China 15,701

US 13,916

Japan 13,150

UK 9,843

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4. Global bank deposits: $54 trillion

• Most significant liabilities of banks.• Indicative of the banks’ ability to collect

financing from economic agents, and is one of the drivers of banks’ lending capacity.

• Was $54 trillion in 2010 or 90% of GDP• Growth by 1.8x in 2000-10.