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1
8 Lessons from the Crisis
Andrew Haldane
Bank of England
May 2009
2
8 Lessons
• Finance is not a Golden Goose…
3
Cumulative ‘Excess’ Returns to Finance
Date(a)
1900-1944
1945-1970
1971-1985
1986-2007
2007-2009
1900-2009
Financials (%) 1.1 5.0 9.7 9.5 -40.8 3.8
Total market (%) 0.1 4.6 10.8 7.3 -19.2 3.6
Difference (pp) 1.0 0.4 -1.1 2.2 -21.6 0.2
(a) Start of first year in range to end of second year in range except 2009, which ends in March.
UK Equity Market Annual Returns
Excess Returns to Finance
-2000
0
2000
4000
6000
8000
10000
12000
1900 1920 1940 1960 1980 2000
Per cent
UK equity market excess cumulative returns
Sources: Global Financial Data and Bank calculations.(a) Cumulative returns since start of 1900.
4
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
5
Leverage and Returns on Equity
-80
-60
-40
-20
0
20
40
60
80
100
120
140
1920 1940 1960 1980 2000
RoA
Effect of leverage
Percentage points
Sources: Global Financial data, MFSD and FRD.(a) Using year-on-year observed RoE and observed unweighted leverage ratio to imply year-on-year RoA using RoE=RoA*Levg. Effect of leverage calculated as RoE - RoA.(b) Green lines show period average effect of leverage on year-on-year RoE, 1920-1945, 1945-71, 1971-86 and 1986-2007.
-15
-10
-5
0
5
10
15
20
25
1920 1940 1960 1980 2000
RoA
Effect of leverage
Percentage points
Contributions to Year-on-year UK Financial Equity Returns
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
0 20 40 60
Pre tax profit/total assets
total assets/tier 1
5, 20 and 40 per cent RoE indifference curves2
Source: Bankscope1 Due to data availability issues2Average RoE = 21%Average leverage multiple = 29Average profit ratio = 1%
Profits and Leverage for Global Banks – End 2007
6
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
7
Size and Leverage
Global Banks’ Size and Leverage ratios (a)
Capital Injections vs. Balance Sheet Size as at End 07
-
10
20
30
40
50
60
- 0.5 1.0 1.5 2.0 2.5 3.0
Capital injections $ billions
Total assets $ trillions
Source:An event study analysis of bank rescue packages, BIS 2009Global policy responses to financial crisis. Range of interventions: Tables I and II, IMF 2009TARP transactions report, Treasury, 20091 Equity injection = 2678350 + 0.01 *total assets P-values (0.235) (0.00)
8
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
• Banks cannot “pass” a stress-test
9
Changing Distribution of Risk
Probability Density for UK GDP Growth Probability Density for UK Unemployment
10
Long-Run Capital Levels for US Commercial Banks 1840-1993
11
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
• Banks cannot “pass” a stress-test
• Payment/settlement systems worked …
12
Daily Volumes and Values Settled in CLS Activity in UK Settlement System (CREST)
Values in Payment/Settlement Systems
13
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
• Banks cannot “pass” a stress-test
• Payment/settlement systems worked …
• …but some OTC markets did not
14
CDS Uncertainty and Central Counterparties
CDS Premia and Network Uncertainty – Pre Crisis CDS Premia and Network Uncertainty – Post Crisis
15
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
• Banks cannot “pass” a stress-test
• Payment/settlement systems worked …
• …but some OTC markets did not
• Poor eyesight generates blind panic
16
Mapping the Global Financial Network
17
8 Lessons
• Finance is not a Golden Goose…
• …unless it is geared
• Size matters
• Banks cannot “pass” a stress-test
• Payment/settlement system worked …
• …but some OTC markets did not
• Poor eyesight generates blind panic
• Banks need to earn profits
18
Profitability of Banks
LCFI’s Return on Common Equity LCFI’s Equity Prices
19
Cumulative Total Returns Pairwise correlation of cumulative returns
Returns to Financial Sectors
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
01 02 03 04 05 06 07 08 09
Correlation
Source: Bloomberg, CreditSuisse/Tremont and Bank calculations.
20
Due Diligence Test
Typical contract details(a)
[1] Pages in CDO^2 prospectus 300 [2] Pages in ABS CDO prospectus 300 [3] Pages in RMBS prospectus 200 [4] Number of ABS CDO tranches in CDO^2 125 [5] Number of RMBS in a typical CDO 150 [6] Number of mortgages in typical RMBS 5,000 Metrics of complexity(a) [1] + [3]*[5]*[2]*[4] Pages to read for a CDO^2 investor 1,125,000,300 [2] + [3]*[5] Pages to read for an ABS CDO investor 30,300 [4]*[5]*[6] Max. number of mortgages in a CDO^2(b) 93,750,000 [5]*[6] Max. number of mortgages in an ABS CDO(c) 750,000
Sources: Bloomberg, deal documents and Bank calculations (a) CDO^2 is used as short-hand for CDO of ABS CDO. (b) Assuming there is no overlap in the composition of the RMBS pools that back the CDO or the CDO pools that back the CDO^2. (c) Assuming there is no overlap in the composition of the RMBS pools that back the CDO.
21
Gross Capital Flows
-80
-60
-40
-20
0
20
40
60
80
85 90 95 00 05
MFI inflow s MFI outf low sFinancial Account Inflow s Financial Account Outflow sCAD
% of GDP
-1500
-1000
-500
0
500
1000
1500
2000
2500
1990 1993 1996 1999 2002 2005 2008
-150
-100
-50
0
50
100
150
200
250
US$ bn US$ bn
Advanced economies (RHS)
EMEs (LHS)
UK gross cross-border capital flows Gross capital inflows
22
Demand ShockPrudential objective
Stabilising Credit Supply
Stabilising Output
00
0
Output
Lending
Capital Gap
0
0
Capital
Lending Gap