Global Financial Meltdown: Implications for Financial Sector Structure

1
Global Financial Meltdown Implications for
Financial Sector Structure
Tsinghua University School of Economics and
Management
Andrew Sheng Adjunct Professor 14 November 2008
2
Outline

• Macro Environment and Trends in Financial
  Services Integration
• Current Global Crisis
• Financial Services Integration International
  Perspective
• Implications for Asian Banks
• Conclusions

3
Key Issues

• Current global financial turmoil brings into
  question the existing regulatory and financial
  architecture.
• What lessons can Asia learn from the current
  turmoil and markets?
• Regulation must follow business structure, but
  where is business structure (financial service
  integration) going?

4
Macro Environment and Trends in Financial
Services Integration
5
Macro - Great Moderation created Great
Complacency

• Supply-side shock of entry of 3 billion workers
  into global markets, plus trade liberalization,
  technology productivity gains and improvements in
  business models created period of high growth and
  low inflation.
• Loose monetary policy, excessively low interest
  rates, excess liquidity and easy bank credit
  created bubbles in asset markets.
• Financial Engineering, permitted by (a) liberal
  regulation (b) accounting standards (c.)
  securitization enabled high level of leverage,
  that actually disguised the level of
  Over-Trading, Inadequate Capital and
  Vulnerability of Households and highly leveraged
  financial institutions.

6
US Current Account Deficit is a Mirror Image of
the Asian Surplus

• Asian and oil exporting nations are counterparty
  to large United States current account deficit.

Source World Bank Financial Structure Dataset,
February 2006
7
Macro - Low Interest Rates led to Real Estate
Bubble and Household Indebtedness - Fed Flows of
Funds data

• From 2001, when Fed Funds rate were reduced to 1
  per annum, to end 2007, real estate value of US
  households and corporate sector increased by
  US14.5 trillion, equivalent to 226.4 of GDP
  163.5 at end 2001. Growth was 86.4 over
  period.
• During the same period, the debt of the Household
  sector increased by US6.1 trillion.
• Household debt remained high at US14 trillion or
  100.9 of GDP.

8
U.S. Housing Market still has not bottomed
1/ NAR refers to National Association of
Realtors.
2/ OFHEO refers to Office of Federal Housing
Enterprise Oversight.
9
Liquidity Strains Remain Amid Solvency Concerns
in Banking Sector
10
Global Bank Writedowns and Capital Infusion (IMF
Oct. 2008)
(in billions of US )
11
The Network Economy
The value of a network goes up as the square of
the number of users
MARKET
Knowledge Content Branding
MARKET
MARKET
(Metcalfs Law)
Infrastructure e.g. utilities, communication
MARKET
Quality of Information
MARKET
NETWORK HUB Winner Take All Situation
Ability to stay ahead of competition
MARKET
MARKET
Economies of scale Critical Mass
Quality of Governance
MARKET
MARKET
MARKET
MARKET
12
Financial Services Integration Current Trends

• In the 1980s, network integration caused
  concentration of financial markets into Large
  Complex Financial Institutions (LCFI) that engage
  in banking, securities, insurance and fund
  management business.
• Network integration occurred VERTICALLY AND
  HORIZONTALLY, across geography, product
  integration and platform integration,
  particularly through FINANCIAL DERIVATIVES.
• Current crisis demonstrates that there are huge
  governance risks when universal banking tries to
  cope with excess leverage in their investment
  banking arm.

13
Global Four Mega-trends

• Wage Arbitrage - cheap labour created low
  inflation and boosted global trade
• Interest Rate Arbitrage - Low interest rates e.g.
  in Yen, gave rise to Carry trade,
• Knowledge Arbitrage - Financial Engineering
  permitted faster trading and higher leverage
• Regulatory Arbitrage - Accounting, Tax and
  liberal regulation allowed higher disguised
  leverage through SIV, OTC markets etc.

14

• Current Global Crisis -
• Macro - No Global Central Bank
• Micro - Failed Investment Banking Business Model
• Mindset - Shadow banking was permitted
  regulatory arbitrage

15
Leverage Increasing Overtime 2006 US trillion
(IMF GFSR, April 2008 Table 3)
16
Size of Derivative Markets - Notional Values
(US trillion) - December 2007 Source
BIS data

• Total contracts 596 gross market value 14.5
• Foreign Exchange 56.2 1.8
• Interest Rate 393.1 7.2
• Equity-Linked 8.5 1.1
• Commodity 9.0 0.8
• CDS 57.9 2.0
• Unallocated 71.2 1.6
• Exchange Traded Derivatives 94.9 trillion (3Q07)

17
Bill Gross (PIMCO) Bank Leverage grew from
1987-2007 by securitizing and moving liabilities
off-balance sheet
18
Financial System Leverage the unstable pyramid
19
Estimated Size of Shadow Banking System
Geithner, quoted in Marketwatch.com

• Conduits, structured investment vehicles and
  similar entities that borrowed in the commercial
  paper market had assets of 2.2 trillion
• Overnight Repo market 2.5 trillion
• Combined balance sheet
• of large brokerage firms 4 trillion
• Hedge funds 1.8 trillion
• Total in shadow banking" 10.5 trillion
• By comparison, the five largest US banks in the
  U.S. held just over 6 trillion at the time, and
  traditional banking system as a whole held about
  10 trillion.

20
How Shadow Banking Functioned

• Insufficient due diligence at Origination level
  (allowed by silo regulatory structure)
• Insured by Monoline insurers and covered by CDS
  where was oversight?
• Leverage moved off-balance sheets into SIVs and
  conduits current IAS Basle rules
• Credit rating misleading and methodology flawed
• High fees from origination and trading - bankers
  and hedge fund compensation rewarded risk taking
• No transparency because all OTC trading
• Clearing and market-making all at Prime Brokers,
  who were too highly leveraged relative to risks

21
Risks were concentrated in top banks and
insurance companies Market Participants in
Credit Derivatives, 2004 and 2006 IMF Global
Financial Stability Report, April 2008 Table 2.3.
(In percent)
22
Dangers of OTC markets

• OTC markets are gross bilateral transactions
• High volume of Gross transactions make unwinding
  impossible to manage in courts
• No transparency
• No idea of embedded leverage and whether
  counterparty is solvent
• Netting of large transactions absolutely
  necessary to control gross leverage
• Must have central counterparty to control
  solvency of all participants.
• Shadow Banking OTC Regulatory Black Hole

23
Four elements of financial innovation and
deregulation helped create toxic products

• Securitization into mortgage-backed papers, using
  special investment vehicles (SIVs) that were
  off-balance and not supervised.
• Accounting and regulatory standards permitted
  such liabilities to be moved off the balance
  sheet so that banks benefited from capital
  efficiency
• Use of insurance cover and credit default swap
  (CDS) markets to enhance credit quality of the
  underlying paper.
• Credit rating agencies gave these structured
  products AAA ratings, for a fee.
• ? insufficient due diligence at origination
  distribution

24
Regulators underestimated Shadow Banking risks

• true level of leverage hidden,
• grossly underestimated the liquidity required to
  support the market,
• grossly misunderstood the network
  interconnections in the global markets and
• enabled key players to over-trade with grossly
  inadequate capital.

25
Wealth Losses as Real Estate and Stock Prices
deflate overwhelming financial institutions
capital Fed Flows of Funds data

• If real estate market declined by more than 20,
  then real estate wealth loss could be more than
  6.2 trillion, which is larger than financial
  institutions capital cushion of 4.6 trillion.
  US bank capital was estimated at 1.35 trillion.
• Clearly, investment banks with above-the-line
  leverage of 30 and below-the-line leverage of 20
  would only be able to sustain 2 swings in market
  or credit risks.
• Shadow banking system had much less capital and
  is therefore being unwound.

26
Acknowledged Regulatory Weaknesses

• Need for System-wide Supervision silo oversight
  does not work
• Insufficient attention to Liquidity issues
• Lack of understanding of risks in derivatives and
  their leverage
• IFRS Basel II both pro-cyclical
• Rating Agencies weaknesses
• International Financial Architecture still not
  representative of world reality
• Huge coordination machinery needed for all forms
  of cross jurisdictional regulation
• Incentive structures drive risk-taking/excess
  leverage

27
US Investment bank Off-Balance Liabilities
US17.8 trillion, additional leverage of 88.8
times
Data source 2007 annual reports
28
Lehmans Borrow Short Invest Long real
estate assets

• On May 29 2007, Lehmans joined a venture to
  acquire Archstone-Smith Trust, a property
  investment company that owned a portfolio of
  apartments in US.
• Lehman had mortgage and asset backed portfolio
  worth 72.5bn, including 20.6 bn level 3 assets
  equivalent to its equity as of May 31,2008.
• Its 33bn portfolio of troubled commercial
  property loans was largely responsible for heavy
  losses in the past two quarters.
• Uncertainty about the true value of those loans
  undermined the bank's share price and scared off
  potential new investors.

29
Lehmans Domino effect

• Major operator in Fixed Income markets,
  particularly Samurai market, shut down inter-bank
  market, because counterparty failure
• Every domestic bank that borrows from global
  interbank market cannot get liquidity, so CDS
  spreads go up.
• As CDS spreads go up, collateral calls on debt
  rises, squeezing liquidity more
• Widening spreads falling asset prices, meaning
  decline in solvency of banks as asset are MTM.
• Banks will not lend to each other..
• Large foreign banks withdraw dollars from their
  large facilities abroad, egg Mexico, Hong Kong
  etc.
• Failure of Icelandic banks etc hurt other banks
• Hedge funds hurt, Money Market Funds hurt, so
  huge redemptions

30
Why bail out AIG?

• AIG was the world largest insurer with a market
  value of 239 billion 74 million customers,
  700,000 agents and 116,000 staff. It wrote
  credit default swaps (CDSs), with a notional
  exposure of 441 billion as of June 2008. Of
  this, 58 billion was exposed to subprime
  securities
• It was exposed to 307 billion of contracts
  written on instruments owned by banks in America
  and Europe and designed to guarantee the banks
  asset quality, thereby helping their regulatory
  capital
• With total derivative exposure 441 bn AIG would
  incur massive losses and would require more
  capital.
• Had AIG gone bust, many banks would have had to
  immediately require capital injection.

31
Unwinding of Unfettered Finance

• Massive mortgage related positions and written
  CDS led to large loss under credit crunch
• High financial leverage ratio gave rise to
  fragile confidence on the companys liquidity and
  capital
• Insufficient regulation and lack of system-wide
  supervision
• Fair value accounting Valuation of Financial
  instruments, especially Mark to Model,
• Complexity of derivatives led to difficulty of
  pricing and liquidation under market turmoil.
• Senior management underestimated market
  difficulties
• US government did not realize complexity of
  situation and could only react under with crisis.

32
Comparison of Financial Crises Costs
Sources World Bank and IMF staff estimates.
Note U.S. subprime costs represent staff
estimates of losses on banks and other financial
institutions from Table 1.2. All costs are in
real 2007 dollars. Asia includes Indonesia,
Malaysia, Korea, the Philippines, and Thailand.
33
Estimated Costs so far

• February 2007 - US150 bn subprime losses
• April 2008 - IMF estimate US945 bn
• September 2008 - IMF revised 1.4 trn
• October 2008 - Bank of England 2.8 trn
• To date, 8 trn of Central bank liquidity
  injection to money markets
• Stock market losses to end October - US40 trn.
• US, EU and Japan may face Recession in 2009

34

• Financial Services Integration International
  Perspective

35
Three Models of Financial Integration

• 1. European Universal Bank, everything within
  commercial bank.
• 1a. UK bank with subsidiary insurance etc.

• 2. US Bank Holding Company with specialist
  subsidiaries
• 3. Financial Holding Company with bank,
  insurance, asset management and investment bank
  arms.

36
Advantages and Disadvantages of Financial
Services Integration

• Pro
• Economies of Scale
• Capital Efficiency
• Financial Supermarket that provides whole range
  of services

• Cons
• Conflicts of Interests
• Connected Lending
• Opacity of risks
• Contagion
• Difficulty of measuring risks and leverage on
  consolidated basis

37
Change in banks business model

• Bank margins in traditional lending and product
  sales have seen severe compression.
• Banks in US and Europe changed their business
  models to generate higher yields.
• Distinct move from the traditional retail
  banking lend and hold model to the originate
  to sell wholesale model.
• Shift in business model made possible by abundant
  liquidity, mature derivatives markets and
  financial deregulation.

38
Traditional lending and product sales have seen
severe margin compression
US mutual fund distribution fee Basis points on
Avg. AUM
US banks net interest margin Percent












39
Current Bank Governance and Incentive Models not
good at controlling risks

• Bankers Compensation overdone -
• Huge silos within Universal Bank, so risks
  not identified and controlled
• People
• Service quality has deteriorated and values
  are short-term and not concerned about
  reputational and long-term solvency risks.
• Platform
• Very often, large banks and insurance
  companies have become mixture of systems and
  financial infrastructure (especially back office)
  not integrated (hence risks unclear and
  uncontrolled).
• Products
• Product innovation did not do enough due
  diligence and often so complex that no one
  understood how toxic they were.

40
IV. Implications for Asia
Banks in U.S. and Europe changed their business
model from traditional "lend and hold" to the
"originate to sell" model
Recent credit crisis revealed risks of this
business model
Where do we go from here? What are the
implications for Asian banks and financial system?
41
Asian markets are seeing traditional business
profitability decreasing over time
41
42
Asias Financial Sector remains unevenly
developed and not strong in derivatives markets
and investment banking skills

• Asia (including Japan and Middle East) accounts
  for
• 66.8 of official reserves (ex. Gold)
• 55 of global population
• 24.5 of GDP
• 23.6 of stock market cap
• 22.0 of bank assets (13.2 exc. Japan)
• 17.8 of bond market (5.2 exc. Japan)
• Ex-Japan, Banking Assets account for 42.4 of
  total financial assets in Asia (19.7 in North
  America and 50.7 in EU).

43
Asian capital market remains small
44
Asian debt markets still relatively shallow and
lack integration
In terms of debt markets

• The scale of regional bond market expanded more
  than 6.9 times in US dollar terms between 1997
  and 2006.
• In terms of its ratio to GDP, it rose from 16.7
  to 57.5 during these nine years.
• However, the U.S. dollar and the Euro still
  account for around 90 of total issues.
• Despite Asian Bond Fund Initiatives, market still
  small.

45
Could banks move back to basics and grow with
their customers?
45
46
Asian financial system cannot afford Shadow Banks
- need to get back to basics of improving service
quality and help risk management - dont add to
risks

• The key issue is simple Finance serves the Real
  Sector
• Financial sector robustness and stability is as
  important as financial innovation
• Hence, regulatory reform will have to take into
  consideration system-wide review of contagion
  risks, higher transparency in institutional and
  system leverage and end-to-end examination of how
  financial products may evolve into toxic
  products.
• Asian financial integration therefore needs to
  have better cooperation between financial sector,
  regulators and policy makers to build a stronger
  regional system.

46
47
What is Right Regulatory Model for Asian
financial systems?

• Financial Holding Company Model seems the right
  model, but with key conditions
• Conflicts of Interest must be managed
• Connected lending and risk concentrations must be
  controlled
• Total Group Leverage and Liquidity must be
  managed within limits.
• Commercial bank deposits must be isolated from
  possible contagion from dynamic trading/high
  leverage activities.
• Financial Regulator and Central Bank be both
  involved in regulatory oversight (through
  regulatory co-ordinating body).

48
Financial Markets, Structure and Oversight
49
Regulation and Reform as a Process(????
SPISSPER)

• Strategize ???
• Prioritize ???
• Incentivize ???
• Standardize ???
• Structurize ???
• Process ???
• Execute ???
• Review ???

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V. Concluding Remarks

• The current global credit crisis is also an
  opportunity for Asia.
• Time to assess in-depth the lessons for
  Macro-policies, Micro-Institution building and
  Mindsets about the need for greater regional and
  global cooperation.
• Clearly, risk management is much more complicated
  than current methods that assume financial
  uncertainties can be reduced to measurable
  (hedgeable) risk.
• We now have two crises (Asian subprime) to
  teach us what not to do. Time to go back to
  basics and drawing boards on institutional
  development.

51
Three phases towards international financial
architecture

• Strengthen domestic financial system based on
  international standards
• Build on regional strength to create regional
  financial markets, taking advantage of economic
  geography
• Work on global international financial
  architecture, building on regional FSF to feed
  into global FSF.

52
Questions to as_at_andrewsheng.net
Thank You