TheFunctionalRoleofABSinToday’sFinancialSystem

PhotisLysandrouandAnastasiaNesvetailova,City,UoL

PaperpreparedforINETAnnualConference,21-23October,Edinburgh

DEBTGlobaldebtlevelsatalltimehigh($217trillion),or325%oftheworld’sGDP.

Theaggregatefiguresconcealmanyformsofdebt,includingasfinancialinstruments.

Securitisation-basedproductsfinanceabout20%ofglobalcapitalmarketsneeds;intheUSitis30%annuallyand40%historically(Moody’s2017).

Asset-BackedSecurities(ABS)

Bondsthatfinancepoolsoffamiliarassettypes,suchasautoloans,aircraftleases,creditcardreceivables,mortgages,andbusinessloans.

CollateralisedDebtObligations

Today:CLOs

Twomainreasonswhyinvestorsaredirectedintomorecomplexandriskysecurities

1. Tightpost-2009regulatoryconstraintsarepreventingtherateofABSsupplyfromkeepingupwithinvestordemand.

2.Intellectual/doctrinal.RegulatorsdonotappeartounderstandthefunctionalroleofABSinthefinancialsystemtoday.

StockofGlobalFinancialAssets

TheDualFunctionofBonds

1.Asafinancialinstrumentfortheissuingentity(governments,banks,corporations,universities,etc.).

2.Asaninvestablesecurity.Thisfunctioniskeytolargeinstitutionalinvestors(pensionfunds,insurancecompanies,endowments,moneymanagersetc.).

Investorsgivemoneywhenpurchasingthebond,butinthemeantimetheyusebondsforconservationpurposes:asvaluestoragecontainersintowhichclients’moniescanbepouredandfromwhichmoneycanbeextractedtorepaytheclients.

Wedonotknowmuchaboutthissecondfunctionofbonds.

GlobalAuM:GrowthIndex

Mainstreameconomicshasneverreallyaccommodatedthenuancesofthefinancialsystem(Minsky,Mehrling).

TherehavebeenprofoundchangesintheorganisationoftheAMsector.Again,theyarenotreflectedintheoryormodels.

ManyfactorsbehindtheriseofAMReformofuniversalpensionandwelfare

=>Hightomid-incomehouseholdsaremoreyield-oriented.

Theyrelylessonbankformsofprovisionandmoreonthecapitalmarkets.

Whilebeingrisk-averse.

Householdgrossfinancialwealthbyassettype(Euroarea)

InstitutionalInvestors

Needtoaccommodatetheeverincreasinginflowoffunds.

Theytendtopreferbonds,ratherthanequities.

“De-equitisation”(Haldane2014)

Fromthepointofviewofinstitutionalinvestor

Bondspayinterestbylaw,notbydiscretion

Theyareabletoconservevalueaslongastheirpricesaremaintainedatastablelevel

=>thefunctionofABS

DemandandSupplyofBonds

Thesupplyofbondfluctuateswiththebusinesscycle

Thedemandforbondsgrowsmonotonically:AMisprojectedtogrowby7-8%peryearby2020,from$70trillionto$110-120(OliverWyman;PwC)

Therearequantitymismatchesthatarenotequilibratedbythepricesofbonds

Theextrademandhastofindventinthesupplyoffinancialsecurities

AgencyMBSformthelargestpartofUSABSsupplies;

ButprivatelabelABShelpresolvethemismatchbetweensupplyanddemand

RegulatoryPolicyPost-2009

Mostdiagnosespointtoasupplysidestory(under-estimationofrisksbyhouseholds,theUSgovernmentandbanks).

Diagnosesof2007-09:theshadowbankingsystem(includingtheprocessofcreationofABSandCDOs).

Butthisisincomplete:overhalfoftheamountofABSandCDOswascreatedbetween2003and2007

Pre-crisisABSissuance

Therewasinfactapressureofdemandforyield(whichwasnotfullymetbyconventionalinstruments)

ConstraintsonABSsupplyPre-2007:lackofcreditworthyborrowers

Post-2009:tighteningfinancialregulation

Progressofregulatorymoves:

“Aspectsofshadowbankingconsideredtohavecontributedtothefinancialcrisishavedeclinedsignificantlyandgenerallynolongerposefinancialstabilityrisks”

(FSB2017:1).

Focusonthesupply-sideandtheincentiveproblem:

“Authoritieshavetakenstepstoaddressbanks’involvementinshadowbanking…Consolidationrulesforoff-balancesheetentitieswereenhancedsothatbanksnowmustbringalargeproportionoftheiroff-balancespecial purposeentityassetsontotheirbalancesheetswheretheyaresubjecttoprudentialrules”(FSB2017:2).

Thisunfoldsinthecontextof:

AdeclineinprivatelabelABSproduction.

QEboostingthedemandforyield,includingfromHNWIs

=>Demandshiftstomorecomplexsecurities.

Therefore,

Havingfailedtoidentifytheglobalexcessdemandforsecuritiesasthemajorcauseofthe2007-09financialcrisis,theworld’s financialregulatorsappeartobedoingtheirbesttoensurethatanexcessdemandforsecuritieswillagainreachtheproportionsthatcancausethenext financialcrisis.