Markets and Banks. Stephen Kealhofer 5Oct11

Transcription

1 Markets and Banks Stephen Kealhofer 5Oct11 1

2 Outline Financial intermediation Characteristics of markets Prior versus current academic views Relationship of information vs liquidity trading Drivers of informational efficiency and liquidity Derivatives and trading in risk Indexes and the creation of liquidity Institutional intermediation Mortgages Role of credit Liquidity and bank intermediation 2

3 Financial intermediation Electronic auction market Brokered multidealer market Market intermediated exchange Dealer market Increasing scale, standardization and liquidity Brokered market Application & approval processes Institutionally Intermediated exchange 3

4 Academic view of markets Prior view: Informationally efficient Price changes reflect changes in expected future payoffs Central role for market portfolio Should be held by all investors Determines systematic risk ( beta ) Current view: Pricing anomalies Small, growth, momentum, others Undermines beta risk view Excessive volatility Prices move more than justified by changing expectations of future payoffs 4

5 Perspective Theories of how markets process information consistent with some excess volatility Individual price moves reflect mostly changes in expectations of future payoffs Some of individual and most of aggregate price moves reflect non-informational trading motives More liquid individual markets => more informationally efficient Hedging supplies/demands accommodated with less price movement 5

6 The emerging structure of credit trading CDX tranche trading $3T CDX (CDS index) trading $8T Individual CDS trading $12T Individual bond trading 6 $7T

7 The emerging structure of credit trading Correlation trading Index arbitrage CDX tranche trading CDX (CDS index) trading Liquidity imported via correlation trading Highest liquidity CDS-bond arbitrage Individual CDS trading Individual bond trading 7 Liquidity imported via index and CDSbond arbitrage

8 The structure of liquidity in equity trading Options arbitrage Stock index options trading Stock index futures trading Information content of trading activity: Medium Low Liquidity imported Highest liquidity Index arbitrage Options arbitrage Individual stock trading Individual stock options trading Medium High Liquidity imported via index and options arbitrage 8

9 Turnover approximately doubled coincident with the increase in equity index trading [source: Campbell, Grossman and Wang 1993]

10 Market structure, information and liquidity Market structure dramatically affects liquidity of market Index trading creates a separation between individual (largely idiosyncratic) and aggregate (largely systematic) information There is much less information asymmetry with respect to aggregate/systematic risk There is much more scale at the aggregate level Scale and information symmetry produce a highly liquid and informative index market Market makers at the individual security level can lay off a high fraction of their risk via index hedging Across 20 securities, 90% of risk can be hedged Creates higher volume, lower bid-ask individual markets with tighter spreads More liquid 10

11 Intermediation Finance is about getting money from savers and putting it to work with people creating real capital You need to have risks correctly priced (allocative efficiency) You need to do it as cheaply as possible (expense) You need to pull everyone into the process so they are not arbitrarily rationed (access) 11

12 Securitizations and structured finance Some major credit asset classes require pooling Small to mid-size enterprises (SMEs) Consumer Pooling has worked poorly for transferring risk Poorly documented, heterogeneous asset pools with little risk transparency Quality of individual credit assessments inaccurate and subject to adverse selection/moral hazard biases o Diversification of pool cannot fix risk biases Complex tranche structures that further reduce transparency Central problem: measurement of pool risk 12

13 Amount of securitization: $4.5 Trillion (2007) Amount of ABS Collateral, by Type of Collateral $2,500,000 $2,000,000 AG&GSE_POOL_abs $1,500,000 LOAN_abs HOME_abs MULTI_abs $1,000,000 COMM_abs CONSUMER_abs TRADE_abs $500,000 $ date 14

14 Significance of securitization: 5%-30% of Funding Securitized Fraction by Asset Class 35% 30% securitized fraction 25% 20% 15% 10% ABS_Trade_Credit ABS_Consumer_Credit ABS_Home_Mort ABS_Multi_Mort ABS_Comm_Mort ABS_Other_Loans 5% 0% date 15

15 Implications for intermediation If innovation is working correctly, it is increasing aggregate credit risk and aggregate defaults Financial transactions always contain an element of credit risk (money now in exchange for money in the future) Increasing access includes the marginal actor who generally has a greater risk of default Financial innovation puts increasing pressure on credit intermediation Credit risk needs to move out of the portfolios of leveraged investors to the portfolios of unleveraged final investors o Balance sheets are a choke point You need to have real risk transfer o Risks must be understood and correctly priced As quickly as circumstances permit, transactions should move from private bilateral trading to public, open, multilateral trading Achieving optimal market structures generally requires co-ordinated actions 16

16 Banks as intermediators of liquidity Use the learning from markets to correctly understand and value liquidity Role of indices and risk-trading Originate and sell Hold illiquid risks; sell liquid risks. Develop liquidity where it does not exist Innovators of markets Expand range of underwriting activity Opportunities are not in more-of-the-same 17