Securitisation, Shadow Banking and the Value of Financial

Innovation

School of Advanced International Studies (SAIS) Johns Hopkins University, Washington DC

19 April 2012 17:30 EDT

Adair Turner

Chairman of the UK Financial Services Authority

Credit derivatives “enhance the transparency of the markets’ collective view or credit risks…. [and thus] … provide valuable information about broad credit conditions and increasingly set the marginal price of credit”

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.”

“The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.”

IMF Global Financial Stability Report, April 2006

The conventional wisdom – 2006

Stability via risk dispersion

Efficiency via price discovery

1

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

2

Development of the crisis: 2007 – 2008

Bear Stearns hedge funds under liquidity pressure

Major losses by ‘market neutral’ hedge funds

Carlyle Capital and Peloton Hedge Funds closed

Liquidity and solvency problems at off-balance sheet SIVs

Stresses at MMMFs: Reserve Primary Fund ‘breaks the buck’

Liquidity run in repo and other secured funding markets

Hedge fund deleveraging and asset sales exacerbate downward spiral of asset values

June 2007:

August 2007:

February 2008:

Autumn 2007 to Mid 2008:

Summer 2008:

August to October

2008:

Late autumn 2008:

3

Source: Financial Stability Board 4 A

Non-financialBusinesses

Governments

Financial Intermediation

Households Households

Non-financial Businesses

4BSource: Financial Stability Board

Banks

Maturity transformation +

leverage

Loans

Non-financialBusinesses

Governments

Households Households

Non-financial Businesses

Financial Intermediation

Deposits

Source: Financial Stability Board 4C

Non-financial Businesses

Direct Investment: Bonds + Equities

Insurance, Pension Funds + other intermediaries

Financial Intermediation

Households

Non-financialBusinesses

Governments

Households

Banks

• Less maturity transformation

• Less leverage

Non-financial Businesses

4D

Households

Governments

Financial Intermediation

Banks

Households

Non-financial Businesses

Non-financialBusinesses

MMFs

Sec

uritis

ation

SP

V

Source: Financial Stability Board

ABCP

Hedge Fund

Broker dealer

Households

Governments

Maturity/liquidity

transformation +

leverage … in multiple

steps

4ESource: Financial Stability Board

Households

Governments

Financial Intermediation

Banks

Households

Non-financial Businesses

Non-financialBusinesses

MMFs

Sec

uritis

ation

SP

V ABCP

Hedge Fund

Broker dealer

Households

Governments

Interconnected via bank sponsorship, liquidity puts, repo markets, funding flows, securities lending

5

US mortgages on bank balance sheets and securitised: 1952 – 2009

Source: U.S. Flow of Funds

0%

10%

20%

30%

40%

50%

60%

70%

80%

19

52

19

55

19

58

19

61

19

64

19

67

19

70

19

73

19

76

19

79

19

82

19

85

19

88

19

91

19

94

19

97

20

00

20

03

20

06

20

09

Private label RMBS issuers (home mortgage RMBS)Agency and GSE backed RMBS (home mortgages)Home mortgages

BANK

Mortgages outstanding as % of GDP

Home mortgages

6

Money market funds and bank deposits:US 1980-2010

US Household holdings of money markets funds

US Non-Financial business holdings of money markets funds

7

Percent of Household Cash and Liquid Deposits Percent of Non-Financial Business Short-Term Assets

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1980 1985 1990 1995 2000 2005 2010

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

Checkable Deposits

Time & Saving Deposits

MMMF

Source: US Flow of Funds

0%

10%

20%

30%

40%

50%

60%

70%

1980 1985 1990 1995 2000 2005 2010

Checkable Deposits

Time & Saving Deposits

MMMF

Source: US Flow of Funds

Growth of assets in four financial sectors 1954 – 2006

Source: Brookings Papers on Economic Activity, 2010.8

1954 Q1 = 1

US Asset-backed commercial paper 1990 – 2008

Source: US Flow of Funds 9

Note: Not including ABCP of chartered banks0

100

200

300

400

500

600

700

800

900

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

Note: Not including ABCP of chartered banks

$bn

US Repo market 1990 – 2011

US repo market ($ trillion)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Reverse Repo Repo

Source: Federal Reserve Bank of New York.Note: US Primary Dealers only.

US

$tn

10

US financial sector assets as % of GDP

0%

50%

100%

150%

200%

250%

300%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Banks MMMFsGSE Agency and GSE- Mortgage PoolsIssuers of ABS Finance CompaniesSecurity Broker-Dealer Funding Corporation

11Source: US Flow of Funds

USA debt as a % of GDP by borrower type

Source: Oliver Wyman

Household

Corporate

Financial

1929

1935

1941

1947

1953

1959

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300%19

29

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300%

12

Underlying features of shadow banking

• Pooling, tranching (and re-tranching) to “create” apparently low risk assets

• Marked-to-market collateral and margin to “create” money equivalent claims

13

Real return on US treasury 20 year index-linked bond, 1999 – 2012

14

0%

1%

2%

3%

4%

5%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

15

Source: Zoltan Pozsar, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper 11/190

Non-Financial corporations' cash and cash equivalents

Increasing demand for cash equivalent assets

Institutional Cash Pools

Banking and other financial balance sheets: in US and Eurozone

Deposit-taking Institutions as % of GDP Other financial institution as % of GDP

Source: IMF World Outlook Database, US Flow of Funds; ECB Statistical Data Warehouse

US

Euroarea

0%

50%

100%

150%

200%

250%

300%

350%

400%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

US

Euroarea

0%

50%

100%

150%

200%

250%

300%

350%

400%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

16

Frequency distribution of debt payouts

100% of principal and due interest

Observed in good times100%

Not observed in good times

0

17

Financial firms’ CDS and share pricesExhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%Dec

02

Apr

03

Aug

03

Dec

03

Apr

04

Aug

04

Dec

04

Apr

05

Aug

05

Dec

05

Apr

06

Aug

06

Dec

06

Apr

07

Aug

07

Dec

07

Apr

08

Aug

08

Dec

08

Ave

rage

CDS

Spre

ad in P

erc

ent

-

0.50

1.00

1.50

2.00

2.50

Mar

ketC

ap Index

CDS SHARE-PRICE-ADJ USTED

Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS.

CDS series peaks at 6.54% in September 2008.Source: Moody’s KMV, FSA Calculations 18

Gennaioli, Shleifer and Vishny, 2010

recent policy proposals, while desirable in terms of their intent to control leverage and fire sales, do not go far enough.

It is not just the leverage but the scale of financial innovation and of the creation of new claims itself, that might require regulatory attention”

“We recognise the benefits of private supply of safe securities, but at least in some cases, such securities owe their very existence to neglected risks…

19

Bank credit and money creation

Asset Liability

Loan to non-financial business

100 Deposit from non-financial business

100

Immediately available “private money”Not immediately repayable

20

Maturity transformation in banks and shadow banks

BANK

Long-term loans

Instant access / short-term deposits

SHADOW BANK CHAIN

Long-term loans

Instant access “deposits”

ABCP SIV /

Conduit MMF

Broker dealer

Hedge Fund

21

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

22

Bank credit and creation of unsecured private money

Asset Liability

Loan 100 Deposit100

Not secured May be secured

23

Shadow bank credit and creation of secured private money

InvestorBorrower Hedge Fund

Broker Dealer

Money Market Fund

Repo /Prime broker

finance

Repo

Secured money equivalent

Secured money equivalent

24

Hardwired procyclicality in secured funding contracts

Asset value falls

• Assets sold to cover margin calls

• Reduced funding available

• More collateral required even if % haircuts/margins unchanged

• Variation margin paid

Increased risk awareness Increased % haircuts

25

Source: Gary Gorton and Andrew Metrick, “Shadow banking and the run on repo, 2009

Average repo haircuts: US bilateral repo market 2007 – 2009

26

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

01/

01

/07

01/

04

/07

01/

07

/07

01/

10

/07

01/

01

/08

01/

04

/08

01/

07

/08

01/

10

/08

01/

01

/09

Four distinctive features of financial innovation

• Regulatory arbitrage

• Tax arbitrage

• Non-transparent embedded options

• Excessive churn

Complexity

and

interconnectedness

27

Hypothesis I: The value of ‘market completion’

Th

eore

tica

lly

avai

lab

le

allo

cati

ve e

ffic

ien

cy

Neg

ati

ve e

xter

nal

ity

of

incr

ease

d p

ote

nti

al

inst

abil

ity

More complete financial markets

Complexity and interconnectedness

Increased financial intensity

Net social value derived

28

Hypothesis II: The value of ‘increased liquidity’?

Eff

icie

ncy

/ p

rice

d

isc

ove

ry

Increased liquidity

Increased market liquidity

Net social value derived?

Po

ten

tia

l fo

r vo

lati

lity

, p

ure

mo

men

tum

ef

fect

s an

d a

rbit

rary

p

rici

ng

Increased role of algorithmic trading

?

29

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

30