24/2/17: Distributed ledger technology in payments, clearing, & settlement

A new research paper from the U.S. Federal Reserve System, titled “Distributed ledger technology in payments, clearing, and settlement” (see citation below) looks at the rapidly evolving landscape of blockchain (distributed ledger technologies, or DLTs) in the financial services.

The authors note that DLT “is a term that [as of yet]… does not have a single definition”. Thus, the authors “refer to the technology as some combination of components including peer-to-peer networking, distributed data storage, and cryptography that, among other things, can potentially change the way in which the storage, record-keeping, and transfer of a digital asset is done.” While this definition is broader than blockchain definition alone, it is dominated by blockchain (private and public) typologies.


Impetus for research

Per authors, the impetus for this research is that DLT is one core form of financial sector innovation “that has been cited as a means of transforming payment, clearing, and settlement (PCS) processes, including how funds are transferred and how securities, commodities, and derivatives are cleared and settled.” Furthermore, “the driving force behind efforts to develop and deploy DLT in payments, clearing, and settlement is an expectation that the technology could reduce or even eliminate operational and financial inefficiencies, or other frictions, that exist for current methods of storing, recording, and transferring digital assets throughout financial markets.” This, indeed, is the main positive proposition arising from blockchain solutions, but it is not a unique one. Blockchain systems offer provision of greater security of access and records storage, higher degree of integration of various data sources for the purpose of analytics, greater portability of data. These advantages reach beyond pure efficiency (cost savings) arguments and go to the heart of the idea of financial inclusion - opening up access to financial services for those who are currently unbanked, unserved and undocumented.

In line with this, the Fed study points that the proponents “of the technology have claimed that DLT could help foster a more efficient and safe payments system, and may even have the potential to fundamentally change the way in which PCS [payments, clearance and settlement] activities are conducted and the roles that financial institutions and infrastructures currently play.” The Fed is cautious on the latter promises, stating that “although there is much optimism regarding the promise of DLT, the development of such applications for PCS activities is in very early stages, with many industry participants suggesting that real-world applications are years away from full implementation.”

Per Fed research, “U.S. PCS systems process approximately 600 million transactions per day, valued at over $12.6 trillion.” In simple terms, given average transaction cost of ca 2-2.5 percent, the market for PCS support systems is around USD250-310 billion annually in the U.S. alone, implying global markets size of well in excess of USD750 billion.

DLT Potential 

Fed researchers summarise key (but not all) potential (currently emerging) benefits of DLT systems in PCS services markets:

• Reduced complexity (especially in multiparty, cross-border transactions)
• Improved end-to-end processing speed and availability of assets and funds
• Decreased need for reconciliation across multiple record-keeping infrastructures
• Increased transparency and immutability in transaction record-keeping
• Improved network resiliency through distributed data management
• Reduced operational and financial risks

One of the more challenging, from the general financial services practitioners’ point of view, benefits of DLT is that it is “essentially asset-agnostic, meaning the technology is potentially capable of providing the storage, record-keeping, and transfer of any type of asset. This asset-agnostic nature of DLT has resulted in a range of possible applications currently being explored for uses in post-trade processes.”

The key to the above is that blockchains ledgers are neutral to the assets that are recorded on them, unlike traditional electronic and physical ledgers that commonly require specific structures for individual types of assets. The advantage of the blockchain is not simply in the fact that you can use the ledger to account for transactions involving multiple and diverse assets, but that you can also more seamlessly integrate data relating to different assets into analytics engines.

Due to higher efficiencies (cost, latency and security), blockchain offers huge potential in one core area of financial services: financial inclusion. As noted by the Fed researchers, “financial inclusion is another challenge both domestically and abroad that some are attempting to address with DLT. Some of the potential benefits of DLT for cross-border payments described above might also be able to help address issues involving cross-border remittances as well as challenges in providing end-users with universal access to a wide range of financial services. Access to financial services can be difficult, particularly for low-income households, because of high account fees, prohibitive costs associated with traveling to a bank. Developers contend DLT may assist financial inclusion by potentially allowing technology firms such as mobile phone providers to provide DLT-based financial services directly to end users at a lower cost than can (or would) traditional financial intermediaries; expanding access to customer groups not served by ordinary banks, and ultimately
reducing costs for retail consumers.”

Lower costs are key to achieving financial inclusion because serving lower income (currently unbanked and unserved) customers in diverse geographical, regulatory and institutional settings requires trading on much lower margins than in traditional financial services, usually delivered to higher income clients. Reducing costs is the key to improving margins, making them sustainable enough for financial services providers to enter lower income segments of the markets.

Incidentally, in addition to lower costs, improving financial inclusion also requires higher security and improved identification of customers. These are necessary to achieve significant gains in efficiencies in collection and distribution of payments (e.g. in micro-insurance or micro-finance). Once again, DLT systems hold huge promise here, including in the areas of creating Digital IDs for lower income clients and for undocumented customers, and in creating verifiable and portable financial fingerprints for such clients.

The Fed paper partially touches this when addressing the gains in information sharing arising from DLT platforms. “According to interviews, the ability of DLT to maintain tamper-resistant records can provide new ways to share information across entities such as independent auditors and supervisors.” Note: this reaches well beyond the scope of supervision and audits, and goes directly to the heart of the existent bottlenecks in information sharing and transmission present in the legacy financial systems, although the Fed study omits this consideration.

“As an example, DLT arrangements could be designed to allow auditors or supervisors “read-only access” to certain parts of the common ledger. This could help service providers in a DLT arrangement and end users meet regulatory reporting requirements more efficiently. Developers contend that being given visibility to a unified, shared ledger could give supervisors confidence in knowing the origins of the asset and the history of transactions across participants. Having a connection as a node in the network, a supervisor would receive transaction data as soon as it is broadcast to the network, which could help streamline regulatory compliance procedures and reduce costs…”

Once again, the Fed research does not see beyond the immediate issues of auditing and supervision. In reality, “read-only” access or “targeted access” can facilitate much easier and less costly underwriting of risks and structuring of contracts, aiding financial inclusion.


Key takeaways

Overall, the Fed paper “has examined how DLT can be used in the area of payments, clearing and settlement and identifies both the opportunities and challenges facing its long-term implementation and adoption.” This clearly specifies a relatively narrow reach of the study that excludes more business-focused aspects of DLTs potential in facilitating product structuring, asset management, data analytics, product underwriting, contracts structuring and other functionalities of huge importance to the financial services.

Per Fed, “in the [narrower] context of payments, DLT has the potential to provide new ways to transfer and record the ownership of digital assets; immutably and securely store information; provide for identity management; and other evolving operations through peer-to-peer networking, access to a distributed but common ledger among participants, and cryptography. Potential use cases in payments, clearing, and settlement include cross-border payments and the post-trade clearing and settlement of securities. These use cases could address operational and financial frictions around existing services.”

As the study notes, “…the industry’s understanding and application of this technology is still in its infancy, and stakeholders are taking a variety of approaches toward its development.” Thus, “…a number of challenges to development and adoption remain, including in how issues around business cases, technological hurdles, legal considerations, and risk management considerations are addressed.” All of which shows two things:

• Firstly, the true potential of DLTs in transforming the financial services is currently impossible to map out due to both the early stages of technological development and the broad range of potential applications. The Fed research mostly focuses on the set of back office applications of DLT, without touching upon the front office applications, and without considering the potentially greater gains from integration of back and front office applications through DLT platforms; and
• Secondly, the key obstacles to the DLT deployment are the legacy services providers and systems - an issue that also worth exploring in more details.

In both, the former and the latter terms, it is heartening to see U.S. regulatory bodies shifting their supervisory and regulatory approaches toward greater openness toward DLT platforms, when contrasted against the legacy financial services platforms.


Mills, David, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kargenian, Max Ellithorpe, Wendy Ng, and Maria Baird (2016). “Distributed ledger technology in payments, clearing, and settlement,” Finance and Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.095. 

21/2/17: The Future of Finance

Last week I was speaking at a forum on Open Societies in Panama City. My speech covered the key threats and transformational changes in the global financial services. Here are my annotated slides:

3/9/16: Fintech, Banking and Dinosaurs with Wings

Here is an interesting study from McKinsey on fintech role in facilitating banking sector adjustments to technological evolution and changes in consumer demand for banking services:
http://www.mckinsey.com/business-functions/risk/our-insights/the-value-in-digitally-transforming-credit-risk-management?cid=other-eml-alt-mip-mck-oth-1608

The key here is that fintech is viewed by McKinsey as a core driver for changes in risk management. And the banks responses to fintech challenge are telling. Per McKinsey: “More recently, banks have begun to capture efficiency gains in the SME and commercial-banking segments by digitizing key steps of credit processes, such as the automation of credit decision engines.”

The potential for rewards from innovation  is substantial: “The automation of credit processes and the digitization of the key steps in the credit value chain can yield cost savings of up to 50 percent. The benefits of digitizing credit risk go well beyond even these improvements. Digitization can also protect bank revenue, potentially reducing leakage by 5 to 10 percent.”

McKinsey reference one example of improved efficiencies: “…by putting in place real-time credit decision making in the front line, banks reduce the risk of losing creditworthy clients to competitors as a result of slow approval processes.”

Blockchain technology offers several pathways to delivering significant gains for banks in the area of risk management:

• It is real-time transactions tracking mechanism which can be integrated into live systems of data analytics to reduce lags and costs in risk management;
• It is also the most secure form of data transmission to-date;
• It offers greater ability to automate individual loans portfolios on the basis of each client (irrespective of the client size); and 
• It provides potentially seamless integration of various sub-segments of lending portfolios, including loans originated in unsecured peer-to-peer lending venues and loans originated by the banks.

Note the impact matrix above.

Blockchain solutions, such as for example AID:Tech platform for payments facilitation, can offer tangible benefits across all three pillars of digital credit risk management process for a bank:

• Meeting customer demand for real-time decisions? Check. Self-service demand? Check. Integration with third parties’ platforms? Check. Dynamic risk-adjusted pricing and limits? Check
• Reduced cost of risk mitigation? Yes, especially in line with real-time analytics engines and monitoring efficiency
• Reduced operational costs? The entire reason for blockchain is lower transactions costs

What the above matrix is missing is the bullet point of radical innovation, such as, for example, offering not just better solutions, but cardinally new solutions. Example of this: predictive or forecast-based financing (see my earlier post on this http://trueeconomics.blogspot.com/2016/09/2916-forecast-based-financing-and.html).

A recent McKinsey report (http://www.mckinsey.com/industries/financial-services/our-insights/blockchain-in-insurance-opportunity-or-threat) attempted to map the same path for insurance industry, but utterly failed in respect of seeing the insurance model evolution forward beyond traditional insurance structuring (again, for example, FBF is not even mentioned in the report, nor does the report devote any attention to the blockchain capacity to facilitate predictive analytics-based insurance models). Tellingly, the same points are again missed in this month’s McKinsey report on digital innovation in insurance sector: http://www.mckinsey.com/business-functions/digital-mckinsey/our-insights/making-digital-strategy-a-reality-in-insurance.

This might be due to the fact that McKinsey database is skewed to just 350 larger (by now legacy) blockchain platforms with little anchoring to current and future innovators in the space. In a world where technology evolves with the speed of blockchain disruption, one can’t be faulted for falling behind the curve by simply referencing already established offers.

Which brings us to the point of what really should we expect from fintech innovation taken beyond d simply tinkering on the margins of big legacy providers?

As those of you who follow my work know, I recently wrote about fintech disruption in the banking sector for the International Banker (see http://trueeconomics.blogspot.com/2016/06/13616-twin-tech-challenge-to.html). The role of fintech in providing back-office solutions in banking services is something that is undoubtedly worth exploring. However, it is also a dimension of innovation where banks are well-positioned to accept and absorb change. The real challenge lies within the areas of core financial services competition presented (for now only marginally) by the fintech. Once, however, the marginal innovation gains speed and breadth, traditional banking models will be severely stretched and the opening for fintech challengers in the sector will expand dramatically. The reason for this is simple: you can’t successfully transform a centuries-old business model to accommodate revolutionary change. You might bolt onto it few blows and whistles of new processes and new solutions. But that is hardly a herald of innovation.

At some point in evolution, dinosaurs with wings die out, and birds fly.

5/2/15: Where the Models Are Wanting: Banks Networks, Risks & Modern Investment Theory

My post for Learn Signal blog: "Where the Models Are Wanting Part 2: Banks Networks, Risks and Modern Investment Theory" covering networks effects on risk propagation in the financial services sector and the impact of these networks on equity pricing models is now available here: http://blog.learnsignal.com/?p=153.

14/1/2015: European Banks: Permanently in the International Isolation Ward

My blog post on the declining fortunes of European banking for Learn Signal blog is available here: http://blog.learnsignal.com/?p=143

17/4/2014: Toothless Shark? EU's Banking Union

EU has been pushing hard on the road toward the Banking Union (BU) with recent weeks seeing completion of the agreement and vote in the EU Parliament on SRM and other aspects of the BU (see: http://trueeconomics.blogspot.ie/2014/04/1642014-eu-parliament-passes-bail-ins.html). But beyond the facade of all this activity, there is a nagging question of the BU's structural effectiveness. This question is yet to penetrate the thick sculls of investors seemingly obsessed with new issuance of debt and equity by the European banks.

The latest BU shape is much improved on the previous versions: gone are national discretions and in is a new streamlined process with ECB and EU Commission in the driving seat. SRM got an efficiency push with new deadline for completion of funding pushed to 8 years from previous 10 years. The fund will be 60 percent mutualised by the end of year two of its operations. Which further reduces potential for national authorities picking at it while bickering with the EU regulators and supervisors. The SRF will have access to ESM while the funds are being accumulated. And the new version cuts the time required to deploy the Single Resolution Mechanism and the Single Resolution Fund, should the banks run into systemic tight spot. All good.

The bad bits are, however, still there.

1. The SRF is still only EUR55 billion at maximum capacity. Which is peanuts for a systemic crisis, give euro area banking system has EUR30.5 trillion worth of assets (which means that SRF can cover just 0.18 percent of the euro area assets).
2. There is no defined mechanism by which banks will be contributing to SRF. Will banks be liable on the basis of their deposits base? If so, the BU will be a de facto mechanism for rewarding less deposits-rich banks and penalising banks that are funded using greater share of deposits. Not a good idea, since alternative to deposits is… err… interbank markets. And a bad idea, because deposits-rich banks are in the euro area's core and in particular - Germany. Alternatively, contributions to SRF can be based on assets. In which case, French, Spanish and peripheral banks are crunched. 
3. There is little in terms of SRF / SRM promise of breaking the contingent liabilities spilling from the systemic crisis in banking sector onto sovereigns. The only way of doing so is to reduce the rate of crisis spread and probability of crisis becoming systemic. 

The break between taxpayers and banks can only be achieved by creating a highly competitive system of diversified, smaller and better capitalised banks (see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2329815).

Step one would be to hike minimum leverage ratio (core capital to total assets) to the US standard. Currently we have 3% standard in the EU (http://www.bis.org/publ/bcbs251.pdf) and in the US the ratio is set at minimum 5% for eight biggest bank-holding companies and 6% for the rest of the banking system (http://www.cnbc.com/id/100880857). Given weakness of euro area SRF (pre-funded and capped) compared to FDIC (pre-funded and backed by a stand by loan from the Treasury of USD30 billion, plus a further US Government guarantee to cover any excess obligations) and the heavier reliance of the European system on bank lending, this means leverage ratios of close to 6.5-7% or more than double current minimum.

Step two would be to test the banking system to identify larger banks that will require splitting up and smaller banks that will require capital raising. This will have to be facilitated by forcing new deleveraging targets and supporting equity issuance and forcing mergers in some cases.

Step three will be removing implicit and explicit barriers to new banks entry into European markets and actively promoting emergence and development of alternative banking institutions.

3/4/2014: Learning from the Irish Experience – A Clinical Case Study in Banking Failure

Our new paper on the future of banking based on Irish experience and lessons from the crisis:

Lucey, Brian M. and Larkin, Charles James and Gurdgiev, Constantin,

Learning from the Irish Experience – A Clinical Case Study in Banking Failure (September 23, 2013).

Available at SSRN: http://ssrn.com/abstract=2329815

Abstract:  
 
We present a review of the Irish banking collapse, detailing its origins in a confluence of events. We suggest that the very concentrated nature of the Irish banking sector which will emerge from the policy decisions taken as a consequence of the collapse runs a risk of a second crisis. We survey the literature on size and efficiency and suggest some alternative policy approaches.

26/5/2013: 'North' out, 'South' in?

The theme of 'North' (advanced economies and primarily EZ) banks deleveraging (exiting) out of the future centres if global growth - the 'South' - has been consistent one in my presentations on the future of global financial services. Here's an example: http://trueeconomics.blogspot.ie/2013/05/2452013-future-in-financial-services.html

It is good to see other researchers also spotting the trend: http://www.voxeu.org/article/european-bank-deleveraging-and-global-credit-conditions

However, my concern is distinct from that of the above authors. I do not think that EZ banks' deleveraging out of the middle income and emerging markets will have a huge detrimental impact, as - in contrast to earlier episodes - we now have emerging markets and BRICS banks more than capable of absorbing capacity created by the EZ banks exits.

24/5/2013: Future in Financial Services

My presentation on risks, disruptions and innovation in global financial services from earlier today

2/5/2013: Microfinance: not really working all too well?

In recent years, there has been some new evidence emerging on the negative aspects of microfinance - the darling of many development quangos. Here's an interesting study showing that, basically, the entire concept might not be working all too well.

"The Miracle of Microfinance? Evidence from a Randomized Evaluation" by Abhijit V. Banerjee, Esther Duflo, Rachel Glennerster and Cynthia Kinnan (April 10, 2013, MIT Department of Economics Working Paper No. 13-09, available http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2250500) carried out "the first randomized evaluation of the impact of introducing the standard microcredit group-based lending product in a new market. In 2005, half of 104 slums in Hyderabad, India were randomly selected for opening of a branch of a particular microfinance institution (Spandana) while the remainder were not, although other MFIs were free to enter those slums."

Core findings from the experiment?

"Fifteen to 18 months after Spandana began lending in treated areas, households were 8.8 percentage points more likely to have a microcredit loan."

However, despite having more credit, households in treated areas "were no more likely to start any new business, although they were more likely to start several at once, and they invested more in their existing businesses."

Did consumption improve due to availability of microfinance? "There was no effect on average monthly expenditure per capita. Expenditure on durable goods increased in treated areas, while expenditures on “temptation goods” declined."

What about longer-term effects? "Three to four years after the initial expansion (after many of the control slums had started getting credit from Spandana and other MFIs ), the probability of borrowing from an MFI in treatment and comparison slums was the same, but on average households in treatment slums had been borrowing for longer and in larger amounts." In other words, availability of credit did not improve due to presence of microfinance lenders in terms of access to credit, but credit did increase for those who have borrowed.

Again, consumption did not improve and neither did the quality of enterprises started in the microfinance covered areas. "Consumption was still no different in treatment areas, and the average business was still no more profitable, although we find an increase in profits at the top end."

Top of the line conclusion? "We found no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and women’s empowerment. The results of this study are largely consistent with those of four other evaluations of similar programs in different contexts."

Much hype has been expanded on microfinance over the years, including a Nobel Prize award and UN and other multinational organisations cheerleading. Subsidies have been lavished on some lenders, while other lenders have gotten off to stock exchange listings on foot of 'doing good' by microlending. Yet, newer evidence continues to emerge that not all is happy in the microfinance world.

30/8/2012: Does Banking & Financial (De)regulation iImpact Income Inequality?

A new paper, titled "Bank Regulations and Income Inequality: Empirical Evidence", by Manthos D. Delis, Iftekhar Hasan and Pantelis Kazakis (Bank of Finland Research Discussion Paper 18/2012, linked here) studied the effects of financial regulations (deregulation) on income inequality in 91 countries over the period of 1973-2005.

The study yields some very interesting results (emphasis is mine):

• "In general, the liberalization policies from the 1970s through the early 2000s have contributed significantly to containing income inequality."
• "... Abolishing credit controls decreases income inequality substantially, and this effect is long- lasting."
• "Interest-rate controls and tighter banking supervision decrease income inequality; however, these effects fade away in the long term."
• "For banking supervision, the negative effect on inequality [higher supervision leads to lower inequality] is reversed in the long run, a pattern associated with stricter capital requirements that tend to lower the availability of credit". 
• "... Abolishing entry barriers and enhancing privatization laws seem to lower income inequality only in developed countries."
• "... The liberalization of securities markets {expanding securitization] increases income inequality." 

What are the policy implications of these findings?

• "Bank regulations and associated reforms aim at enhancing the creditworthiness of banks and at improving the stability of the financial sector. Several studies over the last decade show that regulations do matter in shaping bank risk (e.g., Laeven and Levine, 2009; Agoraki et al., 2009) or in affecting bank efficiency (Barth et al., 2010) and the probability of banking crises (e.g., Barth et al., 2008)."
• "Yet, what if bank regulations have other real effects on the economy besides those associated with banking stability? And, more important, what if these real effects counteract the intended stabilizing effects?"

Two issues should be considered in answering these questions:

1. "The literature on the relationship between bank regulations and financial stability is inconclusive. In fact, different types of regulation may have opposing effects on financial stability, according to the existing research."
2. "... even if we assume that bank regulations like more stringent market-discipline requirements lower banks' risk-taking appetite and enhance stability (Barth et al., 2008), the empirical findings here suggest that these effects are asymmetric and certain liberalization policies (i.e., liberalization of securities markets) or regulation policies (i.e., higher capital requirements) actually increase income inequality. That is, banks pass the increased costs of higher risks (coming from the liberalization of securities markets) and higher capital requirements on to the relatively lower-income population that lacks good credit and collateral. In other words a trade-off between banking stability and inequality may be present" [Note: this trade-off, I would argue, is most certainly a problem for Ireland today, with future borrowers operating in the environment of reduced family wealth due to property bust and financial assets depletion]. 

"Given the contemporary discussion surrounding (i) the rebirth of Glass-Steagall-type regulatory reforms as they relate to securities trading, and (ii) the discussions under Basel III to increase the risk-adjusted capital base of banks, there may be more to think about before taking those steps."

"On the good side, three clear suggestions emerge from this paper and are also consistent with the findings of Beck et al. (2010)": 

1. "... the liberalization of banking markets, primarily through abolition of credit controls, helps the poor get easier access to credit. This in turn allows them to escape the poverty trap and substantially raise their incomes." 
2. "... appropriate prudential regulation should provide less costly incentives to banks to increase regulatory discipline without hurting the relatively poor. Information technologies that would lower the cost of transparency and more effective onsite supervision that would enhance the trust in the banking system may help achieve this goal."
3. "... economies first need a certain level of economic and institutional development to see any positive effect of the abolishment of entry restrictions and privatizations on equality..."

19/09/2011: Highly Leveraged Banks' real impact on economy

An interesting paper from CEPR sheds some (largely theoretical) light on the real side of the current global financial crisis.

CEPR DP8576 titled "Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions" by Sheung Kan Luk and David Vines (September 2011: available here) models the current crisis by adding "a highly-leveraged financial sector to the Ramsey model of economic growth". The paper shows that the presence of high leverage in financial sector "causes the economy to behave in a highly volatile manner" and thus exacerbate the macroeconomic effects of aggregate productivity shocks.

The model is based on the mainstream financial accelerator approach of Bernanke, Gertler and Gilchrist (BGG). The core BGG model assumes leveraged goods-producers are subjected to idiosyncratic productivity shocks, inducing them to borrow from a competitive financial sector.

Luk and Vines, by contrast, assume that "it is the financial institutions which are leveraged and subject to idiosyncratic productivity shocks." As the result of this, leveraged financial institutions "can only obtain their funds by paying an interest rate above the risk-free rate, and this risk premium is anti-cyclical [ in other words the premium is higher at the time of adverse productivity shock, i.e. during the recession], and so augments the effects of shocks."

Luk and Vines parameterise the model to US data under the assumption that "the leverage of the financial sector is two and a half times that of the goods-producers in the BGG model". The assumption is relatively robust for the current environment in the US. It is probably less robust in the case of the EU where financial sector leverage is likely to be higher in a number of countries due to:

1. Traditional over-reliance on debt financing of the banking sector
2. Lower rates of deleveraging in the banking sector than in the US, and
   
3. Greater deposits attrition during the crisis.
   

The study finds that the presence of leveraged financial institutions "causes a much more significant augmentation of aggregate productivity shocks than that which is found in the [traditional] BGG model."

In the nutshell, this provides a plausible explanation as to the channels through which financial sector funding and operational strategy risks (leading to higher leverage) transmit through to real economy. It also links more directly monetary policy to the real economy as well. Ben, keep that printing press running... nothing can possibly go wrong with negative interest rates, mate.

15/06/2011: Few points of the future of FS

This is the presentation I gave at the Roundtable (thanks to all 150+ academic & industry practitioners who came and engaged) on the Future of Financial Services at the Infinity 2011 Conference on International Finance. Slides and few points:
Since I was chairing the event, I had to limit severely my presentation and the core of the event was based on 3 presentations by industry experts and the discussion with the audience - less Q&A, more open discussion.
Consistent with my view, the global financial crisis continues to threaten macroeconomic stability of the global financial and economic systems.

• The core component of the crisis - the crisis across global financial markets has abated due to the efforts of the Central Banks and Governments around the world. But it has not gone away. The system overall remains fragile on the side of liquidity (with quantitative easing rounds now being scaled back and no liquidity traps remaining, holding liquidity already supplied in the system locked away from the process of real lending).
• The crisis continues largely unabated in the sub-geographies of advanced economies and in particular within the banking sector in Europe, Japan and to a much lesser extent - the US. In the US, where balancesheet repairs on the capital side took stronger forms, the crisis in now manifested on the demand side for lending as well as in continued stagnation in the core household asset markets (property in particular).
• The main focus of the crisis has shifted onto debt - with deleveraging of balance sheets being secondary to the need to continue deleveraging households - something that continues to evade the focus of the policymakers.
• A number of large economies are now also experiencing a full-blown or forthcoming sovereign debt crises.

Overall, the duration, the breadth and the depth of the current crisis are so profound that in my view they signal a structural nature of the crisis, leading to a permanent (or long run) shift in:

• Regulatory environments (tightening of regulatory and supervisory systems, higher demand for capital, higher demand for quality capital, etc) all of which, unfortunately, so far, represent no qualitative departure from the already failed model of regulation that led to the current crisis in the first place. In other words, there's 'more of the same' type of a response on the regulatory side that is emerging so far, which does not hold any real promise of change, but suggest dramatic increases in the cost of capital provision, especially via debt instruments.
• The process of re-banking advanced economies - yet to start - will be taking Europe, North America and other advanced economies to a New Normal which will require cardinal rebalancing of the markets for financial services provision. This, in my opinion, will see consolidation of global banking institutions and a decline in their combined market shares, and the emergence of highly competitive and innovative specialization-driven service providers. The latter will be drawing increasingly greater shares of the markets for FS globally and will be largely free from the legacy of the crisis. In this context, the legacy of the crisis that will remain with the sector is the legacy of massive destruction of wealth inflicted onto the clients by the minimal compliance (prudential or suitability tests-based standards) ethos of the pre-crisis investment and wealth management services providers. In their place, the new providers will be adopting (driven by market demand, not regulatory systems) a fiduciary principle-based services ethos, which will put client needs as the main driver of revenues for the sector. Up-selling complexity and risk is out as a business strategy for margins support. Client relationship-building and product-backed client support will emerge as the core replacement strategy.
  
• In terms of re-equilibrating demand and supply of credit, the problem of shrinking pool of savings (due to fiscal austerity-driven tax increases, and demographic aging in the West contrasted with consumption expansion in the New Advanced Economies - NAE) will have to alleviated through new instruments. Debt will remain constrained as long-term process of deleveraging unfolds, equity will be the king, but hybrid instruments (on corporate finance side, less so onr etail side) and some new instruments for investment will have to emerge.
  
• Lastly, the New Normal will be characterized by a drastic scaling back of real off-balancesheet public liabilities (pensions, health and social welfare nets). The age of reduced local (within advanced economies) savings, falling debt levels and tighter global supply of savings (consumption effects in the emerging and NAE economies) will result in reduced ability to finance sustained deficits. This will precipitate emergence of new financing mechanisms (more closely aligned pay and benefits) for public investment, further reducing private investment supply.

The New Normal is already emerging via the divergence of financial services environments across two geographies: the Advance Economies (the "North") and the NAE economies (the "South").
In addition to regulatory pressures of 'Do More of the Same' approach in the advanced economies, and on top of a persistent gap in growth between the advanced economies and NAEs regions, there are emerging gaps in Investment volumes heavily skewed in favor of NAEs, a margin gap and a capital gap (both in terms of quantity and quality of capital, with many NAE banking systems explicitly or implicitly underwritten by solvent and liquid SWFs).

This geographic bifurcation of the FS models will fully emerge, in my view, around 2015-2020 and by 2020-2025 we are likely to see the drive toward convergence of FS across two geographies:
This convergence will be driven, in addition to the above factors, by the rising pressure of competition with 'North' service providers pushing into NAEs to capture higher margins and new markets, and with 'South' service providers pushing aggressively into the advanced economies markets to capture know-how, exercise competitive advantage of relatively cheaper capital available in the 'South' and retaliate against 'North's' competitive drive into their own markets. The end result will be globally lower Returns to Equity (ROE) squeezed on both sides by higher capital requirements and compliance and risk management costs (E-up) and lower margins (R-down) due to lower availability of savings, regulatory costs increases outside capital costs alone and a long-term shift of demand away from high risk high margin products (the shift toward fiduciary standards). Overall risk (sigma) will abate, as global economy settles on a lower structural growth level, further reducing risk premia-driven margin and ability to upsell risk.

In this process of transition to the New Normal, it is, IMO, of interest to have expanded academic and practitioner debate and research relating to the following questions: