Banking in flux: Do we know what to do? Arnoud W. A. Boot University of Amsterdam and CEPR Segovia,
Agenda My assessment of fundamental changes in financial sector Key information technology Inadequacy of current policy response, with emphasis to EU/Euro area Do we understand true value creation in financial sector? 2
Issues Effect of information technology Via deepening of financial markets and financial innovations: extreme tradability and changeability Risk profile can be changed instantaneously Institutions and markets more and more intertwined Risks via Opportunistic behavior Herding behavior (collective euphoria ) Amplification of risk via interbank and financial market linkages 3
Issues 2 Governance problem Ineffectiveness market discipline More broadly perverse incentives coming from financial market Banks suffer from cost of capital fallacy Pricing distorted we are operating in bad equilibrium Bank choices worsen complexity problem Many banks continue to go for size, conglomerate model Intra-financial sector exposures have mushroomed 4
More on marketability, changeability and commitment From finance literature we know that creating trading opportunities also has a dark-side Jacklin (1987) on Diamond-Dybvig (1983) liquidity transformation Bhide (1993) on dark-side of liquidity Myers and Rajan (1998) on paradox of liquidity Boot-Gopalan-Thakor (JF, 2008) on desirability stable shareholder base 5
Market discipline? Seems sensible complementary tool. Idea behind third pillar Basel II Paradox in normal times momentum in financial i market may lead to opportunistic behavior of banks, yet same momentum m driven markets would simultaneously have to impose discipline? Market discipline effective for idiosyncratic differences between institutions, less for financial market driven strategies 6
More capital seems crucial, yet Debt overhang Bankers suffer from cost of capital fallacy 7
Cost of capital fallacy We do not need to like M&M, nor believe M&M has relevance to banking, but to deny that t the cost of capital is affected by the risk that the capital is exposed to is disturbing Implications: - Maximizing ROE fundamental violation of corporate finance theory - Fixed high cost of capital does not make sense Yet self-fulfilling prophecy ( put capital to use ) 8
Are banks reluctant to raise new capital? What do we know from corporate finance when there is high leverage? Reluctance to raise equity because of windfall gain to debt holders Negative spiral Debt overhang induces even more leverage 9
The European problem
Asset quality review and banking union Observe the risks of inadequate action: Bank bail-outs via tax payer financial i repression zombie banks and low growth?? Enormous potential cost in Euro-area additional dimension. [redistribution issues] 11
US better here US showed that raising capital under difficult circumstances is not impossible ibl Contrast with US even bigger: US banks more profitable; Greater diversity of institutions (?) Better access to market financing i 12
The European problem (2) 13
Problem (2) cont d Left picture possibly not disturbing if Lack of deposits is compensated by access of banks to long term funding from financial markets picture on the right points at opposit. 14
More fundamental problem Current regulatory approach characterized by potential fallacy of stability of deposits. Intend of deposits is storing liquidity, is not an investment Institutional investors withdraw deposits upon downgrade of bank Consumers run as well (even if insured) moving deposits around frictionlessly Too much trust in stability of deposits might be like fighting last war 15
What then? What would work are bank funding sources that cannot run (and are considered investments, meaning, involving risk-return trade-off) Equity and long term debt funding from financial markets And do not be fooled by coco s coco s can become equity but coco s drain liquidity from bank. Equity, via capital gain mechanism, really superior 16
Moral hazard: same conclusion Implicit government guarantees make debt as funding source very cheap Induces more leverage and asset risk We need to get out of gaming region We are in the wrong debt-overhang equilibrium with troublesome incentives.. Basel II did not help risk-based capital approach is inducing gaming, and inadequate as regulatory instrument role for Basel III leverage ratio More capital also crucial for effectiveness bail-in, timely intervention, etc. 17
New equilibrium Financial sector has become more fluid we need an effective response New equilibrium fundamental higher levels of capitalization. ti Immediate benefit: - Cheaper equity and access to long term debt Other benefits - Timely intervention easier - Bail-in more effective - Banks less procyclical - Deposits more secure - Less gaming 18
Value creation in financial sector We do not really understand true value creation in financial sector Levine (1997, 2005): the development of financial markets and institutions is a critical and inextricable part of the growth process.. Literature has shown importance relationship orientation see Berger et al, JFE 2005; Diamond, JPE 1991; Petersen and Rajan, QJE 1995; Sharpe, JF 1990; Boot and Thakor, JF 2000); Bolton, Freixas et al (2013) How does this relate to mushrooming intra- financial sector claims? 19
Corporate and Retail Banking: over 70% of profit pool 20
Retail/SME banking profitable 21
Some observations on banks: rediscovering their roots?? The Economist Banks have rediscovered the virtue of knowing their customer Citigroup s head of retail in Business Week Citi should think locally And HSBC billboard in NY-City: The world s local bank 22
You ain t seen nothing yet. Anyone who deals in the financial markets knows that anticipating trends is difficult at best. But he or she also realizes that not to try is tantamount to accepting the most unlikely scenario of all: no change (Sandford, d 1994) 23
Appendix 24
Macro-prudential focus and capital Cyclical capital buffer marvelous idea, but note: Is orthogonal to market forces need to be really tough, market wants to lower it in good times In bad times even bigger problem. Idea of cyclical element is that it can be released in bad times.. But that is what market does not want and possibly at odds with micro- prudential focus Resolution: capital buffers need to be higher than market demands d in bad times 25
How to look at financial innovations? Extensive literature shows value of security design Spanning Other direct benefits for real activities (e.g. commercial letter of credit) Yet this literature may say little about more recent financial innovations (Often?) creating opaqueness rather than resolving asymmetric information Aimed at creating marketable assets or claims Opened up bank balance sheet: marketability and changeability key 26