Lecture notes on risk management, public policy, and the financial system Development of the contemporary financial system Allan M. Malz Columbia University
2018 Allan M. Malz Last updated: March 14, 2018 2 / 34 Overview Postwar changes in the financial system
3/34 Postwar changes in the financial system Postwar changes in the financial system Increased role of markets in intermediation Regulatory developments
4/34 Postwar changes in the financial system Increased role of markets in intermediation Post-1960 s changes in financial intermediation Rise of capital markets and trading volumes Disintermediation: funding via capital markets rather than banks Has advanced further in U.S. than rest of world Rise of wholesale funding, money markets and maturity transformation Closely related to non-bank intermediation, shadow banking Financial innovation Derivatives: exchange-traded and over-the-counter (OTC) Securitization: pooling assets and creating securities through which their cash flows are distributed Large capital pools: hedge funds, private equity, international reserves
Postwar changes in the financial system Increased role of markets in intermediation Growth of U.S. finance 1947 2012 8 7 6 Finance value added GDP 2.5 2.0 5 1.5 4 3 Finance profits GDP 1950 1960 1970 1980 1990 2000 2010 1.0 0.5 Black plot: Finance and insurance value added as a percentage of gross domestic product, annual. Red plot: financial corporate profits as a percentage of gross domestic product, annual. Source: Bureau of Economic Analysis, GDP-by-industry accounts, value added by industry as a percentage of GDP, line 51; National Income and Product Accounts, Table 1.1.5, line 1, Table 6.16A-D, line 3. 5/34
6/34 Postwar changes in the financial system Increased role of markets in intermediation Growth of private-sector bond markets 1980 2011 Growth driven in recent years by mortgage- and asset-backed securities Collapse of subprime MBS and ABS issuance in crisis, but revival of corporate bond issuance Bonds outstanding $ trill. Bond issuance $ bill. 15 2500 corporate MBS CMBS ABS 2000 10 1500 corporate private label MBS ABS 5 corporate MBS CMBS corporate 1000 500 private label MBS ABS 0 1990 2000 2010 0 1995 2000 2005 2010 Par values. Source: SIFMA (http://www.sifma.org/research/statistics.aspx).
Postwar changes in the financial system Increased role of markets in intermediation Commercial real estate debt finance 1960 2013 100 Households, REITs, etc. 80 Insurance and pension funds share in percent 60 40 20 Banks 07Q3: 25.8 CMBS 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Shares of total commercial real estate lending loans held by each sector, quarterly, percent. Banks include U.S.-domiciled commercial banks and savings institutions. Institutional investors include insurance companies and pension funds. Other includes finance companies. Source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Table L.220. 7/34
8/34 Postwar changes in the financial system Increased role of markets in intermediation Shadow banking Key aspect of financial innovation Non-bank intermediation Off-balance sheet treatment: difficult to obtain and aggregate data Falls outside pre-existing regulatory framework Institutional elements MMMFs Structured credit products Structured investment vehicles (SIVs) and conduits
9/34 Postwar changes in the financial system Increased role of markets in intermediation Disintermediation in U.S. finance 1980 2013 By liability type: 70 14 Foreign direct investment Foreign direct investment 12 60 Commercial paper Bank loans 10 Bank loans 50 Corporate bonds 8 Commercial paper 40 6 Corporate bonds 30 4 20 Other 2 10 0 1980 1990 2000 2010 0 1980 1990 2000 2010 Total liabilities of U.S. nonfarm nonfinancial corporations by type. Bank lending is comprised mostly of commercial and industrial loans (C&I loans). Other consists primarily of trade payables and mortgages. Left: $US trillions; right: shares, in percent. Quarterly, 1975 to Q2 2013. Source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Table L.102.
10/34 Postwar changes in the financial system Increased role of markets in intermediation Intermediation by sector 1985 2008 60 50 40 percent 30 20 10 banks insurance pension fund mutual fund money market mutual fund agency ABS specialty finance co. banks insurance pension fund mutual fund money market mutual fund agency ABS specialty finance co. banks insurance pension fund mutual fund money market mutual fund agency ABS specialty finance co. 0 Q4 1959 Q4 1984 Q2 2008 Share of each sector in total credit market assets held by financial sectors, percent. Source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Table L.1 (line nos. in parentheses): banks Monetary authority (34) money market mutual fund MMMFs (47) Banks (35, 40-41) agency GSEs (51) Brokers and dealers (56) Agencies, GSE MBS (52) insurance/pension fund Insurance, pensions (42-47) ABS ABS issuers (53) mutual fund Incl. ETFs (48-50) specialty finance co. Incl. REITs (54-55, 57)
11/34 Postwar changes in the financial system Regulatory developments U.S. regulatory trends Removal of price controls, outright prohibitions, interest rate ceilings Easing of restrictions on bank structure: interstate branching, unit banking Capital adequacy standards and coronation of ratings Financial conglomerates, activities of bank holding companies (BHCs), but no ownership of nonfinancial companies in U.S. Issuance and registration requirements for public securities, qualified investors under Rule 144a Increasing frequency of crises and public-sector rescues Accounting and bankruptcy privileges: 2a7, close-out netting, MMMFs, financial accounting standards (FAS)
12/34 Postwar changes in the financial system Regulatory developments Regulatory and legislative milestones Depository Institutions Deregulation And Monetary Control Act (Garn-St. Germain Act, 1980) Basle Capital Accord (1988) Interstate Banking and Branching Efficiency Act (Riegle-Neal Act, 1994) Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA, 1989) Federal Deposit Insurance Corporation Improvement Act (FDICIA, 1991) Financial Services Modernization Act (Gramm-Leach-Bliley Act, 1999) Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)
13/34 Postwar changes in the financial system Rapid growth of income and wealth The Great Inflation and the Great Moderation The decline in interest rates Increasing frequency of crises
14/34 Rapid growth of income and wealth Rise in world income Rapid rise in world income in postwar era Approx. 4-fold rise since 1950 Compare to approx. 4-fold rise in preceding millennium
Rapid growth of income and wealth Growth in world real income 1950 2011 8000 7000 6000 5000 4000 3000 2000 1950 1960 1970 1980 1990 2000 2010 In 1990 dollars. Source: Through 2008, Angus Maddison, http://www.ggdc.net/maddison/oriindex.htm, 2009-2011 extrapolated using IMF world per capita GDP growth data. 15/34
16/34 Rapid growth of income and wealth Growth in assets Rise in household wealth In U.S. and other countries, recent volatility due to house prices And even greater volatility in ratio to income( leverage) Rise of large capital pools ( safe assets, international imbalances) Hedge funds International reserves and sovereign wealth funds
17/34 Rapid growth of income and wealth U.S. household net worth 1945 2015 75 50 25 Net worth 6.5 6.0 10 5 1 Ratio to disposable income 1950 1960 1970 1980 1990 2000 2010 5.5 5.0 4.5 Logarithm of household net worth, trillions of 2005 U.S. dollars (left y-axis) and ratio to disposable personal income (right y-axis), quarterly. Vertical shading represents dates of NBER business cycles. Source: Federal Reserve Board, Financial Accounts of the United States (Z.1), Table B.101.
18/34 Rapid growth of income and wealth Hedge fund assets under management 1990 2013 2500 2000 1500 BarclayHedge 1000 HFR 500 0 1995 2000 2005 2010 Annual, last observationq2 2013, $ bill. Source: HFR, BarclayHedge.
19/34 Rapid growth of income and wealth World savings rate 1980 2013 25 24 23 22 1980 1985 1990 1995 2000 2005 2010 World gross national savings, percent of GDP. Source: International Monetary Fund, World Economic Outlook Database, October 2013
Rapid growth of income and wealth International monetary reserves 1948 2012 7000 4000 2000 1000 500 Official reserves FRBNY custody holdings 250 100 50 1950 1960 1970 1980 1990 2000 2010 Black plot: Official Reserve Assets, annual, billions of Special Drawing Rights (SDRs), logarithmic scale. On August 31, 2012, one SDR was worth about $1.52. Red plot: Marketable securities held in custody by the Federal Reserve Bank of New York for foreign official and international accounts, week average. SDRs are a currency unit introduced by the IMF in 1969 as a means of increasing its flexibility to provide liquidity to countries experiencing balance of payments problems. Today, it serves primarily as a unit of account. Source: International Monetary Fund, Federal Reserve Board, release H.1.4. 20/34
21/34 Rapid growth of income and wealth Economic globalization Rise in international trade Accompanies income growth and increased international specialization Removal of tariffs, other protectionist measures (GATT, WTO) Increase in cross-border banking activity Bank lending to obligors in other countries Establishment of bank branches and subsidiaries in other countries Ownership shares in banks domiciled in other countries Large increase in activity of U.S. affiliates (branches and offices) of foreign banks Large-scale U.S. dollar deposit-gathering Lent in large part to U.S. residents and entities Large participants in interbank markets
22/34 Rapid growth of income and wealth Growth in world trade 1969 2011 4000 2000 1000 500 1970 1980 1990 2000 2010 OECD Main Economic Indicators, world trade in goods and services (volume), annual, billions of 2005 U.S. dollars.
Rapid growth of income and wealth Bank lending to foreign obligors 1999 2016 35 30 25 20 15 10 5 2000 2005 2010 2015 BIS consolidated banking statistics, total foreign claims by immediate counterparty, quarterly, $ trillions, Q4 1999 to Q1 2016. The data represent the total amount lent by banks domiciled in one country to residents of another, including by foreign affiliates resident in the borrower s country. Source: Bank for International Settlements. 23/34
24/34 The Great Inflation and the Great Moderation From postwar growth to Great Inflation Growth of GDP through 1960 s high by historical and current standards Inflation: rise in general price levels Equivalently: decline in purchasing power of money unit Inflation rises from ca. 1965 Stagflation : high inflation together with low growth Collapse of Bretton Woods Gold-exchange standard in place 1945 1971 Disinflation begins in late 1970s
25/34 The Great Inflation and the Great Moderation U.S. inflation 1958 2012 12 10 CPI-U ex food and energy 8 6 Core PCE 4 2 mean 1996-2015 1.67 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Annual percent change in the consumer price index all urban consumers (CPI-U), all items less food and energy. Vertical shading represents dates of NBER business cycles. Source: U.S. Bureau of Labor Statistics, series CUUR0000SA0L1E.
26/34 The Great Inflation and the Great Moderation The Great Moderation Period of perceived success of monetary policy Ca. 1984 until outbreak of global financial crisis Sharp decline in volatility of GDP growth, level and volatility of inflation Interest-rate smoothing: gradual adjustment of target funds rate Policy below rule 2000 06 But inflation itself suppressed by low import prices
The Great Inflation and the Great Moderation U.S. GDP growth rate and its volatility 1947 2013 7 15 10 5 0 5 10 GDP growth volatility of GDP growth 6 5 4 3 2 1950 1960 1970 1980 1990 2000 2010 Percent change from preceding period in real gross domestic product, U.S. GDP growth, quarterly, percent, seasonally adjusted at an annual rate (black, left y-axis), and rolling standard deviation of the past 5 years growth rates in percent (red, right y-axis). Vertical shading represents dates of NBER business cycles. Source: U.S. Bureau of Economic Analysis. 27/34
28/34 The decline in interest rates Behavior of U.S. interest rates Nominal interest rates: measured relative to money units Real interest rates: measured relative to purchasing power units Equilibrium or neutral or natural or Wicksellian real interest rate: the real rate that would prevail over the medium term if the economy were in equilibrium Market real interest rate is that currently prevailing Nominal rate can be decomposed into real rate plus expected inflation Three-decade decline in nominal rates and flattening of yield curve Early manifestation: the Japan trap Conundrum in U.S. rates 2004 2005: rising short-term rates, but steady or declining longer-term rates Further decline during global financial crisis, policy response Both components of nominal rates falling Expected inflation declining to below 2 percent Real rate of interest declining to zero
29/34 The decline in interest rates U.S. 2- and 10-year nominal rates 1997 2016 15 10 10-yr. conundrum 5 2-yr. 0 1980 1985 1990 1995 2000 2005 2010 2015 On-the-run issues, Bloomberg tickers USGG2YR and USGG10YR Index; daily. Vertical shading represents dates of NBER business cycles.
The decline in interest rates U.S. real interest rates 1984 2016 8 nominal rate overreacts to inflation 6 Laubach-Williams r * 4 2 0-2 market-implied real rate nominal rate lags behind inflation 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Laubach Williams short-term natural rate r based on their Measuring the natural rate of interest, Review of Economics and Statistics 85(4), 2003, 1063-1070, estimates downloadable at http://www.frbsf.org/economic-research/files/laubach_williams_updated_estimates.xlsx; Mar. 1961 Dec. 2015, quarterly. Market-implied real rate is the 5-year U.S. TIPS yield from July 1997 (Bloomberg ticker USGGT05Y) and the 5-year nominal yield (Bloomberg ticker USGG10YR) minus a 10-year moving average of annual CPI-U All Items inflation rates centered on the current month Jan. 1967 June 1997; monthly. 30/34
31/34 The decline in interest rates Why the decline in real rates? Real interest rates unobservable, must be estimated Models of equilibrium real rate Considerable uncertainty around estimates Market real rate based on inflation-indexed bond yields Doesn t account for liquidity, inflation-risk premiums Possible explanations of low real rates: Global savings glut hypothesis: rise in world saving ( international imbalances) Including demographic reasons: aging population motivates higher saving Demand for safe assets Secular stagnation driven by low aggregate demand or by slowing technical progress International balances: capital flows from less-developed to more advanced countries Consistent with low growth of productivity, business formation, and private investment
The decline in interest rates U.S. labor productivity 1947 2016 3.0 2.4 2.3 2.5 1.6 1.2 0.4 1947-65 1966-72 1973-80 1981-90 1991-99 2000-10 2011-16 Percent change in output per hour at an annual rate, nonfarm business, quarterly 1947Q2 2016Q2. Source: U.S. Bureau of Labor Statistics, series PRS85006092. 32/34
33/34 The decline in interest rates Growth of U.S. investment spending 1960 2015 15 10 5 0-5 -10-15 mean 1960-2001 5.5 mean 2002-15 2.5 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Percent change in gross domestic private nonresidential fixed investment, annual, National Income and Product Accounts, Table 1. Source: U.S. Bureau of Economic Analysis (BEA).
34/34 Increasing frequency of crises Major postwar financial crises Often currency/balance of payments focused 1987 stock market crash 20 percent 1-day decline but little lasting effect Japan crisis in 1989 followed rapid rise in stock, land prices Collapse of Bretton Woods 1968-1971, at beginning of 1970 s stagflation European Monetary System of 1992-1993, largest speculative attack on fixed exchange rates S&L crisis of early 1980 s, gambling for resurrection Mexico default 1994-1995, fixed exchange rates, short-term foreign exchange borrowing Asian crisis 1997-1998, fixed exchange rates, short-term foreign exchange borrowing