Comparative financial systems

1. Comparative financial systems The financial system Functions and general issues February, 2010

2. Agenda • The theoretical framework • The functional approach to a financial system • Market vs intermediaries • How to compare financial systems • Financial markets and financial instability • The global financial imbalances • Securitisation and its weaknesses • The originate-to-distribute model

3. A general picture of a financial system Central bank Bank supervisor Market regulator Antitrust Other Financial intermediaries Banks Other Loans Companies Deposits Households Institutional investors Mutual funds Pension funds Insurance Shares Ins. policies Payments (infrastructure) Public sector Bonds Stocks Markets Money Bonds Stocks Derivatives Bonds

4. The financial system is composed of: Intermediaries Markets Infrastructure The financial system links the two engines of growth: savings and investment The greater the division between those who save and those who invest, the greater the importance of the financial system Main agents Regulators Final users (households; nonfinancial companies; government) Channels of intermediation Instruments What the figure tells us

5. Households typically consume less than they earn (saving exceeds investment) they have a surplus of resources S - I = FA- FL > 0 They are therefore surplus units or final lenders Firms and the public sector are in the opposite situation; they have a deficit of resources S - I = FA - FL < 0 They are therefore deficit units or final borrowers Financial intermediation allows for surplus units to lend the resources they need to deficit units Financial assets and liabilities increase year after year The final users

6. Warning • The financial system links economic agents with financial surplus with economic agents with economic deficits • Given the growing debt of the household sector, and given the high profits in the corporate sector, it is no longer true that the financial surplus (deficits) are in the household (corporate) sector • At the international level, the current account surpluses (deficits) are the main driver of international flows of capital

7. Traditional division: banks vs markets Financial intermediaries (mainly banks) vs. financial markets (deposits vs securities) Households could invest their wealth either in bank deposits (majority) or in financial instruments (historically well-off people) Nowadays securities are the most important asset class and are bought indirectly through financial investors (see following graph) Financial instruments and channels of intermediation

8. The theoretical framework • F.Allan – D. Gale, Comparing Financial Systems, MIT Press, Cambridge (Mass), 2000 • R. Merton – Z. Bodie, A Conceptual Framework for Analyzing the Financial Environment, Harvard University Press, 1995 • A.Demirgüç-Kunt – Ross Levine, Financial Structure and Economic Growth. A Cross-Country Comparison of Banks, Markets and Development, Cambridge (Mass), The MIT Press, 2001. • R. Rajan – L. Zingales, Banks and Markets: The Changing Character of European Finance, CRSP Working Paper No. 546 january 2003 • Available at SSRN: http://ssrn.com/abstract=389100 • L.R Wray, Financial Markets Meltdown. What Can We Learn from Minsky?, The Levy Economic Institute, 2008

9. A few stylized facts • Financial systems differ by: • Size (Total financial assets on GDP) • Financial channels of intermediation • Distribution of financial surpluses/deficits • The dimension of the financial pyramid continues to grow

10. The indicators of main economic areas

11. Why focus on functions • Functions are stable; institutions continuously change • Today’s bank is completely different from a bank of only 10-15 years ago • Institutional form follows function • Innovation and competition among institutions ultimately result in greater efficiency in the performance of financial system functions

12. The functions of a financial system • To provide ways of clearing and settling payments to facilitate trade; • To provide liquidity; • To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises; • To provide ways to transfer economic resources through time, across borders and among industries; • To provide ways of managing risk; • To provide price information to help coordinate decentralised decisions-making in various sectors of the economy.

13. To provide ways of clearing and settling payments to facilitate trade • Financial intermediaries provide the monetary means an economy needs • Central banks • Commercial banks • The monetary function performed by banks is the fundamental reason of their uniqueness (they have sight liabilities and non-liquid assets such as loans to final lenders). This is why banks are subject to specific stability regulation and supervision. • Central banks to protect the stability of prices (public trust in money) • See the mission of the ECB

14. The importance of the payment system • An essential infrastructure • A huge volume of transactions every day • A source of important bank earnings • A possible source of systemic risk • Central banks must be ready to lend funds • Settlement is totally safe when executed in central bank money • The settlement among banks participating to the payment system is the heart of the money market • This is why TARGET had to be up and running since the very first day of the monetary union

15. TARGET • TARGET provides real-time settlement, making it possible to transfer large amounts of money between bank accounts from one country participating in TARGET to another within minutes, if not seconds. • TARGET helps in unifying the euro money market, and in particular short-term interest rates, therefore making possible the making of a European monetry policy. • In 2005 TARGET processed more than 76 milllion transactions (dayly avg 296k); the overall value has been 488.900 bn (daily avg 192 bn)

16. To provide liquidity • Money has absolute liquidity • The liquidity of any asset is measured against money • Financial assets are generally more liquid than real assets • Increasing the liquidity of financial assets is one of the most important forms of financial innovation • Example: the securitisation of mortgage loans

17. To provide a mechanism for the pooling of resources and for the subdividing of shares in various enterprises • Increase of opportunities • Diversification of risks • Example: mutual funds, private equity funds, hedge funds

18. To provide ways to transfer (therefore allocate) economic resources through time, across borders and among industries • Through time for a single economic agent: • Financial assets are a safe way of transferring the purchasing power of money (motives why people save) • Pensions in ageing world • Among economic agents: • from those who save to those who invest • From mature industries to new sectors (technological innovation) • Across borders: • From mature countries to emerging ones

19. To provide ways of managing risk • Technically speaking the financial system provides instruments which allow for: • Hedging (the invention of financial derivatives) • Diversification • Insurance • The non-diversifiable risk is managed in different ways in a bank-based or a market-based financial system • Market-based systems: households more exposed directly • Bank-based: financial intermediaries as a buffer

20. The two-edged sword • Financial innovation should not increase the opaqueness of the financial system • Risk models are expected to work • Derivatives can increase systemic risk

21. To provide price information to help coordinate decentralised decisions-making in various sectors of the economy • Information is the main input of financial intermediation • Banks: private information • Markets: public information • Financial intermediaries as a way to cope with asymmetric information (delegated monitoring) • Markets need to control asymmetries of information • Formal procedures to disclosure • Public offers • Relevant information • External ratings • Insider trading and market abuse regulations • Information is one important output of financial information • Bank loan as a signal • Securities prices as a continuous assessment

22. Banks vs markets • There is not such a thing as the “ideal” financial system • Banks based • Pro: long-term relationship • Con: possible misallocation in case of crisis (Rajan-Zingales) • Markets (arm-length) • Pro: Public information through prices • Con: Markets are not perfect

23. Banks vs markets and growth

24. Nobody is perfect: market possible inefficiencies • Bounded rationality • Keynes and the beauty contest • Shiller and irrational exuberance • Bubbles • Endogenous instability (Minsky) • Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is a large weight to units engaged in speculative and Ponzi finance.

25. Financial instability: the Ecb definition • Financial stability can be defined as a condition in which the financial system – comprising of financial intermediaries, markets and market infrastructures – is capable of withstanding shocks and the unravelling of financial imbalances, thereby mitigating the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities.