The Financial Systems Complexity Some Data on the Financial System The Role of the Financial System Information Challenges & the Financial System Government Regulation and Supervision Financial Panics: the Raison d etra for Financial Market Regulation Page 1 1
The Financial System: Inherent Characteristics Perverse Incentives Asymmetric Information Asset Price Bubbles Complexity Tail Risk Complex Products Leverage Page 2 All Characteristics interact to make the Financial System Complex and Inherently Unstable 2
The Role of the Financial System The role of the financial system is a key financial intermediary and channel funds: From households, businesses, and governments with surplus funds (i.e., saving) These are Bank Liabilities Checking, savings, money market, CDs, NOW, etc. To households, businesses, and governments with a shortage of funds. These are Bank assets Loans and leases Page 3 3
The Role of the Financial System A well functioning financial system directs funds to where they will be most efficiently used, promoting economic stability and economic growth. The financial system is very complex. The internal workings of banks are very complex Financial risk is complex Systemic risk is the most complex of all Page 4 4
The Role of the Financial System Page 5 5
Direct Finance Borrowers borrow funds directly from savers by selling (or issuing) financial instruments or securities which include: Equities, which are a ownership share of a business, or Bonds, which are a debt instrument. These securities are liabilities of the entity selling (or issuing) them. Page 6 6
Direct Finance Financial markets include: Exchanges locations where buyers and sellers of securities conduct business. Stock markets Options markets Futures markets Listed prices on websites and newspapers Investment banks financial institutions that trade securities and assist businesses and governments issue them. Over the counter markets Many (not all) derivatives are traded in over-the-counter markets Most securities purchased by banks are through investment banks Prices may be posted, but usually on screens and requiring phone calls, contracts, and agreements Page 7 7
Intermediaries and Indirect Finance Borrowing from banks, credit companies, mortgage brokers, consumer finance companies It is borrowing indirectly through a financial intermediary. This is called financial intermediation. Financial intermediaries include: Banks (or depository institutions), Insurance companies, Pension funds Finance companies Mutual funds Page 8 Hedge funds. 8
Indirect Finance Three major differences between the various financial intermediaries are: The types of liabilities that each issues and whether they are guaranteed by the federal government The types of assets each holds. Gov t regulation Page 9 9
Indirect Finance Savings Investment Intermediary Source of Funds Uses of Funds Banks Deposits, Borrowings, Fees, Capital, Investment Revenues Loans, Leases, Securities Insurance Premiums, Capital, Borrowings, Investment Revenues Investments, Insurance Payouts Pension Funds Contributions, Invesment Revenues Pension Benefits Hedge Funds Equity, Borrowings, Investment Returns Investments of all Kinds Mutual Funds Equity, Bonds, Investment Returns Stocks, Commercial Paper, Bonds, Securities Finance Stock, Borrowings Loans and Leases Financial intermediaries differ from each other, based on their balance sheets, which report on their activities. Page 10 10
Assets of Different U.S. Financial Intermediaries, 1951-2018 Trillions of $2018 Page 11 11
Assets of Different U.S. Financial Intermediaries as % of GDP, 1951-2018 Ratio to GDP Page 12 12
Assets of Different U.S. Financial Intermediaries as % of GDP, 2000-2018 % of GDP Page 13 13
Some Financial Trends to Ponder 1947-2017 Item Avg. Annual Growth Nominal GDP 6.9% Real GDP 3.2% Inflation 3.7% S&P 7.2% HH Net Worth 7.3% Value of financial assets held by households grow at about the rate of GDP but the value of financial assets in intermediary institutions grows 50% Faster HH Fin Assets 7.4% Assets of Fin Institutions 9.2% Nonfarm Employ 1.7% Fin Industry Emp 2.3% Page 14 14
Financial Development, Economic Growth Empirical evidence shows a strong positive relationship between: Financial development or deepening and economic growth Research: A doubling of the size of private credit is associated with a 2% increase in economic growth among less-developed countries Financial development is associated with reductions in poverty and with increased access of the poor to credit Increases in private credit lead to: A more efficient allocation of credit An increase in investment in more productive assets Faster economic growth. Page 15 15
The Financial System Regulators Leverage Risk & Return Capital Financial Institutions Rating Agencies Congress It s a complex system of economic and political institutions with government regulators and Congress playing a key governance role Page 16 16
Purpose Allocation of capital for investment Diversification of risk Intermediary between savings and investment Organizational structures to minimize the costs of financial transactions Page 17 17
Inherent Issues with Financial Systems Asymmetric Information between: Lenders and Borrowers Investors and Managers Managers and Traders Regulators and Bankers Need for leverage (i.e., credit ) which involves risk vs. safety Management of Tail Risk Contagion and Systemic Failure Politics and Ideology Forms of Asymmetric Info: Moral Hazard Adverse Selection Principal Agent Page 18 18
Information Challenges, Financial System Asymmetric information exists when one party to a transactions has more accurate information than the other party. Financial intermediaries exist because of 3 problems endemic to finance systems. This can lead to a less efficient allocation of funds because of problems associated with: Adverse Selection Moral Hazard Principal-Agent Asymmetries Page 19 19
Information Challenges, Financial System Adverse selection takes place before a transaction is completed and arises because the party most eager to engage in a transaction is the one most likely to produce an unfavorable (i.e., adverse) outcome for the counter party. Before Obamacare, health insurance companies who accept all applicants without different premiums Insurers that will insure anyone at the same price Banks that lend to anyone. Page 20 20
Information Challenges, Financial System Moral hazard occurs after a transaction is completed and arises when the other party will engage in activities that are undesirable from your point of view. If a bank is too big to fail, it has an incentive to take on more risk. Deposit Insurance Bailing out banks, but not removing the management and Board of Directors Page 21 21
Information Challenges in the Financial System Financial intermediaries address asymmetric information problems by: Using credit standards (underwriting) to reduce adverse selection and moral hazard, including down payments and collateral Imposing loan covenants to prevent moral hazard. Page 22 22
A Run on a Bank Prior to Deposit Insurance Liquidity Crisis Causing Bank Default: When any institution can t pay its bills it is in default Prior to deposit insurance, DEPOSITORS pulled their funds ( run on a bank ) and the bank closed due to insufficient cash and absence of Federal Reserve playing role of lender of last resort. This didn t happen in 2008-09 to COMMERCIAL banks because of deposit insurance Investment banks are different because they don t have retail deposits Page 23 23
Deposit Insurance Deposit Insurance Created in the 1930s Purpose is let depositors know their money is insured by the U.S. government, prevent bank runs (as in Frank Capra movie It s a Wonderful Life ) Social purpose: prevent contagion Moral Hazard created: Depositors concerns are a constraint on banking activity A run on a bank can cause the bank to fail, which if the Bank is behaving too risk, this market signal is removed. Banks that operate inefficiently or too risky escape the ravages of the market, thereby inducing more risky behavior. Page 24 24
Too Big to Fail Too big to fail is a colloquial term in describing certain financial institutions which are so large and so interconnected that their failure will be disastrous to the economy, and which therefore must be supported by government when they face difficulty. The concept: failure of a big bank can cause a financial chainreaction threatening survival of other banks either directly (losses) or indirectly (borrowing costs) The term "too big to fail" was popularized by Congressman McKinney in a 1984 Congressional hearing, discussing the FDIC s intervention with Continental Illinois. Bear-Sterns was saved under this doctrine Treasury Secretary Paulson (2008) decided to allow Lehman Brothers to fail, in part because of concerns about moral hazard Page 25 25
Too Big to Fail Moral Hazard created: If economic agents think a big bank or other institutions is too big to fail then they will trade with it, more than they otherwise would Too Big to Fail institutions therefore have cost advantages Too Big to Fail have incentive to take on even more risk, since they know if they get into trouble the government will bail them out Page 26 26
Concentration in Banks Pre- vs. Post Meltdown More Concentrated % of Total Bank Assets Page 27 # of Banks in 2008Q2 = 7,371 # of Banks in 2016Q4 = 5,777 27
Information Challenges, Financial System Principal Agent Problem There exists a principal who hires someone to act on the principal s behalf (an agent) Incentives and preferences (particularly in risk-return dimensions) may not be aligned Aligning requires monitoring by the principal Significant asymmetric information is present Page 28 Principal Agent Shareholders Management Bank Management Traders Voters Congress Taxpayers Regulators 28
Principal-Agent Asymmetry: Risk Taking and Perverse Compensation Incentives in Finance Trading Floors operate in a risk taking and risk control environment They are frequently the source of unexpected losses (e.g., Chase) and may be the subject of unauthorized trading Successful traders can make huge bonuses, before positions are closed out, leaving a Bank with potential losses in the future Senior management s compensation is, in part, tied to the performance of their trading areas. Page 29 29
Risk Taking and Perverse Compensation Incentives in Finance (cont.) FAR More Important: Most commercial banks don t have classic trading floors, but they do make substantial investments in complex securities like MBS and CMOs This was the location in most banks where very large losses on private label MBS and CMOs occurred, including the GSEs (Federal Home Loan Banks). Agency Backed MBS and CMOs led to the takeover of Fannie Mae and Freddie MAC Sept. 7, 2008, one week before Lehman Brothers. Successful portfolio managers and their senior managers can make huge bonuses, tied to fiscal year performance, long before positions are closed out, leaving the Bank with potential losses in the future. Page 30 30
Principal-Agent Problems in the Mortgage Market Associated with Originate to Distribute Agency (or principal-agent) problems in the mortgage markets In the mortgage markets, mortgage brokers are agents and investors are principals The originate-to-distribute model in these market creates adverse selection because once a mortgage broker originate a loan, the broker does not own the risk. The agency problems also occur when banks earn fees by underwriting mortgage-backed securities had weak incentives to ensure that loans would be paid off Page 31 31
Financial Innovation and Complexity Securitization a process that bundles smaller loans into standard debt securities made it possible for banks to offer subprime mortgages to borrowers with less-than-stellar credit records Mortgage-backed securities standardized debt securities of underlying high-risk mortgages Financial engineering the development of new financial instruments products, like structured credit products whose income streams come from a collection of underlying assets Page 32 32
Example of Complex Structured Product: Collateralized Debt Obligations (CDOs) Corporate entities, called special purpose vehicles (SPVs), created collateralized debt obligations as a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities The SPVs separate the different payment streams from these assets into a number of buckets called tranches These products can be complicated that it is hard to value the cash flows of the underlying assets or to determine who actually owns these assets Their complexity can worsen the asymmetric information in the financial system Page 33 33
Originate to Distribute: Securitization and Risk Management Thousands of Home Mortgages Originated Distributed to Hundreds of Investors Cash Mortgage Security Cash Banks, insurance, mortgage funds What happens when borrowers defaults? Page 34 34
Originate to Distribute: Securitization and Risk Management Thousands of Home Mortgages Hundreds of Investors Cash Mortgage Security Cash Banks, insurance, mortgage funds Page 35 Agency Securities Freddie Mac, Fannie Mae Taxpayers Private Securities Banks, Lehman Citibank, Bank America, Merrill Lynch Taxpayers 35
Taxpayer Backed Residential Mortgage Securities Currently about 10% of the Financial Assets of the US are in these Securities Trillions of $ Agency MBS Page 36 36
Originate to Distribute Has Only Gotten Larger Bank Holdings of Residential Mortgage Sec. Trillions of $ Agency MBS Insured by U.S. Treasury Page 37 37
Leverage Simple leverage equals the ratio of assets to equity It is a proxy measure for the sensitivity of earnings or market value to an underlying risk factor Example: House Purchase: 10% down payment vs. 20% down payment Page 38 38
Leverage Example: House Purchase Suppose you want to buy a house for $100,000 You have $10,000 as a down payment You need to borrow $90,000 to purchase the house Your down payment is 10% of the price Your leverage ratio is 10 Leverage ratio = $100,000/$10,000 = 10 Page 39 39
Return on Investment Leverage and House Purchase 400% Ret on Inv 300% 10% Down 200% 100% 0% 20% Down -100% -200% -300% -400% -30% -20% -10% 0% 10% 20% 30% % House Price Return on Invested Equity is inversely related to leverage. Potential losses are not as bad, the more equity that is invested See Payoff Diagrams from Lecture 1 Page 40 40
How Does Return on Investment Change with Leverage Ratio? L=10 No Leverage ROI % Invested % The greater the leverage ratio the greater the return BUT ALSO the greater the loss for an underlying change in the value of the house Page 41 41
Return on Investment Leverage with Default and Bankruptcy Default provides a floor on the loss to the borrower Risk of default to the lender increases as equity invested declines Cost of default to the lender increases with limited liability (bankruptcy) 400% 300% 10% Down Page 42 200% 100% 0% -100% -200% -300% -400% 20% Down Once equity goes to zero borrow may default -30% -20% -10% 0% 10% 20% 30% % House Price Borrowers have an economic incentive to default once equity goes to zero. In the case of housing, the risk of default rises significantly when the loan exceeds value of the house 42
Leverage Example: Bank Assets Liabilities and Equity $100 Loans $90 Deposits $10 Equity Leverage ratio = A/E = 100/10 = 10 Page 43 43
Leverage and the Financial System It is a fundamental component of modern financial systems It increases risk to banks It increases risk of a systemic meltdown It increases taxpayer exposure to the three forms of asymmetric information Adverse selection Moral Hazard Principal-agent problem Page 44 44
Leverage and Banks Inherent conflict in every modern banking system Banks want to increase leverage to increase return on invested equity Regulators want to limit leverage by requiring more capital to protect public interest Banks will use political means to reduce regulatory oversight Page 45 45
Leverage, Banks and Non Bank Financial Institutions Capital regulations are a core area of disagreement between the regulators and the regulated How much capital is needed to keep financial institutions from going bankrupt in stressful conditions is not known with certainty and can only be estimated using models Historically, capital and regulations focused on commercial banks because the primary focus was at the time the risk to depositors. It was thought that investment banks could fail without endangering the system This view was significantly challenged by the near failure of the hedge fund: Long Term Capital Management in 1998 Too Big to Fail has become Too Interconnected to Fail. (Think AIG, it s not even a bank!) Page 46 46
Examples of Increasing Leverage Pre Meltdown Entity Households Commercial Banks Example Buying homes they couldn't afford with "risky" mortgages (aka subprime loans) Borrowing against equity in their homes to finance consumption Exploiting accounting loopholes to increase leverage through SPVs Increasing risk through derivative transactions Investment Banks (not regulated by Bank regulators) Directly reducing capital Page 47 47
Credit Losses in Banking and Tail Risk Expected losses: a predictable percentage of loans are going to go bad with some variance around a mean accounted for economically in the price of loans Unexpected losses: an unexpected event could occur leading to a far greater number of loans going into default (e.g., housing price bubble bursts many mortgages go into default) Page 48 48
Tail Risk Many elements of risk in financial markets is described better by the distribution on the right vs. the distribution on the left The outcomes from lending looks more like the distribution on the right Page 49 49
Tail Risk Probability of Occurance This distribution has fat tails : the percentage of outcomes that may be really bad is more than insignificant This is what is referred to as tail risk : the risk of a low probability event that has significant economic consequence Page 50 50
Capital and its Role as Default Insurance The economic purpose of insurance is to limit the loss to the insured from a possible, but unlikely event Households purchase insurance (i.e., reduce consumption of other goods and services) in order to maintain their consumption if the unlikely incomereducing event occurs (e.g., fire, automobile accident, etc.) Capital plays the role of insurance in the banking system Capital provides the bank protection against the bank s BANKRUPTCY associated with costly, but unlikely events Capital also provides a social benefit: it s a form of systemic insurance because it reduces the likelihood of default and therefore the trigger for a financial crisis However, capital comes at an economic cost to the bank: it reduces the bank s leverage and potential return on invested equity Page 51 51
Tail Risk and Capital: Dirty Secret There doesn t exist sufficient capital in the banking SYSTEM to protect leveraged financial institutions from defaulting for 100% of the potential outcomes. The entire system is structured to have sufficient capital in most outcomes, but not all. This was the original mandate for creating the Federal Reserve in 1913. Page 52 52
Tail Risk and Recent Events: Note on Meltdown Measurement of tail risk is a core issue in risk measurement and management It was a major failure at several major commercial and investment banks AND simultaneously it was under estimated by the rating agencies AND regulators relied too heavily on rating agency assessments and underestimated the systemic risk associated with the tail risk Many participants in the industry (including rating agencies) ASSUMED housing prices would never fall simultaneously across the entire country because that hadn t occurred for a long time! Risk models at many institutions at the time would have shown significant economic exposures had the likelihood of this one assumption been recognized. Page 53 53
Financial Systems in Capitalist Economies without Regulation Without regulatory oversight Financial systems without government oversight regularly meltdown Historically, meltdowns were called financial panics Panics frequently led to national (or international) recessions and depressions Page 54 Occurred in 1797, 1819, 1837, 1857, 1873, 1907, 1932, 2008 54
Financial Daisy Chains Simplified Initial Event Significant losses by Bank A Bank A Defaults Bank A defaults on borrowings from Bank B Bank B Defaults Bank B incurs large loss on lending to Bank A and defaults on borrowings from Bank C etc Page 55 55
Financial Networks & Systemic Risk Multiplesimultaneous failures of banks Page 56 56
Need for Regulatory Oversight No Regulatory Oversight Regulatory Oversight Regulatory oversight of banks has been a component of the banking system since the creation of the Federal Reserve System in 1913 A core component of banking regulations is the requirement that banks maintain minimum levels of capital, limiting the amount of leverage at commercial banks Page 57 57
What About Before the Bubble Bursts? Page 58 58
Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Index (Oct-07 = 100) The Stock Market Pre-Burst 120 Financials 100 80 NY Composite 60 40 Lehman files 20 Page 59 59
HH Sector Net Worth Page 60 Life is good! 60
Financial vs. Real Pre-Burst Key Asset Prices Increase Wealth Effects in HH and Business Balance Sheets Perceived Decrease in Uncertainty Incentive to Increase Leverage Increase in Risk Taking Page 61 Increase in Consumption 61
Eventually the Bubble Bursts Year Bubble 1636 Dutch Tulip Bulb 1720 South Sea 1720 Mississippi Land 1927-29 US Equities 1970 Loans to Mexico 1985-89 Japanese Real Estate and Equities 1990 SE Asia Equities 1995-2000 US Hightech Equities 2002-2007 Real Estate in US, Britain, Spain, Ireland and Iceland Page 62 62
Sequence of Events in Financial Crises in Advanced Economies: Generalization Financial crises have progressed in two or three stages: Stage One: Initiation of Financial Crisis Stage Two: Banking Crisis Stage Three: Debt Deflation Stage I Asset Price Declines Deterioration of Financial Institutions Balance Sheets Increase in Uncertainty Page 63 63
Stage I: Initiation of Financial Crisis Financial crises can begin due to: Mismanagement of financial innovation/ liberalization Asset price booms and busts Increase in uncertainty simultaneously by economic agents Perverse incentive structures: risk takers win if bet pays off, taxpayers lose if it doesn t Avoidance of tail risk management: the financial world is not defined by normal distributions, but by fat tail distributions When regulators fail to do what they were hired to do Page 64 64
Predictability of Financial Bubbles: Is this a Bubble? NASDAQ Comp Feb 71 =100 Page 65 Is this an asset price bubble? 65
Financial Bubble: Before and After NASDAQ Comp Feb 71 =100 Page 66 That s known as the Dot-Com bubble 66
Financial Bubble: Before and After NASDAQ Comp Feb 71 =100 What about now? Page 67 67
The Housing Price Bubble Peak Sep 08 The peak in housing prices preceded the meltdown by about 18 months. Housing prices varied significantly by metro region. Not all regions experienced it, but most of them did. Page 68 Note how far prices had fallen by September 2008 68
What about the Current HPIs? Is this the beginning stage of a bubble? HPI 2005Q1 =100 Page 69 69
Mortgage Debt and Borrowings $Trillions $Billions Return of the Housing Sector Page 70 Deleveraging 70
Mortgage Borrowings & HPI $Billions Housing Price Index Index in 2000 = 100 Page 71 71
Stage II: Banking Crisis Asset Price Declines Deterioration of Financial Institutions Balance Sheets Increase in Uncertainty Decline in Economic Activity Banking Crisis Feedback Page 72 72
What Does Deterioration in Bank s Balance Sheets Mean? Assets Liabilities & Equity Assets Liabilities & Equity $100 Loans $90 Deposits $10 Equity $5 of Loans Default $95 Loans $90 Deposits $5 Equity 10% Equity 5.2% Equity Page 73 73
Stage II: Banking Crisis A bank panic occurs when multiple banks fail simultaneously Runs of investment banks and/or liquidity crises: Possible material withdrawals by depositors Unwillingness of lenders to rollover and/or provide short term funds Forces banks to sell off their assets leading their prices to decline so much that banks become insolvent (negative net worth) Page 74 74
Banking Insolvency vs. Liquidity Insolvency: When the value of liabilities > value of assets there exists negative equity and a bank is insolvent. Liquidity Crisis Causing Default: When any institution can t pay its bills it is in default Investment banks with significant needs for cash funding can become illiquid when lenders pulled back lending because they were worried about the bank s equity. Page 75 75
Commercial Banks vs. Investment Banks Commercial banks are regulated by bank regulators. Prior to Financial Meltdown investment banks were not. Commercial banks subject to capital requirements Lehman Brothers was levered over 30 to 1 in Sep 08 Most (not all) commercial banks have core deposits like checking, MMDA, and savings accounts. Because depositors are insured, there wasn t a run on commercial banks Not so for investment banks which rely on professional market funding. (Think Lehman Brothers) Page 76 76
Shadow Banking System The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system includes hedge funds, investment banks and other non-depository financial institutions. Institutions and entities in the shadows are largely funded by repurchase agreements (repos), which are short-term borrowings Page 77 77
Single Bank Contagion in Bank Crises Asset Price Declines Bank Equity Deteriorates Concern about being paid back, lenders stop lending Potential Insolvency Potential Default Page 78 78
Feedback Loop Between Asset Prices and Credit Front End of Bubble Bubble Breaks Page 79 79
The Big Three Takeaways Page 80 80
The Financial System: Inherent Characteristics Perverse Incentives Asymmetric Information Asset Price Bubbles Complexity Tail Risk Complex Products Leverage Page 81 All Characteristics interact to make the Financial System Complex and Inherently Unstable 81
Propagation of Bankruptcy Multiplesimultaneous failures of banks Page 82 Financial Crises will Continue to Occur 82
Financial Systems in Capitalist Economies without Regulation Without regulatory oversight Financial systems without government oversight regularly meltdown Historically, meltdowns were called financial panics Panics frequently led to national (or international) recessions and depressions Page 83 Occurred in 1797, 1819, 1837, 1857, 1873, 1907, 1932, 2008 83