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

Financial innovation and instability in bank-based versus financial market driven economies. Arnoud W. A. Boot University of Amsterdam Presentation at the Bocconi meeting on ‘Central Banking, Regulation and Supervision after the Financial Crisis’ Milan, June 24-25, 2010. Issues.

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

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  1. Financial innovation and instability in bank-based versus financial market driven economies Arnoud W. A. Boot University of Amsterdam Presentation at the Bocconi meeting on ‘Central Banking, Regulation and Supervision after the Financial Crisis’ Milan, June 24-25, 2010

  2. 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

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

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

  5. Information technology and banking 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? A.W.A. Boot Financial innovation Bocconi, Milan, June 24-25, 2010

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

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

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

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

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

  11. 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

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

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

  14. Footloose capitalism: tradability and instability In proper Dutch... Niets is opgewassen tegen het struikroverkapitalisme en de animal spirits die financiële markten in ons losmaken… A.W.A. Boot Financial innovation Bocconi, Milan, June 24-25, 2010

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