2013.11.18 - NAEC Seminar_The role of the Financial System in the Crisis (Presentation 1)

PROJECT A3

FINANCE,

COMPLEXITY &

INTERDEPENDENCE

Adrian Blundell-Wignall Special Advisor on Financial Markets to the OECD Secretary General.

NAEC Seminar, 18 November 2013

In association with the OECD Directorate

for Financial and Enterprise Affairs

What is NAEC About?

2

• Evidence based analysis: --Inconsistent trends in integration & interdependence. --Complexity. --New tools of analysis. --Crisis and lessons from it. • Micro-prudential response. • Macro-prudential issues. • Structural reform in finance—unfinished agenda. • Issues concerning moving from QE and low rates. • New ways of working at the OECD.

Integration v Interdependence Trends

3

• Greater market integration carries with it the connotation of the opening up and expansion of trade in goods and services, with gains from trade likely to enhance economic welfare.

• Greater interdependence, however, is more ambiguous. More interdependent financial institutions and markets carry increased risk for financial instability, particularly with respect to counterparty positions in derivatives and repurchase (repo) agreements between global systemically important financial institutions (GSIFI’s).

• Uneven integration in goods and capital markets. • Dramatic changes in financial interdependence &

complexity.

S-I Correlation OECD Areas

4

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

1960 Q1-64 Q4

1960 Q1-68 Q4

1960 Q1-72 Q4

1960 Q1-76 Q4

1960 Q1-80 Q4

1960 Q1-84 Q4

1960 Q1-88 Q4

1960 Q1-92 Q4

1960 Q1-96 Q4

1960 Q1-00 Q4

1960 Q1-04 Q4

1960 Q1-08 Q4

OECD Europe EU Periphery

S-I Correlation OECD vs Emergers

5

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

1982 Q1-86 Q4

1982 Q1-88 Q4

1982 Q1-90 Q4

1982 Q1-92 Q4

1982 Q1-94 Q4

1982 Q1-96 Q4

1982 Q1-98 Q4

1982 Q1-00 Q4

1982 Q1-02 Q4

1982 Q1-04 Q4

1982 Q1-06 Q4

1982 Q1-08 Q4

1982 Q1-10 Q4

Emergers OECD All

S-I: 5-Year Rolling Window, OECD vs EME

6

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1982 Q1-86 Q4

1984 Q1-88 Q4

1986 Q1-90 Q4

1988 Q1-92 Q4

1990 Q1-94 Q4

1992 Q1-96 Q4

1994 Q1-98 Q4

1996 Q1-00 Q4

1998 Q1-02 Q4

2000 Q1-04 Q4

2002 Q1-06 Q4

2004 Q1-08 Q4

2006 Q1-10 Q4

Emergers OECD All

OECD 5-Year Average Current Accounts

7

-10

-5

0

5

10

15

1964 Q4 1974 Q4 1984 Q4 1994 Q4 2004 Q4 2012 Q2

% GDP

USA

JAP

UK

GER

FRA

ITA

SPA

CAN

SWI

AUS

US Trade Balances

8

-80000

-70000

-60000

-50000

-40000

-30000

-20000

-10000

0$m

TB with OPEC

TB with EEC

TB with Jap

TB with Asia

TB with NAFTA

US TB

FDI: Inward Liabilities/Outward Assets

9

0%

5%

10%

15%

20%

25%

30%

35%

40%% Wld GDP Outward/AssetsBRICS + Indonesia

Continental Western Europe

Switzerland

United Kingdom

Australia

Japan Korea

Canada

United States

0%

5%

10%

15%

20%

25%

30%

35%

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

% Wld GDPInward/LiabilitiesBRICS + Indonesia

Continental Western Europe

Switzerland

United Kingdom

Australia

Japan Korea

Canada

United States

Trends in the Structure of Global Finance

10

0

10

20

30

40

50

60

70

80

90

100 % GDP Fin Sector Debt

GMV Derivatives

Bank Bal. Sheet

NonFin Corp Debt

Gen Gov Debt

Global Banks Leverage & Weighted DTD

11

0

1

2

3

4

5

6

7

0

5

10

15

20

25

30

35

De

c-9

7

De

c-9

8

De

c-9

9

De

c-0

0

De

c-0

1

De

c-0

2

De

c-0

3

De

c-0

4

De

c-0

5

De

c-0

6

De

c-0

7

De

c-0

8

De

c-0

9

De

c-1

0

De

c-1

1

De

c-1

2

De

c-1

3

De

c-1

4

STD DEV'sLev Ratio

Leverage Led 1-year

Leverage_GSIFIs Led 1-year

Weighted DTD

US Financial Sector Share of the S&P500

12

Derivatives vs Primary Securities % World

GDP & the Crisis

13

• Derivatives fund nothing, but carry all the bankruptcy characteristics of debt.

• The bulk is for socially non-useful things, such as structured products to avoid tax or to create enticing products that are risky & dangerous for naive consumers.

• Derivatives are levered, and the inability to meet contractual margin & collateral calls played a key role in defaults in the crisis.

• Rose from 3 times world GDP in 1998 to 12 times by 2007: for huge profits in the 2000’s.

• THE WORLD FINANCIAL SYSTEM DID A BIG PRIVATE EQUITY DEAL ON THE WORLD ECONOMY, GEARED IT UP, TOOK THE CARRIED INTEREST FOR ITSELF, & LEFT THE TAXPAYER THE BILL.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0 Ratio to GDP Total

Primary Securities

Derivatives

Gross Credit Exposure versus Collateral

14

0

1000

2000

3000

4000

5000

6000$bn

Collateral

Gross CreditExposure

Growing Bank Interdependence &

Derivatives

15

The Lessons of the Crisis

16

• The interaction between financial innovation and regulatory change, at a time of artificially low interest rates resulted in 4 key factors:

• (1) Too Big To Fail (TBTF): led to risk being under priced via the cross-subsidisation from implicit and explicit government & lender-of-last-resort guarantees for short-term bank liabilities.

• (2) Leverage: became too high and regulators made it easy for financial firms to avoid capital (Basel & other rule changes).

• (3) Complexity & Interconnectedness (counterparty) risk: Innovation in business models focused on securitisation and derivatives-based financial products raised counterparty risk, so the failure to meet margin and collateral calls can multiply through the system. Mixing traditional banking with losses in complex products resulted in deleveraging, with SME and consumer lending failing to support recovery.

• (4) Conflicts of interest: Corporate governance for self interest of managers and traders.

• Reform requires a financial system that adds value, not subtracting value for itself. This is not happening.

COMPLEXITY

17

• Interdependent counterparties

• Re-hypothecation

• Innovation and technical change in market.

• Passive

• ETF’s

• Stock lending

• Dark pools

• Price discovery

Complexity & Interdependence in

Derivatives and Repo’s

18

Tripartite

repo

20

Broker Dealer 100

B

10 Broker Dealer

90 CCP 20 A

10

Broker Dealer

C 80

Passive, Active, HFT, Dark Pools: Price

Discovery

19

• Physical ETF’s use securities lending (why they appear so cheap) & split the lending. • They offer total liquidity, (through-the-day pricing), when the underlying assets are

often not liquid (e.g. Small caps, emerging market funds, commodity funds, credit fixed income).

• Now the fast growth area in ETF’s is swap-based ETF’s: synthetic. • The swap counterparty is the bank also acting as ETF provider. Investors exposed if

bank defaults. Collateral problems. Contagion & systemic risk issues. • Price discovery issues: HFT algorithms; Dark pools; Passive. • Layers of intermediaries; Boards; lack of engagement by owners; trust; behavioural

finance..

Hedge Fund Short

Stocks lent Lending

return

Cash cash

INVESTOR ETF PROVIDER INDEX ETF S&P500Share Share

Part of Lending

Lending return return

Often the same

bank

IB Stock Lender

Micro-prudential Response

20

• Regulatory arbitrage

• Leverage v counterparty risk

• Bank business models issues

• New tools—the distance-to-default and its analysis

What Changes With Basel III?

21

• Complexity: Retains core features of capital charge system but is infinitely more complex with portfolio invariance based add-ons: multiple risk-weights; Basel II bank modeling (improved?); failure to separate leverage & counterparty risk—all be woven into the RWA capital rules. The 3% leverage ratio “back-up” is too weak and allows derivatives netting. Basel III was never asked to consider bank business model issues & their interaction with leverage and the capital rules.

• Definition of capital: generally for the better, with deductions, like goodwill, deferred tax, minorities, etc, to have a core concept); T1 (hybrids back); T2 (other hybrids).

• Counterparty risk: CCR—capital buffer (3 x 10 day 99% VAR during a period of high stress) added to market risk VAR that will raise RWA. CVA up-front charge, additive across netting sets, valuing unexpected counterparty risk in bond equivalents, and applying the MR for such bond equivalents.

• LCR and NSFR: to deal with liquidity and funding.

• Greater international harmonization, but a slow transition, continuing until 2023.

RWA / TA GSIFI & Traditional Banks

22

Tier 1 Capital / RWA (2008 & 2013)

23

Tier1 / Total Assets GSIFI Banks (2008 &

2013)

24

Distance to Default (3 Std. Dev.= Safe) :

The USA Doing it Better than Europe

25

DTD Model—What Factors Matter for Bank

Default Risk (G20 Banks

26

G-SIFIs

banks

Other large

banks

Constant, ά8.17 ***

(7.15)

6.74 ***

(4.75)

11.21 ***

(6.94)

6.55 ***

(8.72)

LEV: TA/Bank Equity-0.04 ***

(-3.30) -

-0.03 ***

(-3.21)

-0.05 ***

(-2.53)

T1: Basel Tier 1 Ratio - 2.24

(0.58) - -

TD: Trading Book plus Available for Sale Securities/TA4.51 **

(2.06)

3.72

(1.47)

3.34 **

(2.16)

3.79

(1.51)

WFD: Wholesale Funding/Total Liabilities-4.14 ***

(-3.04)

-4.54 **

(-2.31)

-6.78 ***

(-2.47)

-1.81

(-1.30)

GMV: GMV of Derivatives/TA-3.48 ***

(-2.42)

-5.39 **

(-2.21)

-4.79 ***

(-3.02)

-3.26

(-0.37)

BETA: CoVar Bank Stock Ret. with Ntl. Mkt Ret./Var. Mkt-1.47 ***

(-5.36)

-1.33 ***

(-3.61)

-2.61 ***

(-4.75)

-1.21 ***

(-3.47)

%HPI: House Price Index ann. % change16.29 ***

(4.98)

17.45 ***

(4.12)

20.10 ***

(6.70)

17.32 ***

(4.75)

DUM_MA: Dummy equals to 1 following M&A, else 0 - - - -

R2 0.69 0.65 0.73 0.67

Fisher Statistic 11.25 9.47 12.58 9.76

P-Value F 0.00 0.00 0.00 0.00

Total Observations 569 569 201 368

VECM 1 Year lagged residual (Engel & Granger test)-0.85 ***

(-17.72)

-0.85 ***

(-18.01)

-0.78 ***

(-11.05)

-0.90 ***

(-14.20)

All banks

Policy Issues Arising From New Research

27

• Leverage ratio dominates the Basel T1 ratio. Nearly all GSIFI banks in the worst DTD categories of the study have greater than 20 times LEV. A 3% backstop is not enough.

--Dexia: leverage June 2011 59-times, Tier-1 11.4. Year-end failure of the bank follows, & Tier-1 is still 7.6%.

• Business model features. high derivatives & high wholesale funding have separate (from leverage) & highly significant negative implications for bank safety; while trading assets (which can be sold easily or pledged in the event of margin calls) significantly add to safety.

• Systemic importance is a clear negative.

• The asset cycle is important, and hence central banks have a role due to the macro prudential links.

• Banks need little capital in the good times, but there is no ex ante reasonable capital rule that is enough in a major crisis. Bank separation is essential.

83 G20 Banks 2005-12: Characteristics, Quartiles by Business

Model Index (Derivatives%+W/S_Funding%-Trading Assets%)

28

-10

0

10

20

30

40

50

60

70

Index DTD * 10 WholesaleFunding (%TA

IFRS)

Trading Assets(%TA IFRS)

Derivative Assets(%TA IFRS)

CustomerDeposits (%TA

IFRS)

Total Loans (%TAIFRS)

Index & % TA (except DTD)

83 G20 Banks 2005-12: Characteristics, Quartiles by Business

Model Index (Derivatives%+W/S_Funding%-Trading Assets%)

29

-10

0

10

20

30

40

50

60

70

Index DTD * 10 Core Tier 1 Capital (%TAIFRS)

Risk-Weighted Assets(%TA IFRS)

Tier 1 Capital (%RWA)

Index & % (except DTD

DTD Calculations: No Capital Rule is

Enough in a Crisis. Separation Essential

30

2007 2008 2009 2010 2011 2012

Global

Core Tier 1 Cap. 1,222 1,144 1,621 1,708 1,831 1,960

Add. Cap. Req. For DTD 3.0 14 2,225 4,560 363 616 314

G-SIFIs

Core Tier 1 Cap. 820 741 1,138 1,191 1,230 1,335

Add. Cap. Req. For DTD 3.0 7 1,624 3,611 250 449 203

Non G-SIFIs

Core Tier 1 Cap. 402 403 483 516 601 624

Add. Cap. Req. For DTD 3.0 7 602 949 113 166 111

United States

Core Tier 1 Cap. 331 329 530 577 634 702

Add. Cap. Req. For DTD 3.0 5 1285 2473 32 176 17

United Kingdom

Core Tier 1 Cap. 215 211 348 354 352 363

Add. Cap. Req. For DTD 3.0 3 252 1075 79 80 53

Europe

Core Tier 1 Cap. 675 604 743 777 845 894

Add. Cap. Req. For DTD 3.0 6 689 1013 252 359 245

$ billion

Type of bank

Domicile of bank

Macro-prudential Issues

31

• Central bank balance sheets

• The desire to return to sectoral policies

• Complexity and interdependence and macro prudential tools.

• EME’s and capital control tools

Central Bank Balance Sheets v ISDA

Collateral + GCE of Derivatives

32

-2000

-1500

-1000

-500

0

500

1000

1500

2000Ju

n-9

8

Ap

r-9

9

Feb

-00

De

c-0

0

Oct

-01

Au

g-0

2

Jun

-03

Ap

r-0

4

Feb

-05

De

c-0

5

Oct

-06

Au

g-0

7

Jun

-08

Ap

r-0

9

Feb

-10

De

c-1

0

Oct

-11

Au

g-1

2

Jun

-13

Ap

r-1

4

$bn

ISDA Change Collateral+GCE

Cent. Bank Cash RHS

Correlation Matrix: Variables Key for the

DTD of Banks, and Monetary & Macro-

prudential Policy

33

EME’s Control Capital & Manage Rates

34

-20

-15

-10

-5

0

5

10

15

20% CNY

KRW

AUD

-20

-15

-10

-5

0

5

10

15

20

Jun

-06

Oct

-06

Feb

-07

Jun

-07

Oct

-07

Feb

-08

Jun

-08

Oct

-08

Feb

-09

Jun

-09

Oct

-09

Feb

-10

Jun

-10

Oct

-10

Feb

-11

Jun

-11

Oct

-11

Feb

-12

Jun

-12

Oct

-12

% BRL

INR

AUD

Issues on Structural Reform in

Finance

35

• Greater interdependence also increases the difficulty of responding to financial crises and economic imbalances through national policy making.

• Where appropriate and effective policy coordination is not feasible in the face of such events, the risk of winding back openness through regulations and controls becomes more likely.

• Bank structural separation (now a G20 issue)—what is the right model.

• Low rates and QE—what is the right approach, and can it be done in a world with capital controls and large blocs of exchange rate management?

• Allocation of investment globally.

REBUILDING BUSINESS MODELS OF BANKS:

OECD

36

• Separation of high risk securities activities from the core deposit bank in a ring-fenced non-operating holding company (NOHC) structure if the group goes beyond the 10% threshold GMV of derivatives/IFRS assets. The case is strengthened if wholesale funding is above 25% and leverage without netting of derivatives is more than 20 times.

• Banks with prime broking, market making, underwriting and derivatives origination will be caught by the rule. These activities put into non-bank subsidiaries. Derivatives in the core bank for own-hedging only.

• The NOHC structure is ring-fenced so the creditors of one can’t chase the assets of the others or the parent. Risk pricing adjusts AND size of the businesses falls (initial & variation margins & 3rd part custody adjust to the removal of guarantees).

• Basel rules are too complex, leaving banks too much scope to avoid them. We need simple rules that can’t be avoided. A simple leverage rule for the core deposit banks of 5% (=20 times leverage).

• THE CORE BANK IS SAFER. THE OTHER SUBSIDIARIES WILL NOT BENEFIT FROM IMPLICIT GUARANTEES, & WILL BE SMALLER, MORE PRUDENT & EMINENTLY RESOLVABLE.

• NB: the Lehman Brothers example is a huge fallacy that gets counterfactuals are all wrong re a global NOHC regime.

Hypothetical Bank Separation: Derivatives

Issue

37

Universal Broker Dealer Bank A

(Initial Positon net 0 Derivatives)

Asset Liability

Deriv 100 Deriv 100

Other 150 Other 145

Equity 5

Broker Dealer 100 Universal Broker Dealer Bank A Universal Broker Dealer Bank A

B (Borrowing in Repo Mkt Case) (Selling Liquid Assets Case)

Asset Liability Asset Liability

90 Deriv 80 Deriv 100 Deriv 80 Deriv 100

Other 150 Other 145 Other 130 Other 145

Broker Dealer Collat. Rec. 20 Repo 20 Collat. Rec. 20

C 80 Equity -15 Equity -15

Hypothetical Bank Separation Under

NOHC

38

Hypothetical Large Universal Bank and NOHC Separated Bank with 5% Levergae RatioHypothetical Large Universal Bank and NOHC Separated Bank with 5% Levergae RatioUniversal Bank Separated Deposit Separated Securities

Before Separation Bank Subsidiary

ASSET RATIOS € bn Ratio TA € bn Ratio TA € bn Ratio TA

Trading Assets 300 0.15 160 0.25 200 0.50

Loans 400 0.20 400 0.63 0 0.00

Derivative Assets (IFRS) 800 0.40 64 0.10 200 0.50

Other Assets 500 0.25 16 0.03 0 0.00

LIABILITY RATIOS € bn Ratio TL € bn Ratio TL € bn Ratio TL

Deposits/Liabilities 585 0.3 585 0.98 0 0

Wholesale Funding/Liabilities 780 0.40 0 0.00 195 0.50

Other Liabilities/Liabilities 585 0.30 15 0.03 195 0.50

CAPITAL INDICATORS € bn % € bn % € bn %

Core T1 Capital 40 2.0 32 5.0 8 2.0

Tier 1 50 2.5 40 6.3 10 2.5

RWA/TA % 31.3 78.1 31.3

T1/RWA % 8.0 8.0 8.0

MEMO: (see row) (see row) (see row)

Market Beta (elasticity to market stock price) 1.4 1.0 1.6

National HPI % Change 4 4.0 4

Leverage to Core T1 (Ratio) 50 20 50

Size as % National Banking System % 15 5.2 3.2

Hypothetical Bank Separation: Model-

Based Impact on DTD

39

-6

-4

-2

0

2

4

6

8

10

12

K LEV TD WSF GMV BETA HPI DTD

DTD (STD DEV)

UNIVERSAL BANK

SEP. DEPOSIT BANK

SEP. SECURITIES FIRM

Problems with Alternative Approaches to

Separation

40

• Volcker: you simply can’t have a blanket ban on short-term price speculation, and then allow banks to maintain prime broking, market making, underwriting etc: immediacy, inventory and profit making is inherent to this business.

• Vickers: closest to OECD view, but the subsidiaries other than the retail bank are not ring-fenced. Creditors can chase whoever they like—other than the retail bank.

• Liikanen: this needs a major rethinking. The 15-25% 1st stage threshold for trading securities is the wrong variable—it makes banks safer not weaker (Wells Fargo is not a candidate for separation compared to high derivative EU banks).

• Swiss single point entry bail in: for the creditors of the parent bank (which owns all the others) to be ‘bailed in’. Does NOT solve TBTF: (a) not preventive (b) causes run on bank (c) encumbering assets strategy (d) adds to certainty that derivatives counterparties will be paid thereby encouraging concentration.

The Current Low Rates & QE

41

• Low rates and QE—what is the right approach, and can it be done in a world with capital controls and large blocs of exchange rate management?

• Allocation of investment globally.

USA: Cost of Equity vs Yields

42

2.5

4.5

6.5

8.5

10.5

12.5

14.5

16.5

18.5

20.5

Jan

-85

May

-86

Sep

-87

Jan

-89

May

-90

Sep

-91

Jan

-93

May

-94

Sep

-95

Jan

-97

May

-98

Sep

-99

Jan

-01

May

-02

Sep

-03

Jan

-05

May

-06

Sep

-07

Jan

-09

May

-10

Sep

-11

Jan

-13

May

-14

BAA Corp

S&P Eq.Earn.Yld

Hi Yld Corp

AAA Corp

Cost of Equity

%

Business Investment & Growth: Hypothetical

Examples of the Risk Premium, Cost of Equity and

Taxes: ERP=(d+g)(1-tg)-i(1-t)

43

Current With equil With buy Raise cap.

Variables bond back rally gains tax

Tax rate

Personal (t) 0.400 0.400 0.400 0.400

Capital gains (tg) 0.150 0.150 0.150 0.310

Corporate (tc) 0.300 0.300 0.300 0.300

Perpetual earnings growth 0.060 0.060 0.060 0.060

Risk free interest rate (i) 0.020 0.045 0.020 0.020

Credit risk premium (crp) 0.022 0.022 0.022 0.022

Corporate rate after company tax 0.029 0.047 0.029 0.029

Share price par value 1.0 1.000 1.000 2.429 1.000

Dividend cents per 1 dollar 0.030 0.030 0.030 0.030

Dividend yield (d) 0.030 0.030 0.012 0.030

Cost of capital (k) 0.090 0.090 0.072 0.090

Equity Risk premium 0.065 0.050 0.050 0.050

The Incentives for IPO’s and JV’s: USA-China

44

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

Jun

-05

No

v-0

5

Ap

r-0

6

Sep

-06

Feb

-07

Jul-

07

De

c-0

7

May

-08

Oct

-08

Mar

-09

Au

g-0

9

Jan

-10

Jun

-10

No

v-1

0

Ap

r-1

1

Sep

-11

Feb

-12

Jul-

12

De

c-1

2

May

-13

Oct

-13

Mar

-14

Au

g-1

4

Cost_K_CNY

Cost_K_USD

Cost_K_Hedge

Ways of Working at the OECD

45

• Bottom-up research becomes more critical.

• Top-down research combined with bottom-up insights.

• HOW??

• You tell me.