The Future of Financial Markets

Transcription

1 The Future of Financial Markets

2 Also by David Mayes ADJUSTING TO EMU (with B. Ardy, I. Begg, D. Hodson and I. Maher) WHO PAYS FOR BANK INSOLVENCY? (with A. Liuksila) IMPROVING BANKING SUPERVISION (with L. Halme and A. Liuksila) PUBLIC INTEREST AND MARKET PRESSURES (with W. Hager, A. Knight and W. Streeck) MODERN PORTFOLIO THEORY AND FINANCIAL INSTITUTIONS (with D. C. Corner) SOCIAL EXCLUSION IN EUROPEAN WELFARE STATES (with R. Muffels and P. Tsakloglou) SOCIAL EXCLUSION AND EUROPEAN POLICY (with J. Berghman and R. Salais) THE EVOLUTION OF THE SINGLE EUROPEAN MARKET SOURCES OF PRODUCTIVITY GROWTH THE SINGLE MARKET PROGRAMME AS A STIMULUS TO CHANGE (with P. E. Hart) INEFFICIENCY IN INDUSTRY (with C. Harris and M. Lansbury) THE EVOLUTION OF RULES FOR A SINGLE EUROPEAN MARKET (editor) 1 Industry and Finance 2 Rules, Democracy and the Environment 3 Social and International Issues FOREIGN DIRECT INVESTMENT AND TRANSITION (editor with G. Csaki and G. Foti) THE EXTERNAL IMPLICATIONS OF EUROPEAN INTEGRATION (with others) ACHIEVING MONETARY UNION (with A. Britton) A NEW STRATEGY FOR SOCIAL AND ECONOMIC COHESION AFTER 1992 (with I. Begg) THE EUROPEAN CHALLENGE A STRATEGY FOR THE ECU (with A. Britton and Ernst & Young) SHARPBENDERS (with P. Grinyer and P. McKiernan) INTEGRATION AND EUROPEAN INDUSTRY (with M. Macmillen and P. van Veen) THE EXCHANGE RATE ENVIRONMENT (with S. Brooks and K. Cuthbertson) APPLICATIONS OF ECONOMETRICS THE PROPERTY BOOM INTRODUCTORY ECONOMIC STATISTICS (with A. C. Mayes)

3 The Future of Financial Markets David G. Mayes Bank of Finland London South Bank University University of Stirling with Iftekhar Hasan, Timo Iivarinen, Karlo Kauko, Kari Kemppainen, Tanai Khiaonarong, Kari Korhonen, Harry Leinonen, Markku Malkamäki, Alistair Milne, Kirsi Ripatti, Heiko Schmiedel, Oz Shy, Juha Tarkka, Jukka Topi

4 David G. Mayes 2006 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress

5 Contents List of Tables List of Figures Preface Acknowledgements vi viii x xiv 1 Introduction 1 2 The Payment System: Structure, Efficiency, Innovation and 12 Regulation 3 Technical Efficiency in Stock Markets 60 4 Securities Settlement Systems 97 5 E-Money: an Addendum 146 References 163 Index 171 v

6 List of Tables 2.1 Means of non-cash retail payments General characteristics of large value payment systems Payment flows in TARGET and GDP in 25 EU countries, Average unit cost estimates of 31 payment systems 36 by region in Regression results of log-linear cost function Cost and revenue estimates of payment services 39 provided by the Bank of Thailand, Changes in payment market share in Canada, Finland, 40 Thailand, United Kingdom and United States, 1996 and Variables used Representative output statistics for individual stock 72 exchanges Distribution of cost and revenue structures of stock 74 exchanges Descriptive statistics large sample Summary of panel data set of European stock exchanges Regression parameters large sample, Relative efficiency large sample Changes in efficiency scores Correlates of efficiency Maximum-likelihood estimates for parameters of translog 81 stochastic cost frontier function for European stock exchanges 3.11 Ranking and descriptive statistics of inefficiency scores of 83 European exchanges 3.12 Malmquist productivity index sample of European stock 85 exchanges summary of annual means, Malmquist productivity index by size, type and 86 organisational form of European stock exchanges Impact of network on market performance Ordinary least 90 squares estimates vi

7 List of Tables vii 3.15 Impact of network on market efficiency Ordinary least 92 squares estimates 3.16 Impact of network access on market capitalisation and 93 operating cost 4.1 The stages of securities trading, clearing and settlement Stock and derivatives exchanges and CSDs in the 103 euro area CREST payment banks and the currencies in which 114 they offer settlement facilities 4.4 Global custodians US$bn Settlement institutions in the sample Average key performance ratios for selected settlement 128 institutions, Costs regressed on output proxies Translog cost regressions, Decomposition of single- and multi-product scale 133 economies in translog and loglinear model specifications according to size and geographical location 4.10 Relative efficiency of individual settlement institutions 135 4A.1 Barriers identified in the Giovanni Reports 144 4A.2 Variable definitions and data sources E-money systems in the van Hove (2004b) survey Main obstacles for e-cash to replace CB money 159

8 List of Figures 1.1 Network of European stock and derivative exchanges 5 in SIC, Fedwire, TARGET, CHIPS, BOJ-NET Cut-off time and processing cycle Central settlement at the ECB via TARGET Number of cashless payments per inhabitant in 32 EU countries, Cashless payments per capita in the EU 1994 to Cost and revenue estimates of 10 retail payment systems 35 in Cost and revenue estimates of 21 retail payment systems 35 in Comparison of unit cost estimates under alternative 39 policy approaches 2.9 Different structures for the payment system E-settlement stamps are produced by e-settlement 45 modules, which are closely integrated with banks payment systems 2.11 A dedicated interbank network connects all banks and 46 the central bank with each other for payment processing 3.1 Choosing the frontier Distribution of cost inefficiency among European stock 84 exchanges over (Model I) 3.3 The structure of the market The six stages of a domestic securities trade and the 100 information flows between institutions 4.2 Consolidation in European clearing and settlement Consolidation models The overall structure of the network-based securities 116 processing infrastructure 4.5 The FOP-process between two custodians The normal DVP-process between two custodians Decentralised settlement flows Clearing and settlement costs across the 127 value chain (euros) 4.9 Cost and volume of settlement instructions, viii

9 List of Figures ix 4.10 Cost and value of deposited securities, A.1 The e-settlement modules are integrated into the 144 payment and securities processing systems in custodians and banks systems 4A.2 The e-settlement stamp is an encrypted part of the 145 normal transaction messages 5.1 If e-cash can replace CB money, when? Zones of E-money, currency and debit card use Extent of adoption of E-money 156

10 Preface This is the third in a series of books looking at problems in the future development of the monetary and financial system. They all look at the issues from a small country perspective and indeed reflect the concerns that exist in the Bank of Finland about the ways in which it will have to exercise its responsibilities in the future. In the first of these, Improving Banking Supervision, which I wrote with Liisa Halme and Aarno Liuksila, we were motivated by the experience of the Nordic banking crises at the beginning of the 1990s and the wish to learn the lessons. The main message in that book was that supervisors, especially in small countries cannot hope to achieve the financial stability they desire on their own. A large portion of what is required is that the banks themselves should want to manage their risks in a prudent manner. The main force for achieving that would be market discipline, through a regime of adequate public disclosure and a structure of corporate governance that enabled market signals to be translated into action. We took as our example another small open economy, New Zealand, that had introduced a regime of that form in The analysis threw up a number of problems in a European environment. The first was that it was not clear that sufficient information could be disclosed. In the EU/EEA banks have an element of choice over where and how they incorporate and one country cannot run a regulatory system that is materially different from those in the alternative locations. There is thus a degree of regulatory arbitrage. Secondly, it became clear that the neat idea of having an institution that was sited in a single market and offered clear market instruments that related just to its business was the exception rather than the rule. The larger institutions run across borders so the debt they raise or their share price relates to the whole organisation and not just that under the control of the local authority. Furthermore the larger institutions are not just banks but also offer insurance and other services. There is thus a difficulty in getting public indicators of the health of the banking business. Two things therefore seemed inevitable: the responsibility of supervision would be higher than prima facie desirable and that the supervisors and authorities would need to collaborate across borders in a much more integrated manner than had been envisaged when the single European financial market was designed. More than the simple homex

11 Preface xi host arrangements would be needed. The problem came out most acutely when we addressed the problem of bank failure which of course was what lay at the heart of the Nordic crises. In the early 1990s the banks had been primarily national. If they had remained so, it would have been possible to change the rules to offer a clear incentive for prudence. In our view, the Norwegian authorities had been able to follow the more desirable route in the crisis, by intervening when banks became insolvent and effectively taking them into public management until they could be resolved and recapitalised. Thus shareholders could expect to lose their money and senior management their jobs. Such strong action was not possible under Swedish and Finnish law. We were therefore concerned that assertions that banks would not be bailed out in the future would not be believed. Loans were made and banks merged and considerable taxpayer funds employed. This could be an important moral hazard. Aarno Liuksila and I therefore decided to write a second book purely on this aspect, Who Pays for Bank Insolvency?, and bring together a group of experts in the field from round the world to assess the proposals. We argued that the only way to get countries to agree on how to resolve banks was to try to catch them and intervene before losses were so large that they caused a systemic problem. Before that point, resolution could take place without any significant commitment of taxpayer funds. These issues are still under discussion, but two developments have pushed them up the European agenda. The first is the decision by Nordea, the most significantly cross-border bank in Europe, to seek to become a European company, headquartered in Sweden but with branches rather than subsidiaries in Denmark, Finland and Norway (and Estonia). The Deposit Insurance Directive has been reopened and discussions have developed with CEBS, the new Committee of European Banking Supervisors. Secondly, Basel 2 forces supervisors of a financial grouping to come to a joint agreement on how risk management is to be handled and hence they have to come into much closer co-operation than entailed by the original home-host rules. The topic is thus moving steadily forward. The present book should have been the second in the series, taking the horizon onto much of the rest of the financial system beyond the banks. However, the strength of the debate on the first issues led us to defer it. There are some striking contrasts between the two areas. The first is that for financial markets the issue of European integration has been an even stronger driving force. Globalisation and the introduction of the euro have meant that efficient European markets are needed both to ensure European investors get efficient access to the assets available

12 xii Preface and that European firms are able to tap the world s capital to finance their development. This gives the contrast we noted in a piece of parallel work with Geoffrey Wood on The Structure of Financial Regulation (Mayes and Wood, 2006). Whereas in banking the generalised view is that if anything the system is now over-regulated and the role of the market needs to increase, the problem in financial markets is that the market itself has difficulty coming to socially optimal decisions. Financial markets are in many respects networks and therefore require commonly agreed standards not just technical standards but rules for governance and for access as well. There is thus a clear positive role for the authorities to play in trying to steer the market towards the exploitation of network externalities that will increase efficiency, reduce costs and encourage innovation. Added to this is the need for the authorities to ensure sufficient strength in the financial system that it will be stable in the event of unusual shocks, under the mandate to maintain financial stability. This facet of industrial organisation has been a feature of the Bank of Finland s research into financial markets over the years. The Bank has three main research themes: the Future of the Financial Services Sector; Modelling Monetary Policy; and the problems of transition, which now focus on Russia and China, and are handled in a parallel unit, labelled the Bank of Finland Institute for Economies in Transition. This present book is different in character from the other two, for although I have written every word, all of the research is drawn from the work of colleagues, whose names are listed on the title page. I have taken illustrations and tables from Discussion Papers they have produced over recent years (all of which are available on the Bank s website The research unit in the Bank, which was a separate department until early 2005, does not have permanent staff, apart those who supervise or support it. The researchers come for periods of six months or more from the policy departments in the Bank or from outside, in a series of Fellowships that are open to competition. While all of the research I have drawn on was done within the Bank, three of the authors actually remained within the Financial Markets Department while making their contribution, one person has left the Bank and the remaining people who now have external affiliations were visiting researchers. The use I have made of the material is my own responsibility. There is, however, a third strong theme, which underlies the research discussed here, which is technological change and the role of Information and Communication Technology in particular. Innovation in the ICT field features very highly in the success of the Finnish economy in

13 Preface xiii recent years and the work within the Bank is no exception. Not only have Harry Leinonen and Kimmo Soramäki, who is now at the ECB, designed payment and settlement system simulators that are used by central banks round the world to test out their systems and optimise the design of replacements (Leinonen, 2005) but they have also devoted a lot of thought to what a new much more distributed financial system might look like. It represents almost a paradigm shift from the increasing centralisation and scale approach that is currently characterising much of thinking and provides an important contrast in considering how the future might develop. It addresses the network nature of financial markets very directly and in common with the associated work on networks that is reported, provides what I hope is a contribution that will stimulate the way thinking about the future of financial markets goes over the coming years. The next book, on Asymmetry, is in the pipeline but that is another story. DAVID G. MAYES

14 Acknowledgements This book is a joint effort with fourteen colleagues who have been in the Bank of Finland for all or part of the last five years, working on this topic. They are listed below with their current affiliations. Indeed, others in the Bank, took numerous to name, have also contributed in various ways and I am grateful to them all. Those who have contributed are not to blame for what I have chosen to do with their work. Particular thanks are due to Harry Leinonen, who has patiently corrected some of the misconceptions I have had about how the financial system works and might work. Thanks also to Alistair Milne, who although only with us for a reasonably short period, was liberal in advice and comments. The book itself was produced at the suggestion of Juha Tarkka, who was responsible for the research department and hence the research programme for virtually the entire period. I am grateful to the Bank of Finland for providing the facilities for this work. General apologies are due to my colleagues and to the publisher for the various delays when more pressing policy issues and projects have elbowed this work aside. My wife has had to bear the brunt of my frustrations and has been invaluable in helping me prepare the typescript for publication. Those whose work has been used extensively are in alphabetical order: Iftekhar Hasan, who is currently Cary L. Washington Professor at the Lally School of Management and Technology, Rensselaer Polytechnic Institute and still a frequent visitor to the Bank; Timo Iivarinen, Karlo Kauko and Kari Kemppainen who are in the Financial Markets and Statistics Department; Tanai Khiaonarong, who is now in the Bank of Thailand; Kari Korhonen, Financial Markets and Statistics Department; Harry Leinonen, who is Advisor to the Board; Markku Malkamäki, who is now in the private sector working for Pohjola; Alistair Milne, who is Senior Lecturer in Banking, Cass Business School, City University in London and remains a visiting scholar at the Bank; Kirsi Ripatti, Financial Markets and Statistics Department; Heiko Schmiedel, who has moved to the European Central Bank; Oz Shy, who is Professor, Department of Economics, University of Haifa; Juha Tarkka, Advisor to the Board and Jukka Topi, Financial Markets and Statistics Department. I am grateful to the Bank of Finland for permission to include the wide range of charts and tables that have been drawn from its Discussion Paper series and from its Studies in Economics and Finance. These xiv

15 Acknowledgements xv are individually identified in the text. The full Discussion Papers are all available from the Bank of Finland website 6_julkaisut/6.1_SPn_julkaisut/index.stm and the Studies are also available free of charge from the Bank. I am grateful to the European Central Bank for permission to use the material in Table 4.2 from Occasional Paper no. 33 Integration of Securities Markets Infrastructures in the Euro Area, July I am grateful to CrestCo for permission to use the material in Table 4.3 on CREST settlement banks and currencies in which they offer settlement facilities drawn from co.uk/home.html# in December I am grateful to Global Custody for permission to reproduce the material in Table 4.4 on the largest global custodians and their assets under custody which is drawn from Finally I am grateful to The Corporation of London to reproduce Figure 4.8 from page 79 of their City Research Series no. 1, The Direct Costs of Clearing and Settlement: an EU US Comparison. Several of the studies have been revised and published in the international journals or will be in the near future.