SESSION 2

BETTER UNDERSTANDING

AND INTEGRATING FINANCE

New Approaches to Economic Challenges

NAEC Group Meeting, 28 November 2014

Adrian Blundell-WignallSpecial Advisor on Financial Markets to the OECD Secretary General,

& Acting Director Financial & Enterprise Affairs Directorate.

The Rolling Bubble in Finance versus

the Need for Sustainable Demand

2

• The past decades has been characterised by rolling financial bubbles, the complex causes of which are rooted a misunderstanding of structural forces: technology, the rapid growth of emerging markets, financial deregulation and innovation.

• Financial deregulation and innovation created a mountain of derivatives and complex counterparty relationships that exploded into a severe liquidity crisis in 2008. These still remain, but are shifting to non-banks.

• The bubble has likely rolled towards illiquid higher yielding assets (especially EME’s), and matching the need for yield in a zero rates world.

• There is no painless path to prosperity. There is instead a need for finance for sustainable demand.

Derivatives Shifting From Banks to

Shadow Banks

3

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000M

ar-

04

Se

p-0

4

Ma

r-0

5

Se

p-0

5

Ma

r-0

6

Se

p-0

6

Ma

r-0

7

Se

p-0

7

Ma

r-0

8

Se

p-0

8

Ma

r-0

9

Se

p-0

9

Ma

r-1

0

Se

p-1

0

Ma

r-1

1

Se

p-1

1

Ma

r-1

2

Se

p-1

2

Ma

r-1

3

Se

p-1

3

Ma

r-1

4

Se

p-1

4

$US, bn Aggregate Banks Devivatives

Amounts Outstanding of OTC Derivatives

The Emerging Market Bubble in

Corporate Credit

4

50

100

150

200

250

300

No

v-0

8

Feb

-09

May

-09

Au

g-0

9

No

v-0

9

Feb

-10

May

-10

Au

g-1

0

No

v-1

0

Feb

-11

May

-11

Au

g-1

1

No

v-1

1

Feb

-12

May

-12

Au

g-1

2

No

v-1

2

Feb

-13

May

-13

Au

g-1

3

No

v-1

3

Feb

-14

May

-14

Au

g-1

4

No

v-1

4

Feb

-15

May

-15

Index US Tsy Tot Ret 1-3y

US Tsy Tot Ret +10y

Merill Tot Ret EM Credit $

Merill Tot Ret EM Credit EUR

Merill Tot Ret EM Credit JPY

Investment as a per cent of Company Net Sales

5

Debt-to-Enterprise-Value: Japan,

EME’s, USA & Europe

6

0

5

10

15

20

25

30

35

40

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% Debt / (Debt + Equity) Non-Infrastructure

Expect Banks to be More Constrained

7

• The OECD has been at the forefront of the reform of banks—it proposed a higher leverage ratio and bank separation long before Volcker/Vickers/Liikanen. Now the USA have moved to a leverage ratio of 5% and 6% (GAAP; & 3.9% and 4.6% IFRS). And with its new buffer in the 4.05% to 4.95% range for the UK, well above 3%.

• But the game has moved on now: the next crisis will not be like the last one. Banking will play a reduced role, and non-banks need to play a bigger role. Asset prices will have to play a larger role in investment decisions & the transmission of monetary policy.

• If there is to be another crisis, expect it to look more like 1987—a liquidity crisis in securities markets if monetary policy normalisation is not handled well.

Distance to Default Looking Better: New

NAEC Tool

8

-2

0

2

4

6

8

10

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67

DTD DTD End of 2013

DTD End of 2008US Banks European Banks

At 30 June 2014

From Banks to Non-banks in Financing

& the Transmission of Monetary Policy

9

• As banks play a reduced role as liquidity providers, and tend not to have the right business model for very long-term investment, the non-banks will have to step up to the plate in both respects.

• The crucial issue now, is that with safer more constrained banks, who will finance long-term investment and provide liquidity in markets where asset prices will play a larger role in investment decisions & monetary policy transmission.

• New NAEC issues emerge.

Distance to Default: the AQR Remains the

Big Issue for Europe in 2014

10

0

10

20

30

40

50

60

70

80

0

50

100

150

200

250

300

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

$US, tn$US, tn Private Banks

Central Banks

Insurance Companies

Pension Funds

Investment Funds

Hedge Funds & Funds of Funds

Others

Total Asset of Financial Institutions

World GDP (RHS)

New Policy Issues for NAEC

11

• The LCR & other rules mean that bank broker dealers are pulling back, while products that promise daily liquidity while investing in underlying illiquid assets are rising (e.g. ETF’s). Market makers focus on core client, and are reluctant to absorb large positions. Dealer inventory is falling.

• Demand for yield exceeds new issues, and liquidity premia are being driven down—they are too low now. What happens if interest rates rise, demand slows and exit from illiquid positions is attempted?

• Is QE undermining the role of long-term investors as liquidity providers? they should buy at troughs and sell at peaks, but central banks are smoothing both sides and undermining this role.

More New Issues for NAEC

12

• There is need for finance for sustainable demand—QEgives rise to demand shifting (exchange rates), low trust in the future as normalisation lies in front of us. Sensible expectations about the wealth effects upon exit from QE imply no now easy transmission mechanism from low interest rates to consumption and investment.

• Longevity is rising while terminal (after normalisation) interest rates will be lower—posing real problems for liability matching.

• What do we need to do to increase the sustainable role of non-banks in financing investment and matching liabilities, i.e. patient capital—buy and hold business models for non-banks?

1920 to Today: Real S&P500 and Real

10-year Bond

13

-20

-15

-10

-5

0

5

10

15

20

25

Jan

-20

Jun

-24

No

v-2

8

Ap

r-3

3

Sep

-37

Feb

-42

Jul-

46

De

c-5

0

May

-55

Oct

-59

Mar

-64

Au

g-6

8

Jan

-73

Jun

-77

No

v-8

1

Ap

r-8

6

Sep

-90

Feb

-95

Jul-

99

De

c-0

3

May

-08

Oct

-12

% int rate

Roosevelt devalues against gold

Real S&P 500

Real 10y bond

1920 to Today: Nominal 10-year

Below 4% Again!!

14

0

2

4

6

8

10

12

14

16

18

Jan

-20

Jun

-24

No

v-2

8

Ap

r-3

3

Sep

-37

Feb

-42

Jul-

46

De

c-5

0

May

-55

Oct

-59

Mar

-64

Au

g-6

8

Jan

-73

Jun

-77

No

v-8

1

Ap

r-8

6

Sep

-90

Feb

-95

Jul-

99

De

c-0

3

May

-08

Oct

-12

% US 10-yr 1920 to Today

New Policy Issues are Upon Us

15

• Policy must improve liquidity in bond and derivative markets.

• Policy must bring SME financing more towards capital markets.

• Policy must encourage (not discourage) direct loans by non-banks, and buying private bonds.

• Policy might encourage sale and leaseback markets.

• What policies will encourage long-term equity holding (listed and unlisted)?

• What policies will encourage the infrastructure debt markets?

• What policy will encourage longevity bonds and longevity swaps?

4 Sets of Issues for Policy Makers

16

• There are at least 4 sets of issues to develop investment for growth, but in a sustainable demand framework.

• First regulatory, legal and governance impediments to long-term investment.

--accounting, solvency II, macro-prudential, local content requirements, ownership restrictions, capital controls; treaty frameworks; etc.

• Second the institutions themselves are not prepared:

--credit assessment capability; underwriting framework; origination; operational services.

• Third, public participation in resolving transparency and trust.

--market rules; longevity table benchmarks; reliability of contracts for public utility private sector participation (legal framework).

• Fourth, corporate governance and RBC (environment, local communities, labour); due diligence on global supply chains, etc..