Download What does the global financial crisis tell us about Anglo

What does the global financial crisis tell us about Anglo-Saxon
financial capitalism?
Paper prepared for Workshop on
The Financial Crisis, EMU and the Stability of Currencies and the Financial System
University of Victoria, October 1, 2010
Iain Hardie
Politics and International Relations
University of Edinburgh
15A George Square
Edinburgh
EH8 9LD
[email protected]
Sylvia Maxfield
Simmons School of Management
Simmons College
300 The Fenway
Boston, MA 02215
[email protected]
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Introduction
Leaving a G-20 Summit in the wake of the 2008 global financial meltdown, French
President Nicolas Sarkozy reported that the world ―had turned the page on the Anglo-Saxon
model‖. International economist Nouriel Roubini was among others who chimed in declaring the
demise of the Anglo-Saxon model. But what is the Anglo-Saxon model? Political economy
scholarship contrasts it with the ―Continental‖ model typical of Germany, and to some extent
Japan in its high growth period (Zysman, 1983; Streeck and Yamamura 2005; Kwok and Tadesse
2006; Hardie and Howarth 2009). In the political economy literature, the appeal of the
―Continental‖ model lies in the hypothesized corporate governance implications of relationship
banking attributed to the bank-based financial system. Absent corporate governance exercised
through stockholders, creditors work together with private owners and managers to govern
companies. More or less explicit in the varieties of capitalism literature (Hall and Soskice 2001:7;
Hancke 2009; Allen 2004) is the notion that stockholders are looking for a quick buck, they are
impatient. This attribute of the national financial system, stock market capitalization and its
attendant impact on corporate time horizons, is key to arguments in the varieties of capitalism
literature about mutually reinforcing institutional complementarities and about how globalization
may result in divergence rather than convergence.
The assumption of patient capital in capitalist economies with relatively low stock market
capitalization is therefore a key step in the logic underlying the varieties of capitalism literature
(Hall and Soskice 2001: 7; Hall and Gingerich 2009: 461; Gettie et al. 2009). That literature,
however, uses a very limited depiction of both banks and markets within national financial
systems. In either bank- or market-based systems, banks have stable funding bases through
depositors and their main activity is lending to non-financial firms (which facilitates economic
growth). Financial markets, and any change within the market-based system, are meanwhile also
under-analysed (as recognized by Zysman 1983: 287). The depiction is essentially that relatively
low stock market capitalization equals patient capital, or that market-based corporate financing
reduces the government‘s ability to intervene in the economy. This characterization suggests
there is a gap to be filled between the varieties of capitalism literature and scholarship in the
arenas of financial economics and the political economy of finance. A small but growing body of
work on the political economy of European finance illustrates the weakness of the traditional
view of the UK as a clearly capital market based and Germany as a clearly bank-based system
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(Hardie and Howarth 2010; Howell 2007). We extend that work by comparing and contrasting
financial market characteristics in the UK and the US, two supposedly exemplary capital marketbased national financial systems, in the period leading up to the financial meltdown of 20072008.
We argue that the British financial system looked more Continental than Anglo-Saxon in
some ways and the US financial system differed materially from the British system. We question
the existence of a single Anglo-Saxon system. In the UK, not only have banks remained central,
but their importance increased in the years before the crisis. Our conclusion regarding the US is
slightly different, but these differences allow us to reach important conclusions regarding both
bank- and market-based systems. In the UK the increased importance of commercial banks is
apparent, but it is commercial banks increasingly dependent on short-term ‗wholesale‘ funding.
This includes unsecured borrowing from other financial institutions (including foreign entities)
and via money market funds, or secured borrowing via repurchase agreements and derivativesbased structures. It was this wholesale borrowing that represented the key weakness of UK banks
(with the exception arguably of HSBC). In both the UK and the US, the increasing use of
innovative financial instruments, particularly securitization, on both the borrowing and lending
sides, led to the appearance of the dispersed risk that is characteristic of a stereotypical marketbased system. In reality, however, risk was increasingly concentrated on the creditworthiness of a
small number of large financial institutions, as occurs in the bank-based system. Much of this risk
centered on the investment banks that are unique to the US system. Although in some cases these
developments could potentially have some of the claimed relationship advantages of a bank-based
system, in reality these advantages are not manifest when the relationship is between financial
institutions. Both systems therefore moved toward a new bank-based model, in the UK focused
on the increased role of commercial banks, and in the US, although including both investment
banks and other financial market actors as well as commercial banks, but still combining features,
especially weaknesses of the traditional bank-based system without some of its benefits. In this
model, bank intermediation is high but banks rely heavily on various forms of wholesale funding
from other financial institutions rather than from household depositors. Many of the instruments
that trade as a result of this new bank intermediation activity are derivatives bought and sold in
markets very different from the public equity exchanges envisioned in the stereotypical capitalmarket based picture of Anglo-Saxon financial systems, and which involve not a one-off sale but
an ongoing credit exposure to the counterparty. An efffectively bank-based system with this
combination of attributes is prone to opacity, illiquidity, risk concentration and, with potentially
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greater negative consequences, the information asymmetry problems of moral hazard and adverse
selection to which all financial systems are prone (Bebczuk 2003).
Rajan and Zingales (2001) describe these aspects of the bank-based model in a stylized
description of the ―Continental‖ model:
―Risk can be mitigated if the intermediation system is well
capitalized, because capital acts as a buffer…as deregulation and
competition has given investors more choice…the task of
averting the collapse of the system of intermediation has shifted
directly to the government. Governments have had to absorb risk
by promising the intermediation system capital, implicitly or
explicitly, in case the system is in danger. But the promise of
such contingent capital carries with it the risk that intermediaries
will collectively attempt to game the system through moral
hazard. Moreover, once a relationship-based system suffers a
severe shock that the government is not able to counter, the flow
of credit can collapse quickly.‖
It would be easy to mistake this 2001 depiction of how shocks are likely to impact a bank-based
system for an account of what happened in the supposedly quintessentially Anglo-Saxon systems,
the UK and the US, during the 2007-2008 financial crisis. Yet, in the sentences above, Rajan and
Zingales (2001) are describing a bank-based system. They go on to outline the contrasting AngloSaxon financial model, the system supposedly dominant in the UK and US at the time the crisis
unfolded:
―Contrast this with the arm's-length system where the accent is
on providing small investors the confidence to invest directly in
firms. Clearly, such a system is better able to withstand shock,
first, because the healthy can be distinguished from the
terminally ill after a shock and can be dealt with differently and,
second, because unaffected outsiders have the ability to invest
and revive the system, as they obtain confidence from the very
same channels that inspire confidence in small investors.‖
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The way the 2007-2008 financial crisis unfolded in the US and UK highlights a system
where banks intermediated between themselves in markets that were incomplete and therefore
involved aspects of the relationship exchange traditionally associated with the bank-based, patient
capital model, rather than the frictionless arms-length exchange of the impatient capital markets
based system. At the same time, banks in the US and UK had become relatively disconnected
from both household savers and non-financial corporate borrowers, important players in the
archetype bank-based system. Careful analysis of bank business in these cases suggests there is
room for more nuance in how we understand the interplay of the financial sector and the enduring
national differences in capitalist economies described in the varieties of capitalism literature.
Section one unpacks elements of the two archetype national financial systems and
outlines both traditional indicators and more nuanced markers of ―Anglo-Saxon‖ and
―Continental‖ financial system characteristics related to the arms-length versus relational basis of
financial exchanges dominating those systems. Using the traditional indicators of differentiation,
section two explores the extent to which the US and UK financial systems exhibited the
characteristics of Anglo-Saxon and Continental financial systems in the decade leading up to the
2007-2008 global financial meltdown. Section three uses the more complex markers of financial
system differentiation to highlight changes in bank business models in the US and UK prior to the
financial meltdown of 2007-2008. Similarities in the two cases reveal a system that bears little
resemblance to either archetype but has elements of a bank-based system without important
characteristics that encourage stability in the classic bank-based system. In this context we see
attendant problems of informational opacity, illiquidity and risk concentration. Section four
returns to the varieties of capitalism literature and implications for the lynchpin concept of patient
capital.
Characteristics of Anglo-Saxon and Continental National Financial Systems
The base-line characterization of national financial systems used in the varieties of
capitalism literature often goes relatively unquestioned. In this section we review common and
more complex markers of differentiation the two different system types.
National financial systems or structures are stereotypically described as either marketbased or bank-based (Zysman 1983; Allen and Gale 2000; Ergungor 2003, 2004; Levine 2002;
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Schmuckler and Vesperoni 2001). In bank-based systems nonfinancial firms raise funds by
contracting bank loans, equity markets are relatively small and illiquid and bond markets are
mostly for trading government debt. Another common marker of a bank-based system is the
relatively high portion of household assets held as bank deposits (Vitols 2005). These deposits
give the funding stability that supports banks‘ supposed patience in their dealings with corporate
borrowers. In capital market-based systems nonfinancial firms raise funds by issuing stock or
bonds, equity markets are robust and a wide variety of government- and corporate-issued bonds
trade in the capital markets (Antzoulatos et al. 2008). Bank-based systems typically are
concentrated around a relatively small number of large universal banks with investment and
commercial banking businesses under one roof, compared to more diversified capital marketbased systems. Concentration levels in bank-based systems tend to be higher than in capital
market based systems (Pannuzi 2003).
Drawing largely from theory about incomplete markets and information asymmetry, the
economics literature (Allen and Gale 2004; Rajan and Zingales 2001) outlines a variety of
differences between the two financial systems that go beyond the common indicators. These stem
from the qualitative nature of the interaction between financial and non-financial firms as mostly
either arms-length or relational. They include the role of information and transparency,
consequences of information distribution for liquidity and the locus of risk and regulatory
institutions.
Table One
One common distinction is that in market-based systems, exchanges are arms-length. In
this type of exchange a transaction occurs when price aligns willingness-to-sell and willingnessto-pay. The market determines price, parties to the transaction know about one another only what
is required by law and accounting practice, and the market brings them into a one-time exchange.
In a bank-based system the parties to a transaction have previously exchanged information about
themselves. Their previous interactions shape their proclivities in a current transaction. To
transact, they engage directly, without an intermediary.
Incomplete markets and information asymmetries are a pervasive feature of the financial
sector. The theory of imperfect markets (Greenwald and Stiglitz 1986) underpins many of the
conceptual distinctions that financial and political economists draw between capital market and
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bank-based financial systems. The distinction between relational and arms-length exchange is
closely linked to two different kinds of information asymmetries: adverse selection and moral
hazard. Adverse selection occurs in one-time exchanges when sellers into a market have trouble
conveying the quality of their product or service to potential buyers. A classic example is the used
car market where the best used cars may not be offered to the market because buyers tend to
assume that if a car comes to the second-hand market it is a lemon and are only willing to offer to
pay ―lemon prices‖ (Akerlof, 1970). The second type of information asymmetry, moral hazard,
occurs when the transaction involves repeated interactions and parties to the exchange cannot
always directly observe counterparty actions that have material impact on the value of the
exchange. A classic example in financial markets involves insurance where the insurer cannot
observe the insured‘s behavior but has to trust that the insured has been truthful in disclosing their
risk factors. Commonly in financial markets, the potential ‗insurer‘ is either a government or the
International Monetary Fund. Transactions in a bank-based system are stereotypically
characterized as relationship-based exchanges involving repeated interactions and susceptible to
the moral hazard type of information asymmetry. The typical exchange in capital-market based
systems is a one-time interaction vulnerable to the adverse selection type of information
asymmetry.
The incomplete markets literature and information asymmetry models, in particular,
which help illuminate conceptual differences in exchange relations between the capital market
(arms-length exchange) and bank-based (relational exchange) systems, also point to important
differences in how information flows in the two systems. Capital market based systems have high
transparency requirements. These systems are embedded in legal and accounting standards
environments that guide public and semi-public disclosure of information pertinent to the
exchange. We can say that capital market-based systems elicit and organize information for
moderately decentralized consumption. In contrast in bank-based systems, the financier and
finance can keep information pertinent to the transaction relatively closely held. There is a
tendency toward opacity in the bank-based system compared with the capital market-based
system.
Informational aspects of arms-length versus relational exchange are related to liquidity
characteristics of the two systems. Bank-based systems are inherently about debt. Banks sell debt
in the bank-based system. Bank leverage normally remains fairly low, constrained by government
regulations and savers‘ deposits. But liquidity is also relatively low, constrained by household
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deposits, in turn motivated by overall consumer wealth, interest rates and a variety of different
kinds of government policies and social institutions. Liquidity is higher in the capital market
based systems, constrained only by investor‘s appetite for stocks and bonds. The informational
efficiency of capital markets also helps support liquidity. ―Informationally efficient‖ means that
capital markets easily illicit and centralize information. Capital market exchanges depend on
information disclosure and accuracy to attract investors and issuers seeking the lowest cost of
capital, and depend therefore on the quality of accounting standards, their application and
enforcement. Liquidity and informational characteristics of the financial system are mutually
reinforcing, and liquid markets facilitate price discovery (Levine 1997).
Another important difference between the two concerns the locus of risk. In bank-based
systems the first-order risk is bank solvency. Households trust their savings to banks in the form
of deposits and banks are a primary source of financing for non-financial firm activity. As the
lynchpin of the financial system‘s intermediation between savers and investors, the banks‘
financial health is the critical locus of risk. In a capital market-based system the primary locus of
risk is the financial health of nonfinancial firms in whom savers invest directly by purchasing
bonds or stocks. We would expect financial regulation to protect capital market investors to be
more nuanced and intensive than prudential regulation and supervision of banks in capital
market-based systems and vice versa in bank-based systems.
In the following sections we use the basic indicators of comparison between AngloSaxon (capital market-based) and Continental (bank-based) financial systems to analyze the US
and the British financial systems. Researchers have long considered these two systems classic
examples of a capital-market based system.
In Comparative Perspective, the UK Fits the Market-Based Model Poorly
The changing distribution of assets in the US financial system over the past several
decades fits the prototype Anglo-Saxon model to the extent that the assets of savings and
commercial banks and insurance companies have fallen and their share is taken up by mutual
funds, government-sponsored entities (mortgage guarantors) and issuers of asset-backed
securities. The business of each of these types of financial institutions involves trading assets on
capital markets. Both the GSE and asset-backed securities issuers are financial institutions whose
core business involves exploitation of new financial products to be traded in the capital markets.
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Table Two
In the UK over the same period, in contrast, most noteworthy has been the dramatic growth of
commercial bank assets. UK pension and mutual fund assets have all experienced substantial
growth, but the main differences between the UK and US systems are the existence of the very
large government-sponsored entities in the US – a feature of the US system that cannot be seen as
stereotypically market-based – the central position of the US investment banks, and most
noteworthy in terms of the varieties of financial capitalism literature, the difference in the relative
size of the two countries‘ banking systems. Relative to GDP, the UK system is approximately
five times larger than the US. This figure alone calls into question the categorization of the US
and UK as similar financial systems, and the UK as market based.
We can also see the comparative weight of different types of financial institutions and
assets in data from a relatively new World Bank database (Beck and Demirguc-Kunt 2009). This
data indicates that in the decade leading up to the financial collapse in the UK the financial sector
as a portion of GDP grew considerably. Growth in financial sector assets relative to GDP was
consistently higher in the UK than in the US. Although this might be seen as evidence of the UK
playing catch-up to the US on the capital market-based path, the data actually further supports the
view of the UK as becoming more bank-based, because the greatest growth was in asset classes
associated with bank-based systems: deposit banks assets and private credit and money bank
assets. Growth in financial (i.e., capital market) assets is not as high as in banking. As the
financial sector grew relative to GDP in the UK, traditional bank based business grew faster than
capital market based business. In the US, in contrast, capital market business, recorded as
financial assets, grew faster than private credit and money bank assets. The US and the UK
cannot simply be seen as two similar examples of capital market based systems.
Table Three
Sources of Non-Financial Firm Finance
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Sources of non-bank firm finance are a classic differentiator for types of national financial
systems.1 Previous research on the decade before the turn of the millennium showed that while
non-financial corporations in Europe were increasingly using equity and bond finance, the UK
remained an outlier (Murinde, Agung & Mullineux 2000). What we see in national data presented
below is that equity finance as a portion of company liabilities grew more slowly in the UK than
it did in France or Germany. France was starting from a similar level of equity market corporate
financing as the UK yet the portion of company liabilities taken up by equity grew 58% in France
and only 45% in the UK. On the other hand we do see strong growth in UK firms bond financing
between 1980 and 2000. A caveat here is that to some extent financing choices in mature
financial systems are driven by cyclical fluctuations in the economy. Nonetheless the striking
picture in this data is that Germany and France both appear to be shifting more quickly towards
an Anglo-Saxon model than the UK.
Table Four
Turning to the years leading up the financial collapse, we see that British firms look
relatively similar to Continental European firms and fairly different from US firms, at least until
2005. Table 5 reports debt to equity ratios for nonfinancial firms in the US, UK and Continental
Europe. The measure is long-term debt to the value of common stock. Smaller numbers mean
higher equity relative to debt. US equity rises relative to debt from 2002 through 2007, a trend
common to the UK and partly driven by global liquidity and macroeconomic cycles. Equity is at a
much lower level in the UK, even though the trend moves in tandem with the US. After 2005 the
UK trend toward greater equity slows, as it did in the US, while European firms continue to see
equity value increase relative to debt. Given that we are trying to detect secular trends related to
basic financial system structure, the overall picture we see here is that equity is consistently much
higher for US firms than for either UK or European firms and that change in equity levels is also
relatively more stable over time in the US compared to either the UK or the European firms. In
this way, the UK looks considerably more like Europe, than it does like the US.
Table Five
Mullineux (2007) outlines two different interpretations of ―bank-oriented‖: 1) banks are dominant
institutions providing both indirect or intermediated debt finance and direct finance from money and capital
markets via CP, bonds, shares, and 2) bank loans are the most important source of finance for non-financial
companies.
1
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Significant also is the fact that in the UK immediately before the crisis, bank lending to nonfinancial firms increased dramatically, while equity financing was actually negative as equity was
bought back from the secondary market. Increasingly, the UK was moving towards a bank-based
model (Hardie and Howarth 2010). It remains to be seen whether the move by large UK
companies to finance in the bond market in response to a banking credit crunch will be
maintained.
Role of Household Deposits in Funding Financial Institutions
Often largely implicit in discussions of the patient lending of the bank-based system is
that banks do not face constraints on their ability to lend from their own need to borrow.
Therefore, another important distinguishing characteristic of the bank-based versus capital
market-based financial system is the role of stable household deposits as a source of bank finance.
At least until the experiences of Northern Rock in the UK and Washington Mutual in the US,
household deposits are expected to remain stable, despite their formally short-term nature. In a
bank based system, therefore, deposits are expected to constitute a high percentage of bank
liabilities, and in particular, since banks use these deposits to fund their lending, the loan to
deposit ratio should be relatively low. In reality, such an assumption has always been
questionable: German Landesbanks, for example, have long been reliant on wholesale funding of
their lending. However, developments in the US and UK have not followed the same path in
recent years. UK bank dependence on wholesale funding has (again with the exception of HSBC)
increased significantly as the loan to deposits ratio has risen. In the US, in contrast, loan to
deposit ratios have remained stable. By this measure, it could be argued, the UK system has
become more market-based, not because non-bank financial institutions became more active in
corporate finance, but because banking itself became more market-based.
Tables Six & Seven
However, in reality both banking systems became more reliant on wholesale funding.
While the decline in deposits relative to loans in the UK reflects a shift to other sources of bank
funding such as debt and security sales (BIS 2008: 31-32), much of the increased US reliance on
wholesale funding was actually taking place through off balance sheet activities (see below). In
both the US and the UK in the decade prior to the financial crisis, banks began to rely on
‗wholesale‘ markets for their funding needs using commercial paper, repurchase arrangements
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and other interbank loans including deposits from foreign banks. Deposits from foreign banks in
41 countries surveyed by the Bank for International Settlements increased by 122 percent
between 2001 and 2006 (BIS 2008). The decline in deposits was a general trend, especially for
large banks (Raddatz 2009). In the UK, compared to European banks studied (Raddatz 2009),
deposits relative to liabilities fell but did not approach the low levels of Switzerland and Spain.
The falling role of household (retail) deposits in bank funding does not align with either the bankbased or capital market based systems as they are traditionally depicted, but this is largely
because the varieties of financial capitalism literature pays little attention to bank liabilities. In
reality, the developments represented a move to a more market-based system, but one that shared
weaknesses of the bank-based model.
Concentration versus Competition in the Financial Sectors
Another point of differentiation between the bank-based and capital market-based models
is the level of concentration, which is supposed to be higher in the bank-based systems. The
financial system of the UK is significantly more concentrated that that of US, again making the
UK look more Continental (indeed more concentrated than elsewhere in Europe) by this criteria.
Comparing the direction of change in the US and the UK shows that concentration was falling in
the UK while it rose consistently and significantly in the US in the years leading up to the
financial crisis.
Table 8
The changes in the US reflect the repeal of Glass-Steagall that mandated the separation of
retail and investment banking. The rationale for repeal in the US was growing international
competition from institutions whose home countries permitted ―universal‖ banking, including the
UK. Among other characteristics, universal banks combine money and capital market products
and services in one corporate entity. Law required separation of these businesses in the US from
1933 to the repeal of Glass Steagall in 1999 and also in Japan after WWII. Universal banking was
also uncommon in the UK and France prior to the 1970s while it was the norm for Swiss and
German banks from the early 20th century (Mullineux and Murinde 2003). The repeal of Glass
Steagall allowed US commercial banks to become more like the typical Swiss or German
universal bank (Kuntsen 2004). However, a focus on the repeal of Glass Steagall, while
undoubtedly pertinent to any analysis of the problems of the US commercial banks, risks
obscuring the nature of the systemic crisis in the US, and in particular the role of the investment
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banks. While US commercial banks entered investment banking as an activity, they were far from
usurping the position of the large US investment banks at the time of the crisis. Indeed, the
growth of investment banks relative to commercial banks continued in the US after the repeal of
Glass Steagall. The US system remained distinctive for the size and centrality of these investment
banks, and they clearly (and Lehman especially) were central to the crisis. In other words, it is
arguably not the repeal of Glass Steagall, but its initial passing, when combined with the 2005
SEC decision to lift leverage restrictions on the investment banks (Blundell-Wignall et al. 2008:
3), that shaped the nature of the crisis in the United States. The second point regarding
concentration, which we explore further below, is that the reality of risk concentration was
significantly obscured by a focus on banking concentration. Important risks were becoming
concentrated before the crisis in ways banking concentration cannot capture.
The picture emerging from comparison of the two Anglo-Saxon system along the
traditional criteria of banking versus capital market size, non-financial firm financing, role of
deposits in funding firm finance and concentration suggests not only that the US is much closer to
the Anglo-Saxon ideal than the UK, but that the UK is rather more bank- than capital marketbased, and was becoming increasingly so before the crisis. The banking business grew faster than
the capital-markets business for financial firms in the UK. Capital markets financing of nonfinancial firms is much higher in the US than in the UK. By this criteria Germany and France
appear to be moving much more quickly to US levels than is the UK in the decade prior to the
financial crisis. Although UK banks were increasing their lending relative to deposits while US
commercial banks were not, US banks were increasing wholesale funding of their activities in
other ways, discussed further below. Another trend inconsistent with expectations based on the
Anglo-Saxon depiction of these two countries financial systems is that bank concentration is
relatively high in the UK compared to the US but US concentration rises suggesting a shift in the
US toward the bank-based system, at least by this single criteria. It is necessary to consider the
US and UK systems in greater detail to understand the nature of Anglo-Saxon financial
capitalism. We next take a closer look at the business models of US and UK financial institutions,
against the backdrop of the distinctions associated with arms-length and relational exchange, to
attempt this understanding.
The US and UK as Forms of Bank-Based Systems
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Arms-length exchange characterizes the Anglo-Saxon model. Arms-length exchange has
follow-on implications for information, the locus of risk, and liquidity/liquidity risk. In the armslength system, information and public trust in information accuracy is a requisite for healthy
capital markets. The first-order risk is insolvency of non-financial firms, in contrast with bankbased systems were the locus of risk is financial institutions themselves. Risk is distributed in
capital market-based systems among the many non-financial firms whose stocks and bonds trade
in the capital markets. Risk is more concentrated in a bank-based system and the more
concentrated the banking sector, the more risk is concentrated. In arms-length, i.e. capital marketbased systems, compared to bank-based systems, liquidity is relatively high and liquidity risk
relatively low.
A close look at the business model of US banks, mimicked to some extent in the UK, in
the decade prior to the financial collapse reveals not a stereotypical market-based system but
changes in banking activities and the rise of a shadow banking system (see Poznar et al. 2010)
that suffered some of the weaknesses of each type of system, without the benefit.. First, the
system involved relational exchange typical of bank-based systems without the information
content and longer-term time horizon typical of the bank-based system. Second, the system
concentrated risk heavily on a small number of financial institutions. Third, the system involved
high debt-fueled liquidity and liquidity risk.
Relational Exchange Without Information or Patience
The reference to a capital market based system is problematic because securities can be
traded on a variety of markets. Information is elicited, synthesized and distributed in different
ways depending on whether the securities are traded on public exchanges, in an over-the-counter
market through active dealers or, in the past ten years, through electronic crossing networks
(ECNs). Disclosure of information pertinent to valuing securities is critical for public exchanges,
which have been the main focus of varieties of financial capitalism analysis. Public exchanges
require considerable transparency about conditions and circumstances germane to valuing the
companies whose securities are trading.2 Information however flows differently in over-thecounter markets.
2
Floor exchanges involve matching of buy and sell orders directly. Dealers may operate to varying degrees
providing liquidity, i.e. offering to buy for themselves and playing an intermediary role.
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Over-the-counter markets are sometimes called the ―third market‖ because the primary
market is the market for initial public stock offerings (IPOs) and the secondary market is the
market for those stocks as they trade after they are initially purchased in the offering. Over-thecounter trading occurs through dealers who may see bid and offer numbers on a computer screen
but who consummate deals through bilateral arrangements without going through an organized
exchange. The dealer is either selling or buying on behalf of his or her employer – a financial
institution, or, more commonly, on behalf of a client – most likely another financial institution.
Financial instruments resulting from securitization, such as mortgage-backed securities,
collateralized mortgage obligations, credit default swaps, etc., are traded on over-the-counter
markets, as are funding markets such as the inter-bank and repurchase (‗repo‘) markets (see
below). Prices in these trades are set by negotiation.
These markets are more opaque than public exchanges. There are ―search and
negotiation‖ costs in finding a good partner for exchange and an acceptable price (Duffie,
Garleanu and Pederson 2005). Critical information in these exchanges is the financial stability of
the counterparty, which is not directly observable (Acharya and Bisin 2010). To some extent
parties to these trades have to rely on reputation and signals, but repeated interaction with one
counterparty should build trust (Lagos et al. 2010).3 Babus (2010) studied the exchange networks
in OTC markets and found banks forming core-periphery relationships in which repeated
transactions created relationships that brought down trading costs. In the classic understanding of
bank and capital market based national financial systems, the idea of securities being traded
through relational exchange would almost seem oxymoronic. Debate in the US in the aftermath of
the financial crisis about creating central clearinghouses for derivative securities is a response to
the information problems now recognized in the OTC markets for securities derivatives.
It is the information character of the market that gives exchange a relational quality. The
OTC market for securities derivatives was and is a market with two important information
challenges. The first is information about the value of the securities themselves. Several
considerations impact valuation of securities such as collateralized mortgage obligations and the
more general category of asset-backed securities or credit default swaps. Most ABSs involved
chopping up similar financial assets with different credit quality, such as mortgage loans, and
recombining them into a new product with a credit rating assigned by a third-party, a ratings
ECNs are different from traditional OTC markets. In fact they permit vast ―dark pools‖ where large
amounts of securities can be traded anonymously.
3
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agency, in a process that was informationally opaque. The first valuation problem is
understanding the sub-components of the securities derivative. Another way to value these
products is to see the price the highest bidder will pay. But when markets are just bilaterally
negotiated exchanges with no trade disclosure requirements, it is hard to use this valuation
technique, known as ―marking to market‖. In postmortems of US financial institutions conducted
by the Securities and Exchange Commission we know that valuation was a real-time problem
because so-called ―mark disputes‖ were increasingly frequent in the years leading up to the 20072008 crisis (GAO Report). A mark dispute refers to a situation where there is a discrepancy
between two parties to a trade about the agreed upon price and each records it on their banks‘
books as a money making trade. A further indication comes from the discrepancy between the
losses implied on securitized bonds by market prices relative to the losses that can reasonably be
expected from actual defaults on the underlying assets. In one estimate, for example, market
prices implied losses on US sub-prime Residential Mortgage Backed Securities of US$310
billion, but reasonable expections of defaults on those mortgages suggested losses of US$195
billion (Bank of England 2008a: 15). The size of this discrepancy, and its impact on bank
balance sheets, was sufficient to prompt a partial suspension of mark to market accounting rules:
in effect, it was decided that the market was wrong.
Inherent in many derivatives transactions is the added complexity of an ongoing exposure
to a counterparty which must make ongoing payments in a way that is similar to a borrower under
a loan. The information challenge therefore involves not only identifying the fundamental value
of the security derivative based on the value of its underlying component parts, but also assessing
the creditworthiness of the counterparty to the trade. Because so many securities derivatives are
contracts involving promises of future actual or potential payments, the ability of a party to the
trade to deliver on their promise is an important calculation. As elaborated below, the distribution
of risk in this way is very different from (and more partial than) than the distribution of risk
through the outright sale of a security.
Relationships in this financial system, defined as repeated patterned interactions between
traders that can be identified in network maps (Babus 2010), only partly solves the problem of
information about counterparty risk based on past behavior, and the use of collateral only serves
to increase the exposure to market risk. They also do not solve the problem of information about
the component parts of securities derivatives. In this sense the relational exchanges in this bankbased system were different from relational exchanges in the classic bank based system as well as
16
from the non-relational exchanges of the market-based system. In both relational exchanges
information is husbanded between the parties to the trade rather than being shared more widely,
leading to the depiction of bank-based systems as informationally opaque. But in the classic bank
based system the bank has information about the underlying circumstances shaping the
profitability, or ability to repay, of the borrower gleaned by working very closely with or actually
sitting on the board of the company. In a system where the counterparties are financial
institutions, all the evidence of the breakdown of inter-bank lending during the crisis points to
repeated interactions and supposedly close relationships4 that did not yield sufficient information
either about counterparty risk or valuation of underlying securities for those relationships to have
an impact on creditor behavior. The heavy reliance of the UK banks (excepting HSBC) on
wholesale funding – the UK banks‘ ‗funding gap‘ reached £800 billion – made them heavily
reliant on the interbank market, including borrowing from overseas banks. This is a market of
frequent interaction between counterparties who are well known to each other. Yet this market
collapsed in the crisis, resulting in severe strain for banks generally and necessitating the rescue
in the UK of both RBS and HBOS. The repurchase agreement (repo) market, described in more
detail below, also involves the frequent interactions and counterparty knowledge ordinarily
associated with a relationship-dominated bank-based system, for example between US
commercial banks and investment banks. Yet as the demands to Lehman for extra collateral by JP
Morgan demonstrate (Sorkin 2009: 281), none of the supposed benefits of these relationships
applied in that market.
Risk Concentrated on Financial Institutions
The bank-based system involves two markets, the market in which banks compete for
household deposits and the market where banks make loans to non-bank financial firms. The
liability side of bank balance sheets, assumed to be mostly household deposits, was central to the
crisis. In a capital market-based system there is one market where investors buy corporate shares
or bond issues. In a bank-based system, because there are two markets, there are three main risks:
depositors rapidly withdraw funds, firms default on their loan repayments, or banks default on
their loan promises. In the traditional depiction of the capital market-based model, the main risk
is simply that firms default. Developments in both the US and the UK in recent years have moved
the risk far more strongly towards the risk that banks (including investment banks) or other very
4
See, for example, the friendship between the heads of Morgan Stanley and Lehman, the fact that the head
of Citibank had worked at Morgan Stanley and the head of Merrill Lynch at Goldman Sachs (Sorkin 2009).
17
large financial institutions (such as AIG) would default. As banks moved away from funding their
loans and investments through retail deposits, ‗wholesale‘ funding from other banks and the
financial markets filled the gap. The risk of financial institutions not lending to one another
replaced the risk of households withdrawing their deposits. Risk in this system was concentrated
even further than normal on the solvency of financial institutions. What appeared to be a marketbased system looked increasingly bank-based in its locus of risk.
The key to understanding the distribution of risk in the system that evolved in the US,
and to a lesser extent the UK, leading up to the financial collapse, is seeing how asset
securitization is really a form of secured borrowing (or ‗wholesale‘ funding) and that it occurred
in markets that were largely unregulated. In fact regulations themselves spurred this activity. US
accounting standards allowed banks to sell securitized assets, and receive funds, ―off balance
sheet‖. This meant they did not have to report this borrowing on their consolidated financial
statements and could avoid capital requirements that would lower their ability to lend or buy
other assets through which they could boost profits (Landman, Peasnell and Shakespeare 2006).
At June 2008, Citigroup alone reported US$800 billion of such off balance sheet assets (Duffie
2010: 10). In the UK, although the use of off balance sheet activity was lower, securitization was
still a profitable way to increase lending. In a number of cases, wholesale funding risk was largely
disguised by the off balance sheet nature of the risk. Accounting rules and the general belief that
it disperses risk5 allowed banks to use securitization to minimize their liabilities for regulatory
purposes.Securitization helped concentrate risk in banks to an even greater extent that typical in a
bank-based system. It facilitated lending, while allowing banks to understate their liabilities.
Although securitization was supposed to help disperse market risk, and did to some extent, the
system heavily concentrated market risk.
The nature of securities derivatives added further impetus for risk concentration. All
these financial assets are contracts involving promises to exchange certain sums of money under
certain circumstances at some future point. They are only as valuable as the ability of the parties
to the contract to fulfill the promises outlined in those contracts. These counterparties were
concentrated a very small group of financial institutions, rather than being widely distributed.
Although a broad range of institutions were involved – hedge funds, for example sold about
US$800 billion of CDS protection (Bank of England 2007a: 34) – by 2009, exposures in OTC
5
Genuine risk dispersion did occur through the distribution of loans, with the growth in US syndicated
loans in the decade before the crisis mainly the result of institutional investor buying (Iveshina and
Scharfstein 2009).
18
derivatives in the US were concentrated in just five banks (Singh and Aitken 2009), with the
largest bank, JP Morgan, responsible for 17 percent of the $500 trillion notional outstanding
(Durrell 2010: 6). The overall result was ‗the extreme concentration of risk in a highly leveraged
financial sector‘ (Cabellero and Krishnamurthy 2009: 1). 6
Wholesale funding, heavily based on securitization, involved chains of transactions with
risk was concentrated at the weakest link in those chains (Pozsar et al. 2010: 70). Those weakest
links, for example AIG or the monoline insurers, were involved in vast numbers of such chains,
giving rise to concerns regarding an institution being ―too connected to fail‖. Baur and Joosens
(2006) find that securitization does not reduce systemic risk by risk transfer, but rather increases
it through the lower capital of unregulated entities and increased linkages. In addition, it has
become apparent that much of the distribution of risk on the asset side of banks‘ balance sheets,
so central to a market-based system, was largely illusory. Banks were unable to distribute the
‗super senior‘ – the largest and most creditworthy – tranches of securitizations on anything like
the scale necessary for the overall volume of transactions, and retained them on their balance
sheets, frequently with a guarantee from the insurance company AIG or a small number of
‗monoline‘ insurers, a further huge concentration of risk. One estimate is that of the US$240
billion super senior tranches of some of the most problematic securitizations – CDOs of Asset
Backed Securities issued in 2006-07, two-thirds of the risk remained with the arrangers, either
deliberately or as the result of a failure to distribute, with the remainder hedged with monoline
insurers. Importantly, nine arrangers were responsible for over US$10 billion of this risk each,
and one for over $50 billion (Alexander et al. 2007: 32).
The locus of risk in this system was financial institutions, this raised the stakes for
6
The use of securitization to fund lending was high in both the US and the UK relative to other
countries, but there was again a significant difference between the two. In the first quarter of 2009
securitization accounted for 14 percent of outstanding credit in the UK, half the US figure, and 6
percent in the euro area (IMF 2009a, p.32). Outstanding UK collateral at the end of 2008 was 32
percent of UK GDP, comfortably the highest in Europe but less than half the 69 percent in the US
(authors‘ calculations from European Securitisation Forum 2009). The aggregated figures
however mask significant variations across institutions. In the UK, banks securitized from over
half (Northern Rock) to under 5 percent (HSBC) of mortgages (Bank of England 2009: 17). In the
US, the government-backed mortgage agencies were responsible for 53 percent of outstanding
collateral at the end of 2009 (authors‘ calculations from European Securitisation Forum 2009).
Particularly in the US, the use of securitization represented a further concentration of funding risk
on certain institutions.
19
counterparty failure, especially because securitization allowed institutions to hide liabilities. In
addition to hiding liabilities, chains of securitized asset creation, recreation and transfer,
concentrated risk in the weakest links in the chain.
Unpacking the evolution of the US and UK financial systems in the years leading up to
the financial crisis and reviewing how the crisis unfolded, reveals that both were increasingly
effectively bank-based systems with the risks of that type of system and without some of the
expected benefits. Despite attributes of relational exchange typical of bank-based systems,
information flows were opaque rather than transparent. The system concentrated risk on financial
institutions (e.g., Basel Committee on Banking Supervsion 2008; Adrian and Shin 2010), which
is more typical of bank-based than market-based systems. Finally, we explore in the next section
how securities derivative innovation and trading facilitated debt build-up more typical of a bankbased system than a market based system and fueled rising liquidity risk.
Liquidity Risk
Debt is central to a bank-based system. Banks lend a multiple of capital by borrowing. In
capital market based systems financial institutions make money from fees for services such as
underwriting and trading and from proprietary trading, trading for ―the house‖. Bank-based
systems create debt and are more vulnerable to liquidity crunches than capital market-based
systems because the locus of risk lies with financial institutions‘ financial health in the bankbased system. In contrast the archetypical capital-market based system disperses risk among nonfinancial institutions‘ and offers more liquidity than bank-based systems. Historically large
financing requirements of governments, often for war, have spurred the development of capital
markets. The system operating in the US and to some extent the UK in the decade leading up to
the financial crisis was a hybrid in which securitization fueled liquidity and liquidity risk where
the presenting problem was typical of bank-based systems approaching crisis: a mismatch
between short liabilities and longer-term assets.
The market for securities derivatives facilitated a traditional bank business model. A bank
that wanted to lend to a company but did not wish to increase its exposure to that company could
call a series of dealers at other commercial or investment banks (or an insurance company such as
AIG) and ask for quotes on a credit default swap contract on that company. The bank would
negotiate with a series of dealers in this OTC ―market‖ and eventually agree on a counterparty
20
and a price. The bank would pay the dealer for the CDS, which is protection against the company
defaulting, and could expand its lending to the company. The bank making the loan to the
company payed the dealer to take on the risk that the company will default. Note, however, the
role of the CDS dealer: if the company the bank is lending to defaults, the dealer must pay the
bank the amount of the loan. The bank‘s credit exposure has been transferred from the company
to the CDS dealer. Although this exposure to the dealer will generally be collateralized, it is
nevertheless being concentrated on the dealer, specifically the dealer‘s ability to post further
collateral (‗margin‘) in the event of falling markets and/or the dealer‘s declining creditworthiness,
and to cope with the narrowing of the types of collateral that counterparties would accept. The
total volume of collateral demanded in the OTC derivatives market doubled between 2007 and
2008, to US$4 trillion, and 80 percent of this collateral was cash. Some counterparties simply did
not have this amount of cash. It was this ―margin run‖ on huge volumes of CDS contracts that
forced AIG to seek government assistance (Brunnermeier 2009: 96).
Securities derivatives in this system are greasing the wheels of a traditional bank based
model. This occurred with lending to non-financial companies but it also occurred with household
lending. In the decade leading up to the financial crisis in the US, home and auto loans and
leveraged loans increasingly involved securitization. This means a bank gets funds to lend to
customers, not from deposits, but from other financial institutions that buy securitized assets from
the bank. By buying the derivative, the financial institution is lending the bank funds that enable
the original bank‘s lending. One financial economist explains,
―Collectively, the various investors who acquire ABS and finance them with short- term
borrowing are often referred to as the shadow banking system. Just as traditional commercial
banks invest in long-term loans and finance these loans by issuing short-term deposits, the
shadow banking system invests in securities based on the same sorts of long-term loans (e.g.,
mortgages, or auto loans) and finances this investment by issuing short-term claims such as
commercial paper or repo. So on the one hand, the shadow banking system can be said to be
performing an economic function that looks much like that performed by the traditional banking
system—it borrows on a short-term basis to fund longer-term loans…On the other hand, it does
not face the same set of regulations, since the institutions involved are generally not banks per se.
And it does not benefit from the same safety net.‖ (Stein 2010)
Overall in the US, the volume of credit intermediated by the shadow banking system
21
peaked prior to the crisis at close to US$20 trillion, compared to $11 trillion intermediated by the
traditional banking system (Pozsar et al. 2010: 65). Liquidity risk was high because the banks‘
liabilities were so short-term. The very short term nature of the wholesale financing has also not
been widely recognized. 60 percent of the wholesale funding of UK banks falls due within a year,
for example (Bank of England 2010a: 9) The maturity mismatch and liquidity risk was especially
evident in the repo market. The repo market is a source of short term secured financing, and its
volume has doubled since 2002 (Gorton and Metrick 2010: 10). Lending is secured by financial
assets, and because these assets are a broad range of different credits, borrowers‘ funding risk is
theoretically highly dispersed. As long as an institution holds assets that are acceptable to repo
market counterparties, funding will be available. Yet Gorton and Metrick (2010) see the 2007-08
crisis as ‗a run on repo‘. In the crisis, the terms and availability of repo financing worsened
dramatically, pressuring those institutions most dependent on this form of financing. Those
institutions were the US investment banks, which relied on this market for about half their
funding (Hördahl and King 2008) as their assets grew to 30 percent of the commercial banks in
the US by 2007 (Gorton and Metrick 2010: 11). Commercial banks, in the US or UK, were not
heavy users of repos (Gorton and Metrik 2010),1 but turned increasingly to this market as sources
of unsecured borrowing dried up (Committee on the Global Financial System Markets Committee
2010: 5). Once repo financing became prohibitively expensive or unavailable for assets that had
previously been accepted on attractive terms,1 firms such as Bear Stearns1 and Lehman could not
continue to operate. Repo activity by US bond dealers (a partial measure of overall activity) fell
from US$4500 billion to $2500 billion in the year to April 2009 (Krishnamurthy 2008: 11).
Globally, activity more than halved from June 2008 to December 2009 (Bank of England 2009:
40). The bankruptcy of Lehman was then the key event in the widening of the crisis, largely
through the further collapse of the CP market. The ten largest money market mutual funds had at
the end of 2007 been providing UK banks with US$80 billion of financing (Bank of England
2010b: 37).1
Reliance on the repo market was far lower overall in the UK than the US, thanks largely
to the central role of investment banks in the US, but banks turned to this market once the
interbank market faced difficulties. The strains were exacerbated by the short-term nature of
much of the UK banks‘ funding. At the end of 2006, a median of 44 percent of major UK banks‘
wholesale funding matured within three months (Bank of England 2007a: 32).US investment
banks, thanks largely to the short-term nature of their repo activity, had to roll over a quarter of
their liabilities every night after the proportion of assets financed by overnight repos doubled
22
from 2000 to 2007 (Brunnermeier 2009: 5).7
Beyond the repo market, the maturity mis-match and attendant liquidity risk is also
evident in the role of Asset Backed Commercial Paper (ABCP) and Securitized Investment
Vehicles (SIVs) in the US and UK financial systems prior to the crisis. This market involves
banks sponsoring the establishment of special purpose companies. These companies buy mediumterm assets, either from their sponsor bank or elsewhere, and finance those purchases by issuing
commercial paper, short term debt instruments – in July 2008, over 60 percent was 1-4 days in
maturity, and this reached over 80 percent (Bank of England 2008a: 23)8 – sold mainly to money
market funds discussed above (FitchRatings 2007; IMF 2009a: 80; Acharya and Schnabl 2010).
The special purpose companies make profit from the difference between their interest income and
cost, which is returned to the sponsoring bank. Banks provided liquidity support to these entities,
either those they sponsored or other vehicles, committing to lending them money, secured on
their assets, if they are unable to raise financing in the Commercial Paper market.9 At its peak in
2006, ABCP outstandings reached over US$1,350 billion (Basel Committee on Banking
Supervision 2009: 53), but after August 2007 issuance crashed by around US$420 billion (Bank
of England 2008b: 24; Brunnermeier 2009: 84). SIVs reached nearly US$300 billion in 2007, but
by October 2008 none remained in their original form (ibid.: 56). Through a number of routes,10
this left the banks owning the underlying assets of the ABCP and SIV entities to which they had
provided liquidity support, in a process of involuntary balance sheet expansion that increased
demand for funding from the interbank market (Adrian and Shin 2010: 26).11 These entities could
be on or off balance sheet prior to the crisis, depending on their structuring and accounting rules,
and, thanks to US GAAP, were far more likely to be off balance sheet in the US than Europe. By
the end of 2007, off balance sheet liabilities of US banks represented 193 percent of total
liabilities, compared to a still significant 54 percent in the UK, itself more than twice the figure in
any of the major European economies (IMF 2009b: 15). While US commercial banks appeared
less leveraged than their European counterparts, therefore, they were far more exposed to the
market movements than was visible on their balance sheets. The result was that US banks
suffered disproportionately from the requirement to take ABCP and SIVs back onto their balance
7
Approximately 70 percent of repo activity by US bond dealers is overnight (Duffie 2010: 6).
The majority of unsecured interbank borrowing is also for less than a week (IMF 2009c: 75).
9
Assisted by the fact that lines of credit up to 364 days carried a risk weighting of 0 percent (Tucker 2009:
13). .
10
For example, lending to the ABCP vehicle secured on the underlying assets the vehicle holds, or buying
the commercial paper the vehicle is unable to sell elsewhere.
11
In some cases, support was driven by reputational concerns rather than legal requirements (IMF 2009a:
87).
8
23
sheets.
The extent to which a liquidity crunch was at the epicenter of the 2008 financial crisis for
financial institutions in capital-market based financial systems illustrates how derivatives
securitization was fueling a system that looked bank-based for the debt (and leverage) it
facilitated but created great liquidity risk and increasing liability-asset maturity mismatch. For
example, Northern Rock in the UK, a very early casualty of the crisis, had financed well over half
its mortgage lending through a securitization market that then closed (Bank of England 2009: 16),
forcing a reliance on increasingly short-term funding (Shin 2009). Bank analysts in 2008
identified the problem as a liquidity crisis. ―A growing number of banks are being subjected to a
wholesale version of a bank run, with access to wholesale funding evaporating in a matter of
days, if not hours‖ (Economist 2008). Academic reviews of the crisis‘s roots (e.g., Brunnermeier
2009) highlight that banks‘ increasing use of short-term maturity instruments left them
particularly exposed to a dry-up in funding liquidity. The crisis actually unfolded in two stages,
the first beginning with BNP Paribas cessation of redemptions in three investment funds in
August 2007 and the second linked to Lehman Brothers bankruptcy declaration in September
2008. Both stages were marked by events leading to a sharp liquidity contraction. The liquidity
explanation for the roots of the crisis is the focus of recent papers looking at elements of the
liquidity contraction: interaction between margin calls and market liquidity, the cyclicality of
leverage, and the role of Knightian uncertainty (e.g., Brunnermeier 2009; Adrian and Shin 2009).
National Financial Systems, Patient Capital and Varieties of Capitalism
In the decade moving into the financial crisis we see both the US and UK increasingly
exhibiting characteristics of a bank-based system, where banks play a central intermediating role,
despite developments that might superficially be seen as market-based. In both the UK and the
US there has been a shift toward a non-traditional bank-based system with many of the challenges
and few of the benefits typically ascribed to bank-based systems. Identifying a new hybrid
national system is not a new observation. Lall (2006) talks about traditional and ―new‖ financial
intermediation and develops an index for how arms-length intermediation relationships are. Allen
and Gale (2000) speak about a system that is not bank or capital market based but bank
intermediated. Murinde et al. (2004) argue that the bank – capital market distinction is superseded
by global convergence toward systems dominated by large, diversified financial institutions. Prior
24
to the crisis universal banking and sector concentration seemed to be on the rise even in systems,
like the US, known for competitiveness.
Building on this view, our case studies suggest that without strong regulatory
intervention, there is some inevitability in convergence toward a system with many of the
potential weaknesses of a bank-based system and few of the strengths. Many parts of the
derivatives market, including credit default swaps, involve transactions with longer term actual
and potential cashflows, rather than the very short term buying and selling of securities that
dominates a traditional conception of a capital-market based system. This ongoing credit
exposure, even with the use of collateral, favors the most creditworthy, and therefore normally
the largest, dealers, thereby concentrating risk. The increased transaction costs associated with
complex financial products (Allen and Gale 2000: 474) will also favor the large firms that can
pay and recoup those costs. These firms, through the nature of derivative and funding activities,
are omnipresent counterparties. This phenomenon also concentrates risk. For all the attention
given to commercial banks in the crisis, the epicenter was in investment banks, insurance
companies and government-sponsored entities linked together by the financial engineering of
complex securitized derivatives. US investment banks are only tentatively re-emerging from a
crisis-driven interlude as commercial banks and insurance companies are unlikely to repeat
American Insurance Group‘s involvement with derivatives markets. This suggests a US system
dominated by more tightly-regulated universal banks, and therefore closer to the UK and
Continental models than the archetypical Anglo-Saxon model.
For the varieties of capitalism scholarship the important implication is this is not the
traditional bank-based system where banks channel household savings into loans patiently fueling
entrepreneurship and growth of non-financial firms. In the traditional bank-based system the
household is a saver and provides a stable underpinning to the system. In the new system of bank
intermediation the household plays a different role. Households borrow, banks securitize
household loans in order to be able to help households borrow more. Because savings are so low
in this system, banks have to find other ways to fund their lending and investing and at the
simplest level we can say the banks solve this problem by swapping securities derivatives with
one another. This is an in-bred system where banks intermediate amongst themselves, with
consumers playing a new role compared to the traditional bank-based system, and non-financial
firms at the periphery. Innovation using financial engineering creates the products that facilitate
the changing role of the household in this system and financial sector ―inbreeding‖. Using new
25
markers for differentiating between national financial systems, our case analyses highlight a
system where financial institutions increasingly intermediate between themselves in an
increasingly concentrated sector, lack the stabilizing connection to household savers, and are
increasingly disconnected from corporate borrowers. This view fits neither the white knight
patient capital scenario nor the black queen impatient capital picture painted in the varieties of
capitalism literature.
At its best, the financial engineering-heavy system facilitates bond issuance by nonfinancial firms because securitization and derivatives creation and trading allows for risk
dispersion and risk insurance, both of which can minimize credit risk. This bond market financing
is not necessarily impatient capital in the way that equity market financing is portrayed. There is
an impatient element to this system, however, when it supports leveraged buyouts (LBOs). In the
boom years in the US leading into 2007, a type of securities derivative, the collateralized debt
obligation, fueled a surge in LBOs (Iveshina and Scharfstein 2009). The acquirers in these deals
borrowed relatively short term from banks to fund their purchase and faced pressure to ―turn the
firm around‖ and generate profits to repay their bankers. There is also a risk in this system that
poor transparency in the markets, risk of liquidity problems and risk concentration, increase the
potential black hole for any kind of credit.
When not at its best, the financial engineering heavy system fuels the impatient form of
capital that comes with LBOs and/or imposes collateral damage through a credit crunch. Bank
intermediated systems with incomplete markets (characterized by opacity, liquidity vulnerability,
risk concentration) pose an even greater danger to the non-financial sectors of the economy than
impatient capital.
If, as our two case studies seem to suggest, there is a hybrid model in which
―financialization‖ (e.g., Froud et al. 2000) is taking over and threatening to swamp other
dimensions of variation in market-based economies, it is worth considering the potential for
continued differentiation stemming from corporate boards that behave differently because of
social norms, the magnitude of capital under the umbrella of socially responsible investment
funds, or low-profit forms of incorporation (L3C) spawned in the US. Corporate governance is
central to the logic of the varieties of capitalism paradigm but the bank versus market-based
financial systems distinction is no longer sufficient basis for depicting its impact on the national
political economy.
26
TABLES AND CHARTS
Table One: Markers of National Financial System Differentiation
Capital Market
Bank
Capital markets
Comprise high percentage of
financial sector assets, many issuers
participate and trading volume is
high
Sources of nonfinancial
firm finance
Household role
Equity and bond issues
Concentration of financial
sector
Qualitative nature of
financial and non-financial
firm interaction
Information
Relatively low
Household finance bank,
which finances enterprise
Relatively high
Arms-length interaction
Relational exchange
Requires transparency, markets
gather information
Can satisfy large financing needs &
offers liquidity through robust
capital markets
First-order risk is enterprise
insolvency
Protects opacity, information
is concentrated
Relative illiquidity
Liquidity
Locus of risk
Household finances enterprise
Comprise a relatively small
percentage of financial
sector assets, relatively few
issuers participate and
trading volume is lower
Long term bank loans
First-order risk is bank
insolvency
Table Two: Assets held by different types of US financial institutions (percent of total)
1977
1987
1997
2007
Savings banks, commercial
56
42
26
24
banks, credit unions
Insurance companies
12
10
8
6
Pension funds
19
23
26
19
Mutual funds
2
8
17
19
GSEs
5
10
12
13
Issuers of asset-backed
0
1
4
7
securities
Nonbank lenders (finance
5
4
3
3
companies and mortgage
lenders)
Security broker/dealers
1
1
3
5
Other (Real estate investment
2
2
4
trusts, funding corporations)
Source: US Federal Reserve, Flow of Funds data.
27
Table Three: Financial sector assets as a portion of GDP in the US and UK
2001
2002
2003
2004
2005
2006
Deposit bank
assets/GDP
US .58
UK
1.28
US .58
UK
1.33
US .59
UK
1.38
US .59
UK
1.44
2007
US .60
UK
1.52
US .63
UK
1.61
US .66
UK
1.74
Private credit US .52 US .52 US .52 US .54 US .56
& money
UK
UK
UK
UK
UK
bank
1.28
1.33
1.36
1.43
1.52
assets/GDP
Private credit, US.
US
US
US
US
money and
1.73
1.71
1.73
1.83
1.88
financial
UK
UK
UK
UK
UK
assets/GDP
1.23
1.33
1.34
1.43
1.52
Source: Beck and Demirguc-Kunt 2009. World Bank data.
US .58
UK
1.60
US .60
UK
1.74
US
1.95
UK
1.60
US
2.02
UK
1.74
Increase
20012007
US 
19%
UK 
36%
US 15%
UK 37%
US 17%
UK 30%
Table Four: Company liabilities of total liabilities – UK, Germany, France, Italy, US
UK
Germany
France
Italy
US (nonfarm,
nonfinancial)
Loans
1980=27
1980=69
1980=47
1980=44
1980=18
1990=36
1990=67
1990=26
1990=44
1990=24
2000=23
2000=43
2000=16
2000=36
2000=19
Bonds
1980=2
1980=3
1980=5
1980=4
1980=18
1990=5
1990=3
1990=4
1990=4
1990=21
2000=7
2000=1
2000=3
2000=1
2000=24
Equity
1980=48
1980=28
1980=50
1980=52
1980=72
1990=58
1990=30
1990=69
1990=52
1990=73
2000=70 45% 2000=55 67% 2000=79
2000=63 18% 2000=142
58%
Sources: Europe: Byrne and Davis, p. 89. US: US Federal flow of funds data.
Table Five: Non-financial corporate debt-to-equity ratios
US
UK
Euro
2001
.45
.55
.65
2002
.60
.80
.80
2003
.50
.75
.75
2004
.40
.75
.70
2005
.40
.75
.60
2006
.40
.70
.55
2007
.35
.65
.50
2008
.55
1.00
.80
Source: Committee of the Global Financial System 2009. Based on data from DataStream and
national authorities.
28
Table Six: Loans to deposits for key UK banks
2001 2002
2003
2004
HBOS
141 156
154
147
Lloyds
113 116
116
126
HSBC
69
71
92
97
Barclays
110 118
121
128
RBS
96
102
107
121
Northern Rock
162 191
229
271
Source: Authors‘ analysis of bank balance sheets.
2005
171
134
100
113
122
296
2006
178
135
97
110
122
323
2007
177
134
90
117
121
855
Table Seven: Loans to deposits for key US commercial banks
2001 2002
2003
2004
2005
2006
2007
Citi
102 101
101
96
97
94
93
JP MorganChase
69
66
76
74
74
69
Bank of America
89
87
88
83
89
100
107
Source: Committee on Global Financial Stability 2009. p .4 and authors‘ analysis of bank
balance sheets.
Table Eight: Bank concentration in the US and UK 2002-2008
2002
2003
2004
2005
2006
Bank
US .23 US .23 US .23 US .28 US .30
concentration
UK .56 UK .56 UK .75 UK .51 UK .49
2007
US .33
UK .50
2008
US .33
UK .50

US
43%
UK
11%
Source: Beck and Demirguc-Kunt 2009. World Bank data.
29
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