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Financial Markets and the Euro Francesco Saraceno MPA - 2012
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The big payoff on the Euro is, of course, in the capital markets. [. . .] It will move from the dull bankbank-based financing structure to big big--time debt markets and markets for corporate equities that offer transparency for the mismanaged or sleepy European companies companies. Capital markets are good at kicking butt. R di Dornbusch Rudi D b h (2000), (2000) p. 242
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What are financial institutions and markets? Capital markets collect savings and provide producers with the financial means to invest They perform three main functions: 1. Transform maturity 2. Perform intermediation 3. Deal with inherent risk.
Financial institutions: 1. Banks. 2. Bond and stock markets 3. Shadow banking system: non non--bank financial intermediaries that provide services similar to traditional commercial banks. (e.g. hedge funds, money market funds and SIV).
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What do financial markets do? Matching lending and borrowing needs: maturity - Current C accounts versus term deposits, d i with i h interest i differentials diff i l since i time has a value and the market set its price.
Matching lending and borrowing d risk ik needs: - Investors want high returns and no risk - Basic tradetrade-off between risk and return: rate of return is adjusted by incorporating a risk premium.
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What do financial markets do? Diversification: - Pooling together assets with negative risk correlation reduce overall risk; - Financial markets can offer almost unbounded possibilities for diversification, the more so the bigger they are.
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Economics of capital mobility: allocation efficiency Allocation efficiency requires capital to be invested in activities with highest rewards. Capital market barriers inhibit efficiency.
No K Mobility
K Mobility
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Economics of capital mobility: allocation efficiency Allocation efficiency leads to: - Same S returns t from f saving; i - Same borrowing costs; - Capital C i l goes where h it i is i more productive; d i - Not everyone gains. Who wins, who loses?
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Economics of capital mobility: allocation efficiency Home K owners: owners: Lose A Labour: Gain A+B Total (K+L): A+B A+B--A=B
Foreign Fo K owners in Fo: Fo: Gain F Fo K owners in Ho: Gain C+D Labour: Lose D+F Total (K+L): C+F+D C+F+D--D-F=C
TOTAL GAIN FROM MOBILITY C+B The result that both countries benefit from capital market integration is the basis for the Single Market and the Commission directive.
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Economics of capital mobility: diversification effect Diversification leads: - more choice h i to borrowers b andd lenders; l d - risk is reduced.
Effect of single currency: - euro eliminates currency risk within Eurozone Eurozone;; - more competition as national currencies acted as non non--tariff barriers; - better exploitation of scale economies, economies with the emergence of large financial institutions and markets; - potential for diversification shrinks; - potential emergence of euro as another world currency.
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Implication for banks I principle, In i i l banks b k should h ld compete throughout h h the h euro area. In I practice, i many limits to this scenario: - good to be known by your banker (information asymmetry); - large costs of switching banks; - importance of wide branch networks.
Banks merge, but mostly within countries: - regulations l ti remain i local l l in i spite it off harmonisation h i ti efforts; ff t - cultural differences; - tax considerations.
Early effect: - more concentration and less competition; - banks could establish branches abroad (but they don’t).
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Implication for banks Number of banks in the Eurozone: Eurozone:
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Implication for banks Shares of crosscross-border banking activity Interbank relationships increased significantly until the ii crisis Customers did not follow
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Implication for bond markets Bond markets deal in highly standardised loans. They used to be segmented by currency risk, which implied interest rate differentials. Convergence has happened but is not complete The crisis reshuffled everything
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Implication for stock markets Worldwide stock markets are surprisingly national (home bias), bias) due to: y - information asymmetries; - currency risk Æ euro area stock markets should be less subject to h bi home bias. Cross-border holdings of equity Crossissued by euro area residents: Th Euro The E had h d an effect ff t after ft all! ll!
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Characteristics of financial markets Scale economies: - Matching and risk easier with many players and networks. (No perfect competition!)
Networks: - Networks of borrowers and lenders exploiting network externalities (the larger the network, the better it works, but risk of “too i interconnected d to fail”). f il )
Asymmetric information: - Borrowers have incentives to conceal risks; - Lenders are aware and may overprice risk and/or refuse to lend.
Æ Need of regulation.
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Regulation and supervision Because of ‘market failures’, financial markets are regulated and financial institutions are supervised. A single financial market would seem to require a single regulator and a single supervisor. supervisor Instead: - Regulation largely designed at EU level; p remained national (rationale: ( closer to institutions,, and hence less prone p - Supervision to asymmetric information. And of course, subsidiarity) subsidiarity)
The financial crisis that hit Europe p in 2008 showed that this system y was not adequate. For example: - Decision by Ireland in 2008 to offer full guarantee to deposits and liabilities of six I i h banks Irish b k forced f d other th countries, t i which hi h offered ff d limited li it d guarantees, t to t offer ff unlimited guarantees to deposits at their own banks in order not to be at disadvantage.
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Regulation and supervision Crisis led to a task force. The De Larosière Report (2009) showed that: - National supervisors did not share information with one another; - ECB, tasked with the function of lender of last resort, was not any better informed of the true situation of stressed banks.
The European System of Financial Supervision (ESFS) has been created, created which includes 4 new institutions: 1. European Banking Authority (EBA), which is charged with collecting detailed information on all EU banks; 2. European Systemic Risk Board (ESRB), which looks at the overall picture and can issue bindingg recommendations;; 3. European Insurance and Occupational Pensions Authority (EIOPA), focusing on insurance companies and pension funds; 4 Joint 4. J i t Committee C itt off the th European E Supervisory S i Authorities A th iti (ESAs), (ESA ) which hi h brings bi national supervisors together to improve transparency.
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Regulation and supervision “In 2010, US banks had assets of €8.6tn. But those of the EU’s were €42.9tn. 42 9tn In the US US, bank assets were close to 80 per cent of gross domestic product. In the EU, they were 350 per cent. Half of the world’s 30 biggest banks are headquartered in the EU. If the EU makes a mess of banking, it can explode the world economy. In brief, while individual US banks may be “too big to fail”, the EU has a banking sector that is not only too big to fail, but too big to save. European banks have to be safer than American ones because the damage they can do is so much greater. Managing these risks is of overwhelming importance” (Martin Wolf) Liikanen Report p ((October 2012), ), Gives 5 recommendations:
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Regulation and supervision Liikanen Report (October 2012) 1. A “ringfence” around the traders. If trading is too important (more than €100bn or 15 15--25% of total assets), it should be done by a separate legal entity. Low profile version of GlassGlass-Steagal The so so--called “universal banking” model will remain, as the new entity that holds the trading activities will be part of the same overall banking group. But the trading division will have to hold its own capital, meaning that it stands or falls by its own activities and cannot cannot, in theory at least least, knock over the bread bread--and and--butter retail banking operations. There is one grey area, however: the provision of hedging services to clients (for example, arranging derivatives for an exporter to guard against fluctuations in exchange h rates)) would ld remain i part off the h retail il banking b ki arm. Defining D fi i the h difference between that and trading on the bank’s own account could prove tricky. Also, Martin Wolf (FT, (FT, Oct 3, 2012) argues that the threshold is too low
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Regulation and supervision Liikanen Report (October 2012) 2. Disaster management g “The resolution authority should request wider separation than considered mandatory above if this is deemed necessary to ensure resolvability and operational continuity of critical functions. functions ” Banks need to work out in advance how they could go under without pulling the rest of Europe’s financial architecture down with them. If regulators considered that a bank’s trading operations were particularly risky, they should widen the ringfence to include more bits of the investment bank, to better shield deposits in the event of the investment bank failing
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Regulation and supervision Liikanen Report (October 2012) 3. Spreading the pain “Banks should build up a sufficiently large layer of bailbail-inable debt that should be clearly defined, so that its position within the hierarchy of debt commitments in a bank’s balance sheet is clear and investors understand the eventual treatment in case of resolution. Bail Bail--in instruments should also be used in remuneration schemes for top management so as best to align decisiondecision-making with longer longer--term performance in banks.” Objective j to share the losses between taxpayers, p y , private p creditors and executives Top management, similarly, would be penalized in case of bankruptcy, in theory ensuring that their decisions reflect the long long--term interests of the institutions rather than immediate rewards Note: Bonds are a form of debt and as such, they rank higher than equity. This gives them a better claim to get their money back when business turns sour since the owners - equity holders - have an obligation to repay their creditors. A bail--in takes place before a bankruptcy and under current proposals, regulators would have the power to impose losses bail on bondholders while leaving untouched other creditors of similar stature, stature such as derivatives counterparties. counterparties
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Regulation and supervision Liikanen Report (October 2012) 4. The weighting game “The Group proposes to apply more robust risk weights in the determination of minimum capital standards and more consistent treatment of risk in internal models. d l Also, Al the h treatment off reall estate lending l di within i hi the h capital i l requirements i framework should be reconsidered, and maximum loanloan-toto-value (and/or loan loan--totoincome) ratios included in the instruments available for micromicro- and macro macro-prudential supervision.” The committee found that banks’ techniques for assessing how much capital they needed to hold against their trading positions were outdated. They failed to account properly l for f “tail“tail “ il-risks i k andd systemic i risks”. ik” Problem: and if the emphasis on weights led to neglect unun-weighted ratios?
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Regulation and supervision Liikanen Report (October 2012) 5. Living dangerously “The Group considers that it is necessary to augment existing corporate governance reforms by specific measures to 1) strengthen boards and management; 2) promote the h risk i k management function; f i 3) rein i in i compensation i for bank management and staff; 4) improve risk disclosure and 5) strengthen sanctioning powers.” The report diagnoses the failure of boards to rein in excessively risky behaviour and notes that “the increase in size and the advent of banks that are tootoo-bigbig-to to--fail have further reduced market participants’ incentives to monitor banks effectively”. In short, the report’s authors worry that the people who run banks are either illillequipped to control sprawling institutions or incentivised to run them dangerously. dangerously They want part of bankers’ bonuses paid in debt, meaning they could be written down if short short--term profits yield long long--term troubles.
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The international role of the euro Externally, a currency can be: - an international i i l unit i off account: trade d invoicing i i i - an international medium of exchange: a vehicle currency - an international store of value: foreign exchange reserves, individual hoarding.
Internally, these functions are established by law. Externally, they have to be earned.
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The international role of the euro European firms are increasingly able to invoice trade in euros. Share of exports invoiced in euros (% of total exports):
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The international role of the euro Currencies are used on exchange markets: - directly for conversion into/from other currencies; - indirectly as intermediary for other bilateral conversions.
The share of the euro in 2010 is much smaller than the sum of the shares of its constituent currencies.
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The international role of the euro Share of bonds issued in euros has taken off. off C Currency shares h off international bonds, 1994––2010: 1994
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The international role of the euro Dollar seems firmly entrenched as the leading currency for international reserves. Yet, the euro has taken off Foreign exchange reserves: shares of main currencies currencies, 1965––2010: 1965
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Does it matter? For some Europeans, the euro is challenging the supremacy of the dollar. Indeed, the dollar reigns supreme! The wish to displace the dollar is no driven by political sentiment, but what about the economic advantages? Economic benefits of having a world currency are quite modest Æ ECB considers that a possible international role for the euro is something that it should neither encourage nor discourage. Beyond some legitimate pride, it does not really care! And you? Would you care?
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