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Securitisation, Shadow Banking and the Value of Financial Innovation. Adair Turner Chairman of the UK Financial Services Authority. School of Advanced International Studies (SAIS) Johns Hopkins University, Washington DC 19 April 2012 17:30 EDT. The conventional wisdom – 2006.

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Securitisation, Shadow Banking and the Value of Financial Innovation


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    1. Securitisation, Shadow Banking and the Value of Financial Innovation Adair Turner Chairman of the UK Financial Services Authority School of Advanced International Studies (SAIS) Johns Hopkins University, Washington DC 19 April 2012 17:30 EDT

    2. The conventional wisdom – 2006 Credit derivatives “enhance the transparency of the markets’ collective view or credit risks…. [and thus] … provide valuable information about broad credit conditions and increasingly set the marginal price of credit” “There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.” “The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.” IMF Global Financial Stability Report, April 2006 Efficiency via price discovery Stability via risk dispersion 1

    3. Additional credit creation “Securitisation is a good thing. If everything was on bank balance sheets, there would not be enough credit.” “Senior American Regulator”, quoted in the Economist Special Report on Financial Innovation, February 2012 2

    4. Development of the crisis: 2007 – 2008 June 2007: Bear Stearns hedge funds under liquidity pressure Major losses by ‘market neutral’ hedge funds Carlyle Capital and Peloton Hedge Funds closed Liquidity and solvency problems at off-balance sheet SIVs Stresses at MMMFs: Reserve Primary Fund ‘breaks the buck’ Liquidity run in repo and other secured funding markets Hedge fund deleveraging and asset sales exacerbate downward spiral of asset values August 2007: February 2008: Autumn 2007 to Mid 2008: Summer 2008: August to October 2008: Late autumn 2008: 3

    5. Financial Intermediation Non-financialBusinesses Governments Households Households Non-financial Businesses 4 A Source: Financial Stability Board

    6. Financial Intermediation Non-financialBusinesses Governments Banks Households Households Loans Deposits Non-financial Businesses Maturity transformation +leverage Source: Financial Stability Board 4B

    7. Financial Intermediation Non-financialBusinesses Governments Banks Households Households Non-financial Businesses Non-financial Businesses Insurance, Pension Funds + other intermediaries Direct Investment: Bonds + Equities • Less maturity transformation • Less leverage Source: Financial Stability Board 4C

    8. Financial Intermediation Non-financialBusinesses Banks Households Households Households Non-financial Businesses MMFs ABCP Securitisation SPV Governments Governments Hedge Fund Broker dealer Maturity/liquidity transformation +leverage … in multiple steps 4D Source: Financial Stability Board

    9. Financial Intermediation Non-financialBusinesses Banks Households Households Households Non-financial Businesses MMFs ABCP Securitisation SPV Governments Governments Hedge Fund Broker dealer Interconnected via bank sponsorship, liquidity puts, repo markets, funding flows, securities lending 4E Source: Financial Stability Board

    10. 5

    11. US mortgages on bank balance sheets and securitised: 1952 – 2009 Mortgages outstanding as % of GDP Home mortgages Source: U.S. Flow of Funds 6

    12. Money market funds and bank deposits:US 1980-2010 US Household holdings of money markets funds US Non-Financial business holdings of money markets funds Percent of Household Cash and Liquid Deposits Percent of Non-Financial Business Short-Term Assets 7

    13. Growth of assets in four financial sectors 1954 – 2006 1954 Q1 = 1 Source: Brookings Papers on Economic Activity, 2010. 8

    14. US Asset-backed commercial paper 1990 – 2008 $bn Note: Not including ABCP of chartered banks Note: Not including ABCP of chartered banks Source: US Flow of Funds 9

    15. US Repo market 1990 – 2011 US $tn 10

    16. US financial sector assets as % of GDP Source: US Flow of Funds 11

    17. USA debt as a % of GDP by borrower type 300% 300% 250% 250% Corporate 200% 200% Household 150% 150% 100% 100% Financial 50% 50% 10% 10% 1971 1971 1977 1977 1996 1996 1959 1959 1983 1983 1965 1990 1990 2002 2002 1941 1941 2007 2007 1929 1929 1935 1935 1947 1947 1953 1953 Source: Oliver Wyman 12

    18. Underlying features of shadow banking • Pooling, tranching (and re-tranching) to “create” apparently low risk assets • Marked-to-market collateral and margin to “create” money equivalent claims 13

    19. Real return on US treasury 20 year index-linked bond, 1999 – 2012 14

    20. Increasing demand for cash equivalent assets Non-Financialcorporations' cash and cash equivalents Institutional Cash Pools Source: Zoltan Pozsar, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper 11/190 15

    21. Banking and other financial balance sheets: in US and Eurozone Other financial institution as % of GDP Deposit-taking Institutions as % of GDP Source: IMF World Outlook Database, US Flow of Funds; ECB Statistical Data Warehouse 16

    22. Frequency distribution of debt payouts Observed in good times 100% Not observed in good times 0 100% of principal and due interest 17

    23. Financial firms’ CDS and share prices Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS. CDS series peaks at 6.54% in September 2008. Source: Moody’s KMV, FSA Calculations 18

    24. “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 19

    25. Bank credit and money creation Asset Liability Loan to non-financial business 100 100 Deposit from non-financial business Not immediately repayable Immediately available “private money” 20

    26. Maturity transformation in banks and shadow banks BANK Long-term loans Instant access / short-term deposits SHADOW BANK CHAIN Long-term loans Instant access “deposits” ABCP SIV / Conduit MMF Broker dealer Hedge Fund 21

    27. Credit and asset price cycles Increased credit extended Increased borrower demand for credit Increased lender supply of credit Increased asset prices Expectation of future asset price increases Favourable assessments of credit risk • Low credit losses: high bank profits • Confidence reinforced • Increased capital base 22

    28. Bank credit and creation of unsecured private money Asset Liability Loan 100 100 Deposit May be secured Not secured 23

    29. Shadow bank credit and creation of secured private money Money Market Fund Broker Dealer Hedge Fund Investor Borrower Repo Repo / Prime broker finance Secured money equivalent Secured money equivalent 24

    30. Hardwired procyclicality in secured funding contracts Asset value falls • More collateral required even if % haircuts/margins unchanged • Variation margin paid • Assets sold to cover margin calls • Reduced funding available Increased risk awareness Increased % haircuts 25

    31. Average repo haircuts: US bilateral repo market 2007 – 2009 26 Source: Gary Gorton and Andrew Metrick, “Shadow banking and the run on repo, 2009

    32. Four distinctive features of financial innovation • Regulatory arbitrage • Tax arbitrage • Non-transparent embedded options • Excessive churn Complexity and interconnectedness 27

    33. Hypothesis I: The value of ‘market completion’ Theoretically available allocative efficiency Net social value derived More complete financial markets Negative externality of increased potential instability Increased financial intensity Complexity and interconnectedness 28

    34. Hypothesis II: The value of ‘increased liquidity’? Efficiency / price discovery Net social value derived? Increased liquidity Potential for volatility, pure momentum effects and arbitrary pricing ? Increased market liquidity Increased role of algorithmic trading 29

    35. Household deposits and loans: 1964 – 2009 Source: Bank of England, Tables A4.3, A4.1 30