financial innovation and instability in bank-based versus financial market driven economies arnoud...

Financial innovation and instability in bank-based versus financial market

driven economies

Arnoud W. A. BootUniversity of Amsterdam

Presentation at the Bocconi meeting on ‘Central Banking, Regulation and Supervision after the Financial Crisis’

Milan, June 24-25, 2010

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Issues

• Financial sector as facilitator of real economy?– Stiglitz: “financial sector has become an end in itself

rather than a means to an end”???

• How to interpret proliferation financial innovations?– Are we really talking about innovations?– What is link with financial development and economic

growth debate?

• Differential impact financial sector developments on bank-based versus financial market-driven economies?

A.W.A. Boot Financial innovation Bocconi, Milan, June 24-25, 2010

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Overview

• Central role information technology in financial crisis

• How to look at financial innovations?– Impact on marketability

• Differential impact on bank-based versus market-based systems


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Financial crisis...Much can go wrong in the financial sector

• Modern banking suffers from extreme interconnectedness...

• Existing regulation/supervision lacked macro-prudential focus

• Perverse incentives from the market– In euphoric times always too much capital...– Scope for opportunistic behavior

• Where money is being earned rests control

observe role information technology, marketabilityA.W.A. Boot Financial innovation Bocconi, Milan, June 24-25, 2010

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What did information technology do to banking?

Extreme tradability• Risk profile can be changed instantaneously….• Institutions and markets intertwined

Risks via• Opportunistic behavior• Herding behavior

Financial market linkages key

Implications for franchise value?

Information technology and banking


How to look at financial innovations?• Extensive literature shows value of security design

– Spanning– Direct benefits for real activities (e.g. stimulating

information production, overcoming information problems)

• Yet this literature may say little about more recent financial innovations– (Often?) creating opaqueness rather than resolving

asymmetric information– Aimed at regulatory arbitrage?

Opened up bank balance sheet: marketability and changeability key


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More on marketability, changeability

• From finance literature we know that creating trading opportunities has dark-side – Jacklin (1987) on Diamond-Dybvig (1983) liquidity

transformation– Bhide (1993) on dark-side of liquidity– Boot-Gopalan-Thakor (2008) on stability of shareholder

base; Boot (2009): footloose corporations

• Banks increasingly subjected to volatility and momentum in financial markets– Bank-based systems more like market-based systems?– Stability bank-based systems affected more?


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Marketability and stability of investment and relationship banks

First, investment banks (IBs)

• In past IBs were partnerships. Two characteristics:– Personal wealth tied up in IB– Cannot get full value of partnership share upon exit

• Move to shareholder structure– Marketability has created ‘star phenomenon’– Increasing emphasis on trading

stars go for personal franchise value rather than institutional franchise value (less prudent behavior)


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Marketability and stability of investment and relationship banks (2)Now relationship bank (RB)

• Does marketability relationship banks’ assets create similar problems?– Less opaque assets reduce emphasis on institutional

franchise value?

Important issue now: stability of relationship bank threatened by – higher exposure to boom & bust nature of financial

market; – ‘star phenomenon’ in the RB itself


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Bank-based versus market-based systems

Bank-based system typically refers to universal banking – investment banking and relationship banking combined under one roof

If both the IB and RB parts have become less focused on institutional franchise value, the sustainability of the universal banking model might have suffered


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Financial development and economic growth

Levine (1997, 2005): “A growing body of work would push even most skeptics towards the belief that the development of financial markets and institutions is a critical and inextricable part of the growth process and [would push those skeptics] away from the view that the financial system is an inconsequential side show, responding passively to economic growth and industrialization”

More recent financial innovations fit this framework?A.W.A. Boot Financial innovation Bocconi, Milan, June 24-25, 2010

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Fundamental changes in financial sector needed...

• Existing institutional (including regulatory) framework does not fit new reality

Fundamental reform in financial sector needed that goes to heart of the structure of the financial sector

Need to truly understand business of banking!!


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APPENDIX: Observe the role that information technology plays

Information technology

• Increased pressures on corporations. Permanent in the spotlight– Often momentum driven– Pressures coming from media, analysts, investment

bankers, consultants etc

• Created high level of tradability and changeability

Note, both effects reinforce each other inducing more or less permanent change


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Footloose capitalism: tradability and instability

In proper Dutch...

Niets is opgewassen tegen het struikroverkapitalisme en de animal spirits die financiële markten in ons losmaken…


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financial innovation and instability in bank-based versus financial market driven economies arnoud...

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