TOO MUCH DEBT, FINANCIAL SYSTEM

STABILITY AND WIDER ECONOMIC IMPACTS

16th Annual Chicago Federal Reserve Bank International Banking

Conference: Shadow Banking Within and Across National Borders

Adair Turner

Senior Fellow

7 November 2013

www.ineteconomics.org | www.facebook.com/ineteconomics

300 Park Avenue South - 5th Floor

New York, NY 10010

Two Recent Lectures:

• Credit, Money and Leverage: What Wicksell, Hayek and Fisher Knew and Modern Macro-Economics Forgot Stockholm School of Economics, September 2013 http://ineteconomics.org/blog/institute/adair-turner-credit-money-and-leverage

1

• Securitisation, Shadow Banking and the Value of Financial Innovation. The Rostov Lecture on International Affairs School of Advanced International Studies (SAIS), John Hopkins University, Washington DC, April 2012 http://www.econ2.jhu.edu/courses/336/Rostov%20Lecture%202012.pdf

Measures of increasing financial intensity 1

92

9

19

35

19

41

19

47

19

53

19

59

19

71

19

77

19

83

19

90

19

96

20

02

20

07

10%

50%

100%

150%

200%

250%

300%

19

29

19

35

19

41

19

47

19

53

19

59

19

65

19

71

19

77

19

83

19

90

19

96

20

02

20

07

10%

50%

100%

150%

200%

250%

300%

19

29

19

35

19

41

19

47

19

53

19

59

19

71

19

77

19

83

19

90

19

96

20

02

20

07

10%

50%

100%

150%

200%

250%

300%

19

29

19

35

19

41

19

47

19

53

19

59

19

65

19

71

19

77

19

83

19

90

19

96

20

02

20

07

10%

50%

100%

150%

200%

250%

300%

0

50

100

150

200

250

300

350

400

450

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

$T

r

OTC interest rate contracts, notional amount outstanding

0

100

200

300

400

500

600

700

800

900

1,000

1,100

19

77

19

82

19

87

19

92

19

97

20

02

20

07

$b

n

Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

US debt as a % of GDP by borrower type

Growth of interest rate derivatives values, 1987-2009

FX Trading values & world GDP 1977-2007

$Tr

n

2

Global issuance of asset-backed securities

Household deposits and loans: 1964 – 2009

Source: Bank of England, Tables A4.3, A4.1

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% o

f G

DP

Securitisations and loan transfers

Deposits

Loans

3

Measures of increasing financial intensity

US debt as a % of GDP by borrower type

4

1971

250%

1929

1935

1941

1947

1953

1959

19

65

19

77

19

83

19

90

1996

2002

2007

10%

50%

100%

150%

200%

300%

5

US financial sector assets

0%

50%

100%

150%

200%

250%

300%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Banks MMMFs

GSE Agency and GSE- Mortgage Pools

Issuers of ABS Finance Companies

Security Broker-Dealer Funding Corporation

NASDAQ index 1990 – 2003

Source: Datastream

0

1,000

2,000

3,000

4,000

5,000

6,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

6

Categories of credit

Loans to businesses / “entrepreneurs”

Loans to businesses / speculators / investors

Loans to “impatient” /

temporarily cash limited /

poorer households

Mortgage loans to

households

… to finance real investment projects

… to finance purchase of existing assets

… to bring forward consumption

… to finance residential houses

7

8

Categories of debt: UK, 2009

227

1235

243

232 Primarily productive investment

Some productive investment and some leveraged asset play

Mainly purchase of existing assets

Pure life-cycle consumption smoothing

Other corporate

Commercial real estate

Residential mortgage (including securitizations

and loan transfers)

Unsecured personal

£bn

Credit and asset price cycles

Expectation of future asset price increases

Increased credit extended

Low credit losses: high bank profits • Confidence reinforced • Increased capital base

Increased asset prices

Increased lender supply of credit

Favourable assessments of

credit risk

Increased borrower demand for credit

9

10

Lending to UK households

Percentage changes on a year earlier

Secured

Unsecured

Households

Source: Bank of England “Trends in Lending”

-5

0

5

10

15

20

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

20

10

20

12

Households

Percentage changes on a year earlier

Unsecured

Secured

Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012

Source: IMF, Bank of Japan Flow of Funds Accounts

-15

-10

-5

0

5

10

PNFCs Government

%

11

12

Japanese government and corporate debt: 1990 – 2010

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

% G

DP

0

50

100

150

200

250

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20010

Bank lending to non-financial corporates General Government debt

13

Shifting leverage: private and public debt-to-GDP

Source: ONS Note: PNFC = private, non-financial corporates; Public = central and local government

Source: BEA Note: PNFC = private, non-financial businesses; Public = federal, state and local government

Source: ECB Note: PNFC = private, non-financial corporates; Public = central and local government

0

20

40

60

80

100

120

140

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

UK

0

20

40

60

80

100

120

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

US

0

20

40

60

80

100

120

140

160

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

Spain

14

Private credit to GDP and growth

Source: S. Cecchetti and E. Kharroubi, BIS Working Paper No. 381

"Reassessing the impact of finance and growth"

Dimensions of increasing complexity

15

‘Improved’ risk management Secured finance VAR models M-to-M accounting

Securitisation Liquidity Market based pricing M-to-M accounting

Derivatives Interest rates Fx Credit

Multi-step intermediation and

maturity transformation

Credit structuring and

tranching

Increased role for short-term

wholesale funding

Increased trading activity

Increasing complexity – not just a parallel shadow system

16

• Increasing integration of commercial and investment banking

•Multiple bank to shadow bank links (SIVs, repo markets)

• Large expansion of banking trading books

• Increase in wholesale funding – secured and unsecured

• Treasuries become profit centres

• Intra-financial system assets grow rapidly

‘Improved’ risk management Secured finance VAR models M-to-M accounting

Securitisation Liquidity Market based pricing M-to-M accounting

Derivatives Interest rates Fx Credit

Multi-step intermediation and maturity

transformation

Credit structuring

and tranching

Increased role for short-term

wholesale funding

Increased trading activity

17

Credit derivatives “enhance the

transparency of the markets

collective view of credit risks…

[and thus]… provide valuable

information about broad credit

constraints and increasingly set

the marginal price of credit”.

IMF Global Financial Stability Report, April 2006

Additional credit creation

“Securitisation is a good thing. If everything was on bank balance sheets, there would not be enough credit.”

“Senior American Regulator”, quoted in the Economist Special Report on Financial

Innovation, February 2012

18

Credit and asset prices: with securitised credit and mark-to-market accounting

Decreased VAR

Increased credit extended

Increased asset prices – fewer defaults

Decreased margin calls

Increased trading

Increased short-term liquidity

Mark-to-market accounting and VAR based risk management • Bank profit and capital • Required bank capital • Bonuses and animal spirits

Increased price of credit securities

19

20

Irrational exuberance in equity and debt markets

Source: Moody’s KMV, FSA Calculations

Financial firm CDS and share prices

Source: McCulley and Pozsar

Private and public leverage cycles: US

21

1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 0

50

100

150

200

250

Financial Repression

Ho

usi

ng

bu

rsts

WW

II e

nd

s

Private debt as a % of NGDP Public and

China: total social finance to GDP

100

120

140

160

180

200

220

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

% o

f G

DP

22

Non-financial private sector* credit outstanding, % GDP

0 50 100 150 200

Brazil

China

India

Hungary

Indonesia

Korea

Mexico

Russia

South Africa

Turkey

2002

2007

2012

Source: BIS, Citi Research *Households + corporates

23

Leaning against credit cycles: monetary or macro-prudential levers?

24

Monetary policy – interest raises

• Gets into all the cracks

• Elasticity of response variable by category of credit

Macro-Prudential levers

• Can address specific credit categories

• Will stimulate innovation to avoid

Pros

Cons