Long Term Finance Hi Res

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Long-term FinanceandEconomic Growth

Working Group on Long-term Finance


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The views expressed in this report are those of the Working Group on Long-term Finance and

do not necessarily represent the views of the individual members of the Group of Thirty.

ISBN 1-56708-160-6Copies of this paper are available for $49 from:

The Group of Thirty

1726 M Street, N.W., Suite 200

Washington, D.C. 20036

Tel.: (202) 331-2472

E-mail: [email protected]; www.group30.org


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Long-term FinanceandEconomic Growth

Published byGroup of ThirtyWashington, D.C.

2013


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Table of Contents

Abbreviations ...............................................................................................................................................................................5

Glossary.............................................................................................................................................................................................6

Foreword ..........................................................................................................................................................................................8

Acknowledgments ..................................................................................................................................................................10

Working Group on Long-term Finance ......................................................................................................................11

Executive Summary ..............................................................................................................................................................13

Introduction .................................................................................................................................................................................17

1. Principles for an Ideal Long-term Finance Market ....................................................................................19

1.1 Long-term investment is essential or economic growth..................................................................................................20

1.2 Financing long-term investment requires long-maturity

instruments and investors with long time horizons ...........................................................................................................21

1.3 Four key principles should govern the provision o long-term fnance.....................................................................22

2. The Current Financial System Does Not Efficiently Supply Long-term Finance ...............25

2.1 Worldwide demand or long-term investment is rising .....................................................................................................26

2.2 Current provision o long-term fnance oten ails

to conorm with the principles outlined in Chapter 1 ......................................................................................................28

2.3 Three trends are likely to constrain the uture supply o long-term fnance .........................................................43

3. Addressing the Challenges: Objectives and Specific Proposals .....................................................49

Objective I: Ensure investors are better able to take

a long-term horizon in their investment decisions ..............................................................................................................51

Objective II: Create new intermediaries and instruments

geared toward the provision o long-term fnance ..............................................................................................................52

Objective III: Develop debt and equity capital markets in order to promote

a broad spectrum o fnancing instruments............................................................................................................................54


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Objective IV: Ensure that cross-border capital fows support the ecient

global allocation o capital to long-term investment .........................................................................................................56Objective V: Strengthen systemic analysis when setting uture regulatory policy .........................................................57

Conclusion ...................................................................................................................................................................................59

Appendix: Long-term Accounting...............................................................................................................................

60

Group of Thirty Members 2013 .....................................................................................................................................61

Group of Thirty Publications since 1990 ..............................................................................................................65


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Group of Thirty 5

Abbreviations

FDI oreign direct investment

G20 Group o Twenty

G30 Group o Thirty

GDP gross domestic product

IMF International Monetary Fund

IOSCO International Organization o Securities Commissions

NFC nonfnancial corporation

OECD Organisation or Economic Co-operation and Development

PPP public-private partnership

R&D research and development

SWF sovereign wealth und


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6 Long-term Finance and Economic Growth

Glossary

Basel III is a comprehensive set o reorm measures,

developed by the Basel Committee on Banking Supervi-

sion, to strengthen the regulation, supervision, and risk

management o the banking sector. Key components

are the standards or bank capital and liquidity rame-

work that will be phased in between 2013 and 2018.

B20 (Business 20), which is part o the G20 Summit,

is a orum in which international business leaders andbusiness organizations share their views and develop

and issue recommendations to address current inter-

national economic issues. Members are Argentina,

Australia, Brazil, Canada, China, France, Germany,

India, Indonesia, Italy, Japan, the Republic o Korea,

Mexico, Russia, Saudi Arabia, South Arica, Turkey,

the United Kingdom, the United States, the European

Union, and Spain (observer).

Capital markets reers to the part o the fnancialsystem where securities such as debt and equity areissued and traded or the purpose o medium- to long-

term fnancing.

Commercial real estate and other structuresincludesnew housing units and commercial real estate, indus-

trial buildings, and hospitals. These are recorded as

construction cost. The term also includes major reno-

vations, reconstruction, and enlargements o existing

assets. It excludes sales o land or existing properties

and ordinary repairs and renovations.

Defned-beneft pension plan is one in which an em-

ployees benefts during retirement depend on a pre-

defned ormula based on the employees earnings

history, tenure, and age. The benefts are independent

o investment returns in the und, and the unds invest-

ments are managed by proessional investment ofcers.

Defned-contr ibution pension plan is one in which an

employees benefts during retirement depend on thecontributions made to the und, and on the investment

perormance o the assets in his or her account. A key

eature o most defned-contribution plans is that the

plan participants can select the asset allocation.

Education includes spending on education-relatedexpenses, most o which goes to school operating

expenses (including teacher salaries) and books. It

does not include investment in school buildings.

Equipment and sotware includes investment in fxedassets that are not structures. It mainly includes indus-

trial machinery, IT equipment, and any assets that are

used in a manuacturing process or service oering.

External fnancingis the provision o capital rom out-

side investors to corporations, households, and govern-

ments (or example, via bank loans or capital markets).

Financial system is defned as the interconnected web

o fnancial institutions, markets, instruments, and

regulators that acilitates the matching o savers andborrowers.


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Group o Thirty 7

Financing is the provision o capital to corporations,

households, and governments or the purposes o

investment.

Inrastructure includes investment in structures or

transport (or example, railways, airports, roads),

telecommunications, power and water supply, andeducation.

Internal fnancingis the use o corporations retained

earnings or a households savings to und investment,

otherwise known as sel-fnancing.

Long-term fnance/long-term fnancing are used

interchangeably in this report. They reer to the provi-

sion o long-dated unds to pay or capital-intensive

undertakings that have multiyear payback periods.

Long-term investment is spending on the tangible

and intangible assets that can expand the productive

capacity o an economy. We start with the defnition

o gross national investment provided by the

national accounts. This includes residential real

estate, commercial real estate and other structures,

equipment and sotware, inrastructure, education,

and research and development. We exclude fnancing

or consumption smoothing, fnancial institutions,

and liquidity or payments. We also exclude spending

on consumer durables, working capital, or inventory.

We do not impose a precise time horizon on long-

term investment; typically, these investments would

be in assets that have a use over many years.

Research and development (R&D) includes currentspending on innovation-related activities, such as

basic research, applied research, and experimental

development.

Residential real estate includes the construction o

new residential buildings and major renovations o

existing buildings. It excludes any price increases o

existing buildings.

Solvency II is a set o regulatory proposals or theEuropean insurance industry, designed to revise

European-Union-wide capital requirements and risk

management standards.

Sovereign wealth und (SWF) is a state-owned invest-

ment und composed o fnancial assets, whose institu-

tional structure and governance may vary by country.


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Foreword

The Group o Thirtys (G30s) mission is to deepen understanding o international

economic and nancial issues, to explore the international repercussions o decisions

taken in the public and private sectors, and to examine the choices available to market

practitioners and policy makers. The G30 engages the nancial community, its public and

private sectors, and the regulators and the regulated, through identiying major issues o sub-

stantial concern yet to be addressed eectively by other global bodies. The G30 has been

impacting the policy debate in this manner since 1978, and we expect that this study, Long-

term Finance and Economic Growth, will once again meaningully add to the global nan-

cial policy-making process.In March 2012, the G30 launched the Working Group on Long-term Finance composed

o almost two-thirds o the G30 membership, augmented by a number o external leading

gures rom the nancial sector. The project was launched ater the G30 identied an issue o

major concern to both the public and private actors ollowing the nancial crisis: the ecient

provision o a level o long-term nance sucient to support expected sustainable economic

growth in advanced and emerging economies. Flows o long-term nance via various routes

are crucial to bring about sustainable economic growth and job creation.

The report seeks to quantiy uture nancing needs and identiy the barriers that may

hinder the supply o long-term nancing, possibly undermining uture economic growth. To

that end, the report promulgates our principles that should govern the provision o long-term

nance:

1. The nancial system should channel savings rom households and corporations into an

adequate supply o nancing with long maturities to meet the growing investment needs

o the real economy.

2. Long-term nance should be supplied by entities with committed long-term horizons.

3. A broad spectrum o nancial instruments should be available to support long-term invest-

ment.

4. An ecient global nancial system should promote economic growth through stable cross-

border fows o long-term nance, supported by appropriate global regulation.


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Group of Thirty 9

Jacob A. Frenkel

Chairman of the Board of TrusteesGroup of Thirty

Jean-Claude Trichet

ChairmanGroup of Thirty

As with all G30 work products, this report is not an abstract exercise; rather, it is opera-

tional. It contains a series o practical recommendations or global and national actors and

policy makers that would, i acted upon, help create a system o long-term fnance that more

closely matches these principles.

The G30 report makes clear that supporting long-term economic development is one o the

undamental purposes o global fnancial markets. We hope that the recommendations in this

report, which detail a wide array o possible responses, will help oster the creation o a moreefcient system o long-term fnance capable o delivering on that promise.

We wish to thank Guillermo Ortiz, Chairman o the Working Group on Long-term Finance,

and the members o the Steering Committee, Tharman Shanmugaratnam, Adair Turner, and

Axel Weber, all o whom are members o the G30; and to recognize the work o the rest o the

Working Group, whose names are listed on pages 11 and 12.


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Guillermo Ortiz

Chairman

Working Group on Long-term Finance

Adair Turner Tharman Shanmugaratnam Axel Weber

Steering Committee Steering Committee Steering Committee

Acknowledgments

On behal o the entire Group o Thirty (G30), we would like to express our appreciation

to those whose time, talent, and energy have driven this project to a rapid and success-

ul conclusion.

We would like to thank the members o the Working Group on Long-term Finance, who

guided our work at every stage and added their unique insight. The intellectual frepower

repeatedly brought to bear by the twenty members o the Working Group on Long-term

Finance on this important subject was remarkable and essential to the projects success.

No study o this magnitude can be accomplished without the committed eort o a strong

team. The G30 extends its deep appreciation to McKinsey Global Institute (MGI) or theirhard work under tight deadlines. We particularly thank project director Charles Roxburgh,

who was supported by a team including Susan Lund, Toos Daruvala, Elizabeth Foote, and

Georg Hartmann. MGI carried out the core research and drated analyses. The Working

Group on Long-term Finance drew upon this research and analysis in both its discussions,

assessment, and to reach its fnal recommendations and conclusions.

Finally, the coordination o this project and many aspects o project management, working

group logistics, and report production had their center at the ofces o the G30. This project

could not have been completed without the eorts o Executive Director Stuart Mackintosh,

and his team including Meg Doherty and Corinne Tomasi.


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Group of Thirty 11

Leszek Balcerowicz

Proessor, Warsaw School o Economics

Former Deputy Prime Minister & Minister

o Finance, Poland

Mark Carney

Governor, Bank o Canada

Chair, Financial Stability Board

Member o the Board o Directors,

Bank or International Settlements

Jaime Caruana

General Manager, Bank or International Settlements

Former Chairman, Basel Committee on Banking

Supervision

Domingo Cavallo

Chairman & CEO, DFC Associates, LLC

Former Minister o Economy, Argentina

E. Gerald Corrigan

Managing Director, Goldman Sachs Group, Inc.

Former President, Federal Reserve Bank o New York

Jacques de Larosire

President, Eurof

Former Managing Director, IMF

STEERING COMMITTEE

Guillermo Ortiz, Chairman

Chairman, Grupo Financiero Banorte

Former Governor, Banco de Mxico

Former Secretary o Finance and Public Credit,

Mexico

Tharman Shanmugaratnam

Deputy Prime Minister & Minister

o Finance, SingaporeChairman, Monetary Authority o Singapore

WORKING GROUP

Jacob A. Frenkel

Chairman o the Board o Trustees,

The Group o Thirty

Chairman, JPMorgan Chase International

Former Governor, Bank o Israel

Jean-Claude Trichet

Chairman, The Group o Thirty

Honorary Governor, Banque de France

Former President, European Central Bank

Geoffrey Bell

Executive Secretary, The Group o Thirty

President, Georey Bell and Company, Inc.

Adair Turner

Chairman, Financial Services Authority

Member o the House o Lords, United Kingdom

Axel Weber

Chairman, UBS

Former President, Deutsche Bundesbank

Working Groupon Long-term Finance


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Richard A. Debs

Advisory Director, Morgan Stanley

Former President, Morgan Stanley International

Guillermo de la Dehesa

Director & Member o the Executive Committee,

Banco Santander

Former Deputy Managing Director, Banco de Espaa

Roger Ferguson

President & CEO, TIAA-CREF

Former Vice Chairman, Board o Governors

o the Federal Reserve System

Gerd Haeusler

CEO, Bayerische Landesbank

Former Managing Director & Vice Chairman,

Lazard & Co.

John Heimann

Senior Advisor, Financial Stability Institute

Former US Comptroller o the Currency

Philipp Hildebrand

Vice Chairman, BlackRock

Former Chairman o the Governing Board,

Swiss National Bank

William J. McDonough

Former President, Federal Reserve Bank o New York

Peter Sands

Group CEO, Standard Chartered PLC

Former Group Finance Director,

Standard Chartered PLC

Martin Senn

CEO, Zurich Insurance Group Ltd.

Former CIO, Swiss Lie Group

Jose Vials

Financial Counsellor & Director o Monetary

and Capital Markets, IMF

Former Deputy Governor, Banco de Espaa

Sir David Walker

Chairman, Barclays PLC

Former Chairman, Morgan Stanley

International, Inc.

OBSERVERS

Peter Buomberger

Zurich Insurance Group Ltd.

Steven Hottiger

UBS

Anna Marrs

Standard Chartered PLC

* Note: All members part icipated in their private individual capacities, and the views contained in the report are those othe Working Group on Long-term Finance, not those o the institutions with which they are afliated.

PROJECT DIRECTOR

Charles Roxburgh

McKinsey Global Institute

EXPERTS

Toos Daruvala

McKinsey & Company, Inc.

Elizabeth Foote


Georg Hartmann


Susan Lund


Stuart P.M. Mackintosh

Group o Thirty


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Group of Thirty 13

1 Brazil, China, France, Germany, India, Japan, Mexico, the United Kingdom, and the United States.

Executive Summary

supplied by entities with committed long-term hori-

zons; (3) a broad spectrum o nancial instruments

should be available to support long-term investment;

and (4) an ecient global nancial system should pro-

mote economic growth through stable cross-border

fows o long-term nance, supported by appropriate

global regulation.

The current provision o long-term

fnance oten ails to conorm

to best-practice principles

Worryingly, we conclude that the current systems

overseen and designed by policy makers and market

actors ail to adhere to such best practice principles

and thereore may do a poor job in supplying long-

term-nance rom diverse providers to lenders spread

across sectors and the globe. There are a number o

reasons or these regulatory and market ailures.

Potential long-term investors are increasingly

constrained in their ability to provide fnanc-

ing.Pension unds, sovereign wealth unds, insurancecompanies, endowments, and oundations are ideal

candidates to provide long-term nancing. But bar-

riers such as incentives and restrictions on portolio

allocations need to be addressed to make this possible.

Many pension unds ace shortalls that have inten-

sied short-term perormance pressures, while they

also ace risk-mitigation rules that avor low-risk

xed-income securities. For example, allocations toequities in both dened-contribution and dened-

benet unds has dropped by 22 percent in the United

Kingdom, 17 percent in the Netherlands, and 9 per-

cent in Switzerland since 2001. Meanwhile, pension

Growth and job creation require long-term

investment in the assets that expand the

productive capacity o a modern economy,

such as inrastructure, actories and equipment, new

housing and commercial buildings, education, and

research and development (R&D). Eciently and

seamlessly matching global savings with long-term

investment opportunities is a core unction o the

nancial systembut questions loom about whetherthe supply o nancing will be adequate to meet the

worlds needs.

To understand the scale o uture demand, we

examined nine economies1 that collectively account

or 60 percent o global gross domestic product

(GDP) and ound that their annual spending on long-

term investment totalled US$11.7 trillion in 2010.

Drawing on a range o growth orecasts and invest-

ment projections rom external sources, we estimate

that these countries will need annual investment o

US$18.8 trillion in real terms by 2020 to achieve evenmoderate levels o economic growth.

Since the 200709 global nancial crisis, the need

or stability and soundness has dominated the policy

agenda, but there must be equal ocus on ensuring that

nancing is available to the real economyand the

two goals are not mutually exclusive. By its nature,

long-term nance is less procyclical than short-term

nance, and it exerts a stabilizing infuence on the

nancial system.

An ideal market or long-term nance would

adhere to our key principles: (1) the nancial systemshould channel savings rom households and corpora-

tions into an adequate supply o nancing with long

maturities to meet the growing investment needs o

the real economy; (2) long-term nance should be


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unds in emerging markets are relatively small, con-

tributing to the lack o long-term nancing supply.

Sovereign wealth unds represent another set o

potential long-term investors, but some are mandated

to ocus on scal stabilization and thus hold large

shares o cash or low-risk government debt. In major

Asian economies alone, US$3 trillion to US$4 trilliono central bank reserves could be invested through

diversied sovereign wealth unds.

Insurance rms, like pension unds, have long-dated

liabilities, but over the last decade, many have reduced

their allocation to equities. This is a particularly striking

trend in Europe, driven by management-led, risk-

reduction strategies over the last ten years and, more

recently, by anticipation o Solvency II regulations.

Policy makers need to address regulatory and other

barriers that currently constrain and limit the ability

o these key long-term investors to provide the nanceeconomies will need in the uture.

Long-term nancing in many countries rests

on a narrow range o instruments.Policy makersintent on unlocking new sources o long-term nance

should oster the growth o new markets and instru-

ments that can help ll the gap between the current

sources and projected uture demand or long-term

investment.

While US bond, equity, and securitization markets

are mature and liquid, this is not the case in much othe world. Banks are and will remain or the medium

term the dominant source o external nancing outside

the United States, and commercial bank loan maturities

average only 2.8 years in emerging economies and

4.2 years in developed economiesar shorter than

bond maturities.

There is large scope to increase the size o corporate

bond markets in Europe and several other advanced

economies, and in emerging economies over the

medium to long term as a complement to the continuing

important role that banks must play. For example, icompanies with more than US$500 million in revenue

in Canada, France, Germany, Italy, Spain, and the

United Kingdom were to obtain 80 percent o their

credit rom bonds rather than loansless than what

we observe in the United States or companies o this

sizethe corporate bond market could potentially

grow by US$2.7 trillion, or 32 percent, over a long

period o time.

Bank lending will remain an important source o

nancing in Europe. However, with the right stan-

dards and regulations in place, more small businessloans could be packaged into securities and sold to

investors, enabling banks to extend more credit.

Emerging economies account or a rising share o

the worlds wealth, but their corporate bond, securi-

tization, and even equity markets also remain under-

developed. Bank lending provides the majority o

nancing in most o these economies (banks account

or 75 percent o nancing in China). The develop-

ment o debt and equity capital markets is particularly

crucial to economic growth in emerging economies,

where the corporate sector relies heavily on externalnancing or expansion.

Prudent growth o new bond, securitization, and

equity markets, adequately overseen and supervised,

must be part o the solution to the long-term nance

problem.

Cross-border capital fows have been driven

by short-term, volatile lending. Globally, cross-

border capital fows increased rom US$4.9 trillion in

2000 to US$11.7 trillion in 2007. Nearly 60 percent

o this growth was driven by cross-border lending,but most o this was short-term in nature. Since then,

cross-border capital fows have allen precipitously,

and they now remain nearly 60 percent below their

precrisis peak; approximately hal o this drop was

driven by a contraction in cross-border bank lending,

primarily within Europe.

Going orward, it is clear that enabling more stable

fows o long-term capital (such as oreign direct

investment) to countries with large investment needs

must be a priority. Some countries, like China, may

have sucient domestic savings to und their growth.But many rapidly industrializing and urbanizing

emerging markets will need oreign investors to help

und capital-intensive investments.


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Group of Thirty 15

Three major trends on the horizon

are likely to constrain the uture

supply o long-term fnance

Bank deleveraging and new regulation. In theatermath o the fnancial crisis, banks have been

rationalizing their business models by tightening

underwriting standards or orgoing certain types

o lending altogether. The banking industry is also

adjusting to market demands or more and higher

quality capital, and to new regulatory regimes and

higher capital and liquidity requirements. Basel III, in

particular, raises the cost o issuing long-term corpo-

rate and project fnance loans above the cost o issuing

mortgages and short-term loans. This is not to argue

or a reversal o the new capital regime, but to call or

the emergence o new sustainable sources o fnance

beyond bank lending.

Fiscal consolidation. Mature economies are strug-

gling to manage a heavy burden o public debt. Fiscal

consolidation over the medium term is likely to be a

reality in many countries, a trend that could particu-

larly constrain government investments in inrastruc-

ture and education. Going orward, the private sector

will need to be mobilized to fll the gap.

Aging populations. Aging is one o the most

powerul demographic trends worldwide, including in

Australia, Canada, China, Europe, Japan, the Republic

o Korea, and the United States. Older investors are

already shiting their portolios toward lower-risk

assets such as deposits and fxed income. Equity is a

crucial source o long-term fnance or corporations,

but the cost may increase signifcantly in the ace o

declining demand.

Addressing the barriers to long-term

fnancing calls or a multiaceted

policy response

To stimulate public debate, the G30 Working Group

on Long-term Finance has set out fve core objec-

tives and fteen proposals that, i acted upon, would

support the growing need or long-term fnance and

address regulatory changes, market developments,

issues o international coordination, and the creation

o new institutions. The core objectives are outlined

below, and they are discussed in detail in Chapter 3,

which begins on page 49.

1. Ensure investors are better able

to take a long-term horizon in

their investment decisions.

Action by national and international regulatory

bodies will be essential in achieving this objective.

We urge national regulators and international bodies

such as the International Monetary Fund, the World

Bank, the Organisation or Economic Co-operation

and Development, and the Financial Stability Board

to propose new best-practice guidelines to promote

long-term horizons in the governance and portolio

management o public pension unds and sovereign

wealth unds.

National policy makers should consider steps to

dierentiate between short-term and long-term debt

(whether public or private), and should consider

weighing the pros and cons o phasing out the pre-

erential treatment o sovereign debt in insurance and

bank regulation over an extended time horizon.

The Financial Stability Board, in coordination with

relevant standard-setting bodies, should review the

regulatory and accounting treatments o assets held

with long-term horizons to avoid excess ocus on

short-term market volatility.

2. Create new intermediaries and

instruments geared toward the

provision o long-term fnance.

We support the creation o new instruments to enable

the public sector to leverage private sector capital or

long-term fnancing, including greater use o public-

private partnerships and the creation o new dedicatedlong-term fnancing institutions.

Creating and ostering new savings pools that can

act as sources o long-term fnance in the uture will also

be necessary. Long-term pension and insurance-based


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savings can be encouraged by setting up compulsory

auto-enrolled savings programs. Governments should

also consider redirecting a portion o structural

surpluses in national savings to diversied sovereign

wealth unds with a long-term investment mandate, in

line with objective 1.

3. Develop debt and equity capital

markets in order to promote a broad

spectrum o nancing instruments.

Policy makers seeking to achieve this objective must

balance careul systemic and supervisory oversight

with the need to grow markets that support new

instruments and channels or fows o long-term

investments rom providers to end users. We also

support the implementation o the Financial Stabil-

ity Boards regulatory reorms designed to transorm

shadow banking into resilient market-based nance.

We urge policy makers to take the necessary steps

to develop corporate bond markets that support the

ecient and sound securitization o long-term debt,

particularly in Europe and emerging markets. Develop-

ing the inrastructure or capital markets in emerging

economies to lengthen nancing horizons and diver-

siy sources o unding will also be important.

I policy makers are to develop and support markets

they should also aim to eliminate regulatory biases

and perverse incentives. In particular, they should

consider removing the bias against equity in countries

where it is present.

4. Ensure that cross-border fows

support the ecient global allocation

o capital to long-term investment.

It is clear that open markets help support sustainable

economic growth, and cross-border capital fows assist

in the ecient allocation o capital to that end. But we

also recognize that volatile short-term capital fowscan create nancial instability. Policy makers must

support the international diversication o investment

portolios in both developed and emerging markets.

Policy makers should also gradually move toward

liberalization o capital accounts in emerging markets

while maintaining nancial stability, using macro-

prudential policy tools.

5. Strengthen systemic analysis when

setting uture regulatory policy.

Policy makers must consider the systemic impact o

ongoing and uture regulatory changes on long-term

investment. Failing to do so could result in todays

modest unintended consequences becoming tomor-

rows much larger real economic problems.

Ensuring a supply o long-term nance adequate

or the needs o the global economy as it emerges

postcrisis will be a huge task. Above all, addressing

the need or adequate long-term nance requires a

sense o urgency. The solutions are not simple: they

are complex, multiaceted, and multidimensional. No

single authority can drive change in this arena. But the

ndings o this report make clear that strengthening

the provision o nancing or long-term investment

will be critical to the building o a solid oundation or

economic growth and job creation in the years to come.


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Group of Thirty 17

Introduction

The 200709 global fnancial crisis was a major

shock to the fnancial system and to the global

economy. Not only did it destabilize the fnan-

cial sector, it also led to a major contraction o pro-

ductive investment in the real sector.

The crisis itsel resulted rom major imbalances

in the fnancial system and shortcomings in public

policy. The response has been to develop regulation

to address the weaknesses exposed by the crisis andthereby reduce the probability and economic cost o

any uture disruption. However, global policy makers

also ace the urgent challenge o reigniting economic

growth and job creation. They need to ensure there

are measures to complement new regulations, in order

to stimulate investment, and to be alert to potential

negative unintended consequences o their decisions.

A undamental part o reigniting growth is ensur-

ing the availability o sufcient resources to meet

long-term investment needs. Productive investment

provides a strong basis or both economic growthand job creation. Yet, there is mounting evidence that

the postcrisis fnancial system is not well structured

to provide the level o long-term fnancing that is

required to support global economic growth.

There are multiple reasons or this, starting with

long-standing problems in incentives and governance

that encourage investors to ocus on short time hori-

zons and ollow procyclical investment strategies.

Several o the mechanisms that fnanced long-term

investment prior to the fnancial crisis were not sus-

tainable, such as bank lending that relied on short-term unding and excessive maturity transormation.

There are additional hurdles to overcome, including

underdeveloped capital markets in many countries

and a declining demand or equities that will become

more acute as populations age.

Moreover, in the atermath o the global fnan-

cial crisis, the principal aim o regulators has been

to limit potential economic costs rom episodes o

systemic fnancial stress and increase the resilience

o the global fnancial system. By contrast, less atten-

tion has been paid to improving the global fnancial

systems efciency and aligning its incentives with the

long-term investment needs o the real economy. This

relative lack o policy ocus has become increasinglyproblematic in the current international context o

weak cyclical growth. This is not to argue or a roll-

back o regulatory reorms, but rather to suggest that

it is important to review the regulatory ramework to

ensure that reorms aimed at increasing the saety o

the fnancial system are ully supportive o economic

growth, investment, and job creation. There should

be a shit o attention to active support o long-term

growth by encouraging structural innovations that

oster the supply o fnance.

To sustain growth, economies must build andcontinually renew the physical and intangible capital

that uels productivity growth and innovation. The

ability to develop modern inrastructure will determine

whether emerging nations can ulfl their economic

potential. It will take an enormous inusion o capital to

build transportation networks and deliver education,

health care, water, housing, and electricity to growing

populations. Advanced economies, too, need long-

term investment, since it is one o the ew ways to

boost economic growth during a time o deleveraging

and necessary fscal consolidation. Many o thesecountries need to address their aging inrastructure;

dramatically accelerate educational attainment and

training to build a 21st century workorce; and

revitalize innovation, which is the oundation o uture

progress. Ensuring that businesses can invest in plants,


20/75


machinery, and commercial buildings not only creates

jobs in the immediate term but also enhances uture

productivity. Amid a ragile recovery, investments o

this magnitude are not easily undertaken, but they

cannot be deerred indenitely without risking urther

economic stagnation.

In addition to ueling economic growth, long-terminvestment underpinned by the right kind o risk capi-

tal coners an additional benet. By denition, long-

term investors must be patient and willing to take

advantage o illiquid opportunities; their presence can

thereore exert a stabilizing, countercyclical infuence

on the nancial system as a whole.

The Group o Thirty has undertaken this study to

quantiy uture nancing needs and identiy the bar-

riers that are likely to hinder the supply o long-term

nancing, dampening uture growth prospects. This

report oers proposals or both international and

national policy makers to increase the availability o

sustainable long-term nancing. These should not beconstrued as ormal recommendations that carry the

unanimous endorsement o all members o the G30

Working Group on Long-term Finance. Instead, we

have detailed a wide array o possible responses that

merit urther public debate. While all members o the

Working Group may not agree with every detail o the

report, they ully endorse its main thrust.


21/75

Group of Thirty 19

Principles for an IdealLong-term Finance Market1.


22/75

20 Long-termFinanceandEconomicGrowth

Long-terminvestmenttypicallyrepresents2530%ofGDP,thoughitcanbe

muchhigherineconomiesundergoingrapideconomictransformation

E x h i b i t 1

NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute.

LONG-TERM INVESTMENT BREAKDOWN BY ASSET TYPE FOR 9 SAMPLE COUNTRIES

Percent of GDP, most recent data (2011 or 2010), country sample represents over 60% of world GDP

26%

0

5

6 4

26%

1 6 10

35%

24%

2 7 6 5

24%

3 7 8 3

2

1

3

2

6

2

6

2

27%

4

4

2

5

627 6 2

28%

3

3

3

10

9

4

9

11 5 3

29%

13

14

4 2

51%

6

10 5

1

3 6 8 3

Residential real estate

Research and development

Education

Infrastructure

Equipment and software

Commercial real estate and other structures

UNITED

STATES

UNITED

KINGDOM

GERMANY FRANCE JAPAN CHINA INDIA BRAZIL MEXICO

3.6 0.6 1.0 0.8 3.8 0.6 0.31.6 0.4

DEVELOPED MARKETS EMERGING MARKETS

Tangibles

Intangibles

TOTAL

INVESTMENT,

USD TRILLION

Advanced and emerging economies alike ace

very large-scale investment needs in the years

ahead. The availability o long-term fnance

will determine whether governments, businesses, and

households can invest or the uture, raising produc-

tivity and living standards.

1.1 Long-terminvestmentis

essentialforeconomicgrowth

This report defnes long-term investment as spend-

ing on the various types o inrastructure that, all

things being equal, can expand the productive capac-

ity o an economy. This encompasses tangible assets

(such as roads, bridges, ports, machinery, actories,

commercial buildings, hospitals, and new housing

units) and intangible assets (such as education and

research and development) that increase uture pros-

pects or innovation and competitiveness.2

Many o these investments are at least partially

public goods that eventually generate greater returns

or society as a whole by expanding vital services,increasing quality o lie, or enabling the movement

o people and goods. They enable companies and gov-

ernments to produce more goods and services with

ewer resources, raising productivity growth.

Using this defnition o long-term investment, we

have analyzed the level and mix o investment across

nine major economies.3 This sample includes the fve-

largest developed economies and our o the largest

2 See the glossary at the beginning o this report or additional details.

3 The sample comprises Brazil, China, France, Germany, India, Japan, Mexico, the United Kingdom, and the United States.


23/75

Group of Thirty 21

Frameworkorunderstandingtheprovisionofnancingorlong-terminvestment

E x h i b i t 2

INTERMEDIATION SYSTEMS USERS OF FUNDS

Financial intermediaries

Banks

Insurance companies

Other asset managers

Sovereign wealth funds

Pension funds

Alternative investment vehicles

PROVIDERS OF FUNDS

Sources of funds

Domestic

Households

Corporations

Government

Foreign

Households

Corporations

Government

Self-financing instruments

Householdincome/wealth

Governmenttax receipts

Corporateretained earnings

Long-term investment

Maintenance ofphysical capital

Research anddevelopment

Education

Equipmentand software

Property, plant,and equipment

Commercialreal estate

Infrastructure

New stock ofresidential real

estate, foremerging

economies

Capital markets

Other

Bonds

Equity


developing economies, together representing over

60 percent o world gross domestic product (GDP).

Exhibit 1 shows that investment levels are typically

between 25 percent and 30 percent o GDP, though

they can be much higher in countries undergoing

rapid industrialization and urbanization (India and

China, or example, have investment levels equivalentto 35 percent and 51 percent o GDP, respectively).

Underscoring the pivotal role o the private sector, we

nd that equipment and sotware is the largest cat-

egory o long-term investment, averaging 8.8 percent

o GDP across this sample o economies. This is two

to three times greater than inrastructure, and even

exceeds investment in residential real estate.

1.2 Financinglong-terminvestment

requireslong-maturityinstruments

andinvestorswithlongtimehorizons

Exhibit 2 illustrates the fow o long-term nance

rom providers through the intermediation process to

the end users. Long-term nance is the provision o

long-dated unds to pay or capital-intensive under-

takings that have multiyear payback periods. Various

sources act as providers o long-term nance including

domestic and oreign households, corporations, and

governments. Funds may also come rom corporate

earnings, government revenues, or household income

and wealth, and a proportion o the nancing may

go directly to the end users. Long-term nance also


24/75


fows through various intermediaries (such as banks,

insurance unds, pension unds, and so orth), or

alternatively the intermediation may be undertaken by

capital markets; the precise balance within this inter-

mediation process, between nancial institutions and

capital markets, varies across the globe. The users o

long-term nance apply them to dierent investmentsincluding inrastructure, commercial and residential

real estate, plant and equipment, equipment and sot-

ware, and so orth.

The academic research on the connection between

nance and growth is well established.4 However, this

literature has oten not distinguished between long-

term and short-term nance. Nevertheless, we believe

it is important to ocus on long-term nance since it is

less procyclical than short-term nance and plausibly

more supportive o long-term economic growth. More-

over, a prevalence o long-term nance may promote amore stable nancial system. Because many long-term

investments require an extended gestation period to

account or complex development or construction,

investors must be prepared to accept a long time hori-

zon or debt repayment or return on equity. They must

also be prepared or the likelihood o major down-

side risk along the way. This is a crucial consideration

in designing the appropriate nancing mechanisms,

because relying on short-term nance or long-term

projects likely adds an additional layer o instability.

1.3 Fourkeyprinciplesshouldgovern

theprovisionolong-termfnance

By articulating a set o undamental principles that

dene how an ideal market or long-term nance

should unction, we can diagnose the current systems

shortcomings and begin to identiy policy solutions to

address these faws. It is important to note, however,

that the ollowing analysis does not deal with indi-

vidual institutions but considers nancial intermedi-

aries at an aggregate level. Thereore, the ollowing

principles should be understood in the context o

sound and solid nancial institutions.

Principle 1. The fnancial system should channel sav-

ings rom households and corporations into an ade-

quate supply o fnancing with long maturities to meet

the growing investment needs o the real economy.The world needs to invest in inrastructure, educa-

tion, R&D, housing, and business expansion in order

to meet even moderate consensus growth orecasts.5

Policy makers should aim to ensure that the nancial

system ulls this core unction o providing the capi-

tal that allows businesses, governments, and house-

holds to invest and build or the uture.

Principle 2. Long-term fnance should be supplied by

entities with committed long-term horizons. Beore

the crisis, nancial innovation attempted to bestowan articial liquidity on long-term instruments. But

when long-term investment rests on the shaky oun-

dation o short-term nancing, the resulting maturity

mismatch increases riskor borrowers, or investors,

and or the nancial system as a whole. That risk is

substantially reduced when investors with the appro-

priate time horizons, risk appetite, and liquidity needs

are matched with the right investment opportunities.

Principle 3. A broad spectrum o fnancial instruments

should be available to support long-term investment.Borrowers in advanced and emerging economies alike

should have a ull menu o options or nancing,

including bank loans with longer maturities, equity,

and bonds. Long-term instruments oer a degree o

insulation rom the volatility o the business cycle and

minimize the potentially disruptive eects o wide-

spread maturity mismatches, which have contributed

to past nancial crises. Deep and robust capital mar-

kets provide a range o options or the needs o diverse

borrowers. In addition, investors should have the

choice o a ull range o instruments, including the use

4 See R. Levine, Finance and Growth: Theory and Evidence, in Handbook of Economic Growth, ed. P. Aghion and Durlau (Amsterdam:

North-Holland Elsevier, 2005); S. G. Cecchetti, and E. Kharroubi, Reassessing the Impact o Finance and Growth, Bank for International

Settlements Working Papers (Basel, 2012); T. Beck, A. Demirguc-Kunt, and R. Levine, Financial Institutions and Markets: Across Countries

and Over Time, World Bank Economic Review (2010); W. Easterly, R. Islam, and J. Stiglitz, Shaken and Stirred: Explaining Growth

Volatility, Annual World Bank Conference on Development Economics, (Washington, D.C., 2000).

5 See section 2.1 or GDP growth projections or major economies.


25/75

Group o Thirty 23

o hedging instruments and other means o risk miti-

gation. A gradual shit rom the traditional and essen-

tial role that banks play as credit intermediaries and

lending entities will take time, and systemic stability

considerations need to also be taken into account as

this takes place, mindul o potential uture risks.

Principle 4. An ecient global nancial system should

promote economic growth through stable cross-border

fows o long-term nance, supported by appropri-

ate global regulation. An ideal system would enable

the ecient transer rom capital-rich economies

to capital-poor economies to promote economic

growth.6 This would also enable risk diversication

across economies. For this to be achieved in a stable

environment, an ideal system would contain the risk

o volatile short-term wholesale bank lending and

would acilitate greater fows o portolio investmentand long-term oreign direct investment into pro-

ductive enterprises. This type o investment tends to

exert a stabilizing infuence that promotes economic

growth. Investors in advanced economies would gain

diversication, while emerging economies would be

able to tap into nancing or urgently needed devel-

opment projects.

One o the goals o the nancial system is to eciently

and seamlessly match global savings with long-term

investment opportunities. In reality, however, long-

term nancing is oten executed with terms and

vehicles that are not appropriately tailored to the

needs o the borrower or the investorand in some

instances, these rictions can substantially increase

risk. There is a need to increase the level o savings

available, and to more eectively match savings to

long-term investment opportunities. The ollowingsection analyzes how the market or long-term nance

currently unctions in order to identiy areas in which

the system alls short o the principles described above.

6 Many observers have noted that emerging markets have been net providers o capital to rich countries over the last decade. However, excluding

the large central bank oreign reserve accumulations o developing countries, which are then invested in sovereign bonds o advanced economies,

most emerging nations are becoming net recipients o oreign investment (see orthcoming McKinsey Global Institute report, February 2013).

Concerning the determinants o the global allocation o capital, there is still much academic debate because currently there is no economic

theory that ul ly accounts or the observed patterns o cross-border capital fows (see Pierre-Olivier Gourinchas, and Olivier Jeanne, Capital

Flows to Developing Countries: The Allocation Puzzle (University o Caliornia, Berkeley, and International Monetary Fund, 2006).


26/75


27/75

Group of Thirty 25

The Current Financial SystemDoes Not Efciently SupplyLong-term Finance2.


28/75


Worldwide demand or long-term investment

continues to rise, but the analysis that

ollows raises concern about whether the

global nancial system is congured to meet these

growing needs eciently and sustainably. In recent

years, the provision o long-term nance has not

satised the principles or an ideal market as outlinedin Chapter 1. Our analysis indicates that the result is an

emerging divergence between the supply and demand

or long-term nance which, i let unaddressed,

will increase the cost o capital and limit long-term

economic growth and development.

The divergence between supply and demand can be

partially explained by a natural repricing o risk ater

the nancial crisis, and by transitional diculties as

banks repair their balance sheets and adjust to the new

capital adequacy regime. However, even in this case, i

there is a relatively low supply o savings, the repricingwill lead to a high cost o capital, preventing some

investment projects rom going ahead.

In addition to repricing, there are also market

ailures or fawed market designs that should be

mitigated by policy responses. Financing outside the

United States, in particular, relies on a narrow range o

instruments (primarily bank lending), which limits the

options available to borrowers. While other countries

can learn rom some aspects o the U.S. system, this

model is also ar rom ideal. Too oten in the United

States and elsewhere, long-term investment has beenunderpinned by short-term nancing or by institutions

with large maturity mismatches that are sources o

systemic risk. In addition, three looming trends, i let

unmanaged, are likely to constrain access to long-term

capital or governments, corporations, and households

in the years ahead, leading to even greater diculties

in creating jobs and maintaining economic growth.

2.1 Worldwidedemandforlong-term

investmentisrising

In the coming years, the demand or long-term invest-

ment is projected to rise substantially as mature

economies address long-deerred inrastructure needs

and emerging nations continue to urbanize and

industrialize. In both sets o countries, long-terminvestment will be crucial to achieving uture produc-

tivity gains and employment growth.

By 2020, nine major economies will needto invest an additional US$7 trillionannually to support growth

To better understand long-term investment patterns,

we undertook a granular analysis o long-term invest-

ment in ve mature economies and our major develop-

ing economies that collectively account or 60 percent

o global GDP. Annual spending on long-term invest-

ment in these nine countriesBrazil, China France,

Germany, India, Japan, Mexico, the United Kingdom,

and the United Statestotaled US$11.7 trillion in 2010.

Exhibit 3 shows how these levels are set to rise over

the course o the current decade. Drawing on consen-

sus growth orecasts, we project that by 2020, annual

long-term investment in these countries will need to

increase to US$18.8 trillion in real terms to achieve

even moderate levels o economic growth.7 This equals

34 percent o these nations GDP, up rom 30 percento GDP, currently.8 In this projection analysis, we use

orecast growth rates to estimate uture investment

levels (that is, quantity o investment needs), assuming

a constant productivity o capital. As such, any poten-

tial mismatch between long-term savings and invest-

ment represent an ex-ante mismatch. We also perorm

a sensitivity analysis, examining a scenario with

renewed economic growth and another that assumes a

7 This scenario is based on a consensus growth orecast, which is the average o the country orecasts rom the International Monetary Fund,

Global Insight, Oxord Economics, and the Economist Intelligence Unit. It uses constant 2010 prices and constant exchange rates. Projected

cumulative annual GDP growth rates through 2020 are 2.6 percent or the United States, 1.8 percent or the United Kingdom, 1.5 percent or

both France and Germany, 1.1 percent or Japan, 7.8 percent or China, 7.6 percent or India, 3.6 percent or Mexico, and 4.0 percent or Brazil.

8 For a more in-depth look at the implications o rising investment demand in emerging markets, see McKinsey Global Institute, Farewell to

Cheap Capital? The Implications o Long-Term Shits in Global Saving and Investment (December 2010).


29/75

Group of Thirty 27

In a consensus growth scenario, long-term investment

is projected to grow signifcantly by 2020

E x h i b i t 3

USD trillion (real)

2020 (F)

18.8

1.6

3.6

1.6

5.4

3.1

2.4

2.8

2010

11.7

0.9

2.4

3.5

1.8

1.4

1.7

Research anddevelopment

Education

Equipment

Other structures

Infrastructure

Residential real estate


F = Forecasted

a Sample countries include Brazil, China, France, Germany, India, Japan, Mexico, the United Kingdom, and the United States, representing 60% of world GDP in 2010.


Constant 2010 prices, constant exchange rates

CUMULATIVE

ANNUAL

GROWTH RATE

CUMULATIVE

ANNUAL

GROWTH RATE

4.9%

5.2%

5.3%

5.7%

4.2%

4.5%

5.2%

REAL INVESTMENT BY TYPE

FOR SAMPLE COUNTRIESa

USD trillion (real)

2020 (F)2010

18.8

6.5

2.6

1.9

2.7

5.2

11.7

1.4

1.6

2.2

3.5

China

Other emerging

Japan

Western Europe

United States

4.9%

3.9%

2.1%

1.8%

6.3%

7.9%

INVESTMENT EVOLUTION BY REGION

FOR SAMPLE COUNTRIESa

PERCENT OF GDP PERCENT OF GDP

30% 34% 30% 34%

3.0

global economic slowdown. The outcomes conrm the

growing need or long-term investment under a range

o dierent outcomes or global growth: the higher-

growth scenario projects investment o US$20.4

trillion, or 35 percent o GDP, while the slowdown

scenario projects investment o US$17.0 trillion, or 33

percent o GDP.China accounts or roughly hal o the increase,

with its long-term investment set to rise rom US$3

trillion today to US$6.5 trillion in 2020, in real terms.

Chinas currently very high investment rate is projected

to remain stable over the decade in our analysis

(moving rom 51 percent o GDP to 52 percent o

GDP), but this disguises a signicant shit in the type o

investment. China is projected to decrease investment

in xed assets such as inrastructure and actories as it

rebalances its economy toward more consumption and

domestic services. But this will be oset by higher levels

o spending on education and R&D, both o which are

currently well below the levels o mature economies.9

The United States accounts or 23 percent o the

growth in our sample o countries, with annual invest-

ment reaching US$5.2 trillion by 2020, in real terms.

This increase refects a projection o solid though not

spectacular economic growth over the decade, with

real GDP growth averaging 2.6 percent annually.

9 We also tested a scenario in which there is a global slowdown and Chinas investment rate in tangible assets alls more sharply, implying an even

aster rebalancing o growth to domestic consumption. I Chinas growth slowed to a rate comparable to Latin Americas, it would be investing

US$4.5 trillion rather than US$6.5 trillion, representing 30 percent o the total in the sample o countries.


30/75


Roughly40%olong-terminvestmentisfnancedthroughequity,bonds,orloans

E x h i b i t 4

a Estimates for a typical global project based on data from sample countries including Brazil, China, France, Germany, India, Japan,Mexico, the United Kingdom, and the United States, representing over 60% of world GDP in 2010.

b Internal financing here defined as financing from household income/wealth, corporations retained earnings/cash holdings.

c Loans for residential and commercial real estate are as originated; depending on the country, a large portion of these loans could subsequently be securitized.

d Typical commercial real estate investment (including in existing structures) used as a proxy for investment in new commercial structures.

e Total debt and equity financing increase as a share of capital expenditure for nonfinancial corporations across the sample of countries.


0.8

2530%

7075%

2.1

510%

7585%

1015%

1.4

510%

2025%

510%

6065%

3.5

510%

2530%

1520%

4550%

1.8

6070%

3040%

Bonds

Loansc

Equity

Government

Internal financing

from households

and corporationsb

100% 11.2

04%

3033%

05%

2530%

3033%

FINANCING BY TYPE OF INVESTMENT

Financing type as a percent of total investment, total in USD trillion for sample countriesa

1.6

7080%

2030%

Residential

real

estate

Equipm

ent

&softwaree

Infra

stru

ctur

e

Educ

ation

Research

&

deve

lopm

ent

2011 LT

investment

for sample

countriesaCom

mercial

real

estated

=

Aside rom China, the other emerging markets in

our sampleBrazil, India, and Mexicotogether

account or 18 percent o the growth, with their col-

lective long-term investment rising to US$2.6 trillion

per year by 2020.

European investment is projected to remain largely

stagnant, refecting the low growth rates assumed inthe consensus orecast (1.5 percent average annual

GDP growth or France and Germany, and 1.8 percent

or the United Kingdom).

Ensuring an adequate supply o long-term nancing

to meet the needs o the real economy is the most

undamental o the principles outlined in Chapter

1. But as we explain in the next section, the current

nancial system is straining to provide such nancing,

and several trends ahead will exacerbate the problems.

Policy adjustments will be required to ensure that these

projected large-scale increases in demand can be met.

2.2 Currentprovisionolong-termfnanceotenailstoconormwith

theprinciplesoutlinedinChapter1

Long-term investment relies on a mix o sel-nancing

(through current earnings and savings) and capital

raised through the nancial system. As illustrated in

Exhibit 4, we estimate that corporate retained earnings

und approximately 45 to 50 percent o all equipment


31/75

Group of Thirty 29

Government accounts for about 30% of long-term investment in most countries

E x h i b i t 5

LONG-TERM INVESTMENT BREAKDOWN BY SECTOR

Percent of total long-term investment, most recent data (2011 or 2010), country sample represents over 60% of world GDP

TOTAL

LONG-TERM

INVESTMENT,

USD TRILLION

3.6 0.6 1.0 0.8 3.8 0.6 0.31.6 0.4


31

100%

3427

3239

17

34 32 31

5444

4642

43

6329

4445

1522

27 2618 20

38

23 24Households

Corporations

Government



UNITED

STATES

UNITED

KINGDOM

GERMANY FRANCE JAPAN CHINA INDIA BRAZIL MEXICO

and sotware; the remaining capital must be raised

through bank loans, bond issuance, or equity issuance.

As shown in Exhibit 5, we estimate that govern-

ments typically account or about 30 percent o long-

term investment, fnanced either through current tax

revenues or issuance o government bonds. Inrastruc-

ture is the prime example o this type o investment,and across our sample o countries, governments drive

some 60 percent o inrastructure spending. Another

30 percent o long-term investment is sel-fnanced by

corporations and households via corporate retained

earnings and household savings.

The remaining 40 percent o long-term invest-

ment must be fnanced through bank lending and the

capital markets. A sustainable and eective system o

intermediation would guarantee that adequate capital

is available or productive purposes, but the actual

delivery o this fnancing oten alls short o the idealmarket described in Chapter 1.

Banks are the dominant source o externally

intermediated fnancing outside the United

States. Lending is oten short term and

potentially volatile

Banks provide only 19 percent o long-term external

fnancing in the United States, while the remaining

81 percent is provided through capital markets. Inact, the diversity o fnancing methods available in

the United States provides policy makers with useul

templates to ollow (such as deep and well-developed

corporate bond markets) and cautionary tales o

what can go wrong (such as securitization markets

that operated without adequate transparency beore

the crisis and still rely heavily on two government-

sponsored enterprises whose uture status remains

uncertain). Exhibit 6 shows that, by contrast, in major

European economies bank lending accounts or 59 to

71 percent o external fnancing or long-term invest-ment and 75 percent o fnancing in China.


32/75


Banks provide over 50% o external long-term fnancinga outside the United States,

mainly through residential mortgages

E x h i b i t 6

Residential mortgages

Commercial

real estate loans

NFC loans with

maturities >5 yearsd

Asset-backed/mortgage-backed

securities

NFC book equity

of listed companiesb

Capitalmarkets

Banking

PERCENT TOTAL AS SHARE OF GDP

UNITED

STATESe

11

7

48

26

6

2

129

UNITED

KINGDOM

43

9

21

11

9

7

156

GERMANY

43

12

3

12

14

16

100

FRANCE

36

12

2

14

23

13

115

CHINA

26

11

11

14

38

73

100%

NFC bondsc

TYPES OF DOMESTIC LONG-TERM FINANCING OUTSTANDING, 2011

Percent of total domestic long-term financing

a External long-term financing here includes nonfinancial corporations (NFCs) book equity, NFC bonds, asset-backed/mortgage-backed securities, longer maturity

NFC loans, commercial real estate loans, and residential mortgages. Part of book equity are changes in retained earnings, which could be classified as internal.

b Calculated by dividing total market capitalization by the average price-to-book ratio for NFC for each economy, and therefore covers only public (listed) companies.

Due to data unavailability, the equity of private companies is not included.

c Used Bank for International Settlements data for bonds outstanding to be consistent with corporate bonds data.

d We estimate the portion of 5-year maturities using a broader set of loans.

e US bank lending includes loans to domestic and foreign entities. The other countries include only domestic entities as counterparties.


While banks have historically met a large part o

fnancing needs due to their expertise in credit origi-

nation and monitoring unctions, bank loans are

not the most appropriate instrument or all types o

long-term fnancing. As shown in Exhibit 7, commer-

cial bank loan maturities average only 2.8 years in

emerging economies compared to 4.2 years in devel-oped economies. These terms are ar shorter than

either investment-grade or high-yield bond maturities;

in developed countries, these are 8.0 years and 7.7

years, respectively, and in emerging markets they are

6.0 years and 6.9 years, as shown in Exhibit 8. Over-

reliance on bank lending thus undermines the act that

long-term fnance is best delivered by intermediaries

and instruments with long time horizons.

Moreover, a signifcant share o bank lending prior

to 2008 was fnanced in short-term wholesale markets.

This created an excessive maturity mismatch. When

liquidity in that market dried up and short-term interest

rates spiked during the fnancial crisis, the inherent

instability o this fnancing model was laid bare.10

Mortgages make up more than hal o all long-termlending in the sample countries (with the exception o

China, where banks lend mainly to nonfnancial cor-

porations). In the United States, long-term fnance or

residential real estate is largely provided outside the

banking system, since a signifcant share o the mort-

gage loans originated by banks are subsequently sold

to two large government-sponsored enterprises to be

securitized and sold to investors. In theory, this model

10 See Raghuram Rajan, Fault Lines: How Hidden Fractures still Threaten the World Economy (Princeton, NJ: Princeton University Press, 2010).


33/75

Group of Thirty 31

Bank lending is typically short term, especially in emerging markets

E x h i b i t 7

BRAZIL

49

INDIA

35

CHINA

42

UNITED

KINGDOM

29

GERMANY

19

FRANCE

29

UNITED

STATES

31

4.2

2.8

28

41

41

31

46

35

45

26

33

26

18

47

10

42

Up to 1 year15 yearsOver 5 years

Developed markets Emerging markets

Bank lendingb

Emerging

markets

loans

Developed

markets

loans


a Calculated using the countries and weights from the chart on the right, using 0.5, 2.5, and 8 years as average maturities for each category.

b Bottom-up analysis of banks balance sheets for banks representing at least 70% of the total market share in each country, except for China and India

(top ten banks used for both) and European countries (all domestic banks with assets above USD 5 billion used).


AVERAGE MATURITYa PROPORTIONS OF MATURITIES

Years Loans outstanding, percent

BANK LENDING MATURITIES

Corporate bonds have signifcantly longer maturities than bank loans

in both developed and emerging markets

E x h i b i t 8

Bank loans

4.2

High-yield

bonds

7.7

Investment-

grade bonds

8.0

Years Years

AVERAGE MATURITY OF FINANCIAL INSTRUMENTa


Bank loans

2.8

High-yield

bonds

6.9

Investment-

grade bonds

6.0

a Based on 3-year weighted average of maturity from sample countries (the United States, the United Kingdom, Germany, France for developed markets;

China, India, Brazil for emerging markets).



34/75


WHy MORTGAGE LENDING IS

NOT NECESSARILy FINANCE

FOR LONG-TERM INVESTMENT

Mortgage lending typically involves long-maturity loans.

However, not all investment into housing ts our denition

o long-term investment. In emerging markets, where popu-

lations are growing and moving into cities, investment into

housing or these populations clearly expands the nations

productive capacity. It acilitates movement o people rom

rural areas into cities, where their productivity rises. Urban-

ization also provides citizens with better access to health

care, education, and sanitation services. Mortgage lending or

expanding the housing stock in these countries thus repre-

sents nance or true long-term investment.

In advanced economies, however, there is already exten-

sive housing stock, and most mortgage lending supports the

purchase o existing residential properties, not construction

o new ones. In these cases, mortgages do not nance an

expansion o productive capacity in the economy, but may

be viewed instead as supporting the consumption o hous-

ing. Exceptions to this would include the nance o construc-

tion o new residential buildings to support rising household

ormation, and investments in retrotting existing housing

stock to improve energy efciency (which would improve

overall economic productivity by reducing energy costs andalso reducing carbon emissions).

should disperse mortgage credit risk. However, just

under 20 percent o the investors who bought mortgage-

backed securities beore the fnancial crisis were com-

mercial banks and savings institutions, while mutual

unds held just over 10 percent; these institutions some-

times used short-term borrowing to buy these assets.

Just over 15 percent o those securities were held by

the government-sponsored institutions themselves. As

a result, mortgage credit risk was not being

dispersed beyond the fnancial system.

Going orward, policy makers can reduce

the instability that accompanies maturity

mismatches by creating incentives or inves-

tors with long time horizons to fnance long-

term investments.

Potentiallong-terminvestorsare

increasinglconstrainedintheir

abilittoprovidefnancing

Pension unds, sovereign wealth unds,

insurance companies, endowments, and

oundations would all be ideal candidates to

provide long-term fnancing, given their long

investment horizons. At the end o 2010,

these investors had assets o roughly US$57

trillion; we project that these institutionalinvestors will see asset growth o up to US$3

trillion per year in real terms by 2020.11 This

raises the prospect that they could supply up

to hal o the external fnancing needed or

long-term investments in major economies.12

Today, as shown in Exhibit 9, these inves-

tors do allocate a substantial share o their

portolios to long-term instruments, includ-

ing equity, private equity, and other illiquid

long-term investments. Some o their invest-

ments in fxed-income instruments, such as

corporate bonds, are also long term. Even

so, there is an opportunity or them to invest

more into long-term fnancing. And in some

cases, such as European pension unds and insurance

companies, we have seen a major shit out o long-

term assets over the last decade, in response to market

developments and risk assessments.

Several actors limit the incentives o these inves-

tors to provide more long-term fnancing. When per-

ormance measurement and compensation are tied

to benchmarks that are measured quarterly, und

11 See McKinsey Global Institute , The Emerging Equity Gap: Growth and Stability in the New Investor Landscape (December 2011).

12 We project annual long-term investment will reach US$18.8 trillion in real terms by 2020 in nine major economies. Currently, about one-third

o long-term investment is fnanced through external sources (the remaining two-thirds is fnanced through governments, corporate retained

earnings, and household savings). This implies that external fnancing will be needed or around US$6.25 trillion o long-term investment in

these sample countries.


35/75

Group of Thirty 33

Institutional investors hold long-term assets, but have room to increase the proportion

E x h i b i t 9

Insurers

23

28

67

5

Households

85

31

18

51

Endowments

& foundations

2

56

29

16

Sovereign

wealth funds

4

56

29

16

Pension funds

28

57

37

6

Mutual funds

24

55

38

7

INSTITUTIONAL INVESTORS ASSET ALLOCATION, 2010 OR LATEST

Percent of portfolio, USD trillion

100% =

Long termb

Fixed incomea

Cash and other


a Fixed income includes some risky long-term investment, such as corporate bonds, but the data are unavailable for a further breakdown.

b Long-term investment defined as equities and 80% of alternative assets; cash and other includes cash and 20% of alternative assets.

SOURCE: McKinsey Global Institute, The Emerging Equity Gap: Growth and Stability in the New Investor Landscape (December 2011).

managers that ride through short-term market move-

ments are penalized. In addition, many und managers

ace explicit guidelines on their portolio allocations

that limit equity exposure, private equity, and other

alternatives, and even the international share o assets.

These constraints on institutional investors under-

mine the principles or efcient provision o long-termfnance discussed in Chapter 1. In addition to dimin-

ishing the overall supply o savings available or long-

term investment, these limitations prevent mobilization

o a pool o investors with the appropriate time hori-

zons; reinorce reliance on bank lending, thus ailing to

broaden the instruments used or project fnance; and

restrict cross-border investment that can match savings

in one country with long-term investment opportuni-

ties in another. Changes to governance and accounting

rules should ease these constraints and enable institu-

tional investors to play a greater role.

PENSION FUNDS

Because they have clearly defned long-term liabilities,

traditional defned-beneft pension unds would seem

to be particularly well suited as a source o fnance

or long-term investment. Globally, these unds have

roughly US$16 trillion in assets.13 But many defned-

beneft unds around the world, both public andprivate, ace substantial fnancing shortages that

have intensifed short-term perormance pressures.

In addition, pension und accounting encourages

risk-mitigation strategies that have steered defned-

beneft unds toward low-risk fxed-income securi-

ties and away rom higher-risk, higher-return equity

investment. Not only does this decrease the supply

o risk capital, but it also homogenizes the invest-

ment approaches o pension unds, creating a lack

o diversifcation that has negative implications or

fnancial stability.

13 This includes both public sector pension unds (although not pay-as-you-go systems) and private sector defned-beneft unds.


36/75


The rise o defned-contribution pension plans in Europe

will lead to a urther shit out o equity

E x h i b i t 1 0

Percent of

portfolio

Other financial assetsEquities

United KingdombSwitzerlanda Netherlands

201020052000Percent

a In Switzerland, defined-contribution stands for funds where the plan sponsor shares the investment risk and all assets are pooled. There are almost no pure

defined-contribution assets where members make an investment choice and receive market returns on their funds.

b UK data do not include personal and stakeholder assets but do include insurance-administered vehicles. If the latter were excluded as well,

the proportion of defined-contribution assets would fall to 25%.

c Allocation based on a sample of the following plans: ABP, Alecta, ATP, FRR, PFZW, Royal Dutch Shell, Universites Superannuation, Varma.

d Allocation based on a sample of the following plans: Barclays Bank UK, Bayerische Versorgungskammer, British Coal Pension Schemes,

BT Group, Ilmarinen, PFA Pension, Royal Bank of Scotland Group, Royal Mail.


0.7 2.3 1.0

TOTAL PENS ION ASSET S, 2 010, USD TRILLION

The share of defined-contribution pension plans

has been increasing in Europe

Defined-contribution plans allocate less to equity

than defined-benefit plans

48

53

60

3

33

40

2

Defined benefit

Total assetsc

USD 850 billion

65

35

Defined contribution

Total assetsd

USD 341 billion

78

221

6

DEFINED-CONTRIBUTION SHARE

OF TOTAL PENSION ASSETSSHARE OF EQUITY IN THE ASSET ALLOCATION

In most advanced economies, defned-contribution

retirement plans are supplanting the defned-beneft

model, a trend driven by increased longevity and the

chronic underunding o defned-beneft plans. As a

share o all pension assets, defned-contribution plans

have risen rom 3 percent in 2000 to 40 percent in

2010 in the United Kingdom, as shown in Exhibit 10;in the United States, they have risen rom 27 percent

to 30 percent.14 Because participants choose their own

asset allocations, these plans typically have a simplifed

menu o investment options relative to those available

to proessional pension und managers. They also have

lower contribution levels than defned-beneft schemes

in all countries that lack a compulsory savings program

(such as Australia and Singapore). Outside the United

States, where individual investors still have a relatively

strong appetite or equities, participants in defned-

contribution plans have much lower allocations to

equities and other long-term fnancing instruments;

Exhibit 10 also illustrates the divergence between thetwo dierent types o plans in Europe. The shit to

defned-contribution plans has thus unintentionally

constrained the provision o long-term fnance in two

ways: by reducing the quantity o unds in retirement

plans, and by shiting the allocation o these savings

toward instruments with lower risk and lower return.

14 McKinsey Global Institute, The Emerging Equity Gap: Growth and Stability in the New Investor Landscape (December 2011).


37/75

Group of Thirty 35

Epe pes s e bee s eqy, bs ee sses

E x h i b i t 1 1

45

39

64

24

67

18105

75

142

58

39

44

44

44

27

2011

27

38

2006

33

38

2001

36

35

Bonds

Equities

Alternative assets

Cash

EUROPEAN PENSION FUNDS ASSET ALLOCATIONPercent of portfolio


UNITED KINGDOM

FRANCE

SWITZERLAND

11

1

9

2022

7

161

141

28

7

Exhibit 11 shows that allocations to equities in

both types o pension unds (defned-contribution and

defned-beneft) have dropped by 22 percent in the

United Kingdom, 17 percent in the Netherlands, and

Documents

Long Term Finance Hi Res