Financial markets in an interconnected world Hyun Song Shin* Bank for International Settlements CFS Colloquium Seminar, Goethe University 23 March 2015 * Views expressed are my own, not necessarily those of the BIS.
Two themes Changing pattern of financial intermediation Shift from banking sector to capital markets Focus on market liquidity Shift from banks to long-term investors as protagonists Impact on real economy; what happens in financial markets doesn t always stay in financial markets Global perspective US dollar as global unit of account in debt contracts Stronger dollar constitutes a tightening of financial conditions for dollar borrowers 2
Where to draw the boundary in international finance? Conventional approach to international finance presumes triple coincidence of 1. Economic territory defined by national income boundary 2. Decision-making unit 3. Currency area In world with globalised finance, the triple coincidence no longer holds 3
Traditional approach: Start with boundary for national income accounting Economic territory 1 Economic territory 2 Output 1 Output 2 4
Traditional approach: National income boundary defines decision making unit Economic territory 1 Economic territory 2 A L A L 5
Traditional approach: National income boundary defines currency area Economic territory 1 Economic territory 2 Central bank 1 Exchange Central bank 2 rate Residents in 1 Residents in 2 6
US dollar-denominated credit to borrowers outside US 3.7 Banks US border Non-bank borrowers 2.7 1.0 trillion 1.3 trillion Bond investors Banks Bond investors Source: McCauley, McGuire and Sushko (2015) BIS working paper (data as of end-2013) http://www.bis.org/publ/work483.pdf 7
US dollar credit to non-banks outside the United States Outstanding stocks (USD trillion) Percent 9 65 6 60 3 55 0 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Bank loans to non-banks (lhs) Bank loan share, including non-bank financial bonds (rhs) Bonds issued by non-bank financial sector (lhs) Bonds issued by non-financial sector (lhs) 50 Notes: Bank loans include cross-border and locally extended loans to non-banks outside the United States. For China and Hong Kong SAR, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80% are denominated in US dollars. For other non-bis reporting countries, local US dollar loans to non-banks are proxied by all BIS reporting banks gross cross-border US dollar loans to banks in the country. Bonds issued by US national non-bank financial sector entities resident in the Cayman Islands have been excluded. Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence; authors calculations. 8
US dollar credit to non-banks outside the United States Year-on-year growth rate, in per cent 30 20 10 0 10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Bank loans to non-banks Bonds issued by non-financial sector Notes: Bank loans include cross-border and locally extended loans to non-banks outside the United States. For China and Hong Kong SAR, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80% are denominated in US dollars. For other non-bis reporting countries, local US dollar loans to non-banks are proxied by all BIS reporting banks gross cross-border US dollar loans to banks in the country. Bonds issued by US national non-bank financial sector entities resident in the Cayman Islands have been excluded. Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence; authors calculations. 9
US dollar credit to non-banks outside the United States By counterparty country, in trillions of US dollars 4 8 3 6 2 4 1 2 0 1998 2000 2002 2004 2006 2008 2010 2012 World (rhs) Euro area (lhs) United Kingdom (lhs) Other advanced countries (lhs) Offshore centres (lhs) Emerging markets (lhs) Non-reporting countries (lhs) 0 Notes: Bank loans include cross-border and locally extended loans to non-banks outside the United States. For China and Hong Kong SAR, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80% are denominated in US dollars. For other non-bis reporting countries, local US dollar loans to non-banks are proxied by all BIS reporting banks gross cross-border US dollar loans to banks in the country. Bonds issued by US national non-bank financial sector entities resident in the Cayman Islands have been excluded. Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence; authors calculations. 10
Direct and Intermediated Finance Ultimate Borrowers Intermediated Credit Banks Claim Ultimate Creditors Directly granted credit 11
Year-on-year rate of growth in international bank claims 1 In per cent 48 20 32 10 16 0 0 10 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 VIX (lhs) Credit to non-banks (rhs) Credit to banks (rhs) The vertical lines indicate: 2007 beginning of global financial crisis; 2008 collapse of Lehman Brothers. 1 Includes all BIS reporting banks cross-border credit and local credit in foreign currency. Sources: Bloomberg; BIS locational banking statistics by residence.source: Bloomberg. 12
Two phases of global liquidity Banking sector-led credit growth (2003 2008) Procyclical leverage driven by wholesale bank funding as marginal source of finance Driven by combination of - steep yield curve - certain path of short-term rate Bond market-led credit growth (2010 ) Long-term investors as creditors Focus on corporate borrowers, especially EME corporates Driven by low long rates and flat yield curve 13
US Treasury 10 year and 3 month rates Percent 16.0 14.0 12.0 10 year 3 month 10.0 8.0 6.0 4.0 2.0 0.0 Jan-12 Jan-10 Jan-08 Jan-06 Jan-04 Jan-02 Jan-00 Jan-98 Jan-96 Jan-94 Jan-92 Jan-90 Jan-88 Jan-86 Jan-84 14
Term premium used to be determined by short rate; but not any more 5.0 12 month change in term spread (%) 4.0 3.0 2.0 1.0 0.0-1.0-2.0-3.0-4.0-5.0-4.0-3.0-2.0-1.0 0.0 1.0 2.0 3.0 4.0 12 month change in 3 month rate (%) Jan 1985 - June 2010 July 2010 - Dec 2012 15
McCauley, McGuire and Sushko (2015): US yield curve flattening associated with US dollar offshore bond issuance Estimates based on 16-quarter rolling regressions for growth in offshore US dollar bond market credit on lagged term premium; controlling for the financial market conditions using lag VIX; the dependent variable persistency is controlled for via the lag term. All the variables enter in first-differences or in logdifferences, expressed in per cent. The ten-year real term premium is estimated using term structure models as the deviation in nominal yield from the sum of expected growth rate, expected inflation, and inflation risk premium. Sources: Bloomberg; Consensus Economics; BIS international debt statistics; BIS locational banking statistics by residence; authors calculations 16
Traditional boundaries are not sufficient in understanding the second phase of global liquidity Bank Border A L A L Local currency Local currency Local currency US dollars International capital market Non-financial corporation 17
Using overseas subsidiaries as financial vehicles: case from the 1920s Source: Borio, James and Shin (2014) http://www.bis.org/publ/work457.pdf 18
Capital flows through non-financial companies Avdjiev, Chui and Shin (2014) BIS Quarterly Review, December http://www.bis.org/publ/qtrpdf/r_qt1412h.pdf 19
Surrogate intermediation: borrowing and holding deposit claims Leverage ratio of EME corporations 1, ratio to earnings 2.4 1.8 1.2 0.6 2009 2010 2011 2012 2013 Gross leverage Net leverage 0.0 1 Firm-level data from S&P Capital IQ for 900 companies in seven EMEs; simple average across countries; gross leverage = total debt/earning; net leverage = (total debt-cash)/earnings. 20
Debt and leverage in the energy sector US corporate bonds outstanding 1 Oil and gas producers: total debt to assets 2 USD bn USD bn Per cent 1 Face value of Merrill Lynch high-yield and investment grade corporate bond indices. companies. 3 Companies with total assets in 2013 exceeding $25 billion. 2 Integrated oil, gas and exploration/production Sources: Bloomberg; Thomson Reuters Worldscope; BIS calculations. Domanski, Kearns, Lombardi and Shin Oil and debt BIS Quarterly Review, March 2015 http://www.bis.org/publ/qtrpdf/r_qt1503f.pdf 21
Credit spreads in the energy sector Investment grade High-yield Note: US corporate bond indices; option-adjusted spread over Treasury notes, in basis points. Source: Merrill Lynch. Domanski, Kearns, Lombardi and Shin Oil and debt BIS Quarterly Review, March 2015 http://www.bis.org/publ/qtrpdf/r_qt1503f.pdf 22
Oil and finance ecosystem 23
Oil producers and hedging behaviour Merchants short positions and returns on oil price 1 Oil supply and hedging activity 3 Million barrels per day Million barrels 1 Weekly data (five-day moving average for oil price). The solid regression line indicates statistical significance at a 95% confidence level; the dotted line indicates no statistical significance. 2 Futures and options short open positions on WTI light sweet crude oil traded at the NYMEX, in millions of barrels. 3 Twelve-month changes. Sources: CFTC; Datastream. Domanski, Kearns, Lombardi and Shin Oil and debt BIS Quarterly Review, March 2015 http://www.bis.org/publ/qtrpdf/r_qt1503f.pdf 24
Energy bonds and bond markets Swap dealers short positions and volatility Projected redemption of selected foreign currencydenominated EME corporate bonds 3 Thousands Index USD bn 1 Futures and options short open positions on WTI light sweet crude oil traded at the NYMEX, in thousands of contracts. 2 CBOE Crude Oil Volatility Index. 3 Summed across Brazil, Bulgaria, Chile, China, Colombia, the Czech Republic, Estonia, Hong Kong SAR, Hungary, Iceland, India, Indonesia, Korea, Latvia, Lithuania, Malaysia, Mexico, Peru, the Philippines, Poland, Romania, Russia, Singapore, Slovenia, South Africa, Thailand, Turkey and Venezuela. Sources: CFTC; Datastream; Dealogic. Domanski, Kearns, Lombardi and Shin Oil and debt BIS Quarterly Review, March 2015 http://www.bis.org/publ/qtrpdf/r_qt1503f.pdf 25
Projected redemption of foreign currency denominated EME corporate bonds In billions of US dollars 10 8 6 4 2 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Foreign currency US dollars Foreign currency US dollars Oil and Gas Real Estate/Property Utility and Energy Other 0 Country sample: Bulgaria, Brazil, Chile, China, Colombia, Czech Republic, Estonia, Hong Kong SAR, Hungary, Indonesia, India, Iceland, Korea, Lithuania, Latvia, Mexico, Malaysia, Peru, Philippines, Poland, Romania, Russia, Singapore, Slovenia, Thailand, Turkey, Venezuela and South Africa. Source: Dealogic. 26
Leverage-like behaviour without leverage Relative performance evaluation Ranking influences asset gathering ability (La Spada (2014)) The real business of money management is not managing money, it is getting money to manage [WSJ 16/11/95] Selling volatility through writing straddles and then hedging price moves with delta hedging Marking to market with thin secondary market Risk limits and mandates on minimum credit quality What scope for feedback loop with real economy? What scope for interactions with other regulatory/accounting restrictions in place for governance motives? 27
Asset managers derivatives positions Weekly change in institutional asset managers net long positions; 000 3-month Eurodollar futures contracts 250 0 250 500 750 Apr 14 May 14 Jun 14 Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 1,000 Source: Bloomberg. 28
Rearview mirror Our understanding of crisis propagation is heavily influenced by the experience of the 2008 crisis; watch words are Credit growth Leverage and maturity mismatch Complexity Insolvency and Too-Big-To-Fail Still relevant for key EMEs and some advanced economies (BIS 2014 Annual Report, chapter 4) But it does not follow that future bouts of financial disruption must follow the same mechanism as the past Yet accountability exercises can focus on known past weaknesses 29