Download Joseph Stiglitz Beijing May 13 Possible Concepts

Keys to Future Stability and
Growth: Institutional
Investors and Regulation
Joseph E. Stiglitz
Beijing
May 13, 2009
Outline

Some basic concepts/lessons from the
current crisis

Traditional roles of institutional investors
and asset managers

New roles of asset management in the
new regulatory framework?
The current crisis and where
the system failed

Incentives
 Market participants had incentives to engage in
excessive risk taking/short sighted behavior
 Conflicts of interest

Transparency
 Market participants had incentives and
instruments for non-transparency
 But failure was more than that of transparency:
complexity

Competition
 Too big to fail institutions had incentives to
engage in excessive risk taking
 Competition didn’t work—race to the bottom
Failures of America’s Financial System
Didn’t manage risk—created risk
 Misallocated capital

 Too much into housing, too little to real
investment, innovative sector, improving
environment

High transaction costs
 Resisted creation of an efficient electronic
transfer system

Predatory lending practices
Failures of America’s Financial System

Innovations directed at regulatory,
accounting, and tax arbitrage
 Little innovation at meeting society’s real
needs
Failed at both micro and macro level
 Major social problems—devastation of the
poor in America
 Global macro-problem

“Model” didn’t work

Self-regulation didn’t work
 Perverse incentives
 Self-regulation can’t work—externalities

Model of risk diversification (securitization)
didn’t work
 Increased information asymmetries
 Systems of market checks and balances failed
(credit rating agencies)
 Regulatory checks and balances failed
○ Ideology
○ Capture
What are the key factors in the design of a
new regulatory structure and system ?
Asymmetries and imperfections of
information
 Moral hazard
 Human fallibility/ “behavioral” economics
 Externalities

Key features of new regulatory system

Regulation has to be comprehensive
 Globally, domestically
 Products, Institutions





Restrictions on incentives
Restrictions on size
Restrictions on risk taking
Transparency/complexity
Financial product safety commission
Key principles to be
safeguarded/ put in place

Mark-to-market—best information available
 Care in regulatory use of information
 Care in design of mark to market system
Restrict or inhibit the use of over-the- counter
derivatives
 Restrictions on leverage, countercyclical
provisioning/capital adequacy
 Have the voice of those whose interests are
likely to be hurt be well represented in the
regulatory structure


A good regulatory system can contribute to
a more dynamic, innovative economy, a
more efficient economy, a more stable
economy, and a more “harmonious”
society

Can’t return to the world as it was before
the crisis
Outline

Some basic concepts/lessons from the
current crisis

Traditional roles of institutional investors
and asset managers

New roles of asset management in the
new regulatory framework?
A distinctive feature of this financial
crisis versus previous ones

It has occurred in highly securitized and
institutionalized context
 Theory was that risk would be spread/diversification would
make economy more stable
 Banks didn’t move as much risk off their balance sheet as
they pretended
 Securitization worsened problems of information asymmetry
 Securitization worsened problems of ex post resolution

Increasingly important role of institutional investors




Pension funds
Life insurance
Mutual funds
Sovereign and other government-sponsored funds
Household and Sovereign portfolios –
The flip-side of securitization

Securities are increasingly held by households,
either directly or indirectly through institutional
investors

Pension funds and life insurance mean an
increasing number of households access securities
markets

Recently sovereign funds and other governmentsponsored funds have gained increasing relevance
and become important investors
Share of institutional investors
Households are, to varying degrees, exposed to
securities and to institutional investors
70%
60%
Netherlands
50%
UK
40%
Austria
30%
20%
10%
40%
Japan
Germany
Spain
US
France
Italy
50%
60%
70%
Securities in household portfolios (%)
80%
The degree of institutionalization refers to the share of family financial assets in pension funds, life
insurance policies and mutual funds, which e usually considered institutional investors.
With the term securitization, we refer to the transferability of the assets in the financial market,
and specifically all financial products excluding deposits.
Source: PGAM Research elaboration on Central bank statistics
90%
The effect of the current crisis on household
financial wealth has been dramatic
In terms of net wealth/GDP, the crisis has brought us below the 1995 levels
and significantly so for the UK. which seems to have missed most of the equity
market rebound after 2003 and also to have suffered more in the downturn
Household financial wealth: net fin.
wealth/GDP ratio (nominal data)
300%
USA
Emu
260%
Italy
UK
220%
180%
140%
source: Fed, Banca d'talia, BCE, ONS
100%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
USA: Flow of funds figures as of December 2008,
Italy, UK : National accounts data as of 3rd quarter 2008, PGAM Research estimates for fourth quarter
Outline

Some basic concepts/lessons from the
current crisis

Traditional roles of institutional investors
and asset managers

New roles of asset management in the
new regulatory framework?
Challenges facing institutional
investing…
Securitization, for all the virtues of
diversification, has introduced new
asymmetries of information
 Some institutional investors also act in short
sighted manner, exhibiting “herding” behavior
 Increased reliance on 3rd party valuations—
power of credit rating agencies

The new regulatory framework
What institutional investors want


Institutional investors’ interests coincide broadly with
social objectives of a good regulatory system
Marginalize over-the-counter transactions
 Increased transparency, lower transactions costs, better risk
management—at a slight loss of ability to “tailor” products


Use exchanges that are also hubs for full information
on the origin and evolution of securities, reduce
scope for counterparty risk, reduce scope for hidden
leverage
Enforce high levels of product standardization and
transparency in transactions/pricing
The new regulatory framework
What institutional investors can offer

Portfolio diversification

Continuous monitoring of securities in the
portfolios through fundamental analysis

Mark-to-market and mark-to-maturity
The new regulatory framework
What should institutional investors look like





With independent governance, independence
from “sell side”: reduce scope for conflicts of
interests
Main mandate: avoid potential negative
impacts of information asymmetries on final
investors (households/governments)
Provide effective diversification
Low transactions costs
Offer simple and understandable “default
solutions”
The new regulatory framework
How institutional investors would fit in a 21st
Century Regulatory Framework
A good alternative to the “too big to fail”
institutions- they basically decentralize risk
 Have limited or non-existent leverage
 Appropriate to represent a vast array of final
interests (employees, retirees, governments,
plan sponsors)

 Help think through appropriate risk analysis
 Help improve corporate governance?

Have a culture of transparency
Rethinking our Financial System
America’s financial system failed—at great
cost to America and the world
 It is important for America and all other
countries to learn the right lessons
 Securitization can/will be an important part
of 21st century financial markets
 But for securitization to work, there has be
much better regulations of all aspects of the
financial market

Rethinking our Financial System

With appropriate regulatory structures,
institutional investors can play an
important role in enhancing the ability of
ordinary citizens to manage the risks
they face

And can contribute to a more efficient
and stable economy