Abstract
The current financial downturn has had numerous effects worldwide. There is great demand in 2009 for tighter regulation in order to overcome this crisis and prevent future ones. The author warns, however, that this must not result in the dismantling of financial market integration and the stifling of financial innovation. Though it seems hard to believe these days, the market-based financial system has made a big contribution to global growth. While some of the structures created have not been sustainable, reverting to fragmented, nation-based, and overregulated banking markets is not the answer. Walter stresses the need for greater resilience in terms of more sophisticated market participants, stronger market infrastructure and supra-national structures for the regulation and supervision of the global financial system.
When the global collateral damage of the financial crisis emanating from the US in the summer of 2007 became apparent, financial markets themselves were decried as the agents of the demise of Germany's social market economy. Such a view is not only factually incorrect; if this perception were to become widely accepted it would also do major long-term damage to the global economy and the market principle. After all, efficient financial markets are the basis for a dynamic economy, which is, in turn, the basis for social transfers. Furthermore, financial markets perform a monitoring function with regard to economic policy, which is important for setting reasonable limits on state management and redistribution.
Financial markets contribute to the growth and dynamism of an economy in a variety of ways. First of all, financial markets make a direct contribution to growth, which, though small compared to the indirect contributions to growth mentioned below, is certainly not insignificant (see [6]). In fact, the financial sector–-the banks, insurance companies and other providers of financial services such as stock exchanges–-creates around 4.5% of annual gross value added in Germany. This is higher than the contribution from Germany's feted flagship sectors such as the electrical and chemical industries–-a fact not widely known to most people. In terms of employment, too, the financial sector is a major player, with no fewer than 670,000 people (1.5% of the total work force) employed by banks and 1.3 million (3%) in the credit and insurance business. Nor is this contribution of the financial industry to direct growth by any means a reflection–-though some may suppose it is–-of an irrational ballooning of the financial sector that accompanied the formation of the global financial market bubble which burst not so long ago; in fact, the contribution made by the financial sector in Germany is still relatively low by international standards. By comparison, in the US the contribution to gross value added is around 8%, in the UK it is no less than 8.5% and in Switzerland it is as much as 10.5%.
Of considerably more importance and greater quantitative significance, however, is the indirect contribution of the financial markets, namely that of (1) financing economic activity and allocating scarce resources for alternative purposes; (2) the inherently associated assuming and spreading of risk; as well as (3) mirroring their financing function by investing savings in order to smooth out consumption over the life cycle.
With regard to the financing function, the decentralised market mechanism of the financial markets ensures the most efficient allocation of available savings. The more efficient the financial system, the more effectively the allocation function can be performed. Several analyses have provided empirical evidence that economies with a more efficient and developed financial system grow faster than those without (see for example [
The relevance of the completeness (or breadth) of financial markets relative to the depth of financial markets is often underestimated–-a serious mistake. It should, however, be obvious that different funding projects require completely different instruments. This is made particularly clear by a comparison between investment projects with differing characteristics. For illustrative purposes we shall compare a company's expanding investment in an established sector with a start-up sector's development of a human-capital-intensive innovation. In the first case, the body of available historical data allows us to make a relatively reliable forecast of the stream and profile of the return on investment. In addition, the company presumably has access to collateral on account of its many years in business. In such a situation the investment can largely be financed using a fixed-interest loan, since on the one hand the funding burden (relative to the revenue flows) can be reliably projected by the investor, while on the other hand the potential risk for providers of capital is low thanks to the history and the availability of collateral. In the latter case, by contrast, a funding structure is required that on the one hand takes into account that the future revenue stream of the investment is uncertain and cannot be projected (which rules out a fixed, regular interest claim for the capital providers), and on the other guarantees the right of the providers of capital to exercise influence in order to sufficiently safeguard their claims. In this case the appropriate solution would be quasi-equity financing instruments that grant the providers of capital a say in decision-making and a risk-adjusted high return on the capital they have invested, if the venture is successful.
It is precisely those investment banking products that are so often harshly criticised that offer the variety of financing instruments which can meet the requirements of diverse financing projects, and thus help to satisfy the respective preferences of both the providers and recipients of capital. This underlines how misguided it would be to phase out this segment of the financial markets in favour of simple types of financing (such as traditional bank loans) that are presumed to better serve the interests of the real economy.
For the sake of completeness (and not least because of the ongoing political debate), note that the correlation between the heterogeneity of the financial system and the contribution to growth applies not only to corporate finance but also to household financing. For example, a report prepared by Mercer Oliver Wyman [10] for the European Commission showed that economies with a broader range of instruments for private real estate financing grow faster than those where only a limited number of financial instruments is available. In this market segment too it would thus be counterproductive to reduce the range of available funding investments by imposing onerous regulation. Incidentally, this applies not only to the potential growth contribution but also to the social policy dimension: more flexible funding models–-for example, with variable repayments or longer repayment periods–-also allow demographic groups with initially low incomes and few assets to acquire real estate.
The important function of the financial markets of dispersing risk also applies beyond the straightforward financing of investments by companies and households. This wider significance is illustrated by the example of the hedging of currency risk. As a rule, companies that export their products to, or acquire goods from, other currency areas want to avoid exchange-rate fluctuation risks. These risks can be hedged by using currency derivatives and forward transactions. Here too the availability of such financing instruments makes a significant contribution to growth: it is well known that open economies grow faster than closed ones. If, and to the extent to which, the availability of instruments for hedging exchange-rate risks boosts the willingness of companies to integrate into the international division of labour, this makes a direct contribution to growth.
What is less well known is that using other derivatives allows other categories of risk to be managed. This applies to commodities derivatives with which companies protect themselves from the risks of fluctuations in commodity prices; to interest rate derivatives with which not only banks but also companies can hedge the risk of unwanted fluctuations in their financing costs; to the recently introduced weather derivatives, with which utility companies and other sectors whose output is weather sensitive can hedge against weather-induced fluctuations in their output (and thus in their payment streams).
The use of financial markets for hedging extends even further: just like companies, households and individuals also use financial instruments to hedge risk. This is evident in protecting against sickness, accident and property risks by using insurance products. What is less obvious is that the ability of a financial sector to provide protection against such risks has resulted in increasingly close ties between the traditional insurance sector and the capital markets: the ability of insurance companies to assume risks is determined by as we know–-by the probability of loss or damage, the potential size of the loss and the correlation between individual risks. While these parameters for traditional risks like mortality risk are easily calculable, there are several areas of the property insurance segment where there is growing uncertainty about the probability and size of losses. This is obviously the case with disaster risks that are dependent on extreme weather events (hurricane, floods etc.) or terrorism. There is a danger that the inability to calculate such risks will result either in unaffordable insurance premiums or, in the worst case, in the non-insurability of risks, which in turn would hamper economic activity. A wider public became aware of this following the 11 September terrorist attacks, when the continuation of civil aviation was threatened by the prospect of airlines being unable to insure their aircraft. Less dramatic, but of increasing importance on account of global climate change, is the concern of the insurance companies that they will face excessive burdens from climate-induced losses [4]. In this segment, insurance companies have in the recent past made greater use of the facility to pass on such risks to the capital market using insurance-linked securities–-and thus to capital market players outside the insurance sector [9]. This example shows how the innovative drive of financial markets and the financial sector can be utilised to meet new economic policy challenges.
The complement to the financing function is the investing of savings. From a saver's point of view savings represent delayed consumption. A particularly important aspect of this–-given that the demographic shift is edging up to the limitations of the state-financed pay-as-you-go pension system–-is safeguarding one's standard of living during old age. From the saver's point of view the key is striking the right balance between the complementary objectives of a return on investment regarded as satisfactory (the higher this is, the more likely one is to refrain from consumption) and the security of the investment (so that one has reliable access to the desired amount of funds in old age). In this connection the international nature of capital markets is particularly important: the demographic contraction of traditional industrial nations like Germany will be accompanied by a decline in the potential growth rate of these economies. A reasonable return on savings can, therefore, only be attained via the international diversification of invested assets–-with this diversification having to be hedged suitably to mitigate exchange-rate fluctuations and other risks in order to ensure the security of the investment. This shows, once again, that the more developed, more diverse and deeper financial markets are, the more likely they are to succeed in fulfilling the desired objectives of old age provision.
To prevent any misunderstanding, note that financial markets themselves do not generate growth (apart from their direct contribution to growth); efficient financial markets are, however, essential for the efficient utilisation of scarce resources in an economy and boost the growth impact of these resources. Growth is not only the basis and expression of a country's increasing prosperity. 1 Growth is also the best means of ensuring that broad segments of the population can play their part in the economy and thus benefit from prosperity or–-should they be unable to do so for whatever reason–-that they can obtain some form of financial compensation, via transfer payments for example. Those who pretend to be able to implement elegant solutions to disputes about redistribution while the economy is contracting or stagnating are simply entertaining illusions. Such conflicts can best be solved when there is good growth of national income.
It hardly needs mentioning that this must of course be sustainable, qualitative growth, which for example rules out growth that is derived from the non-sustainable exploitation of nature.
Another function of the financial markets that generally receives little attention also has social policy significance ([1], pp 5-15). Admittedly, it may appear inappropriate to point this out in the current environment, but even in the aftermath of the financial crisis the fundamental truth remains that open financial markets are an important indicator of the quality of the economic policy of a country. Financial markets sanction, for example, monetary policy that is inflationary compared with that of other countries by demanding higher interest rates or withdrawing (or reducing the flow of) capital. They do the same to countries whose debt policy is too lax.
Likewise, deep and wide stock markets can be an indicator of the attractiveness of a country as a business location. Of course, too much cannot be, nor should be, read into every swing in the stock market as an indication of the location's appeal to investors–-the very price fluctuations of the recent past should serve as a warning not to do this. What also applies, however, is that if a country's stock market valuations and capitalisation systematically lag behind those of other nations, this must and should certainly be interpreted as a vote of no confidence in the economic fundamentals and the economic performance of that country.
Note that this does not mean that financial markets determine the superiority of a specific economic model–-each country is free to choose its economic policy in accordance with the political preferences of its population; in this sense the financial markets perform merely an indicator function, illustrating more clearly the economic consequences of the selection of a specific policy. Contrary to elections, this assessment is made not only on polling days, but is more of an ongoing process–-which is certainly positive in the decision-making process but may not always be welcome as far as the (political) players involved are concerned.
In turn, those that derive the most from this indicator and control function are the socially disadvantaged: it is those on low incomes, those who are immobile, pensioners and people with few assets, for example, who benefit most from monetary stability. Rich, mobile people can diversify their assets more easily or shift them abroad if necessary to protect themselves from the negative consequences of currency devaluation.
In sum, efficient financial markets not only make a contribution to financing investments, hedging risk, evening out consumption and boosting the potential growth rate of an economy; they also perform a social policy function of major importance. Both political leaders and financial industry institutions should, therefore, attach a high priority to communicating this importance and intensifying the promotion of viable financial markets. The current situation, with uncertainties in the markets and growing doubts about the effectiveness of the market economy as a whole, makes this task even more pressing. The private banking sector is playing its part by actively working on the problems and discrepancies that have been revealed as the financial market crisis has unfolded. However, the options available to the private sector to respond appropriately are limited when it comes to regulatory policy measures. Financial structures and individual institutions that had been the bedrock of the financial system for decades disappeared literally overnight. Central banks and governments have to respond, therefore, with corrective measures to complement private sector initiatives (for an overview, see [3]). This implies a strong need for intersectoral cooperation.
The following discussion will concentrate on private sector options. If 2008 was one of the worst years in living memory, 2009 will be recorded in history as the year that reshaped the global financial system. Banks will need to restore not only their capital base, but their clients’ trust and confidence. They need to reconsider their business models and the design of financial markets and products. The authorities, for their part, will need to continue doing what is necessary to maintain the functioning of the financial system. At the same time, they will need to design the building blocks of a regulatory and supervisory system that is commensurate with global, interdependent financial markets.
The financial industry is vigorously addressing all areas in which deficiencies have been revealed by the crisis. A wide range of recommendations has been presented by the Institute of International Finance [5] and the Counterparty Risk Management Policy Group [2], and these are now in the process of being implemented by banks world-wide.
Three issues stand out. First, much more attention must be given to the issue of liquidity. Liquidity is at the heart of the stability of any financial system, but especially of a market-based financial system. Yet the crisis has revealed that the previously held assumption of continuously available liquidity no longer applies, while at the same time there is a gap in our understanding of market dynamics in times of illiquidity. Moreover, the repercussions for the valuation of illiquid assets in a mark-to-market accounting regime need to be addressed with urgency.
Second, there is the issue of transparency. It would be thoroughly misunderstanding the nature of this issue if we limited it to greater and more comparable transparency about banks’ exposures. Rather, greater transparency must extend to better disclosure of banks’ institutional arrangements for risk management, risk models and techniques used. Moreover, greater transparency must be achieved for financial products, especially the complex structured credit products that lie at the heart of this crisis. Investors will only return to these markets if originators disclose sufficient data on the underlying assets so as to enable investors to make their own due diligence rather than rely passively on the judgement of originators and rating agencies. Realistically, though, even this will not save these markets from shrinking dramatically as investors’ preferences shift to simpler products and business models.
Third, we need to strengthen the infrastructure of financial markets, the ‘plumbing’. In order to increase price transparency, transaction data should be pooled and made available. In order to reduce settlement risk and to enable reigning in over-the-counter (OTC) markets, central counterparties will have to be established, as has already been the case for credit default swaps. Greater automation in these markets will also reduce settlement risk, but will obviously require a higher degree of standardisation.
While banks’ individual and collective efforts will be sufficient and successful in many areas, intervention by standard-setting bodies and authorities will be needed in others. Greater transparency in the distribution of risks in the financial system and, connected to this, coordinating a large number of diverse creditors in case of a crisis are obvious areas where this holds true. The same applies to valuation issues. Here, reform efforts must recognise that this is more than merely an accounting issue. Mark-to-market accounting imposes stricter discipline on banks’ risk management and increases market discipline, because it acts as an early warning system–-losses show up in banks’ profit and loss statements before they materialise in the real economy. Any changes must respect these benefits of fair-value accounting, but must, at the same time, address the issues of illiquid markets, procyclicality and consistency between accounting standards.
Intensive international coordination is an indispensable condition for these efforts as well as for any state action aimed at stabilising financial markets and banks. It is recognised that state action needs to be attuned to individual circumstances. Nonetheless, uncoordinated action using a plethora of diverging instruments will only create yet more uncertainty, spread the virus and distort competition. It also limits the effectiveness of rescue measures.
This holds particularly true for the European Union, where Member States will be faced with a stark choice in response to the crisis: they can choose either to act jointly and to finally create a supervisory system that is commensurate with a truly integrated financial market, or to relapse into a system of essentially separate national financial markets (see [2]).
The choice is clear. There is no doubt that the financial crisis will cost us dearly, and the financial industry bears as much responsibility for this as past policy mistakes in both macroeconomic and regulatory policies. Comprehensive yet targeted action, as outlined above, is needed to re-establish the foundations of the global system. More and louder calls for tighter regulation will be heard in 2009. This is understandable in light of the mounting fiscal burden stemming from the crisis.
But this must not result in the dismantling of financial market integration and the stifling of financial innovation. Though it seems hard to believe these days, the market-based financial system made a big contribution to global growth. While some of the structures created have not been sustainable, reverting to fragmented, nation-based and overregulated banking markets is not the answer. What we need is Greater resilience in terms of market participants that are more sophisticated, a stronger market infrastructure and supra-national structures for the regulation and supervision of the global financial system are called for.
Footnotes