Global Financial and Eurozone Reform:

Five questions on a common theme

Riksbank

Stockholm, 18 February 2013

Adair Turner

Five questions on a common theme

1

Are optimal capital ratios higher still than Basel III

standards, and if so, what should we do about it?

Should macro-prudential regulators seek to constrain

aggregate economy wide leverage and if so, how?

How much federalism is needed to make the Eurozone a

sustainable and successful monetary union?

Are we too worried about fragmentation of global banking?

Should banks have the right to cross-border branching

within the European Union?

Measures of increasing financial intensity

0

50

100

150

200

250

300

350

400

450

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

$Tr

OTC interest rate contracts, notional amount outstanding

0

100

200

300

400

500

600

700

800

900

1,000

1,100

1977

1982

1987

1992

1997

2002

2007

$bn

Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

2

Growth of interest rate derivatives

values, 1987-2009 FX Trading values & world GDP

1977-2007

Global issuance of asset-backed

securities

1929

1935

1941

1947

1953

1959

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300% 1929

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300% 1929

1935

1941

1947

1953

1959

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300% 1929

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300% US debt as a % of GDP by

borrower type

Share of the financial industry in US GDP

3

Source: Philippon, T (2008), The

Evolution of the US Financial

Industry from 1860 to 2007:

Theory and Evidence. (As

referenced by Andrew Haldane in

The Future of Finance, LSE

Report, 2010)

0

1

2

3

4

5

6

7

8

9

50 70 90 10 30 50 70 901850 1870 1890 1910 1930 1950 1970 1990

4

Market perception of private credit risk

Source: Merrill Lynch

Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway,

Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill

Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS

CDS series peaks at 6.54% in September 2008.

Source: Moody’s KMV, FSA calculations

Non-investment grade

corporate bond spreads Average CDS of major

financial firms

0

200

400

600

800

1000

1200

1400

2002 2003 2004 2005 2006 2007 2008

Op

tio

n-a

dju

ste

d s

pre

ad

Global, non-financial corporates BB-rated

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

De

c 0

2

De

c 0

3

De

c 0

4

De

c 0

5

De

c 0

6

De

c 0

7

CD

S-S

EN

IOR

Average CDS-SENIOR

NASDAQ index: 1990 – 2002

5 Source: Datastream

6 6

Three drivers of financial instability

Debt contracts create specific risks

Unregulated bank credit and private

money creation is inherently unstable

Lending secured against real assets can

be strongly pro-cyclical

Real economy leverage,

credit creation dynamics, and

credit/asset price cycles are

crucial macro-economic

variables, and phenomena

7

Observed payout distributions for debt and equity

Debt payouts Equity payouts

100% of principal and due interest

Full distribution

continuously observed

Observed in good times

100%

Not observed

in good times

Credit and asset price cycles: the upswing

Expectation of future

asset price increases

Increased credit

extended

Low credit losses: high

bank profits

• Confidence reinforced

• Increased capital base

Increased asset

prices

Increased lender

supply of credit

Favourable

assessments of

credit risk

Increased borrower

demand for credit

8

9

Leverage in real and financial sectors

Source: Oliver Wyman

UK debt as a % GDP by borrower type

(1987-2007), Debt Liabilities on B/S

Household

Corporate

Financial

USA debt as a % GDP by borrower type

(1929-2007)

Household

Corporate

Financial

1987

19

29

19

35

19

41

19

47

19

53

19

59

19

65

19

71

19

77

19

83

19

90

19

96

20

02

20

07

10%

50%

100%

150%

200%

250%

300% 1987

0%

100%

200%

300%

400%

500%

600%

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Private non-financial corporate deposits and loans:

1964 – 2009

10

0%

5%

10%

15%

20%

25%

30%

35%

40%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% o

f G

DP

Securitisations and loan transfers Deposits Loans

11

Household deposits and loans: 1964 – 2009

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% o

f G

DP

Securitisations and loan transfers

Source: Bank of England, Tables A4.3, A4.1

Financial deepening: the pre-crisis consensus

12

Neutral: “We assumed we could ignore the details of the financial system”

(Olivier Blanchard, October 2012)

The dominant new Keynesian model of monetary economics “lacks

an account of financial intermediation, so that money, credit and

banking play no meaningful role”

(Mervyn King, October 2012)

Welcome: Axiomatically beneficial since reflects more complete markets and

contracts between rational private agents

13 13

Private credit to GDP ratio and growth

Source: S. Cecchetti, BIS

Working Paper No. 381

"Reassessing the impact

of finance and growth"

Long-term trends in bank capital & liquidity ratios

14

Sterling liquid assets

Source: US: Berger, A. Herring, R and Szegö, G (1995) and FDIC.

UK: Sheppard, D.K (1971), BBA and Bank of England calculations.

Source: Bank of England and Bank calculations.

Capital ratios for US and UK banks

0

5

10

15

20

25

30

1880 1900 1920 1940 1960 1980 2000

UK

US

0

5

10

15

20

25

30

35

1968 1975 1982 1989 1996 2003 2010

Broad ratio (b)Reserve ratio (c)Narrow ratio (d)

% of total assets

(all currencies)%

Five questions on a common theme

15

How much federalism is needed to make the Eurozone a

sustainable and successful monetary union?

Are we too worried about fragmentation of global banking?

Should banks have the right to cross-border branching

within the European Union?

Are optimal capital ratios higher still than Basel III

standards, and if so, what should we do about it?

Should macro-prudential regulators seek to constrain

aggregate economy wide leverage and if so, how?

Single currency and single market completion

16

“A major effect of EMU is that balance of payments

constraints with disappear […] private markets will

finance all viable borrowing, and savings and

investment balances will no longer be constraints at

the national level”

One Market, One Money, European Commission, 1990

Eurozone current account deficits

17 Source: International Monetary Fund, World Economic Outlook Database, October 2012

-16

-14

-12

-10

-8

-6

-4

-2

0

2000 2001 2002 2003 2004 2005 2006 2007 2008

%

Year

Greee

Ireland

Portugal

Spain

% of GDP 2000-2008

Eurozone government bond spreads

18

Source: Bloomberg

10 year benchmark spreads to German bunds

Note: Bloomberg doesn't quote a 10Y benchmark for Ireland and so 9Y has been used instead.

-2

0

2

4

6

8

10 Jan

02

Ju

l 02

Jan

03

Ju

l 03

Ja

n 0

4

Ju

l 04

Jan

05

Ju

l 05

Jan

06

Ju

l 06

Jan

07

Ju

l 07

Jan

08

Ju

l 08

Jan

09

Ju

l 09

Jan

10

Ju

l 10

Jan

11

Ju

l 11

%

Italy Portugal Spain Greece Ireland

19

Credit extension and house prices

House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007

Source: BEA; ONS; ECB

0

20

40

60

80

100

120

Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007

% G

DP

US UK Spain Ireland

0

50

100

150

200

250

Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007

Index:

2000 =

100

Spain US UK Ireland

Source: Ministry of Housing (Spain), S&P (US), DCLG

Decomposition of cumulative capital inflows (% of 2007 GDP)

SPAIN

PORTUGAL

IRELAND GREECE

-30%

-10%

10%

30%

50%

70%

90%

110%

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Jan

-10

Jul-

10

Jan

-11

Jul-

11

Jan

-12

Jul-

12

PRIVATE INFLOWS TARGET Liab.

PROGRAMME Disb. TOTAL INFLOWS

-70%

-50%

-30%

-10%

10%

30%

50%

70%

90%

20

02

Q1

20

02

Q3

20

03

Q1

20

03

Q3

20

04

Q1

20

04

Q3

20

05

Q1

20

05

Q3

20

06

Q1

20

06

Q3

20

07

Q1

20

07

Q3

20

08

Q1

20

08

Q3

20

09

Q1

20

09

Q3

20

10

Q1

20

10

Q3

20

11

Q1

20

11

Q3

20

12

Q1

20

12

Q3

PRIVATE INFLOWS TARGET Liab.

PROGRAMME Disb. TOTAL INFLOWS

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Jan-0

2

Jun-0

2

No

v-0

2

Apr-

03

Sep-0

3

Feb

-04

Jul-0

4

De

c-0

4

Ma

y-0

5

Oct-

05

Ma

r-0

6

Aug-0

6

Jan-0

7

Jun-0

7

No

v-0

7

Apr-

08

Sep-0

8

Feb

-09

Jul-0

9

De

c-0

9

Ma

y-1

0

Oct-

10

Ma

r-1

1

Aug-1

1

Jan-1

2

Jun-1

2

PRIVATE INFLOWS TARGET Liab. TOTAL INFLOWS

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Jan-0

2

Jun-0

2

No

v-0

2

Apr-

03

Sep-0

3

Feb

-04

Jul-0

4

De

c-0

4

Ma

y-0

5

Oct-

05

Ma

r-0

6

Aug-0

6

Jan-0

7

Jun-0

7

No

v-0

7

Apr-

08

Sep-0

8

Feb

-09

Jul-0

9

De

c-0

9

Ma

y-1

0

Oct-

10

Ma

r-1

1

Aug-1

1

Jan-1

2

Jun-1

2

PRIVATE INFLOWS TARGET Liab. TOTAL INFLOWS

Cross border capital flows:

Hierarchy of economic value

21

Foreign direct investment

Equity portfolio flows

Debt portfolio flows

Long-term bank lending

Short-term bank lending Inc

rea

sin

g s

tab

ilit

y

See: Committee on the Global Financial System: Report of the Working Group on Capital Flows

to Emerging Market Economies, BIS, 2009

Total cross-border capital inflows: 1980–2011

22

Loans and deposits

Bonds

Equity

Foreign direct investment

2005 2000 1995 1990 2007 2011

12

10

8

6

4

2

0

-2

-4

5.8

2.0

11.7

4.9 4.8

5 5 13 15 7 21 % Global

GDP

Source: Future of Long-term Finance, Group of Thirty Report, MGI, December 2012

US

D t

rilli

on

s, co

nsta

nt 2

011

exch

an

ge

ra

tes

Coefficient of variation of inward cross-border

flows by maturity

23 Source: Future of Long-term Finance, Group of Thirty Report, MGI, December 2012

Long maturity Short maturity

FDI Equity Bonds Long-term

bank claims

Short-term

bank claims

Emerging

Markets

Developed

Markets

Five questions on a common theme

24

How much federalism is needed to make the Eurozone a

sustainable and successful monetary union?

Are we too worried about fragmentation of global banking?

Should banks have the right to cross-border branching

within the European Union?

Are optimal capital ratios higher still than Basel III

standards, and if so, what should we do about it?

Should macro-prudential regulators seek to constrain

aggregate economy wide leverage and if so, how?

Required steps to Eurozone long-term viability

25

Banking union – including ability to recapitalising with

“federal” resources

“Federal level” deposit insurance

Eurobonds – held as banking systems safe liquid

assets

Significant but still limited (e.g. 5% of GDP)

federal fiscal budget – and associated automatic

stabilisers

Cutting the

sovereign/bank

solvency link

Macro–prudential levers deployable at

national level?

Five questions on a common theme

26

How much federalism is needed to make the Eurozone a

sustainable and successful monetary union?

Are we too worried about fragmentation of global banking?

Should banks have the right to cross-border branching

within the European Union?

Are optimal capital ratios higher still than Basel III

standards, and if so, what should we do about it?

Should macro-prudential regulators seek to constrain

aggregate economy wide leverage and if so, how?