Ch_02_Armour.pdf

2 The Financial System 2.1 Introduction To understand what ﬁnancial regulation is and should be doing, we need to begin by understanding the object of regulation—that is,...

2 The Financial System 2.1 Introduction To understand what ﬁnancial regulation is and should be doing, we need to begin by understanding the object of regulation—that is, the ﬁnancial system. We are all familiar with some aspects of the ﬁnancial system. As savers we deposit our money in banks or special savings institutions. As purchasers we use cheques and cash drawn from banks and borrow money from banks and specialized lenders. As investors we buy shares on the stock market and give our money to fund managers who invest on our behalf. But each of us is only exposed to a tiny fragment of the ﬁnancial system. Behind what we see is a massive engine of individuals and institutions that keep it functioning. Why is the ﬁnancial system so large and complex? Everyone needs ﬁnance in some form or another, but the needs of individuals and companies differ appreciably and the facilities that are required to satisfy their needs are diverse. Yet this diversity alone is not enough to explain the complexity we see. The complexity is multiplied by the need to relate the future to the present. The ﬁnancial system does more than simply keep capital ﬂowing round the economy today. It is also a time machine, linking the economy of today to the economy of tomorrow. That is a Herculean task and it demands a measure of sophistication that is the source of both its successes and failures. The ﬁnancial system is often distinguished from the so-called ‘real’ economy—the ﬁrms who make things or provide services and the people who consume them. The signiﬁcance of the ﬁnancial system lies in the functions it performs in relation to the real economy. It does these through intermediating between the personal sector of an economy comprising individuals and households and the corporate sector consist- ing of start-ups, small entrepreneurial ﬁrms, medium-sized enterprises, and large corporations. We will see how as companies expand the nature of their ﬁnancing needs alters, and how the ﬁnancial system responds by providing funding in a variety of different forms. This chapter will guide you through the structure and functions of the ﬁnancial system. Its purpose is not to describe in precise detail the role of all of the different components, but to give you a sufﬁcient understanding to appreciate what it does, why it matters, and what can go wrong. This will in turn give you a sense of the activity that ﬁnancial regulation seeks to cover. With that, you should be equipped to understand why, where, and how we seek to regulate and control its functioning. We begin in section 2.2 with ﬁve fundamental roles of ﬁnancial systems. These are: (i) providing a secure mechanism for payments at a distance; (ii) mobilizing capital from savers who have more ﬁnancial resources than uses for them; (iii) selecting projects from amongst those seeking investment to capital; (iv) monitoring the per- formance of those executing projects in which investment has been made; and Principles of Financial Regulation. First Edition. John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer, and Jennifer Payne. © John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N. Gordon, Colin Mayer, and Jennifer Payne 2016. Published 2016 by Oxford University Press. The Financial System 23 (v) managing risk. There are institutions and ﬁnancial instruments that monitor and manage risk and there are others that assist investors with taking risks. In section 2.3 we introduce the institutional components of ﬁnancial systems. Traditionally, these have been broken down into two components: ﬁrst, ﬁnancial intermediaries such as banks, savings and lending institutions, pension funds, mutual funds, and insurance companies; and second, ﬁnancial markets such as equity markets, bond markets, derivative and options markets, futures and commodity markets, and ancillary actors which facilitate the production and dissemination of information that enable markets to operate. We will see that each of these traditional institutional ‘pockets’ is capable of performing most, if not all, of the core functions. This begs the question as to whether there is an optimal mix, or whether one has comparative advantage over the other. That question is taken up in section 2.4. The structure of ﬁnancial systems, under- stood as bundles of ﬁnancial intermediaries and ﬁnancial markets, has varied markedly across countries. This naturally provokes reﬂection as to why it should be the case, and whether particular aspects have comparative advantages in certain contexts. In par- ticular, we emphasize the size of ﬁnancial markets in relation to domestic economic activity, the role of intermediaries as against markets, and the way in which ﬁnancial systems interact with their corporate sectors. The structure of ﬁnancial systems is far from static, however. Over the past few decades, two secular trends have reshaped ﬁnancial systems beyond recognition. The ﬁrst is the impact of globalization—in this context meaning the removal of barriers to international trade and capital ﬂows—which has transformed the functions performed by, and the way we conceive of, the ﬁnancial system from a mainly domestic to an increasingly international web of activities. This has resulted from international ﬂows of capital through banks and ﬁnancial markets, the internationalization of ﬁnancial intermediaries themselves, and, relatedly, the interconnections that have occurred as a result of the transmission of risks between actors from different domestic ﬁnancial systems. The second trend has been the growing blurring of the boundaries between the ‘intermediated’ and the ‘market’ components of the ﬁnancial system. On the one hand, market actors have begun to encroach on activities traditionally performed only by institutions; this has been mirrored by a growth in intermediaries’ investment in markets and reliance upon them for fundraising. The implication—that the traditional institutional divisions are increasingly difﬁcult to draw—is a central theme of the book. We sketch this process in section 2.5, and treat the issue more fully in Chapter 20. Finally, in section 2.6 we consider pathologies in the operation of ﬁnancial systems. Why have ﬁnancial crises occurred repeatedly in history, up to and including the global crisis that began in 2007? We will consider some of the main causes of failure, in particular, problems of information, problems of contractual failure and bankruptcy, and system-wide failures that arise from the interconnections that are described in section 2.5. By the end of the chapter, you should have a sense of what ﬁnancial systems do, how they do it, how they differ, how they interact with each other, and how and why they are subject to failure. You should be aware of the interconnectedness of the ﬁnancial 24 Principles of Financial Regulation system as a whole and how different ﬁnancial institutions and instruments perform similar roles. In particular, the chapter will suggest that the boundaries between institutions and markets are increasingly blurred and that the conventional distinction that is drawn between ﬁnancial institutions and securities markets is becoming less relevant. As subsequent chapters of the book suggest, this has important implications for the design and limitations of ﬁnancial regulation. By the end of this chapter you should therefore have an initial appreciation of the subject-matter to which ﬁnancial regulation applies, and hence the issues that lie at the heart of this book. 2.2 The Functions of Financial Systems Financial systems perform at least ﬁve fundamental roles in the economy.1 First, and most obviously, they facilitate exchange through the payments system. By providing secure mechanisms for payments conducted over large geographic distances, the payments system facilitates arm’s length transactions across the entire economy. Second, they mobilize savings from households who have funds surplus to their requirements for current consumption, permitting them to earn a return on their capital and thereby to enjoy greater consumption in the future. Financial systems provide the channel through which ﬁnancial resources in an economy can be allocated between those individuals and institutions that need them and those that have them. Typically, companies need resources to invest in plant, equipment, buildings, people, research, and the development of new ideas. Individuals save during their working lives to have money when they retire, are in ill-health, or wish to make large-scale purchases such as houses or cars. In practice it is not as straightforward as that, as some individuals need to be able to borrow to meet their family commitments or to purchase housing and some companies generate more earnings and proﬁts than they can employ themselves and so lend to others.2 We can illustrate this function by reference to the UK. Figure 2.1 shows the balance sheet of UK households and corporations between 1994 and 2007. It reveals several striking features of the composition of both groups’ assets and liabilities. First, the dominant form of asset holding of UK households is housing. Much of the debt that households raise is used to ﬁnance the purchase of houses through mortgages. The second most important asset is pensions. Saving for retirement is a critical element of household saving. Finally, a signiﬁcant fraction of household assets is bank deposits. Direct holdings of equity and other ﬁnancial instruments are relatively modest for households, reﬂecting the fact that these are primarily, in the case of the UK, owned by ﬁnancial institutions. On the liability side of the corporate balance sheet, the primary source of corporate capital is equity. Most of this does not come from raising new equity on the stock 1 R Merton and Z Bodie, ‘A Conceptual Framework for Analyzing the Financial Environment’, in DB Crane, KA Froot, SP Mason, A Perold, RC Merton, Z Bodie, ER Sirri, and P Tufano (eds) The Global Financial System: A Functional Perspective (Cambridge, MA: Harvard Business School Press, 1995), 3. 2 For further descriptions of ﬁnancial systems see F Allen and D Gale, Comparing Financial Systems (Cambridge, MA: MIT Press, 2001) and S Gurusamy, Financial Services and Systems (Noida: McGraw-Hill Education, 2008). The Financial System 25 Households £ billions 10,000 Net worth Pensions Debt Houses 9,000 Deposits Other financial assets 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1994 96 2000 03 07 Corporates 4,000 Equity and DI Net worth Other 3,500 Debt securities Deposits Loans Tangible capital 3,000 2,500 2,000 1,500 1,000 500 + 0 – 500 1,000 Liabilities Liabilities Liabilities Liabilities Liabilities Assets Assets Assets Assets Assets 1994 96 2000 03 07 Fig. 2.1 The Balance Sheet of UK Households and Corporations, 1994 to 2007 Source: R Barwell and O Burrows, ‘Growing Fragilities? Balance Sheets in the Great Moderation’ Bank of England Financial Stability Paper 10 (2011). 26 Principles of Financial Regulation market but from the proﬁts that companies retain in their businesses and do not distribute to their shareholders in the form of dividends or repurchases of shares. Loans from banks are the most signiﬁcant source of debt ﬁnance for companies. Debt securities, primarily bonds, are a comparatively modest (although still signiﬁcant in absolute terms) part of the overall capital that corporations raise. On the assets side, companies primarily invest in tangible capital, plant and equipment, and buildings. They also hold a signiﬁcant amount of shares in other companies, some of which they purchase in the process of acquiring controlling stakes in other ﬁrms. Like households, corporations also hold substantial deposits at banks to ﬁnance their day-to-day work- ing capital. In terms of changes over time, the graphs show how the accumulation of household assets increased in the UK up to the time just before the start of the ﬁnancial crisis in 2007. In particular, there was an explosion in the value of housing reﬂecting the property booms that occurred over this period. The ‘net worth’ of the household sector therefore increased appreciably. The assets and liabilities of the corporate sector also grew appreciably and on the liabilities side there was a signiﬁcant increase in both equity (predominantly retained earnings) and debt, especially loans. In particular, there is evidence of a substantial build-up of debt in the corporate sector prior to the ﬁnancial crisis. Once the ﬁnancial crisis unfolded, this acted as a signiﬁcant burden on the corporate sector, prompting a substantial decline in corporate investment and activity that exacerbated the post-crisis recession across Europe as a whole.3 In channelling capital mobilized from savers to fund projects that require invest- ment,4 ﬁnancial systems perform further crucial tasks. Their third function is to select those projects that will yield the best return. Done well, there is a virtuous circle. Getting project selection right generates more returns for savers—and hence encour- ages further mobilization of capital, while at the same time ensuring that the most valuable projects are the ones that get funded. Closely related to this is a fourth function, monitoring the performance of those projects which have received funding, ensuring that they remain true to their original promise and that those who manage their execution do not divert resources to other goals. We can also identify a ﬁfth function, which has grown in importance in recent years—the facilitation of risk management by ﬁrms and individuals. These functions are in turn of vital importance to the functioning of the real economy. A well-functioning ﬁnancial system is associated with overall economic growth, as illustrated by Figure 2.2.5 Of course, to simply point to this association does not establish the direction of causation. It might not be that the availability of ﬁnance stimulates growth, but rather that economic growth stimulates demand for ﬁnance. However, the better view is that development in the ﬁnancial system is causally important for economic growth. As a matter of theory, we have seen that the functions 3 European Central Bank (2013), ‘Corporate Finance and Economic Activity in the Euro Area: Structural Issues’, Occasional Paper, No 151. 4 Some part of this is for households who prioritize present over future consumption, but the more important component is to fund business projects that will yield goods and services for consumption. 5 See eg R Levine, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 Journal of Economic Literature 688, 688–703. The Financial System 27 180 160 140 Percentage of CDP 120 100 80 60 40 20 0 Financial Central Commercial Nonbank Stock Market Stock Market Depth Bank Assets Bank Assets Assets Capitalization Trading Low Income Middle Income High Income Fig. 2.2 Financial Structure in Low-, Middle-, and High-Income Economies, 1990 Source: R Levine, ‘Financial Development and Economic Growth: Views and Agenda’ (1997) 35 Journal of Economic Literature 688, 716. of the ﬁnancial system include the selection of good projects and the monitoring of their execution. These are crucial steps to get right to secure economic growth. And as a matter of evidence, studies document a robust association between ﬁnancial system development in 1960 and economic growth over the following thirty years.6 It seems implausible that subsequent economic growth should have generated prior demand for ﬁnance. The importance of the ﬁnancial system for the economy generally can also be framed in a negative way. The Great Depression of the 1930s was preceded by a stock market crash and coincided with a collapse of the US banking system. Ben Bernanke’s early work as an academic economist identiﬁed the channels through which banking collapse led to economic contraction.7 This is consistent with the key role banks played in selecting which projects should receive credit. Bankers specialized in making these difﬁcult decisions; their failure resulted in both a contraction in the supply of capital for investment, and in the less effective allocation of such capital as was still available through other channels. This is echoed in the dramatic contractions of economic growth that followed the ﬁnancial crisis of 2007–9.8 6 RG King and R Levine, ‘Finance, Entrepreneurship and Growth: Theory and Evidence’ (1993) 32 Journal of Monetary Economics 513. 7 BS Bernanke, ‘Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression’ (1983) 73 American Economic Review 257. See also M Friedman and AJ Schwartz, A Monetary History of the United States, 1867–1960 (Chicago: NBER, 1963). 8 However, new monetary policy measures deployed by central bankers during and after the 2007–9 ﬁnancial crisis—stimulated by a desire to avoid repeating earlier errors—helped ensure the economic consequences were generally not as severe: see B Eichengreen, Hall of Mirrors: The Great Depression, the Great Recession, and the Uses—and Misuses—of History (New York, NY: OUP, 2015). 28 Principles of Financial Regulation 2.3 The (Traditional) Components of the Financial System We have traditionally understood the ﬁnancial system as being comprised of a mixture of ﬁnancial intermediaries and ﬁnancial markets, with a range of supporting institu- tions that facilitate the effective operation of markets. As we will discuss in section 2.5 and subsequent chapters, this neat partition no longer holds. However, it is neverthe- less useful to review these respective components, and how they each perform the functions described in section 2.2. This helps to explain the historical evolution of the ﬁnancial system, and—of crucial importance for this book—the structure of the ﬁnancial regulation that has been applied to it. It provides a solid foundation for understanding the subsequent developments in the ﬁnancial system, and for framing current debates about how regulatory initiatives should best respond to them. 2.3.1 Direct intermediaries: banks Commercial banks act as intermediaries between savers and borrowers. Lenders deposit money in banks in checking deposit and time accounts, and borrowers are lent money for a variety of terms. Banks lend and borrow at ﬁxed and variable rates of interest.9 To give a sense of the extent of this intermediation activity, Figure 2.3 presents a snapshot of the balance sheets of the world’s thousand largest banks in 2011. It shows that loans accounted for approximately 40 per cent of the assets of large banks and deposits and short-term funding for nearly 60 per cent of liabilities. So a big part of what banks do is to take in deposits and lend them out as loans to the corporate and the household sectors. In so doing, banks also perform most of the functions we described the ﬁnancial system as a whole as performing for the real economy. Transactions between banks effected as agents for savers in respect of their funds on deposit with the bank perform the function of payment services. Second, banks mobilize capital by providing depositors with both a return on their investment and liquidity.10 Savers want to be able to convert (some part of) their investments to cash at short notice, in case they suffer a ﬁnancial shock—loss of employment, illness, divorce—or decide to change their consumption patterns. Many investments in business projects, however, are illiquid, meaning that investors could not get their money back in the short run without a signiﬁcant loss.11 By pooling savings from many different households, bank intermediation enables savers to get 9 There are many other institutions that perform similar functions, most notably specialist savings institutions that lend to particular types of borrowers, for example, to small and medium-sized enterprises and home owners. Some institutions such as pension funds raise money from individuals at one stage in their life, while they are working, to pay out to them when they retire. Similarly, insurance funds raise money when savers have a surplus and provide a payout based on the occurrence of some pre-speciﬁed event in the future. 10 DW Diamond and PH Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’ (1983) 91 Journal of Political Economy 401. 11 Imagine that a ﬁrm decides to invest in a new product, for example. Funds must be spent upfront on the manufacturing equipment, before sales revenue is generated. If the project were liquidated in the short run, then this would compromise its value—the machinery is unlikely to be worth as much in any other use. The Financial System 29 Fig. 2.3 Aggregate Balance Sheets of the Largest Thousand Banks in 2011 Source: Bankscope. access to the higher returns offered by illiquid investments, but still to have access to liquid funds. This works if savers’ needs for liquidity are not correlated with one another—that is, only a fraction at any time need to have access to their funds. The bank simply maintains a portion of its assets as cash or near-cash, which can be used to repay those who need funds. Banks also perform project selection and monitoring functions. To this end, their personnel develop considerable expertise in assessing the quality of credit decisions and in monitoring borrowers’ performance. Why does this need an intermediary, as opposed to investors performing this function directly? The answer has to do with economies of scale. If we assume (plausibly) an asymmetry of information between borrowers and investor—that is, borrowers know more about the quality of their projects and the actions that they take to execute them than do their investors—then investors must incur costs to screen and monitor borrowers in making effective lending decisions. If individual savers only have small amounts of capital to invest, it is not economic for them each to perform these screening and monitoring functions. Rather, it is efﬁcient for them to delegate this function to an intermediary who can then specialize in performing these functions.12 Astute readers will see that the tricky part of this analysis lies in the fact that the savers now need to worry about whether the intermedi- ary performs its job effectively, but we defer detailed discussion of this until Chapter 13. That banks’ specialized screening and monitoring have value is evidenced by the fact that when a bank re-ﬁnances a loan, other investors become more willing to advance funds to the ﬁrm. Similarly, if a bank fails, its corporate borrowers suffer a loss in value reﬂecting the fact that it will be costly for another lender to acquire the same private 12 DW Diamond, ‘Financial Intermediation and Delegated Monitoring’ (1984) 51 Review of Economic Studies 393. See also G Gorton and A Winton, ‘Financial Intermediation’, in G Constantinides, M Harris, and R Stulz (eds), Handbook of the Economics of Finance: Corporate Finance (2003). 30 Principles of Financial Regulation knowledge about its business that its original lender did, and consequently that it will become more costly for the ﬁrm to raise capital in the short run.13 Banks can in turn be divided into commercial banks, which are concerned primarily with the taking and investing of deposits and other funds which they raise, and investment banks, which provide similar services to commercial banks but using sources of funds other than deposits. Finally, banks can manage risks associated with investment at lower cost than the investors themselves. They can derive the diversiﬁcation beneﬁts from investing in a large array of assets which it would be too costly for the individual investors to hold themselves. They can hedge risks of investment in a form which might be infeasible for the ultimate investors. For all these reasons, there are signiﬁcant beneﬁts of credit intermediation through banks that cannot be derived from direct investment and as a consequence, a substan- tial amount of ﬁnancial activity is undertaken via credit intermediaries. Examples of a Small Regional Bank and a Large Commercial Bank in the US Folsom Lake Bank is a small regional bank in California. As at September 2012 it had total assets worth about $130 million. In order to acquire those assets it utilizes deposits which are about 85% of its total assets, has shares worth about 12% of its total assets, and the residual 3% comes from mortgage indebtedness and capitalized leases. The bank keeps about 5% of its assets in cash, 35% in securities most of which are issued by Freddie Mae and Fannie Mac, and 56% in loans most of which are secured by real estate. On the other hand, Bank of America Merrill Lynch (‘BAML’) is a large commercial bank in the United States. As at September 2012 it had total assets worth about $1.45 trillion. In order to acquire those assets it utilizes deposits which are about 75% of its total assets, money market funds worth 7% of total assets, and shares worth 12% of total assets. The residual 6% of funding is raised from bond markets. The bank keeps about 8% of its assets in cash, 23% in securities which are predominantly government securities, and 50% in loans for real estate, commercial and industrial use, individuals, and leases. Clearly there are a number of similarities between the two banks. However, they differ in some important respects. Most evidently, BAML utilizes money market funds and owns a broader range of assets. Other differences which are not apparent from a comparison of their balance sheets include the signiﬁcant amounts of off-balance sheet liabilities and the use of derivatives by BAML. 2.3.2 Financial markets Alongside ﬁnancial institutions such as banks are ﬁnancial markets that allow savers and borrowers to connect directly with each other. There are a large number of such markets but the most important are those for equities, bonds, commodities, derivatives, and currencies. 13 MB Slovin, ME Sushka, and JA Polonchek, ‘The Value of Bank Durability: Borrowers as Bank Stakeholders’ (1993) 48 Journal of Finance 247. The Financial System 31 Equity markets are markets where companies sell their shares to investors, thereby raising equity capital (‘primary’ markets), and investors then trade shares, usually on a stock exchange (‘secondary’ markets). Typically companies are established as private organizations in which the shares of the ﬁrm are held by a small number of, often family and closely related, shareholders. The shares will not be much exchanged and may be held for lengthy periods of time. Some of the shares may be held by venture capital ﬁrms which will look to sell their shares either to other companies, in what are known as trade sales, or on stock markets. If the latter is the exit route of the family or outside investors, then the company will access the primary market via an Initial Public Offering (‘IPO’) of its shares on a stock exchange both to sell some of the shares of the owners and to raise new capital for the company. Once listed on the exchange, the company may also raise further capital through seasoned issues. In addition to raising money in the form of equity, companies also borrow in the form of debt, which in contrast to equity pays a return as interest payments and repayment of capital. As discussed, under ﬁnancial intermediation, banks play a critical role in lending to companies. However, companies can also borrow directly from investors by issuing bonds or commercial paper. These are issued for particular periods of time—in the case of commercial paper, for less than a year—and over that period pay interest at a pre-agreed but not necessarily constant rate. In some cases the interest rate may vary in line with other interest rates in the market and in other cases they are ﬁxed for the duration of the bond. At the end of the period when the obligation matures, the principal (the amount borrowed) is repaid. In contrast, equity does not offer a pre-set return but only pays shareholders a dividend if there are sufﬁcient earnings (proﬁts) to do so. Furthermore, equity is typically permanent capital in the sense that it is never repaid to its shareholders but is retained in the company. Shareholders are merely rewarded from the uncertain dividends that they receive and the possibility of being able to sell their shares at a proﬁt (a capital gain) to other investors at some stage in the future. As in the case of equities, there are often secondary markets on which bonds are traded. This allows bondholders to sell their bonds or to purchase other bonds after they have been issued. In addition to companies, governments, international agencies, and other organizations issue bonds.14 Bond markets provide what is termed liquidity to the bonds that are traded, allowing those who hold the bonds to be able to sell their holdings easily and at low cost. They may wish to do so to invest in other bonds or other ﬁnancial instruments or because they need to make a purchase of a good or service. In both equity and bond markets, the investors are a mixture of private individuals and institutional investors. Historically, individuals were important investors on both markets but increasingly they have been replaced by institutions such as banks, insurance companies, mutual funds, and pension funds. As we will discuss later, one of the reasons for the growth of institutional holdings has been the knowledge and the 14 Governments in particular are important issuers of bonds to fund the public sector deﬁcit, which is the difference between the amounts that governments raise in the form of taxation and the amount that they spend in the form of government expenditure on public goods and services such as defence, education, and health care. 32 Principles of Financial Regulation expertise that institutions have developed in determining which ﬁnancial instruments to buy and sell. Commodity markets are the markets for trading a range of primary commodities such as foods (soya beans and wheat), metals (gold and copper), and energy (oil and gas). They are the markets in which those countries that are rich in natural resources sell their commodities to those who have a need for the commodities as part of their production and supply activities. Derivatives markets are markets on which ﬁnancial instruments based on other ﬁnancial instruments are traded. The ﬁnancial instruments are described as ‘deriva- tives’ to reﬂect the fact that their payoffs are derived from movements in other ﬁnancial securities or assets (the ‘underlying’). What these do is to allow investors to hold and trade ﬁnancial instruments whose value ﬂuctuates in line with movements in the underlying equities, bonds, commodities, or currencies without them actually having to hold the equities, bonds, commodities, and currencies themselves. Options are a type of derivative, the value of which is dependent on the price of shares or bonds being above or below certain levels. So for example, a ‘call’ option is the right to purchase a share in a company at or prior to some date in the future (the ‘expiration’ date) for a ﬁxed price (the ‘exercise’ or ‘strike’ price) in exchange for a sum usually paid upfront (the ‘premium’). The right will be exercised if the share price rises above the strike price. There are several advantages of trading derivatives as against the underlying secur- ities. First, it is possible to produce a richer array of ﬁnancial proﬁles than the underlying securities themselves offer. For example, a call option which gives a right to invest in a security at a particular strike price is only of value if the underlying security is worth more than the strike price. Otherwise the option will remain unexer- cised at the expiration date. It therefore offers an upside gain for strong performance of the underlying security while protecting the investor from losses in the event of weak performance to which those holding the security are subject. Second, it allows investors to earn returns from securities at low cost. Since the holder of a call option only has to pay if they decide to exercise the option, the purchase of an option involves small initial costs (the premium) in relation to those that would be incurred in buying the underlying securities themselves. Third, markets in derivatives may be more liquid than the underlying securities, in the sense that there is an active market in them which allows investors to buy and sell them easily. In particular, the difference between the purchase and sale prices (the ‘bid and offer’ or ‘bid and ask’ prices) can be low for derivatives in relation to those of the fundamental equities and bonds. One reason for this is the low cost at which derivatives positions are bought and sold, thereby allowing the trading of larger volumes of securities than would otherwise be the case. Another example of derivative markets are ‘futures’ markets, where contracts are traded under which parties agree to exchange securities, commodities, or currencies at a future date for a pre-set price. They thereby allow some investors to ‘hedge’ their risks by purchasing or selling futures that relate to the underlying risks of their portfolios. For example, companies seek to hedge the exchange rate risks to which they are exposed as a consequence of their trading or investment activities. Financial The Financial System 33 Global stock of debt and equity outstanding1 Compound annual $ trillion, end of period, constant 2010 exchange rates growth rate % 1990–09 2009–10 212 202 201 7.2 5.6 179 Stock market 175 54 48 capitalization 8.1 11.8 155 65 34 55 Public debt securities 45 37 41 outstanding 7.8 11.9 114 30 32 28 Financial institution 36 25 44 42 bonds outstanding 9.5 –3.3 41 41 72 35 Nonfinancial corporate 16 29 8 9 10 bonds outstanding 6.7 9.7 54 17 7 8 15 19 6 15 16 16 Securitized loans 9 11 13 11 14 12.7 –5.6 8 3 11 6 5 outstanding 3 3 38 40 43 45 47 49 Nonsecuritized loans 2 22 24 31 4.1 5.9 outstanding 1990 95 2000 05 06 07 08 09 2010 Financial 261 263 321 334 360 376 309 356 356 depth2 1 Based on a sample of 79 countries. 2 Calculated as global debt and equity outstanding divided by global GDP. NOTE: Numbers may not sum due to rounding. Fig. 2.4 Global Debt and Equity Markets Source: McKinsey Global Institute. institutions seek to hedge interest rate risks and commodity producers offset commod- ity price ﬂuctuations. On the other side of the market, when the counterparty does not itself hedge the risk it is taking by similarly buying protection against adverse price movements, futures markets allow investors to speculate on movements in the under- lying asset price. The currency (or foreign exchange—‘forex’) market is the market in which parties exchange one currency for another, say US dollars for British pounds. It is by far the largest market in the world and is dominated by international banks acting as dealers— that is, trading on their own account, often with each other. The forex market includes the spot market, in which currencies are traded at the current market price and transactions are immediately executed, and the derivatives forex market, which has currencies as the underlying asset. Figure 2.4 shows that the world’s stock of debt and equity outstanding amounted to over $200 trillion in 2010. That compares with a total world Gross Domestic Product (GDP) of approximately $60 trillion. So the stock of outstanding debt and equity is more than three times global GDP. Within that, Figure 2.4 shows that global stock markets accounted for approximately $50 trillion in 2010 and the remainder is bonds and loans. Bonds, including public sector debt securities, amounted to around $100 trillion and the remainder is loans. The ﬁgure shows that there was a particularly rapid growth in securitized lending (namely, loans that were sold on to other institutional investors in securitized forms) from the beginning of the 2000s. Interestingly, well-functioning ﬁnancial markets are capable of performing the same functions as traditional bank intermediation. Where ﬁrms issue securities that are traded in liquid markets—that is, there is a lot of trading activity, meaning that 34 Principles of Financial Regulation investors who wish to sell their shares in a particular company can readily ﬁnd a buyer—then investors can achieve liquidity. Rather than pooling their savings with other investors in the hands of a bank, they exit the investment by selling their claim to another investor. There is no need to liquidate the underlying project. Offering investors liquidity means that markets can mobilize savings effectively. Markets can also perform project screening and monitoring functions. They do this through the price mechanism. As Chapter 5 will explain in more detail, in a well- functioning capital market, the price serves to aggregate information about the expected value of the activities of securities issuers. In making investment decisions, savers and speculators are making assumptions about the likely prospect for econ- omies, ﬁrms, and markets. They invest where they hold a positive view about future prospects and they withdraw funds and sell ﬁnancial instruments where they hold a negative view. These ﬂows in and out of ﬁnancial instruments, institutions, companies, and markets affect the prices at which they trade and these prices in turn reﬂect the information that individuals have about their likely future prospects. Buoyant expect- ations result in high prices and negative sentiment in low prices. If corporate managers use the stock price as a guide to their investment decisions, which corporate governance practices have increasingly encouraged them to do,15 then the market’s aggregation of public information serves to guide project selection and monitoring. In essence the market is a large machine for collecting the information of everyone participating in markets and producing prices that reﬂect that information. In some markets, such as stock exchanges and bond and commodity markets, there are computers which do exactly that. In many cases the prices reﬂect the trades of a large number of individuals that do not necessarily pass through a central computer. Whatever the mechanism, ﬁnancial markets are potentially a vital source of informa- tion about individuals’ views of future ﬁnancial performance. This brief survey suggests that there is an important degree of substitution between banks and ﬁnancial markets in performing the basic functions of the ﬁnancial system. Indeed, the only one of the core functions of the ﬁnancial system that cannot readily be performed by markets is payments. 2.3.3 Market-facilitating institutions Markets are generally complemented by a number of institutions that assist in their functioning. A uniting theme is the production and analysis of information that assists in the pricing process. Most obvious amongst these are equity analysts and credit rating agencies (CRAs), which facilitate price formation by analysing information about the performance and valuation of equities and bonds, respectively. Credit rating agencies evaluate the ﬁnancial soundness of companies, ﬁnancial institutions, and governments that issue bonds and other ﬁxed-income securities. Equity analysts evaluate the likely future prospects of shares of individual companies and make recommendations of whether investors should buy or sell the shares. We discuss these intermediaries further in Chapter 6. 15 See Chapter 17, especially section 17.2. The Financial System 35 Example of Credit Rating Agency and Equity Analyst Standard & Poor’s (S&P) is one of the three big credit rating agencies. The other two are Moody’s Investor Service and Fitch Ratings. In the United States an institution is able to provide a credit rating after being designated a Nationally Recognized Statistical Rating Organization (NRSRO) by the Securities and Exchange Commission (SEC). There are currently ten ﬁrms, including the big three, with the NRSRO designation. S&P is paid by issuers of public and private debt to provide a rating (which is an opinion) on debt instruments on a scale from AAA to D. The ratings are used by investors to determine the credit risk of issuers. They are both a simple and a standardized way to convey information about the credit risk of the issuer. The ratings are also used in capital and liquidity requirements for ﬁnancial and institutional investors. Equity analysts are not institutions but individuals within an institution. They provide a recommendation to investors to buy, sell, or hold a share, frequently focusing on particular sectors of the market, such as engineering and construction. They are generally distinguished on the basis of being buy-side or sell-side. Sell-side analysts are employed by an investment bank, while buy-side analysts are employed by an institutional investor or an independent research ﬁrm that sells its reports to investors. Perhaps the most important information intermediaries, however, are investment banks. Investment banks help companies to raise money when they come to stock markets for the ﬁrst time (IPOs) and when they are raising additional equity capital (so-called ‘seasoned’ issues) and debt. They assist governments and public sector organizations to issue bonds on primary markets. They organize the creation and distribution of new securities, such as derivatives, which allow investors to hedge risks, for example, from foreign currency or interest rate ﬂuctuations. The key role per- formed by the investment bank in all these instances is that of setting the price for the security on the primary market—that is, establishing the market price before the standard information-aggregation mechanism that is secondary trading has begun.16 Activities of Investment Banks Investment banks have historically performed four main activities that generate fees or result in speculative earnings. First, their traditional function is providing advisory and underwrit- ing services to ﬁrms. This activity involves investment banks identifying or assisting ﬁrms to issue equity or debt securities. It also involves identifying potential investors and generating information to ascertain a market price for the securities. Finally, an investment bank underwrites (guarantees) that the securities will be sold at a particular price to give comfort to the issuing ﬁrm that the securities will be sold. A second activity of investment banks that is also related to the functioning of securities markets is brokerage: when acting as a broker, the investment bank executes trades on the market on behalf of its customers. Sometimes, investment banks also execute clients’ orders by entering into the contract themselves on the other side, in which case they act as dealers. The third activity of investment banks consists of asset management. Asset management generates fees from the investment advice and portfolio management services provided to 16 AD Morrison and WJ Wilhelm Jr, Investment Banking: Institutions, Politics, and Law (Oxford: OUP, 2007), Ch 1. 36 Principles of Financial Regulation retail and institutional clients. It includes funds management services to retail and institu- tional clients and acting as prime brokers for institutions such as hedge funds.17 Fourth, from the 1980s onwards, investment banks increasingly began to engage in trading and principal investment using their own funds. This activity requires the investment bank to either speculate or hedge its exposure. For instance, an investment bank might speculate as a limited partner in a private equity ﬁrm. Similarly an investment bank might own a hedge fund management company. Another example of speculation is an investment bank acting as counterparty in an over-the-counter derivatives arrangement. The investment bank could be approached by a Brazilian agricultural exporter wanting to eliminate ﬂuctuations between the real and the US dollar. The investment bank may act as counterparty to the exporter. It might then eliminate its exposure to the US dollar by entering itself into a currency swap with another counterparty. Proprietary trading can also take the form of market making, by which the investment bank declares itself ready at the same time to buy and sell a given securities at two different prices, one lower (the bid price) than the other (the ask price), thus providing liquidity to the market for that security. This is often done by posting ‘quotes’ on an exchange. Since the ﬁnancial crisis, policymakers have sought to distinguish between market- making, which is vital for the functioning of securities markets, and ‘pure’ proprietary trading, which involves simply participating in such markets. As we will see in Chapter 23, this distinction is far from straightforward to apply. Secondary trading itself requires institutions that facilitate the matching of buyers and sellers. This was for centuries the exclusive job of exchanges. Historically, these were organized as physical locations (trading ﬂoors) on which individuals made of ﬂesh and blood (its ‘members’) traded the securities. Over the last few decades trading ﬂoors have been replaced by computers that automate the process by which the prices of shares are determined and the markets are ‘cleared’ (demands for shares are brought into line with the supply by ﬁnding a price at which the two are equated). Nowadays, a number of intermediaries similarly contribute to facilitating secondary trading: other liquidity services providers, such as alternative trading systems, compete with exchanges in the supply of liquidity services, while central depositories and clearing and settlement institutions provide ancillary services. As reported in the text box above, investment banks also contribute to secondary market liquidity by acting as market makers, dealers, and brokers. We discuss these intermediaries further in Chapters 5 and 7. 2.3.4 Asset managers Finally, some intermediaries specialize in the management of retail investors’ ﬁnancial assets by investing in publicly traded securities on their behalf. They also qualify as market-facilitating institutions, in that they facilitate retail investors’ access to secur- ities markets in three ways: ﬁrst, they let them beneﬁt from diversiﬁcation, however small the amounts they have to invest; second, they choose investments on their behalf based on their supposedly superior expertise; ﬁnally, they execute investment decisions at a lower cost given their larger size. 17 Prime brokers are investment dealers which offer brokerage, lending, clearing and settlement, custody, and other services to hedge funds and other institutional investors. The Financial System 37 The core examples of this type of intermediary are collective investment manage- ment schemes. In particular, mutual funds—or, in EU parlance, ‘UCITS’ (Undertak- ings for Collective Investment in Transferable Securities)—pool the capital of investors and invest it collectively. There is little or no investment risk borne by the asset manager itself—all the risk is borne by the ultimate investors. Mutual Funds Mutual funds are investment companies that pool investors’ capital to invest it collectively as a single portfolio. Total worldwide assets invested in mutual funds in 2011 amounted to US $23.8 trillion. The mutual fund industry offers investors a number of beneﬁts. First, investors can quickly liquidate their positions. Liquidity intermediation is a recent development that differentiates the modern open-end mutual funds from their closed-end predecessors. Second, by pooling the resources of different investors, mutual funds allow them to access securities they may not have otherwise had the capital to invest in. Third, mutual funds provide a way for investors to diversify their portfolio of securities. Fourth, because of the size of mutual funds they may incur lower transaction costs for executing trades than an individual investor. Finally, retail and institutional investors display a preference for having a professional money manager make their investment decisions. This preference exists despite empirical evidence that suggests that mutual fund managers frequently underperform the market. BlackRock is an asset management ﬁrm and operates one of the largest mutual fund complexes in the world. In 2012 BlackRock had US$3.8 trillion in assets under management and generated revenue of US$9.3 billion. BlackRock mutual funds pool the assets of investors to purchase a number of different securities. There are four primary classes of mutual funds: equity funds, bond funds, hybrid funds, and money market funds. BlackRock generates its revenue from management fees and advisory, administration, and securities lending agreements. Other ﬁnancial intermediaries, such as pension funds and insurance companies, also have signiﬁcant asset management functions. Pension funds invest for the long term in assets that will beneﬁt employees on retirement and insurance companies offer pro- tection to the insured against risks of loss sustained on their property and themselves. They do so by investing contributions, fees, and premiums levied in assets that yield returns and in this regard act in a similar fashion to asset management ﬁrms. Unlike these, however, they bear of course the risks they ensure their policyholders against. The combination of markets and intermediaries specializing in asset management poses a fundamental question. If markets serve to aggregate information for investors, what role do these institutions play in monitoring and screening investments? The answer depends on how well the market in question functions. For highly liquid markets—such as shares in large companies on the FTSE100 or the S&P 500—there is probably little that asset managers’ expertise can add that the market price does not already ‘know’. In this case, by pooling their funds in the hands of an asset manager, investors mainly aim to beneﬁt from diversiﬁcation and gain economies of scale on the transaction costs of buying and selling shares. On the contrary, expertise regarding 38 Principles of Financial Regulation investment decisions is less likely to yield any gains for investors in such asset class. That is why passively managed funds, which limit themselves to replicating a market index, have become increasingly popular in the last twenty years, especially in their exchange traded variety (exchange traded funds or ‘ETFs’).18 How Mutual Funds Assist Savers with Diversifying Risks A mutual fund is able to pool the savings of a broad range of savers in a wider range of investments than any individual investors on their own could make. For instance, in order to purchase shares in a company, a saver might need to spend a minimum of £100. In order to purchase company debt, the minimum cost might be £10,000 and to purchase a commodity it might be £500. A saver who only has £300 is unable to invest in securities other than shares. However, by investing in a mutual fund he can get access to these other asset classes. This is because a mutual fund is able to pool the savings of other savers such that a proportion of our saver’s £300 can be invested in shares, company bonds, and commodities. On the other hand, where the securities are in less liquid markets, then the markets cannot be expected to price them so accurately. In this case, specialist asset managers can add value for investors (so-called ‘alpha’) through the screening and monitoring of the investments in question. At the extreme, specialist asset managers focus on particu- lar types of market, or on particular types of risk. These offer investors the opportunity to share the costs of buying into the expertise of the manager in question. Some of these funds have traditionally marketed themselves to sophisticated investors only and thereby avoided the regulatory regime otherwise applicable to collective investment schemes. Such funds are known as ‘hedge funds’ or ‘alternative investment funds’.19 A Hedge Fund Greenlight Capital is a hedge fund founded by David Einhorn in 1996. It described itself as a value oriented, research driven investment management fund. Hedge funds are usually established as partnerships or limited liability companies with the funds managed by individuals such as Mr Einhorn. By the end of 2012 the fund had earned an annual 8.3 per cent on invested capital. Hedge funds like Greenlight obtain funding from savers such as sophisticated retail investors and institutional investors and channel those funds into a broad range of securities. Greenlight invests primarily in company shares and debt. It is particularly well known for taking short positions in stocks (ie betting that the stock price will decrease once the market price reﬂects unfavourable information that Mr Einhorn and his team will have unearthed based on their own research) and for seeking change in how companies are managed as an active investor. Before Lehman Brothers’ collapse in September 2008, Greenlight had held a short position on its stock for months and Mr Einhorn had repeatedly attacked Lehman for having fudged its numbers and being seriously undercapitalized. 18 See further Chapters 11 and 22. 19 See generally, RM Stulz, ‘Hedge Funds: Past, Present, and Future’ (2007) 21 Journal of Economic Perspectives 175. The Financial System 39 2.4 International Differences in Financial Systems One of the striking features of ﬁnancial systems around the world is the extent to which they differ across countries. First the size of ﬁnancial systems varies appreciably across countries. Table 2.1 shows the level of savings and investment as a proportion of GDP in Australia, Canada, China, the EU, Hong Kong, India, Japan, Singapore, the UK, and the US. It also shows the stock of ﬁnancial assets held by individuals as a proportion of GDP. Of the world’s $200 trillion of ﬁnancial assets in 2010, $60 trillion of them are held by US residents, $50 trillion by European residents, just under $50 trillion by Japanese and Chinese residents, and the remaining $40 trillion spread around citizens of the rest of the world. In total, households hold nearly $90 trillion of the world’s ﬁnancial assets, pensions and life insurance companies around $50 trillion, and the corporate sector about $40 trillion. Households in the US, Europe, and Japan, pension funds in the US, and banks in Europe are particularly signiﬁcant investors in ﬁnancial assets, holding more than $10 trillion each. More striking than the variation in the size of savings and holdings of ﬁnancial assets are the differences in the mix of components discussed in section 2.3. Figure 2.5 shows the capitalization of stock markets, compared with the size of the economy— represented by GDP—for several major economies in 2011. As can be seen, the market capitalization in the US and UK is larger than GDP, whereas in the EU as a whole, and in important growth markets such as China, India, and Brazil, stock market capitalization is much lower relative to the size of the economy. This implies that less capital is channelled to business through the stock market, with correspondingly more being intermediated by banks.20 Not all ﬁnancial transactions take place on exchanges. Some are done directly between traders in bilateral ‘over-the-counter’ (or ‘OTC’) transactions. Figure 2.6 shows that in 2011 around two-thirds of OTC derivatives transactions were associated with interest rate contracts on debt instruments; 10 per cent of trades were related to foreign exchange (currency) trades and the remainder were credit default swaps (used to exchange the risks on the underlying credits), equity, and commodity linked contracts. In total, outstanding OTC derivatives trades amounted to around $700 billion. One reason for the pronounced variation in the size and nature of ﬁnancial systems is the different functions that they perform. In particular, the way in which corporate sectors ﬁnance themselves varies appreciably among countries. For example, stock markets play an important part in corporate ﬁnancing in some but not all countries, whereas banks tend to be of considerable signiﬁcance in most countries. Similarly, the signiﬁcance of bond markets for the ﬁnancing of corporations varies from the US, where it is critically important, to some Continental European countries, where it remains of modest importance. Table 2.2 shows the way in which corporations funded their activities over thirty years to the end of the last century in four countries: 20 See F Allen and D Gale, Comparing Financial Systems (Cambridge, MA: MIT Press, 2001). Table 2.1 Savings and stocks of ﬁnancial assets held by individuals, as proportion of GDP Financial assets owned by residents, 2010 ($ trillion) Other United Western devel- Other Latin Rest of States Europe Japan China oped Asia America MENA World Total Households 27.0 23.0 11.6 6.5 4.1 5.4 3.5 3.7 1.4 85.2 Institutional investors. Pensions 15.0 5.3 3.3 0.5 2.4 0.6 0.7 0.4 0.1 28.3. Insurance 6.6 9.6 3.5 0.6 0.7 1.0 0.3 0.1 0.3 23.0. Endowments & foundations 1.1 0.2 0.0 – 0.1 – 0.0 0.0 – 1.5 Corporations. Banks 4.0 11.9 6.7 3.9 1.4 0.9 0.9 0.5 0.5 30.7. Nonfinancial corporations 2.0 1.7 1.2 3.8 0.3 1.3 0.3 0.2 0.2 11.0 Governments. Central banks 2.3 1.7 1.0 2.5 0.2 1.9 0.5 0.4 1.5 12.0. Sovereign wealth funds 0.1 0.6 – 0.7 0.1 0.9 0.1 1.7 0.2 4.3. Other government – – – 1.1 – 0.4 0.5 0.3 0.1 2.4 Total 58.1 54.0 27.3 19.8 9.3 12.4 6.8 6.3 4.3 198.1 Notes: ‘Other developed’ countries include Australia, Canada, and New Zealand. ‘Other Asia’ countries include both developed countries and emerging markets. ‘Pensions’ include defined contribution plans and individual retirement accounts. Total numbers may not sum due to rounding. Source: McKinsey Global Institute. The Financial System 41 20000 18000 16000 14000 12000 10000 8000 6000 4000 2000 0 US EU Germany UK France Australia China Japan India Brazil GDP Stock mkt cap Fig. 2.5 Stock Market Capitalization and GDP for Leading Economies, 2011 ($bn) Source: World Bank, World Development Indicators. Global OTC derivatives National amounts outstanding, in $trn1 750 500 250 0 2006 2007 2008 2009 2010 2011 1 By data type and market risk category. Interest rate Other Equity CDS Foreign exchange Commodities Fig. 2.6 Size of Global OTC Derivative Markets Source: Bank for International Settlements. Germany, Japan, the UK, and the US. It records that the dominant source of ﬁnance is internal, namely the proﬁts of businesses that are not distributed as dividends. These account for between three-quarters of corporate funding in Japan and Germany and over 90 per cent in the UK and the US. Most of that goes towards funding the replacement of the existing capital stock. 42 Principles of Financial Regulation Table 2.2 Net sources of ﬁnance for corporations in Germany, Japan, the UK, and the US, average 1970–98 Germany Japan UK US Internal 78.9 69.9 93.3 96.1 Bank ﬁnance 11.9 26.7 14.6 11.1 Bonds 1.0 4.0 4.2 15.4 New equity 0.1 3.5 4.6 7.6 Trade credit 1.2 5.0 0.9 2.4 Capital transfers 8.7 — 1.7 — Other 1.4 1.0 0.0 4.4 Statistical adjustment 1.2 0.0 8.4 8.3 Source: J Corbett and T Jenkinson, ‘How is Investment Financed? A Study of Germany, Japan, the United Kingdom and the United States’ (1997) 65 The Manchester School S69. Of external sources of funding, loans from banks are the most important in all countries. However, bond markets play a signiﬁcant role in North America and increasingly in Europe since the development of the corporate bond market at the end of the 1990s and the ﬁrst decade of this century. New equity is a small and in some cases negative source of ﬁnance for ﬁrms. The negative ﬁgures reﬂect the fact that corporations purchase as well as sell equity. In particular, they purchase equity in other ﬁrms when they take them over and buy the shares of the companies they are acquiring.21 They also repurchase their shares from their shareholders. Takeovers and share repurchases are particularly signiﬁcant in the UK and the US—hence the negative ﬁgures in those two countries. While stock markets are not in aggregate a large net source of capital for corporate sectors in developed economies, they are very important for two particular groups of ﬁrms: ﬁrst, new equity is a vital source of funding for start-ups and small companies; and second, they are a much larger source of funding of enterprises in developing and emerging markets than in developed economies.22 In other words, large well-established ﬁrms in developed economies tend to buy a lot of shares in acquisitions and repayment of capital whereas small start-up companies, particularly in developing and emerging economies, tend to raise a large amount of capital. An important source of ﬁnance for ﬁrms in their early stages of development is their own capital and that of families and friends. Informal sources of ﬁnance are the primary way in which ﬁrms get going. In some cases, they raise funding from wealthy private individuals, business angels that are often actively involved in the development of the ﬁrm. External early stage funding may come from venture capital ﬁrms that raise money from a variety of sources including institutional investors such as pension funds, life insurance companies, and university endowments. These investors frequently 21 See J Franks, C Mayer, P Volpin, and HF Wagner, ‘The Life Cycle of Family Ownership: International Evidence’ (2012) 25 Review of Financial Studies 1675. 22 See eg M Isakssob and S Çelik, ‘Who Cares? Corporate Governance in Today’s Equity Markets’, OECD Corporate Governance Working Paper No 8 (2013). The Financial System 43 Syndicated Credit Facilities (2011) (by borrower nationality) Value of Syndicated Credit Facilities (in billions) 1000 600 200 0 Australia Canada Japan United Kingdom United States Hong Kong SAR Singapore China India Europe Fig. 2.7 Syndicated Bank Finance Source: Bank for International Settlements. seek a way of exiting from the investments within a period of ﬁve to seven years by selling the ﬁrms on stock markets as IPOs or trade sales to other ﬁrms.23 Once established, the main external source of ﬁnance for ﬁrms is bank borrowing. In evaluating the creditworthiness of a borrower, loan ofﬁcers use several sources of information. These relate primarily to: (i) accounting data—balance sheets, proﬁt and loss statements, and ﬁnancial ratios of, for example, leverage, and earnings coverage of interest payments; (ii) projections of cash ﬂows; (iii) information about the sector in which the ﬁrm is operating; (iv) the ﬁrm’s customers and suppliers; (v) the account history of the borrower; (vi) judgemental information on the quality of management; and (vii) collateral and personal security of the directors that can be provided in the event of a ﬁrm default. The other source of debt ﬁnance for companies is bonds, which are usually under- written by commercial and investment banks, often acting as a ‘syndicate’ coordinated by one or more lead managers, and then placed directly or via other banks among institutional and retail investors. Figure 2.7 shows the value of syndicated credit facilities outstanding in 2011 across various countries. Another important cause of differences in the nature of ﬁnancial systems is the way in which pension provisions for retired employees are structured. In some countries they are primarily provided by the state and the state uses tax revenues to fund retirement schemes. In other countries, such as Germany, corporations fund their own pension schemes. In contrast, in the UK and the US, pension funds are established 23 See generally, P Gompers and J Lerner, The Venture Capital Cycle, 2nd ed (Cambridge, MA: MIT Press, 2004). 44 Principles of Financial Regulation independently of both companies and the government, and invest contributions in ﬁnancial assets, such as equities and bonds. Given the scale of pension funds, a funded scheme that is invested through ﬁnancial markets augments the size of bond and stock markets appreciably. 2.5 Changes in the Financial System The structure of the ﬁnancial system is not static, but subject to near-continuous evolution. In this section, we highlight two of the biggest changes of the past thirty years. These are the impact of globalization and consequent growth of international connections between domestic ﬁnancial systems, and the blurring of the boundaries between banks and markets. 2.5.1 International ﬂows of ﬁnancial services While the foregoing discussion has placed a great deal of emphasis on national ﬁnancial markets and the differences that exist across countries, increasingly ﬁnancial markets are becoming integrated across borders. There are three principal drivers for this development. The ﬁrst is the scale of international ﬂows of capital across borders, especially after most states abandoned capital controls and embraced global trade in the 1970s and 1980s. The second is developments in information and communication technology, which have greatly facilitated ﬁnancial transactions among parties in distant locations. The third, which follows from the other two, is the internationaliza- tion of ﬁnancial institutions and the multinational nature of their operations. Table 2.3 provides data on companies cross-listed on US exchanges (NYSE, NAS- DAQ, and AMEX). It shows that in the forty-six countries surveyed, approximately 5 per cent of the companies are cross-listed in the US. Cross-listing clearly gives ﬁrms access to US investors because as can be seen from the table, the average holding by US investors of the cross-listed ﬁrms is appreciably higher than of non-cross-listed ﬁrms. By cross-listing, companies may therefore have access to deeper overseas capital markets. One reason for cross-listing may therefore be to gain access to larger and more liquid foreign markets which assist companies with raising ﬁnance at lower cost. A second motivation could be that the quality of regulation of foreign stock exchanges is greater than that of domestic ones and companies may seek overseas listings as a way of demonstrating their quality. For example, it has been argued that companies have cross-listed on the New York Stock Exchange and NASDAQ as a way of demonstrating that they can meet the exacting standards of these exchanges and, as importantly, of the US regulatory framework.24 24 See eg C Doidge, GA Karolyi, and RM Stulz, ‘Why Are Foreign Firms Listed in the US Worth More?’ (2004) 71 Journal of Financial Economics 205. The Financial System 45 Table 2.3 Cross-listing of shares in 1997 Firm Market Capitalization Firm Market Float Available Available Number of ﬁrms available 12,236 8,528 Number of countries 46 46 Total market value of equity ($bn) 11,080 5,927 Value of US holdings ($bn) 1,020 802 Implicit share held by US investors 9.2% 13.5% Firms cross-listed on a US exchange 498 293 Average share held by US investors 17.5% 26.3% Average share held in ADR form 6.4% 12.4% Firms not cross-listed on US exchange 11,738 8,235 Average share held by US investors 2.9% 5.6% Note: This table reports aggregate US holdings, the number and market capitalization of the sample ﬁrms, and US holdings in cross-listed and non cross-listed ﬁrms. Data on the value of US holdings are from the US Treasury/Federal Reserve Board survey of US holdings of foreign securities. Market capitalization ﬁgures are from Worldscope. Market ﬂoat is calculated by scaling market capitalization by the ﬁgure given in Worldscope’s closely held share ﬁeld. A non-US ﬁrm is labelled as cross-listed if its shares are listed on the NYSE, AMEX, or NASDAQ. Level I ADRs trade only on OTC markets and are not considered to be cross-listed on a US exchange. Source: J Ammer, SB Holland, DC Smith, and FE Warnock, ‘Why Do US Cross-Listings Matter?’ FRB International Finance Discussion Paper No 930, 26 (2008). Table 2.4 Foreign bond issuance ($bn), and as a percentage of GDP, 2011 Region/Exchange Foreign GDP % of GDP Americas NYSE Euronext (US) 0.00 2,517.90 0% TMX Group 0.04 1,758.70 0% Asia-Paciﬁc Hong Kong Exchanges 15.52 246.90 6% National Stock Exchange India 0.09 1,843.40 0% Osaka Securities Exchange 0.00 5,855.40 0% Shanghai Stock Exchange 0.00 6,988.50 0% Shenzen Stock Exchange 0.00 6,988.50 0% Tokyo Stock Exchange Group 0.00 5,855.40 0% Europe Deutsche Börse 21,722.18 3,628.60 599% Luxembourg Stock Exchange 8,085.25 62.90 12854% Oslo Børs 0.86 479.30 0% SIX Swiss Exchange 312.94 665.90 47% Weiner Börse 103.31 425.10 24% Notes: GDP is IMF estimated data for 2011. TMX Group owns and operates Toronto Stock Exchange and TSX Venture Exchange. Source: World Federation of Exchanges. International ﬂows of bond ﬁnance are particularly signiﬁcant. In the face of regulations on bond ﬁnance in the US in the post Second World War period, many US companies raised bond ﬁnance from overseas, in particular European, bond markets. The ‘Eurobond’ market emerged as a way of satisfying the demand for 46 Principles of Financial Regulation Table 2.5 Number of Countries of Operation of Leading Multinational Banks Bank Group Name Home No of Host Country Country Subsidiaries Banco Bilbao Vizcaya Argentaria SA ES 12 AR, CL, CO, MX, PE, PT, US, VE Banco Santander SA ES 13 BR, CL, DE, MX, PT, GB, US, VE Bank of America Corp US 2 BR, GB Barclays Bank plc GB 2 ES, ZA Bayerische Hypo- und Vereinsbank DE 9 HR, CZ, HU, PL, RU, AT AG BNP Paribas FR 3 IT, US Citicorp US 5 BR, CA, MY, MX, PL Commerzbank AG DE 3 NL, PL, SK Deutsche Bank AG DE 6 AU, IT, ES, US HSBC Holdings plc GB 12 BR, CA, FR, DE, HK, IND, MY, MX, SA, US Royal Bank of Scotland plc GB 3 IE, US Société Générale FR 4 AU, CA, CZ, DE Standard Chartered plc GB 5 HK, KE, KR, MY, TH UBS AG CH 2 GB, US UniCredit SpA IT 10 BG, HR, CZ, DE, HU, IE, PL, RU WestLB AG DE 6 BE, BR, FR, IE, PL, RU Country names are according to ISO 3166-2 classiﬁcation. Source: R De Haas and I Van Lelyveld, ‘Multinational Banks and the Global Financial Crisis: Weathering the Perfect Storm?’ (2014) 46 Journal of Money, Credit and Banking, 333, 337, 358 (identifying as ‘signiﬁcant’ subsidiaries those accounting for at least 0.5 per cent of parent-bank assets and that are at least 50 per cent owned by the parent). overseas bond ﬁnance. International capital ﬂows of bond ﬁnance have grown mark- edly since then, with governments, international agencies, as well as companies raising ﬁnance on international capital markets. Table 2.4 shows the scale of foreign bond issuance on various exchanges. In addition to international ﬂows of capital, ﬁnancial institutions have become increasingly internationally global in their operations. Table 2.5 shows the number of countries in which some of the leading international banks have a signiﬁcant presence. The signiﬁcance of international ﬂows of capital and the internationalization of banks comes in terms of the international linkages that these create among the ﬁnancial systems of different jurisdictions. Whereas at one stage it was possible to insulate a country’s ﬁnancial system from the effects of failures elsewhere in the world, that has become increasingly difﬁcult to achieve. Shocks in one country are rapidly transmitted to institutions and markets abroad. A clear example of that was the failure of Lehman Brothers in the US. Its failure and the refusal of the US authorities to rescue it had widespread repercussions around the world. The process of untangling the complex set of obligations that Lehman Brothers had to investors and other institutions from all over the world is still in process and will continue for many more years. We explore the consequences of inter-linkages between ﬁnancial institutions and markets in the next section. The Financial System 47 The International Consequences of the Failure of Lehman Brothers The Lehman Brothers (Lehman) failure had international consequences in at least ﬁve ways. First, it affected international clients of the institution. For instance, hedge fund clients were unable to exit positions with Lehman. Second, international credit markets reassessed the existence of an implicit guarantee behind institutions like Lehman which were thought to be too-big-to-fail. The market had previously priced a credit discount for institutions such as Lehman that were believed to be beneﬁciaries of implicit government guarantees. The repricing (temporarily) removed that discount. Cash-poor institutions found it very difﬁcult to borrow. Third, institutions that were unable to obtain credit were forced to sell their assets in order to satisfy their debts. Fourth, because of the pressure to hold liquid assets, ﬁnancial institutions had neither the capacity nor the willingness to provide credit to companies with investment projects. Fifth, fearing the failure of more institutions and the detrimental effect of ﬁnancial institutions providing credit to institutions in the real economy, governments around the world borrowed funds to bail out ﬁnancial institutions. Many European countries were forced to bail out their largest institutions. Irish and Icelandic institutions had to receive signiﬁcant bail-outs which in turn threatened the solvency of their governments. The solvency of governments across Europe is now constantly being scrutinized by investors as the consequences of the failure of Lehman continue to be felt. 2.5.2 Interconnections between banks and markets Collective investment schemes and asset managers have grown dramatically around the world. This has meant that banks have been responsible for a declining share of the total amount of funds intermediated. This change has been driven in part by tax incentives to save for retirement, but also by growing efﬁciency of stock markets, meaning that collective investments offer comparable liquidity and higher returns than bank savings accounts. As a result, banks have been under competitive pressure. We describe this phenomenon in more detail, and analyse its consequences, in Chapter 20. At the same time, banks have become more directly reliant on ﬁnancial markets themselves. Banks increasingly raise funds from the money markets in which banks lend and borrow from each other (inter-bank markets) and from bond markets in which they raise funds over longer periods from individual and institutional investors. And, through investment banking arms, they have invested directly into markets. Relatedly, non-bank institutions—often linked to, or sponsored by, banks—have stepped into the credit intermediation role traditionally performed by banks. Most signiﬁcant amongst these are ‘shadow banks’ and special purpose vehicles used for securitization.25 Shadow banks—discussed in detail in Chapter 20—perform many of the functions of banks—lending and savings—without being deposit-taking institu- tions or being regulated as banks by the central authorities. Examples of shadow banks include money market funds, which provide investors with similar savings and trans- action functions to banks, but rather than lending their assets to companies and individuals invest in liquid money markets, and ﬁnance companies, which originate 25 See section 1.2. 48 Principles of Financial Regulation loans to borrowers, funded through wholesale ﬁnance markets.26 These shadow banks extend the range of services offered to savers and borrowers, make the market for these services more competitive, and allow banks to delegate some of their activities such as mortgage lending to these institutions. 2.6 Where Financial Systems Go Wrong This chapter has described the structure and functioning of ﬁnancial systems. But really the focus of the book is on the malfunctioning of ﬁnancial systems and what needs to be done to avoid and correct it. What we have described as the strengths of ﬁnancial systems are also often the source of their weakness. For example, ﬁnancial markets are far from a perfect mechanism for aggregating and disseminating informa- tion. The contractual provisions of ﬁnancial contracts and instruments, which make them sophisticated forms of investing, make them prone to opportunistic behaviour and fraud. The interrelations between investors and ﬁrms that ﬁnancial markets establish are a cause of the transmission of risks and disturbances. Financial systems are therefore prone to the failure of precisely those characteristics that are in theory their main contributions. In principle, the value at which ﬁnancial instruments trade should reﬂect the present value of the earnings associated with holding those instruments. So for example, a share yields ﬁnancial beneﬁts in the form of dividends paid to its investors and capital gains. The price of the share should reﬂect the amount at which shareholders value today the stream of dividend which will accrue in the future. However, this process of deriving a value of future dividends is complex and prone to mistakes. For one thing, forecasts have to be made of the likely future earnings of a ﬁrm from which the dividends will be paid. Second, an assessment has to be made about the way in which the future dividends should be discounted back to the present. Third, and most serious of all, the future dividend stream will be of little interest to those shareholders who are intending to sell their shares in the near future. They will be more concerned about the price at which they will be able to sell their shares to other investors. In principle that too should reﬂect the future dividend stream but prices might move out of line with these ‘fundamental’ determinants of valuation. Instead, investors might start to try to determine the amount at which they believe that other investors value the shares. This can lead to ‘bubbles’ when shareholders are over- optimistic about likely future prices at which they will be able to trade shares and ‘crashes’ when they mark down their assessments substantially. We will be discussing information problems a great deal in this book. A second cause of problems is contractual failure. Financial institutions contract to deliver certain services at particular prices. They are required to pay returns on savings, to hold securities, to manage assets in their clients’ interest, and to execute trades with them or on their behalf. If they fail to do so, then they are liable for their failure. They should pay their customers’ compensation and correct as far as possible the errors that they have made. However, if the institutions incur ﬁnancial problems, then they may 26 The scope of the shadow banking sector is considered further in section 20.5. The Financial System 49 not be in a position to pay compensation—they may not have the funds to do so. In particular, investors are exposed not just to risks of mistakes but to opportunistic behaviour and, in the worst-case scenario, fraud. Money is a very fungible commodity which can readily be transferred to activities for which it was not intended. As a result, customers of ﬁnancial institutions are particularly vulnerable to fraud. Finally, there are risks that result not from the failure of a particular institution but as a consequence of the interrelations between institutions and markets that exist in a ﬁnancial system. Financial institutions lend to and borrow from each other. They issue securities that are held by other ﬁnancial institutions. When one institution fails, it can have repercussions across the entire ﬁnancial system. Financial institutions are par- ticularly prone to these systemic risks because of the interactions that exist between them and the fact that they depend on the conﬁdence of their investors. If investors are concerned about the likely solvency of an institution in which they have invested they may seek to withdraw their investments at the earliest possible opportunity. Those withdrawals in turn threaten the solvency of the ﬁnancial institution and make it prone to collapse, which in turn may make investors at other institutions similarly concerned about solvency, given the (likely) existence of credit relationships between the troubled institution and their own. For information, contractual, and systemic reasons, ﬁnancial institutions and mar- kets are particularly prone to failure and collapse. This is the rationale for their regulation and attempts to protect customers and investors from certain types of risks. The nature of the failures of ﬁnancial institutions and markets will be examined in depth in this book and it will form the basis for evaluating the regulations that have been put in place to correct these failures. 2.7 Conclusion This chapter has described the functions that ﬁnancial systems perform, the compo- nents of a ﬁnancial system, the differences that exist across countries in the nature of ﬁnancial systems, the internationalization of ﬁnancial markets and institutions, and the failures to which ﬁnancial systems are prone. Several striking features emerge. The ﬁrst is the scale of ﬁnancial markets and the range of forms in which individuals, institutions, companies, and governments save and raise ﬁnance. Traditionally, a distinction is drawn between the role of ﬁnancial institutions and capital markets, and regulation is currently categorized in terms of ﬁnancial institutions and securities markets. However, as this chapter has suggested, that distinction is becoming increasingly untenable as borrowers look to both institu- tions and markets to raise ﬁnance and ﬁnancial markets perform roles traditionally undertaken by ﬁnancial institutions. Furthermore, while ﬁnancial intermediation has traditionally been associated with banks, their activities have been replicated by non- bank intermediaries that employ ﬁnancial markets to raise capital and spread risks. There are two consequences of failing to take adequate account of the blurring of the distinction between ﬁnancial intermediaries and markets. First, equivalent activities are regulated in different ways, which encourages market participants to arbitrage between the resulting different costs of transacting. Second, regulation fails to recognize the 50 Principles of Financial Regulation alternative ways in which similar activities are undertaken and thereby does not provide comprehensive protection for investors and customers. What this suggests is that the traditional distinction that is drawn on the basis of institutional form is misplaced and should be replaced by a focus on function rather than form. The book will explore the implications of these developments for the way in which regulation should be designed and respond in the future.

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