THE OPERATION AND REGULATION OF FINANCIAL MARKETS

Transcription

1 THE OPERATION AND REGULATION OF FINANCIAL MARKETS

2 Studies in Monetary Economics Published by Macmillan. THE OPERATION AND REGULATION OF FINANCIAL MARKETS (edited by Charlet Goodhart, David Currie and David T. Llewellyn) ADVANCES IN MONETARY ECONOMICS (edited by David Currie) ISSUES IN MONETARY ECONOMICS (edited by H. G. Johnton and A. Nobay) READINGS IN BRITISH MONETARY ECONOMICS (edited by H. G. Johnson and A. No bay) Series Standing Order If you would like to receive future titles in this series as they are published, you can make use of our standing order facility. To place a standing order please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address and the name of the series. Please state with which title you wish to begin your standing order. (If you live outside the United Kingdom we may not have the rights for your area, in which case we will forward your order to the publisher concerned.) Customer Services Department, Macmillan Distribution Ltd Houndmills, Basingstoke, Hampshire, RG21 2XS, England.

3 The Operation and Regulation of Financial Markets Edited by Charles Goodhart Norman Sosnow Professor of Money and Banking London School of Economics and Political Science David Currie Professor of Economics Queen Mary College, University of London and David T. Llewellyn Professor of Money and Banking Loughborough University MACMILLAN in association with PALGRAVE MACMILLAN

4 The Money Study Group 1987 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmissiojj. 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 Act 1956 (as amended). Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published 1987 Published by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 2XS and London Companies and representatives throughout the world OJ British Library Cataloguing in Publication Data The operation and regulation of financial markets.-(studies in monetary economics) 1. Finance I. Goodhart, Charles II. Currie, David III. Llewellyn, David T. IV. Money Study Group V. Series 332 HG173 ISBN ISBN (ebook) DOI /

5 Contents Acknowledgements Notes on the Editors and Contributors Introduction David T. Llewellyn vii viii xi PART I REGULATION AND STRUCTURAL CHANGE IN FINANCIAL MARKETS 1 UK Banking Supervision and the Johnson Matthey Affair Maximilian J. B. Hall 2 Structural Changes in the British Capital Markets Charles Goodhart Personal Financial Services in the United States: A Transatlantic Perspective Mervyn Lewis 54 4 The Variability of Monetary Growth in France and the UK, David Cobham and Jean-Marin Se"e 78 v

6 vi Contents PART II MODELLING MONEY AND BANKING 5 Buffer-Stock Money: An Appraisal Keith Cuthbertson and Mark P. Taylor 6 Disequilibrium Money: Some Further Results with a Monetary Model of the UK James Davidson 7 In What Sense Do Compulsory Ratios Reduce the Volume of Deposits? Anthony S. Courakis PART III MODELLING FINANCIAL MARKETS 8 Rational Forecasts in Models of the Term Structure of Interest Rates Richard T. Baillie and Patrick C McMahon 9 Did High-Powered Money Rule the Roost? Monetary Policy, Private Behaviour and the Structure oflnterest Rates in the United Kingdom: Christopher J. Green 10 Variability in Some Major UK Asset Markets since the mid-1960s: An application of the ARCH Model Rodney Dickens

7 Acknowledgements The production of this volume would not have been possible without the help of a number of people. Thanks are due to the Committee of the Money Study Group for their help in the editorial process, particularly to Anthony Courakis, who organised the Conference at Brasenose College, Oxford, where many of the papers were presented; and to Christopher Green, the Secretary of the Money Study Group. Finally, the Money Study Group owes a great debt to the ESRC (Economic and Social Research Council) for its continuing financial support and encouragement over many years. CHARLES GOODHART DAVID CURRIE DAVID T. LLEWELLYN vii

8 Notes on the Editors and Contributors Richard T. Baillie studied economics and econometrics at the London School of Economics and has been Visiting Professor at the University of California at San Diego, Visiting Associate Professor at the University of Toronto and at Wayne State University, and Research Fellow at the Australian National University. His main research interests are econometric methodology for dynamic models and applied monetary and macroeconomics. He is currently on the staff of the Eeonomics Department at the University of Birmingham. David Cobham is a lecturer in economics at the University of St Andrews in Scotland; he specialises in monetary policy and control and has published a number of articles in this field. Anthony S. Courakis is an Official Fellow of Brasenose College, Oxford. He studied economics at the University of Manchester and Nuffield College, Oxford. Prior to joining Brasenose in 1974 he was a lecturer at Merton College, Oxford, , a senior economist at the Inter-Bank Research Or8anisation, , and a research officer at the Oxford Institute of Economics and Statistics, He has served as an economic adviser to the Bank of Greece and the Bank of Portugal, and as a member of the Greek Government Committee on Financial and Monetary Reform. A member of the Committee of the Money Study Group since 197 4, he is also a founding member of the Greek Society for Economic Research and Managing Editor of the Greek Economic Review. His publications relate to bank behaviour, financial regulation, the demand for money, and monetary policy, and include articles in Economica, the Review of Economic Studies, the Economic Journal, and the Oxford Bulletin of Economics and Statistics. viii

9 Notes on the Editors and Contributors ix Keith Cuthbertson is a lecturer in economics at the University of Newcastle. He previously taught at Thames Polytechnic and has worked in HM Treasury, and more recently at the National Institute of Economic and Social Research. David Currie is Professor of Economics at Queen Mary College, University of London, and Director of the International Macroeconomics Research Programme, Centre for Economic Policy Research. He has published extensively in the areas of monetary economics, macroeconomics and international macroeconomics. James Davidson is a lecturer in economics at the London School of Economics. He received the degrees of BSocSc from the University of Birmingham in 1973 and MSc (Econometrics and Mathematical Economics) at LSE in He has also taught at the University of Warwick. Rodney Dickens was on secondment at the Bank of England over the period this research was undertaken. He subsequently returned to his job as an economist at the Reserve Bank of New Zealand, where he has been employed since Charles Goodhart is the first Norman Sosnow Professor of Mon~y and Banking at the London School of Economics. He was appointed in 1985, having previously worked for 17 years as an adviser at the Bank of England, specialising in domestic monetary issues. He is the author of a number of books and articles on monetary history and policy. Christopher J. Green is Sir Julian Hodge Professor of Banking and Finance at the University of Wales Institute of Science and Technology. Educated at Oxford and Yale universities, he has been on the staff of the International Monetary Fund in the African Department, and has taught at Manchester University. Prior to tjking up his present appointment, in 1985, he was an assistant adviser in the Economics Division of the Bank of England. Maximilian J. B. Hall graduated from Nottingham University in 1975 and remained for a further two years to undertake a PhD on the monetary ramifications of local authority borrowing arrangements in the UK. In 1977 he was appointed a lecturer in economics at Loughborough University, where he has remained ever since, duly completing his PhD in He has lectured and published widely on domestic and international money and banking issues (his book entitled Monetary Policy Since 1971: Conduct

10 X Notes on the Editors and Contributors and Performance was published in 1983) and since 1982 has acted as economic adviser to the Macao Business Centre. Mervyn Lewis is Midland Bank Professor of Money and Banking, and Co-director, Nottingham Institute of Financial Studies at the University of Nottingham. His previous position was Reader in Economics at the University of Adelaide. He has visited University College, Swansea, and the University of Manchester, and has been Visiting Scholar, Economics Division, the Bank of England, and a Consultant to the Australian Financial System Inquiry. He has published four books on monetary economics. David T. Llewellyn is Professor of Money and Banking and Head of the Economics Department at Loughborough University, and Chairman of the University's Banking Centre. He has previously worked at HM Treasury and the International Monetary Fund. He is also Consultant Economist to money and foreign exchange brokers Butler Till Ltd. He is a committee member of the Money Study Group and on the Editorial Board of Banking World and Retail Banking International. Patrick McMahon is a graduate of Trinity College, Dublin, and has studied at Oxford and Birmingham. He has been Visiting Professor at the Universities of Kyoto, Bordeaux, Mannheirn and Wayne State among others. His main research interests are macroeconomics, monetary and financial economics and applied econometrics, and he is currently in the Department of Economics at the University of Birmingham. Jean-Marin Serre is maitre-assistant in the Faculte des Sciences Economiques of the Universite de Clermont I in France; he specialises in monetary and fiscal economics, and has contributed to the field of development economics as a member of the Centre d'etudes et de Recherches sur le Developpement International. Mark P. Taylor was educated at Oxford and London Universities and is currently a lecturer in economics at the University of Newcastle upon Tyne. He has previously worked as a foreign exchange dealer in the City.

11 Introduction David T. Llewellyn The Money Study Group (MSG) was formed in 1969 with two main objectives. The fust is to bring together people (in the United Kingdom and from abroad) who are concerned with the functioning of the British and international monetary systems, whether as academic scholars and researchers, economists working.in the financial sector, or officials of the Bank of England and the Treasury. The areas of interest of the Group include monetary theory and policy, and the operation of financial markets, institutions and systems. The second objective is to promote research into monetary economics and, through its regular seminars and conferences, to provide a forum for the discussion of the results of research. The Group subscribes to no particular school of thought, and takes no collective position on policy and other questions. This volume is the second of a new annual series of selected papers given to the regular meetings of the MSG and its Annual Conference held in September. The current volume includes papers given at its meetings in the academic year, and the conference held at Brasenose College, Oxford, in September Generally the MSG will not prescribe an annual theme and the selected papers may cover a wide range of topics within the broad area of monetary economics. On this occasion the papers have been brought together under the current title: The Operation and Regulation of Financial Markets. The volume is divided into three sections: Regulation and Structural Change in Financial Markets, Modelling Money and Banking, and Modelling Financial Markets. These areas clearly reflect the nature of much of the research currently being undertaken in monetary economics. The first section covers particularly timely issues in the context of major structural and operational changes in the UK, US and international financial systems and changes in the regulatory environment. Financial systems in many countries are undergoing substantial structural and operational changes due in large part to various combinations of a more xi

12 xii Introduction intensive competitive environment, official deregulation moves and the impact of technology. At the same time the pace of financial innovation has accelerated bringing with it changes in the risk characteristics in the financial system. The changes are likely to have important implications both for the structure of financial systems, the operation of financial institutions and the conduct and operation of monetary policy and prudential regulation. The changes in many countries (but notably the UK and US) are affecting, for all institutions, the range of business operations, how services are being provided and the industrial structure of the financial services industry but, above all, the extent, intensity and nature of competition. In particular the basic trend is increasingly towards the breaking down of traditional demarcations between different sets of financial institutions. This is comparatively easy in the UK (certainly compared with the US) because the historic demarcations have been largely, though not entirely, self-imposed rather than forced by legislation. In fact, unlike in most countries, there has not been a well-defined legal framework defining and regulating the scope and nature of the business of financial institutions in the UK. Regulation in general has tended to be informal and discretionary with a large element of self-regulation. In some cases demarcations have been maintained by restrictive practices. Building societies are an obvious and major exception to this general rule in that their activities have been substantially circumscribed by legislation. Nevertheless, the specialist distinctions in the UK have had the full informal backing of the authorities. More generally, financial intermediation and the provision of financial services are becoming increasingly internationalised in three dimensions: users of services increasingly have global options, suppliers of services have a widening range of international options, and institutions are increasingly diversifying their location internationally. In the process national financial systems are becoming subsets of a global fmancial system. This is most apparent in securities trading, as technology may have the effect of making physical location of institutions and markets less important than in the past. Powerful pressures have recently developed on regulatory authorities throughout the world, but notably in the major financial centres, towards deregulation. In the first place, international competition can have the effect of diverting financial intermediation away from those national fmancial systems which are most constrained by regulation. The concomitant danger is that international competition in deregulation can emerge. Secondly, in the increasingly competitive environment, financial innovation spurred by aggressively competitive financial institutions and markets can

13 David T. Llewellyn xiii have the powerful effect of circumventing regulatory constraints. Thirdly, in some countries (most notably in the UK) an ethos has developed that the free play of market mechanisms (albeit with some residual prudential constraints) is more likely to enhance efficiency and the interest of consumers. Technology has also had a powerful impact in the process of deregulation as it widens the range of business options available to financial institutions and hence is a factor weakening traditional boundaries. It also has the effect of making location an increasingly less important consideration in the provision of financial services (most especially to the corporate sector) and accentuates the trend towards an internationalisation of finance. If the regulatory environment in other countries confers a competitive advantage on foreign institutions, pressure develops to adopt a similar regulatory arrangement. To the extent that technology has the effect of integrating financial systems, it contributes to a trend towards developing similar regulatory arrangements between countries. Overall, regulation in the financial system cannot now be regarded as exclusively a national issue with national regulatory arrangements framed without any reference to those in other major financial centres. Regulation in the financial system is always a mixture of statutory, self-regulatory arrangements, moral suasion and self-imposed constraints. There has never been a comprehensive legal framework governing the regulation of financial institutions. The role of legislative regulations, however, has been considerably less dominant in the UK than in most other countries. The 1979 Banking Act in the UK was the first comprehensive legislation governing the business of banking. Financial regulation in the UK has tended to rely little upon the law, substantially upon the general authority of the Bank of England, and reinforced by voluntary arrangements based in part upon various forms of cartel and restrictive practices. In the first paper Maximilian Hall offers a detailed account of the collapse in 1984 of Johnson Matthey Bankers and the controversial response of the Bank of England; the discussion is set in the context of the case for and against prudential regulation and supervision of financial institutions (most especially banks) and a detailed review of the system of banking regulation and supervision in the United Kingdom. Hall also considers some broader issues related to prudential regulation and supervision of banks in the light of the JMB affair. The structure and operation of the British financial system changed substantially during the 1970s in the context of competitive pressures induced partly by measures of deregulation. Two major sectors, however, were not affected by deregulation: the Stock Exchange and domestic

14 xiv Introduction securities industry, and building societies. The Stock Exchange maintained its restrictive practices over pricing, single capacity and membership which had the effect of excluding banks and maintaining the historic demarca tion between banking and securities business. The structure and operation of the Stock Exchange and British securities industry are now, however, changing substantially, and this is the focus of the second paper, by Charles Goodhart. The UK has traditionally been sensitive about conflict of interest in the securities industry, as shown by the division of functions on the Stock Exchange. This institutional division has been underpinned by two restrictive practices of the Stock Exchange: the rules enforcing single capacity, that is, the separation of the functions of broker and jobber, and the restrictions on outside ownership, which meant that after 1982 and until March 1986, any entity not a member of the Stock Exchange could not own more than 29.9 per cent of any Stock Exchange firm. Single capacity operation was also buttressed by agreement over minimum commission charges. All of this is now being dismantled and represents a process of deregulation that is not primarily a product of a change in the law (though it has the full support of the Bank of England and government) but of the force of external competitive pressures. Charles Goodhart describes recent and prospective developments in the London Stock Exchange and securities markets where the structural changes are likely to be substantial. He considers the historical structure of the Stock Exchange, and the factors producing it, and the development of international competition which has contributed to the current structural changes and the injection of (bank) capital into the British securities market. In the final part of his paper the important issue of the role of information in the market is considered. Structural change and deregulation are not unique to the UK. Similar trends have emerged in the US as a series of deregulatory moves (such as, inter alia, the Depository Insititutions Deregulation and Monetary Control Act of 1980, and the Garn-St Germain Depository Institutions Act of 1982), combined with the market impact of technology and the evolution of new strategies by financial institutions, have induced substantial structural change in the US financial services industry. Historically (since the 1930s) regulation has been designed to impose geographical limitation on the business of financial institutions and a strict demarcation between banking, insurance and securities business, following an interpretation that the bankiitg failures of the early 1930s were associated with banks' securities trading. In fact there is little empirical evidence to support this interpretation, not the least because in general the banks that failed were not sub-

15 David T. Llewellyn XV stantial traders in securities. Nevertheless, the tradition of regulation in the US has been to maintain a specialised function for fmancial institutions. The third paper by Mervyn Lewis reviews the structural changes occurring in the fmancial services industry in the United States, which are undermining the historical functional divisions partly imposed by regulations. This is done in the context of an analysis of the characteristics of financial firms and the nature of the demand for financial services. The paper makes the point that, contrary to the implicit assumption in much of US financial regulation, diversification has the normal effect of reducing risk rather than making financial institutions more vulnerable. The paper concludes with a useful summary of the arguments for and against financial supermarkets, which debate is as relevant in the context of current developments in the UK as it is to the US experience. In the final paper of the first section David Cobham and Jean-Marin Serre observe that monetary growth has been significantly more variable in the UK than in France over both the medium term and the short term. They consider seven specific factors that might have contributed to this and conclude that differing influences are responsible for short- and longterm differences in variability, and that the relevance and power of some of the factors varies over the period considered. The paper ends by suggesting that the apparently more ambitious use of monetary policy in the UK may have been a perverse response by policy-makers to the difficulties of operating monetary policy in a more open economy where financial markets adjust more speedily than do goods markets. The second section of this volume comprises three papers brought together under the title Modelling Money and Banking. The paper by Keith Cuthbertson and Mark Taylor provides an appraisal of the role of money as a buffer stock, and in a review of a number of buffer-stock models concludes that some of these models are not necessarily inconsistent with rational expectations hypotheses, and that the two approaches can be usefully combined. The analysis is presented in the context of micro-theoretic arguments, and consideration is given to the main methods applied to empirically implementing buffer-stock models. Policy implications are considered and the paper concludes: 'on all fronts we believe the (buffer-stock) approach has reasonable theoretical appeal and enough empirical support to warrant further research'. The paper by James Davidson also adopts the buffer-stock approach, and models the demand for money in the context of a system of equations describing money supply, prices and income. Money is treated as the residual component of the short-run portfolio decisions of the non-bank private sector, but the deviations from the implicit long-run demand

16 xvi Introduction schedule, while they can persist (and such persistence is empirically estimated), act through a servo-mechanism to stabilise the system. The equations are estimated for the UK subject to appropriate cross-equation parameter constraints, under alternative assumptions about the definition of money. In the next paper Anthony Courakis challenges the conventional view that compulsory balance sheet ratios imposed on banks (for example, cash ratios) are equivalent to a direct tax on deposit returns and have the effect of reducing the profit-maximising level of bank deposits. He shows that imposed cash ratios (even when no interest is paid on them) can have the effect of raising both deposit interest rates and the equilibrium volume of bank deposits. The analysis is developed on various premises, including allowing for real resource costs of intermediation, perceptions of loan default, different types of assets and liabilities comprised in bank portfolios, and the presence of other intermediaries in competition with banks. The over-all conclusion of the paper is that the effect on the volume of deposits of imposed cash ratios depends inter alia upon the characteristics of supply and demand for the assets and liabilities traded by banks, and that in general there exists some compulsory positive cash ratio that, other things being equal, implies a higher equilibrium volume of deposits than in the case of a zero ratio. Three papers make up the third section of the volume under the title Modelling Financial Markets. Richard Baillie and Patrick McMahon focus upon rational expectations in financial markets and the efficient markets hypothesis and in this framework consider alternative models of the term structure of interest rates. The authors compare a simple distributed lagtype model (based on the notion of one-way causality running from short- to long-term interest rates) with a bivariate autoregressive model allowing for joint determination of short and long rates. This is followed by a discussion of rational expectations models of the term structure. Their conclusion is that the usual form of the rational expectations model of the term structure as adopted in the US literature is found not to be supported by the data of the bond market. It is not necessarily incompatible with alternative specifications of the rational expectations term structure. Christopher Green considers the structure of interest rates from a different angle. He derives asset price expectation formation equations and argues that these can be used in empirical research aimed at circumventing the Lucas critique. The conclusion is that the mean-variance model with rational expectations can explain a significant proportion of the movement of UK asset returns in the estimating period Over the period the

17 David T. Llewellyn xvii authorities avowed strategy was to 'peg' short-term interest rates and the results produced suggest that this was correctly perceived by private agents and incorporated into their calculations. The volume concludes with Rodney Dickens's paper on the variability in UK asset markets since the mid-1960s. The paper presents the results of an investigation of the volatility of UK gilts, interbank, foreign exchange and share markets through the application of the ARCH model developed by Engle and which measures the dispersion around the conditional mean rather than about the sample mean. The paper notes that variability in the selected markets was 'relatively low, stable, and co-ordinated up until the early 1970s, (while) more distinct 'cycles' in variability were in evidence after this period'. The collection of papers demonstrates the variety and quality of current research being conducted in monetary economics encompassing theory, empirical testing and the detailed formal analysis of financial markets and institutions. All of the papers have an 'applied' orientation and some have immediate policy implications. They all cover important issues and the Money Study Group, through its series of annual volumes, is pleased to be able to advance analysis and debate in these areas.