Global financial Markets and their regulation after the crisis

Howard Davies
Sciences Po Introduction 8 September 2011

Schedule
Sep 8: An Anatomy of the Crisis Sep 9: Regulatory Problems revealed by the Crisis Sep 15: Global Financial Regulation Sep 16: Global Financial regulation (2). Changes post-crisis and where next? Oct 6: Regulation of Bank Capital Oct 7: Scarce Capital Oct 13: Too Big to Fail Oct 14: Corporate governance in banks Nov 17: European Financial regulation work in progress? Nov 18: World Financial Centres Nov 24: Bankers pay Nov 25: The Future of Finance

Assessment
30%: Mid-term homework essay (1500 words).
Details: Choose one out of 6 given topics

70%: Final Exam

Declaration of interest
I have been - Principal, Monetary Policy in the UK Treasury - Deputy Governor of the Bank of England (1995-1997) - Chairman of the Financial Services Authority (1997-2003) I am now - Independent Director and Chair of the Risk Committee at Morgan Stanley - Non-executive Director and Chair of the Risk Committee of Prudential (UK) - Member of the Investment Committee of the Government of Singapore Investment Corporation - Advisor to two hedge funds in London and New York - Member of the International Advisory Board of the China Banking Regulatory Commission

Outcomes
I guarantee - lively arguments - real-time analysis of markets and public policy I do not guarantee - a job at Goldman Sachs (but by the end you wont want one)

GLOBAL FINANCIAL MARKETS AND THEIR REGULATION AFTER THE CRISIS

An Anatomy of the Crisis

Howard Davies
Sciences Po Lecture 1 8 September 2011

The crisis delivered a sharp recession GDP Growth 2007-10

Source: International Labour Organization - Global Employment Trends 2011

With a large increase in unemployment

Global unemployment trends: 2000-2010

Source: International Labour Organization - Global Employment Trends 2011

As severe as in any post-war recession

Source: propublica.org

Recessions which begin in the financial sector are severe and long-lasting
Cycles of past unemployment and banking crises

Source: This Time its Different, Rogoff, K. and Reinhardt, C.M., 2009

But not everywhere in some countries they talk of a North Atlantic credit crisis
The proportion of countries with banking crisis, weighted by their share of world income

Source: This Time its Different, Rogoff, K. and Reinhardt, C.M., 2009

The crisis boosted government debt in developed countries

G-20 Advanced Economies: Evolution of Government Debt (in % of GDP)

Source: Fiscal Implications of the Global Economic and Financial Crisis, IMF

Advanced G20 countries are impacted severely

Source: Fiscal Implications of the Global Economic and Financial Crisis, IMF

What are the underlying causes?

global imbalances growing inequality leading to consumer borrowing loose monetary policy, leading to mispricing of risk credit bubble excess leverage, facilitated by procyclical regulation, and regulatory arbitrage excess unmanaged growth of the financial sector, which magnified risks, rather than diversifying them

Global current account imbalances grew rapidly from 2003

Estimates of account balances for selected countries ($ Billion), 1993-2007

Source: Datastream, FSA Calculations.

Monetary policy was loose, especially in the US

Deviation of policy rates from Taylor rule (%), 2000-2009

Source: Bank of England, Speech of Charles Bean at the Annual Conference of the European Economic Association, 25th Aug 2009.

Household debt rose sharply

Household debt as % of GDP, 1987-2007

Source: FSA, ONS, Federal Reserve, Eurodata, Datastream

US house prices doubled in five years

Case-Shiller Home Price Index (2000 Q1 = 100), Jan 1987 - 2005

Source: Silverlake, Case-Shiller Price Index.

House prices rose rapidly in much of Europe also

Real increase in house prices (%), 1996 2006

Source: David Miles, Morgan Stanley (derived from the ECB, National Statistical Offices, the IMF, the European Mortgage Federation, the Italian Ministry of Infrastructure, and Morgan Stanley Research).

The 20 years to 2007 saw rapid and unsustainable financialisation

Bank Assets vs Nominal GDP, 1980-2007
CAGR (1980 2007) 19.0%

17.9%

6.3%

5.9%

Executive Summary
Source: Datastream, IMF Note: Bank asset indices are calculated based on total assets for listed banks only

European banking assets grew rapidly

Assets of European listed banks, 1987-2009
Danske Bank A/S
20

Nordea Bank AB Banco Bilbao Vizcaya Argentaria, S.A. Dexia SA Intesa Sanpaolo SpA Commerzbank AG UniCredit S.p.A. Societe Generale Group Banco Santander, S.A. Lloyds Banking Group plc Deutsche Bank AG Barclays plc

Total assets (EUR tr)

15

10

Credit Agricole SA HSBC Holdings plc Royal Bank of Scotland Group plc BNP Paribas

0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Capital IQ Note: Chart shows total assets over time for top 16 listed European banks. The bank ranking used was based on total assets

US Bank Balance Sheets expanded

Large-cap banks aggregate assets rose to 43x tangible book equity

Source: Silverlake, Capital IQ.

The Leverage Ratios of Investment Banks rose

Leverage ratios, 2003 - 2007

35 30 25 20 15 10 2003 2004 2005 2006 2007

UK banks leverage grew sharply from 2003 onwards

Major UK banks leverage ratio, %, 1998 - 2008

Note: Leverage ratio defined as total assets divided by total equity excluding minority interest. Excludes Nationwide due to lack of interim data.

Source: Bank of England, Financial Stability Report, Issue 24, 28 October 2008.

The shadow banking system magnified credit creation

Shadow Banking Liabilities vs. Traditional Bank Liabilities ($BN)

$15,000

Shadow Banking Liabilities

$10,000

Traditional Banking Liabilities

$5,000

$0

Executive Summary

Mar-87

Sep-91

Mar-95

Sep-00

Mar-05

Sep-09

Jun-10

Source: Datastream, 2010 US Federal Reserve Statistical Release via Zero Hedge website

Derivative volumes exploded

Outstanding Notional amounts of Derivatives

World GDP US $ trillions

Source: Datastream, BIS/ Financial Stability Report October 2008 by Bank of England

The sub-prime crisis triggered the sell-off

The trigger
- US house prices stopped rising - Sub-prime mortgages depended on regular refinancing, facilitated by price rises - Default rates rose sharply, precipitating a collapse in the prices of complex securitisations

Synthetic CDOs magnified risks through re-securitisation

Source: propublica.org

The Credit Crisis: A Five-Act Shakespearian Tragedy Act One: Act Two: Act Three: Act Four: Act Five: Subprime Liquidity Unravelling Meltdown Pumping

Whom do the British blame for the current financial crisis?

Question: Who is most to blame for the current financial crisis? %
Bank executives Governments Financial regulators The media Central Banks Thatcher and Reagan 1980s deregulatory reforms Consumers for borrowing too much Everyone (democratic society for its collective failure to policy the above) Other
Source: Thisismoney.co.uk, June 2009 1 9 12 2 3 11 10 24 28

Whom do the French blame for the current financial crisis?

Question: Among the following categories, which in your opinion are the two that bear the greatest responsibility for the origin of the world financial and economic crisis? %
Banks Politicians Hedge Funds Shareholders Big Firms Experts and Economists Insurance Companies
Source: TNS-Sofres/ Logica. 5 11 18 23 29 41 58

Who blames the Jews for the financial crisis?

Source: N Malhotra, Y Margalit: State of the Nation. Boston Review, May/ June 2009.

Such a complex failure has many parents

Macro imbalances, loose monetary policy and financial innovation Rapid credit growth, asset price bubbles, overborrowing Badly managed and unscrupulous financial firms Flawed assumptions about market efficiency and investor rationality Global finance without global government

 Bank failures are caused by depositors who dont deposit enough money to cover the losses due to mismanagement.
Dan Quayle

Rolling Stone described Goldman Sachs as a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

Failures in the financial firms themselves were important contributors

Poor risk management
excessive reliance on Value at Risk Models herding behaviour inadequate hedging

Flawed capital allocation mechanisms

trading strategies under-capitalised

Incentive structures which reward short-term risk-taking Weak corporate governance: boards ignorant of the risks management were taking on

Problems with Economics...

Much of the past 30 years of macroeconomics was spectacularly useless at best, and positively harmful at worst - Prof. Paul Krugman, Princeton The unfortunate uselessness of most state of the art academic monetary economics
- Prof. Willem Buiter, LSE

The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year
- Alan Greenspan

 and efficient markets

The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders [...] It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight - Jeremy Grantham, GMO [This proposition] is 'fantasy' [] Most investing is done by active managers who don't believe markets are efficient. [...] Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. - Gene Fama, University of Chicago

Was the crisis a Boy Thing?

risk-taking in an investment game with potential for real monetary payoffs correlates with salivary testosterone levels
(Scientific American)

Maybe, but
- the presence of women on the trading floor may ratchet up testosterone levels among men, and - during menstruation, when levels of oestrogen and progesterone are the lowest, women do not bid differently from men
(Centre for Economic Research and Graduate Education)

GLOBAL FINANCIAL MARKETS AND THEIR REGULATION AFTER THE CRISIS

An Anatomy of the Crisis

Howard Davies
Sciences Po Lecture 1 8 September 2011