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AGEING AND FINANCIAL STABILITY

AGEING AND FINANCIAL STABILITY. Course on Financial Instability at the Estonian Central Bank, 9-11 December 2009 – Lecture 11. E Philip Davis NIESR and Brunel University West London e_philip_davis@msn.com www.ephilipdavis.com groups.yahoo.com/group/financial_stability. Introduction.

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AGEING AND FINANCIAL STABILITY

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  1. AGEING AND FINANCIAL STABILITY Course on Financial Instability at the Estonian Central Bank, 9-11 December 2009 – Lecture 11 E Philip Davis NIESR and Brunel University West London e_philip_davis@msn.com www.ephilipdavis.com groups.yahoo.com/group/financial_stability

  2. Introduction • Focus on pitfalls for financial stability arising from ageing • Draw on extant theoretical and empirical work on these two areas • Focus is on “systemic risk” leading to heightened risk of a financial crisis, impairing provision of payments services and credit allocation • Link to retirement income security for individuals

  3. Structure • Indicators of financial instability • The ageing problem • Consequences of ageing for the macroeconomy and pension systems • Financial market effects of savings patterns • Effects on systemic risks

  4. Indicators of financial instability • Selective synthesis required of different theories • Financial fragility • Monetarist • Uncertainty • Disaster myopia • Asymmetric information and agency costs • Bank runs • Herding • Industrial

  5. Inadequacies in regulation • International aspects of financial instability • Development of macroprudential indicators • Regime shifts, first to laxity, later to rigour • Entry conditions to financial markets • Debt accumulation and asset booms • Innovation, risk concentration and lower capital adequacy

  6. Econometric work on indicators of banking crises • Often accompany currency crises (Kaminsky and Reinhart) • Highlight indicators such as GDP growth, interest rates, inflation, fiscal deficits, ratio of broad money to Foreign Exchange reserves, credit to the private sector/GDP ratio, lagged credit growth, GDP per capita, deposit insurance, financial liberalisation (Demirguc Kunt and Detragiache 2005) • Or in OECD countries, bank capital, bank liquidity and property prices (Barrell, Davis, Karim, Liadze 2009)

  7. The ageing problem • Increase in life expectancy…. • ….decline in the birth rate…. • ….giving rise to an ageing population… • ….and financial difficulties for generous pay-as-you-go systems

  8. Consequences of ageing • Growth decelerates as ageing proceeds (lower labour supply) • Investment unlikely to fill the gap (diminishing returns, crowding out) • Labour force participation and higher productivity growth could help • Private saving likely to decline, according to macro studies, possibly mitigated by pension reform… • …also public saving falls, reflecting fiscal effects

  9. System of retirement income provision also impacts on: • Growth – reduced by pay-as-you go as distortionary; funding may boost growth by improving resource allocation etc. • Saving – unfunded social security reduces saving if confidence maintained – may boost if confidence lost (precautionary saving) – switch to funding may boost saving

  10. Projections of saving, growth and investment - no clear consensus but common features: • Possibly initial rise in private saving (baby boomers), falling later • Initial balance of payments surplus, deficit later • Lower growth • Lower public saving • Flat or declining investment

  11. External imbalance depends on saving-investment pattern, possibly surplus initially for EU, later deficit • Projections: • OECD (1998) GDP growth in 2030 0.25% per annum in Japan, 1% in Europe and 1.4% in the US • All OECD run external surpluses to 2025, thereafter deficits • EU (2003), US deficit, EU and Japan surplus (enhanced risk of bubbles) • Key issue absorptive capacity of slow ageing emerging market economies (EMEs)

  12. Financial market effects of saving patterns • Pay-as-you-go • could boost precautionary saving in life insurance and bank deposits • Rise in supply of government bonds • Funding • generates increased demand for securities, also relative to deposits • Gross capital flows to EMEs, exceeding net • Eventual reduction of demand for securities • Switch from equities to bonds

  13. Systemic risks 1 – overall macroeconomic development • Initial rise in saving generating currency appreciation/loss of competitiveness, excess liquidity, asset price volatility, possible policy errors (as Japan) • Later balance of payments deficit, with risks of currency crises and exchange rate volatility accompanying banking crises • Underlines need to promote growth in EU – and slow growing EMEs…but also central bank vigilance during overall process

  14. Systemic risks 2- pay-as-you-go • Trace extreme case of no-reform • Precautionary saving owing to uncertainty • If directed to banks, may lead to underpricing of risk in domestic credit or international interbank markets • Life insurers could invest in high yield bonds, property, vulnerable to credit cycle • Case of tax finance • major economic difficulties generating credit losses and falls in asset prices, which are unlikely to be accurately anticipated • Ultimately “factor flight” especially if tax system distortionary

  15. Case of bond finance • sharp rise in long term interest rates, loss of credit rating, crowding-out, recession • Hence major credit losses for lenders (most past fiscal crises were with unliberalised banking systems) • Government’s ability to recapitalise banks declines • Ultimately fiscal-solvency crises, which could be contagious, “snowball” and temptation to monetise • In EMU, spillovers to countries that have reformed

  16. Systemic risks 3 – institutional investors • Financial structure with sizeable institutional sector should have strong stabilising properties: • Accuracy of asset pricing • Liquidity • Transparency/marking to market • Distance from safety net • “Multiple avenues of intermediation”

  17. …but risks in transition, requiring possible intervention • Further disintermediation, leading to risk taking by banks to maintain profitability • Especially where banking systems have low profitability and excess capacity • And some unfamiliar risks arise: • Extreme price volatility after a shift in expectations and asset allocations • Protracted collapse of market liquidity and issuance after similar portfolio shifts • Threat to EMEs, banks and non financial sector… • …and possibly to institutions themselves given e.g. exposure to credit risk in real estate cycles

  18. Systemic risk 4 – asset accumulation and funding • Possible effects of institutional flows on equity market in 1990s • Bubbles in debt and property feasible • Vulnerability of EMEs to institutional flows • Falls in asset prices during ageing: • Lower real returns on capital • Lower saving (“baby bust”) affecting real interest rates or risk premium • Switch from equities to bonds

  19. Estimated demographic effects on equity prices and bond yields

  20. Projected US asset prices without AGE65

  21. Projected US asset prices with AGE65

  22. Re-evaluation of theories and indicators • Public finance will play a crucial role in pay-as-you-go… • …financial instability will be more driven by institutional investor behaviour than that of banks… • … but many of the theories and indicators will remain relevant, with some reinterpretation

  23. Examples of theory adaptation: • Agency costs in relation of investor to asset manager • Uncertainty about impact of ageing on economy and financial flows • Disaster myopia about effects of ageing • Herding by institutional investors • Industrial competition among asset managers

  24. Examples of indicator adaptation: • Focus on size and composition of retirement saving flows • Debt accumulation by government and its side effects come to the fore • Relevant regime shifts may include small changes in institutional investor regulation • Exchange rate effects on the economy driven by saving flows may also come to the fore

  25. Conclusion • Process of ageing seems likely to generate major shifts in financing, leading to potential financial turbulence • Risks arising from pay-as-you-go much more serious • Funding risks partly require adaptation to “institutionalisation” which is happening in any case • Economy should be more robust with funding to withstand turbulence

  26. Policy issues include: • Reform of unsustainable pay-as-you-go • Appropriate regulation of funding and investment for institutional investors (prudent person investment, international investment) • Banks and their regulators need to be vigilant for side effects of ageing

  27. References • Davis E P (2005), "Demographic and pension-system challenges to monetary and financial stability", Geneva Papers on Risk and Insurance • Davis E P (2002), "Ageing and financial stability", in eds H Herrmann and A Auerbach, "Ageing and Financial Markets", Springer Verlag - Deutsche Bundesbank

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