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Financial Globalization and Instability Azim Premji Winter School January 15, 2013.

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Presentation on theme: "Financial Globalization and Instability Azim Premji Winter School January 15, 2013."— Presentation transcript:

1 Financial Globalization and Instability Azim Premji Winter School January 15, 2013

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3 The challenge of financial globalization Globalization – Supply chains, Trade flows, Labor mobility – State law/policy vs. private international Financial – Capital Markets, Cross-border lending, FDI – Real/equilibrium vs. hierarchy/instability Global dollar funding market – E.g. Asian financial crisis, GFC

4 Shadow banking as characteristic institutional form “Money market funding of Capital market lending” Global funding of local lending Market pricing, both money and capital Key role of market-making institutions Key role of central bank as backstop

5 Backstopping Global Funding Markets

6 Transformation of the Fed

7 A Bagehot Moment

8 Touching the Elephant

9 Economics View Monetary Walrasianism – Marschak, Patinkin, Tobin, Friedman: M d (.) = M s QThM: MV=PT NIPA: C+I+G=Y Arrow-Debreu Walrasianism – Intertemporal GE, DSGE: β(1+r) = E{U’(C t )/U’(C t+1 )} Practical Macro (accounting models, flows) – Flow of Funds: ∑ i S(i,j) = ∑ i U(i,j), ∑ j S(i,j) = ∑ j U(i,j)

10 Finance View Asset pricing: P k = ∑(1/1+r) t CE t Modern: – CAPM, ER i = R f + β i (ER m -R f ) – “Banking in a World without Money” (1970) Practical finance: – “Economics of the dealer function” – “Funding Liquidity and Market Liquidity”

11 The Money View Resources from the Past 1.Copeland (1952):A Moneyflow Economy 2.Minsky (1957):The Survival Constraint 3.Hawtrey (1919):Hierarchy of Money and Credit, Inherent Instability 4.Hicks (1989):Centrality of the Dealer Function 5.Bagehot (1873):Central Bank as Dealer of Last Resort

12 Money and Banking defined Money = “transferable credit” – “inside” not “outside” – “public” and “private” hybrid – Payment system as credit clearing Banking = “swap of IOUs” – On-balance sheet: “loans create deposits” – Derivatives, e.g. Interest Rate Swaps – Banks as money dealers, market makers

13 Simple Hierarchy of Market Makers

14 Leverage vs. Liquidity Equity Finance Bond FinanceMoney Finance Leverage: Equity vs. Bond – Modigliani-Miller Thm, vs. bankruptcy (insolvency) Liquidity: Bond vs. Money – Minsky: Hedge, Speculative, Ponzi (illiquidity) – Timing (mis)match of cash inflows/outflows AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities PV(Future earnings) Bonds 10 Equity 90 PV(Future Earnings) Bonds 90 Equity 10 Bonds 100Deposits 90 Equity 10

15 Liquidity, Old and New Money Finance Shadow Bank Asset Manager Survival Constraint, old and new – Payment system clearing – Collateral system clearing Secured lending Derivative settlement AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Bonds 100Deposits 90 Equity 10 Bonds 100 CDS 0 ‘Deposits’ 100‘Deposits’ 10CDS 0 Equity 10

16 Making Markets, Money and Risk Capital Funding BankGlobal Money Dealer Asset Manager Derivative Dealer AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities RMBS CDS IRS FXS MM funding “deposits” Capital CDS IRS FXS AssetsLiabilities Credit Default Swaps Interest Rate Swaps FX Swaps Credit Default Swaps Interest Rate Swaps FX Swaps

17 Backstopping Markets: Funding and Market Liquidity Global Bank (money) Derivative Dealer (risk) Central Bank (or C5) AssetsLiabilities MM funding Liquidity put (funding) “deposits” AssetsLiabilities CDS IRS FXS Liquidity put (market) CDS IRS FXS AssetsLiabilities Liquidity put (funding) Liquidity put (market)

18 Regulation I: Systemic Risk “Inherent Instability of Credit” Hawtrey (1919) Currency and Credit Minsky (1986) Stabilizing an Unstable Economy Adrian and Shin (2010) “Liquidity and Leverage”

19 Centrality of the Dealer Function Treynor, 1987

20 Funding Liquidity and Market Liquidity

21 Boom Order Flow: Asset Manager > Capital Funding Bank

22 Bust Order Flow: Capital Funding Bank > Asset Manager

23 Bust Order Flow: Dealer Funding Stress

24 Fed Balance Sheet Transformed Dec 15, 2011 Dec 15, 2011 (restated) Fed as Dealer of Last Resort – Global Money Dealer (OIS) [and FX swap] – Global Derivative Dealer(IRS, CDS) AssetsLiabilitiesAssetsLiabilities Treasuries $1.7 MBS/GSE.9 Other.3 TOTAL 2.9 Currency $1.0 Reserves 1.6 Other.3 TOTAL 2.9 [TBill $2.6 [Tbond 2.6 [Risky Secs.9 Other.3 TOTAL 6.4? Curr./Res. $2.6] Tbill 2.6] Tbond.9] Other.3 TOTAL 6.4?

25 Regulation II: Plumbing Collateral and Payment Flows Aitken and Singh (2010) “The (sizable) role of rehypothecation in the shadow banking system.” Minsky, “survival constraint”, settlement in the payments system

26 Why is Backstop Needed? CFB GMD AM DD Abstracting from Counterparty Risk – Lending (RMBS collateral as security) – Derivatives (Pre-funding and hedging) AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities RMBS 100 CDS 0 IRS 0 MM 100 Deposit 100 Capital 100 CDS 0 IRS 0 AssetsLiabilities CDS 0 IRS 0 CDS 0 IRS 0

27 Value Fluctuation and Collateral Flows CFB GMD AM DD Blocking a liquidity spiral (firesale of RMBS, CDS) – Lender of Last Resort to GMD, DD – Dealer of Last Resort for RMBS, CDS AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities RMBS 90 CDS 10 IRS 0 MM 100 Deposit 100 Capital 90 CDS 10 IRS 0 AssetsLiabilities CDS 10 IRS 0 CDS 10 IRS 0

28 Value Fluctuation and Payment Flows CFB GMD AM DD Blocking a liquidity spiral (firesale of RMBS, CDS) – Lender of Last Resort to GMD, DD – Dealer of Last Resort for RMBS, CDS AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities RMBS 90 CDS 10 IRS 0 MM 100 Deposit 100 Capital 90 CDS 10 IRS 0 AssetsLiabilities CDS 10 IRS 0 CDS 10 IRS 0

29 “Making” Markets, Money and Risk Capital Funding BankGlobal Money Dealer Asset Manager Derivative Dealer AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities RMBS CDS, IRS MM funding Liquidity Reserves “deposits” Capital Reserves “deposits”Capital CDS, IRS AssetsLiabilities CDS, IRS Liquidity Reserves CDS, IRS Capital Reserves

30 Implications for development Tapping global dollar funding markets, for domestic currency lending==FX risk National central bank as dollar liquidity backstop C5 (and IMF) as crisis backstop for NCB – Japan, Switzerland, BoE, ECB, Fed? – IMF Normal backstop? – Payments system—home country NCB – Collateral system--???

31 Implications for development Tapping global dollar funding markets, for domestic currency lending==FX risk National central bank as dollar liquidity backstop C5 (and IMF) as crisis backstop for NCB – Japan, Switzerland, BoE, ECB, Fed? – IMF Normal backstop? – Payments system—home country NCB – Collateral system--???

32 Tutu: The “Pipeline” Career Stage: Young tenured Assistant professors Post-doctoral students Doctoral students Fall 2012 Governing Board Meeting 32 Value Proposition: Grant program Research programs Young Scholars Initiative INET Online university

33 Connecting the Dots Fall 2012 Governing Board Meeting 33 Amplification Nurture Community INET Online University

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