Comparative financial systems

1. Comparative financial systems The financial system Functions and general issues Market based vs Bank based systems February 16th - 21st, 2011

2. Agenda • The theoretical framework • The functional approach to a financial system • Market vs intermediaries • How to compare financial systems • Financial markets and financial instability

3. The theoretical framework • F.Allan – D. Gale, Comparing Financial Systems, MIT Press, Cambridge (Mass), 2000 • R. Merton – Z. Bodie, A Conceptual Framework for Analyzing the Financial Environment, Harvard University Press, 1995 • A.Demirgüç-Kunt – Ross Levine, Financial Structure and Economic Growth. A Cross-Country Comparison of Banks, Markets and Development, Cambridge (Mass), The MIT Press, 2001. • R. Rajan – L. Zingales, Banks and Markets: The Changing Character of European Finance, CRSP Working Paper No. 546 january 2003 • Available at SSRN: http://ssrn.com/abstract=389100 • L.R Wray, Financial Markets Meltdown. What Can We Learn from Minsky?, The Levy Economic Institute, 2008

4. A general picture of a financial system Central bank Bank supervisor Market regulator Antitrust Other Financial intermediaries Banks Other Loans Companies Deposits Households Institutional investors Mutual funds Pension funds Insurance Shares Ins. policies Payments (infrastructure) Public sector Bonds Stocks Markets Money Bonds Stocks Derivatives Bonds

5. The financial system is composed of: Intermediaries Markets Infrastructure The financial system links the two engines of growth: savings and investment The greater the division between those who save and those who invest, the greater the importance of the financial system Main agents Regulators Final users (households; nonfinancial companies; government) Channels of intermediation Instruments What the figure tells us

6. Households typically consume less than they earn (saving exceeds investment) they have a surplus of resources S - I = FA- FL > 0 They are therefore surplus units or final lenders Firms and the public sector are in the opposite situation; they have a deficit of resources S - I = FA - FL < 0 They are therefore deficit units or final borrowers Financial intermediation allows for surplus units to lend the resources they need to deficit units Financial assets and liabilities increase year after year The final users

7. Warning • The financial system links economic agents with financial surplus with economic agents with economic deficits • Given the growing debt of the household sector, and given the high profits in the corporate sector, it is no longer true that the financial surplus (deficits) are in the household (corporate) sector • As deficits must be mirrored by surpluses, if households (and Governments) have deficits, someone else must have surpluses (companies) • Allocative problems

8. The current account surplus (deficit) measures the quantity of resources a country lends (borrows) from other countries A current account surplus (deficit) is equal to the increase (decrease) of external financial assets Domestic assets and domestic liabilities offset each other (national wealth is given only by real wealth plus net external financial position) Borrowing in an international perspective 8

9. Traditional division: banks vs markets Financial intermediaries (mainly banks) vs. financial markets (deposits vs securities) Households could invest their wealth either in bank deposits (majority) or in financial instruments (historically well-off people) Nowadays securities are the most important asset class and are bought indirectly through financial investors (see following graph) Financial instruments and channels of intermediation

10. A few stylized facts • See slides of the previous lecture • Financial systems differ by: • Size (Total financial assets on GDP) • Financial channels of intermediation • Distribution of financial surpluses/deficits • The dimension of the financial pyramid continues to grow • To compare financial systems we must focus on functions

11. Why focus on functions • Functions are stable; institutions continuously change • Today’s bank is completely different from a bank of only 10-15 years ago • Institutional form follows function • Innovation and competition among institutions ultimately result in greater efficiency in the performance of financial system functions • Focussing on functions we understand why Governments were forced to the most dramatic rescue ever (remember Dunkirk)

12. The functions of a financial system • To provide ways of clearing and settling payments to facilitate trade; • To provide liquidity; • To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises; • To provide ways to transfer economic resources through time, across borders and among industries; • To provide ways of managing risk; • To provide price information to help coordinate decentralised decisions-making in various sectors of the economy.

13. To provide ways of clearing and settling payments to facilitate trade • Financial intermediaries provide the monetary means an economy needs • Central banks • Commercial banks • The monetary function performed by banks is the fundamental reason of their uniqueness (they have sight liabilities and non-liquid assets such as loans to final lenders). This is why banks are subject to specific stability regulation and supervision. • Central banks to protect the stability of prices (public trust in money) • See the mission of the ECB

14. The importance of the payment system • An essential infrastructure • A huge volume of transactions every day • A source of important bank earnings • A possible source of systemic risk • Central banks must be ready to lend funds • Settlement is totally safe when executed in central bank money • The settlement among banks participating to the payment system is the heart of the money market • This is why TARGET (Trans-European Automated Real-time Gross settlement Express Transfer system) had to be up and running since the very first day of the monetary union

15. The ECB on Target 2 • TARGET2 plays an important role in the execution of the single monetary policy and the functioning of the euro money market. • It offers a real-time settlement service in central bank money and broad market coverage. It processes large-value and urgent transactions without any upper or lower value limit and has also attracted a variety of other payments. • The system’s market share (in 2009) was 89% of the total value of payments in euro large-value payment systems • The average number of payments processed each day is 345,771, while the average value is €2,153 billion (average single payment = € 6,22 million)

16. To provide liquidity • Money has absolute liquidity • The liquidity of any asset is measured against money • Financial assets are generally more liquid than real assets • Increasing the liquidity of financial assets is one of the most important forms of financial innovation • Examples: • A bond is more liquid than a loan • The securitisation of mortgage loans

17. To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises • Instruments and institutions designed to channel funds (banks, savings banks, mutual funds, etc) • Advantages • Delegated monitoring (solution of asymmetries of information) • Increase of opportunities • Diversification of risks

18. To provide ways to transfer (therefore allocate) economic resources through time, among industries and across borders • Through time for a single economic agent: • Financial assets are a safe way of transferring the purchasing power of money (motives why people save) • An alternative to hoarding • Pensions in an ageing world • Among economic agents: • From those who save to those who invest (and/or consume) • From mature industries to new sectors (technological innovation) • Across borders: • From mature countries to emerging ones

19. To provide ways of managing risk • Risk is intrinsic to financial assets • A bond offers a different way of managing credit risk than a loan • A share offers a way of managing entrepreneurial risk • Generally speaking the financial system provides instruments which allow for: • Hedging (the invention of financial derivatives) • Diversification • Insurance

20. To provide price information to help coordinate decentralised decisions-making in various sectors of the economy • Information is the main input of financial intermediation • Banks: private information • Markets: public information • Financial intermediaries as a way to cope with asymmetric information (delegated monitoring) • Markets need to control asymmetries of information • Formal procedures to disclosure • Public offers • Relevant information • External ratings • Insider trading and market abuse regulations • Information is one important output of financial information • Bank loan as a signal • Securities prices as a continuous assessment

21. Banks vs markets • There is not such a thing as the “ideal” financial system • Banks based • Pro: long-term relationship • Con: possible misallocation in case of crisis (Rajan-Zingales) • Markets (arm-length) • Pro: Public information through prices • Con: Markets are not perfect

22. A bank-based view • Based on private information • Pros: positive role of banks in mobilizing resource, identifying good projects, monitoring managers and managing risk. • Typical of the take-off phase of economic development • Cons: possible inefficiencies in allocation of resources when lenders try to keep afloat their borrowers

23. A market based view • Based on public information • Rajan-Zingales arm-length finance (pro) • Pro: more open to financial innovation (derivatives) • Pro: wider appeal to investors • Con: Markets can be irrational (bubbles)

24. Stylized facts about banks vs markets • Banks, nonbanks and stock markets are larger, more active and more efficient in richer countries. Financial systems, on average, are more developed in richer countries. • In higher-income countries, stock markets become tend to be larger, more active and more efficient. • In higher income countries, banks and other financial intermediaries tend to be larger, more active and more efficient. • A contradicion between b. and c.? No, because: • … see next slide

25. Stylized facts about banks vs markets • In higher income countries, banks do not become larger or smaller relative to the size of domestic stock market • Complementarity not Alternative • Measures of financial structure produce intuitively plausible classification of countries as either bank-based or market-based for both financially developed and underdeveloped economies. • Countries with a Common Law tradition, strong protection of shareholders rights, good accounting regulations, low levels of corruption, and no explicit deposit insurance tend to be more market based. • Poor contract enforcement goes hand-in-hand with underdeveloped financial systems, contract enforcement is not strongly linked with whether a country’s financial system is bank-based or market-based.

26. Markets and growth

27. The complementarity

29. To sum up • Economic growth and financial development go hand in hand • Therefore, financial deepening and financial innovation are good • Financial growth and innovation do not dwarf the role of the banking system

30. The big question (Adair Turner): did the financial system grow too much? • On a whole series of measures, therefore, the sheer scale of financial activity has increased dramatically, both in absolute terms and relative to real economic variables such as GDP, over the last 30 years. This followed several decades in which no such trend had been apparent. • The crucial issue which we now need to address, after two terrible crashes in just 12 years, is whether this increasing scale of financial activity truly has been beneficial, which elements are beneficial and which are harmful, and what trade-offs are required in public policy between any benefits of increased financial liberalisation and sophistication and the instability which seems at times to accompany it.

31. Two schools of thought: the neoclassical view • The predominant neoclassical school of economics has perceived increased financial activity – greater market liquidity, more active trading, and financial innovation – as a broadly positive development. This is because extensive financial activity is essential to complete markets. The first fundamental theorem of welfare economics, ( Arrow and Debreu), illustrates that a competitive equilibrium is efficient. But this is only true if markets are complete, i.e. if there are markets which strike all possible desired contracts, including insurance contracts and investment contracts linking the present and the future, as well as markets for current goods, services and labour. Therefore, the more liquid are financial markets and the more extensive is financial innovation, the more efficient the economy will be. • Moreover, these advantages of financial markets apply not merely within an economy, but between countries. The less restricted and the deeper the markets for capital flows between countries, the more efficient the international allocation of capital will be, with globalisation and financial liberalisation therefore naturally and beneficially linked.

32. The influence of the neoclassical view on regulators • Certainly in the case of the UK Financial Services Authority, the idea that greater market liquidity is in almost all cases beneficial, that financially innovation was to be encouraged because it was likely to expand investor and issuer choice, and that regulatory interventions have to be specifically justified by reference to the specific market imperfections which they are designed to overcome, formed key elements in our institutional DNA in the years ahead of the crisis. • And the predominant tendency of the International Monetary Fund, both at the time of the Asian crisis and in the run up to 2007 to 2009, was to stress the advantages of free capital flows and financial innovation, making reference to theories of market completion and allocative efficiency.

33. Two schools of thought: the Keynes/Minsky view • Keynes, (in part. in Chapter 12 of The General Theory) argued that liquid financial markets do not ensure allocative efficiency through the attainment of a rational competitive equilibrium • The beauty contest • Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. • Kindleberger: an historical approach • Minsky: a Keynesian model with intrinsic financial instability

34. Adair Turner’s conclusion • The sensible conclusion on the overall benefits of financial intensity and financial liberalisation, would seem to be that it is valuable up to a point in some markets, but not in all markets and not limitlessly. There is a strong case that the development of a modern financial system, combining banks and corporate bond and equity markets, and basic retail and wholesale insurance services, is strongly favorable for economic growth. • But we cannot extrapolate from the beneficial impact of financial deepening and sophistication up to a point, and assume that still more financial deepening, innovation and complexity is limitlessly beneficial. That if a good basic banking system benefits a country, so too does ever more active trading in all categories of derivative. And it is possible that beyond some point, increased financial intensity, measured by the many sorts of indicators, may cease to deliver positive benefits or indeed have negative effects.

35. Nobody is perfect: market possible inefficiencies • Bounded rationality • Keynes and the beauty contest • Shiller and irrational exuberance • Bubbles • Endogenous instability (Minsky) • Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is a large weight to units engaged in speculative and Ponzi finance.

36. A re-cap • A financial system is defined by its functions • There is a positive (bi-directional) relationship between finance and growth • Finance is a mean to achieve growth, not an objective in itself • The overall efficiency of a financial system depends on its contribution to the economy at large • Reduction of transaction costs • Allocation of resources to the most efficient use (highest marginal productivity of capital) • Reduction of financial risks for the final users • Finance is inherently subject to bubbles and instability

37. Financial instability: the Ecb definition • Financial stability can be defined as a condition in which the financial system – comprising of financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances, thereby mitigating the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities.