LACK OF THEORY OR LACK OF PRATICE? HOW TO DEAL WITH
FINANCIAL MARKETS IN THE GLOBALISED WORLD?
Paper for the 8th Pan-European Conference on International Relations
Warsaw, 18-21 September 2013
Małgorzata Smagorowicz
Polish Academy of Science/Institute of Political Studies/PhD Candidate
Bank Pekao SA/Head of Interbank Market *
[email protected]
Section: The financial crises in Europe
Panel: Knowledge, Ideas and the Financial Crises in Europe
Abstract
Since the bankruptcy of Lehman Brothers scholars, market practitioners and laymen all
over Europe have formulated countless questions about the nature of the crisis and the
end of that era. But the picture is not becoming clearer with time. Further questions are
needed in order to find the explanation – we still seem to be in the stage of the hypothesis
testing process. One such hypothesis which can be put under investigation is: The theory
of International Political Economy and the theory of financial decision making process
are sufficient to predict and tackle a crisis, but the fact that the centres of knowledge
and/or centres of political decision are separated from the centres of decision within
financial markets creates an inefficiency in the international system. This work will test
the above hypothesis as well as examining issues such as sustainability of knowledge,
asymmetry of knowledge, efficiency of communication channels and the real interest of
each center, in order to make a step forward in curbing future financial crises.
* Presented ideas express personal views and not those of the Company
1
Introduction
The very first idea of the subject appeared almost two years ago – in mid-July 2011,
when the Euro area was close to a break-up, when the financial markets participants were
trying to find stable ground
and when the heads of governments were meeting almost
every weekend. Rising yield on Italian and Spanish bonds1 combined with the lack of
demand on the primary market, depressed by cuts of sovereign ratings by leading
agencies2 created an atmosphere of a never-ending crisis environment.
At the same time the financial markets were blamed again and again for triggering the
crisis, which wasn’t – in the industry opinion – really fair. But this view was rather
internal – although shared by dealers, traders and portfolio managers from different
financial institutions. This sentiment was expressed in papers circulated within the
industry rather than discussed publicly. It became tempting to understand why the
financial world became so separated from the non-financial world and how the process of
alienation is growing. The next question mark was: may this separation influence the
severity or even frequency of financial turmoil?
When the subject of the 8th Pan European Conference on International Studies has been
published – One International relations or Many? Multiple Worlds, Multiple Crises – it
occurred that maybe this question is worth exploring. Especially in context of security
and wealth which, after all, should be the ultimate service delivered by the financial
markets to society, based on the knowledge and power accumulated across the industry.
1
Since October 2010 to July 2011 yield on 10Y Italian bond benchmark increased by 330 bp and yield of
Spanish 10Y BMK increased almost 250 bp, which was reflected in an almost 20% drop in bond prices.
Chats 1-3 shows the yield fluctuation on the 10Y benchmarks.
2
Since the middle of 2011 Italian Long Term local currency debt rating has been cut by Moody’s from
Aa2 to Baa2 in July 2012, by S&P from A+u to BBBu, and by Fitch from A+ to BBB+ (based on
Bloomberg CRPR function). The case in Spain was similar.
2
Power and knowledge of the financial markets
With growing economic activity and growing private savings, financial markets are
holding more and more power – power lying in hands of the people responsible for this
activity. Although the first impression may be that the harm done by the latest financial
crisis has upset the power,
data shown by McKinsey Global Institute doesn’t confirm
that. Based on the McKinsey Global Institute data the global financial assets have grown
to 225 trillion USD at the end of the second quarter of 2012 compared to 206 trillion
USD in 2007 or 56 trillion USD at the end of 19903. If we compare this data to the GDP
in order to get the relative value we will notice the decline in the past 5 years – in Q2
2012 global financial assets compared to GDP were at 313% compared to 355% at the
end of 2007, but the growth is significant in comparison to 1990 where this ratio stood at
263%4. And then if we add the outstanding amount of OTC derivatives – in Q2 2012 it
was equal to 639,36 billion USD5 and the outstanding amount of derivative financial
instruments traded on organised exchanges: futures 24,121.3 billion USD and options
30,313.1 billion USD at the end of 2012 (there is lack of data for the Q2 2012)6 – we are
getting a broader picture of the financial markets’ power. A power never seen before.
But the financial markets as a concept are not new. The oldest
markets
documented financial
phenomena could be found in the Hammurabi code. Two financial instruments
– called in contemporary language “ loan contracts with embedded options”, bottomry
loans and loans backed by the upcoming grain harvest get their legal basis
from the
Hammurabi code. The bottomry loan was a conditional loan – dependent on the success
of the captain and paid back (with interest) only when the ship completed the trip
successfully. Loan collateralised by grain also had the option of deferring payments in
case of a bad harvest. In such case the repayment of the loan and its interest was
postponed for one year8. Old and complex financial contracts show therefore that the
financial markets were and are the practical utilisation of human needs and knowledge,
3
McKinsey Global Institute: Financial Globalisation: Retreat or Reset?, March 2013, p. 2,
http://www.mckinsey.com/insights/global_capital_markets/financial_globalization, accessed 18 August
2013.
4
Ibid, p. 5.
5
Bank For International Settlements Derivatives Statistics, Table 19: Amount outstanding of the over-thecounter (OTC) derivatives by risk category and instruments type, http://www.bis.org/statistics/derstats.htm
accessed 18 August 2013.
6
Bank For International Settlements Derivatives Statistics, Table 23A: Derivative financial instruments
traded on the organised exchanges. By instrument and location: http://www.bis.org/statistics/extderiv.htm,
accessed 18August 2013.
8
Nicholas Dunbar: Inventing Money, John Willey&Sons 2000, pp. 23-25.
3
as well as excess of capital . It also confirms that the opportunities created by the excess
of money were always of interest to active people, even without the access to the
advanced pricing models9.
The financial markets – even at a very early stage of their development – attracted
people looking to increase their wealth by investing their own money , very often without
luck. One of the victims of one of the most significant and well described financial
bubbles was Issac Newton. He fell victim to the South Sea Bubble. When in September
1720 London
faced the crash of the South Sea stocks his loss reached 20.000 pounds.
His reaction was rather emotional: I can calculate the motions of the heavenly bodies, but
not the madness of people. Possibly, if he had had a chance to chat with another member
of The Royal Society, French mathematician de Movier, he would have invented one of
the first financial formulas and maybe he would have done much better. But he didn’t.
Six years after Issac Newton’s death in 1733, De Movier published for his friends a
brochure in which he described his research about the normal distribution10. But his work
wasn’t officially published in his lifetime and it took almost a century for the normal
distribution to be discovered by Pierre Simon de Lapance and Carl Fridrich Gauss11.
Later on in the 20th century the normal distribution was to become the foundation
of
contemporary financial knowledge – in terms of both financial instruments pricing and
risk management. Without this milestone works like Luis Bachelier’s, Albert Einstein’s,
Henry Mrakowitz’, William Sharp’s and Robert C. Merton’s couldn’t have been
published. But the normal distribution and its characteristics like standard deviation,
combined with the Brownian motion which describes assets price movements, are crucial
elements for understanding financial markets. The normal distribution finds
implementation in risk models and in return valuations, but it is also a key step toward
a better recognition of the nature of the last financial crisis.
Apart from the mathematical foundations of the financial markets there is yet another
aspect which is drawing more and more attention, especially since the Lehman Brothers
collapse in September 2008 – the human factor. But as a subject of research this aspect
isn’t new.
The book The Fountain of Gold – The Three Monkey Record of Money is considered the
first comprehensive work about the psychology of the financial markets. The book was
9
F. J. Fabozzi, S. Focardi, P. N.Kolm: Financial Modeling of the Equity Market, Wiely Finance 2000,
pp. 2-7.
10
Amir D. Aczel: Statystyka w zarządzaniu, Warszawa 2005, pp. 155-156.
11
Ibid: p. 156.
4
written by Munehisa Homma (1724-1803), the most respectable Japanese rice futures
contract player, and published in 1755. The three most important conclusions of
Homma’s were: don’t look (when the prices are falling treat this as the opportunity to
buy), don’t hear (don’t listen to the gossip or other news, try to concentrate on your own
strategy) and don’t speak (don’t disclose your strategies and ideas)13. His advice can be
summarised as the rule: be independent in your decision making process (which the
market calls investment process). Unfortunately, technical foundations of contemporary
financial markets generally exclude such independent attitude.
But the story of Homma is interesting not only due to his book. It’s also worth noting that
he was operating on the first futures exchange established during the Edo era (Tokugawa
Shogunate). The futures on rice appeared in order to enable the daimios to collect cash
before the rice harvest. This money was used to finance their expensive lifestyle.
Operating on such markets he discovered that the prices of the futures
often greatly
deviate from the fundamental price of rice traded on spot. Although he didn’t use any
mathematics, his experience and deep understanding of the psychology of the rice market
resulted in two ways.
Homma’s ideas and thoughts gave him the position of
government advisor and won him the samurai distinction, but what’s most important –
made him the father of the candlestick technique
(which
depicts not only price
movements – as western technical analyses do – but also the mood and emotions of the
market).
Figure 1. Candlestick formation –
The morning star14
13
S. Nison: Beyond Candlesticks. New Japanese Charting Techniques Revealed, Willey& Sons Inc, 1994,
pp. 13-15.
14http://www.tradeforextrading.com/forex_candlesticks_file/morning_star_candlestick_pattern.png
accessed 14 September 2013.
5
,
Homma’s ideas were rediscovered by the western world in the late 1980’s. In the
meantime, western financial knowledge had been broadened based on
mathematical input and new theorems. As
strong
financial market theories can be tested by
practical implementation, the industry was paying special attention to Fischer Black,
Myron Scholes and Robert C. Merton – the fathers of option pricing models15. In 1993
Long Term Capital management (LTCM) hedge fund was formed, with Myron Scholes
and Robert C. Merton (both awarded with the Nobel Prize in Economics in 1997 for a
new method to determine the value of derivatives16) as co-founders. The first years
were proving their theoretical assumption and bringing real results.
But in 1997
LTCM changed its strategy, decided to explore the volatility factor and play the role of
“Central Bank of Volatility”17. And this factor (and the overconfidence toward models,
historical data and normal distribution), combined with
the risk-off sentiment on the
markets as the response to the Asian crisis in 1997 and the Russian crisis in 1998 led to
the liquidation of that fund, although its
collapse was avoided. The Federal Reserve
Bank of New York lent a helping hand organising the bail out by collecting USD 3.6
billion in order to avoid further losses for the financial markets.
At this point LTCM was like a warning bell for the supervisors and regulator. All the
risks caused by LTCM were later to be repeated by Lehman Brothers.
One of the positive results of LTCM failure was the increased attention toward risk
management. Such concepts as VAR (Value at Risk) have been extensively utilised,
combined with other complex sophisticated models/procedures, e.g Monte Carlo
Simulation and stop-loss structure. They became popular among banks, but also rating
agencies. Unfortunately quant and risk managers’ experience didn’t payoff during the
last crisis, when Mortgage Backed Securities and other credit derivatives based on them –
like Collateralised Debt Obligation – were losing real market value.
The model was estabilshed in the 1960‘s but published in 1973. A detailed description followed by case
studies can be found in J.C. Hull: Options, Futures and Other Derivatives, Pearson New Jersey 2006 (6-tx
edition), pp.281-305 , pp. 611-631.
16 http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1997/press.html, access
11.09.2013.
17 N. Dunbar: Inventing Money, John Willey&Sons 2000, p. 181.
15
6
Alienation of financial markets
It is a fact that the financial markets, and in particular the theory of finance, emerged
from classic economics . However, the financial world
came to be more and more
dependent on mathematics and statistics19 and, eventually, became almost independent
from economic foundations. Davis and Servigny raised this issue and highlighted the
dominating founding principles of finance driving the industry way of thinking20. The
following concepts have been chosen and critised by them21:
1. Market efficiency: this makes forecasts useless because current price are believed
to be the best mechanism to aggregate all market participants’ forecasts
instantaneously.
2. Static portfolio construction: this is seen as a way to mitigate
risk through
diversification.
3. A long-term focus: this is needed because a regular rebalancing of the asset
allocation would be susceptible to market timing and the associated risk. It is also
assumed that a stable allocation should enable us to benefit from excess returns
over cash generated by risky assets, thanks to the existence of the risk premium
toward which returns revert to over the long term.
4. Asset class indices as the basis for asset allocation: Under the CAPM approach,
active managers can add value only if they can rely on superior information.
5. The existence of a single asset allocation: This occurs once the risk tolerance of
an individual has been determined.
In response to the above ideas the evaluation of risk measures and performance has been
developed. There are three main classes of historical risk statistics22:
1. absolute risk measures – defined as the total variability in returns and primary
measured by using standard deviation of periodic short-term returns
2. benchmark relative risk measures – the measure which enables to isolate value added
by manager over the value generated by the benchmark itself.
19
The handbook of risk management written and updated every two years by Philippe Jorion is one of the
best examples of how financial markest are now „formula“ dependent: P. Jorion: Financial Risk
Management Handbook, Wiely Finance 2009.
20
G. B. Davis , A. de Servigny: Behavioral Investment Management, MC Graw Hill 2012, p. 28.
21
Ibid, pp. 28-32.
22
B. J. Feibel: Investemnt Performance Measurement, Willey&Sons 2003, pp.128-129
7
3. downside risk measures – used when only the returns which are below a predefined
reference return are treated as risk. Downside risk measures are also used when the
assumptions underlying the use of standard deviation do not hold.
The most commonly used measures of risk are the absolute risk measure and the
benchmark relative risk measure. This methodology is strictly related to the theoretical
financial framework which has been criticised by Davis and Servigny. Downside risk
measure is combined with the risk attributed to subjective utility function rather than the
expected utility function incorporated by
Modern Portfolio Theory assumption.
Unfortunately, Postmodern Portfolio Theory (reflecting behavioural economic23 findings
rather than neo-classical economic assumptions) wasn’t received as warmly as the
Modern Portfolio Theory 24within the financial world.
Apart from the theoretical foundation mentioned above and the benchmarking process,25
the financial markets are also bound by other “technicalities” – like risk models and risk
limits.
Within the risk management field there is only one territory which is not fully covered by
mathematics – political risk. Political risk is defined in the financial literature in the
following way: It’s a risk associated with changes in the political environment. Political
risk can take many forms, both overt (e.g., replacement of a pro-cpitalist regime with one
less so) and subtle (e.g., the potential impact of a change in party control in a developed
nation), and it exists in every jurisdiction where financial instruments trade26. Political
risk is included within the sovereign risk generally assessed by credit rating of the
country. Categories analysed during the assessment of sovereign ratings of given country
are as follows27: political risk, income and economic structure, economic growth
prospects, fiscal flexibility, public debt burden, contingent liabilities, monetary
flexibility, external liquidity and external debt burden. When credit rating agencies assess
the rating of any company within the country the sovereign credit rating becomes the
23
Sendhil Mullainthan, Richard H. Thaler: Behavioral Economis, NBER Working Paper no 7948, 2000,
www.nber.org.
24 F. Sortino, S. Stachel: Managing downside risk in financial markets, Elsevier 2001, p. 59-71.
25
John L. Manginn, Donald L. Tuutle, Denis W. McLeavey, Jerald E. Pinto: Managing Investment
Portfolios, John Willey&Sons, 2007,(3-rd edition) p. 731-782
26
Ibid, pp. 595.
27
P. Jorion: Financial Risk Manager Handbook, Wiley Finance 2009, pp. 472-474.
8
dominant factor. It shows that such political risk can also be recognised as political
opportunity when the country is properly governed compared to other countries. And
what is most important – also for the financial markets – the economic future is designed
by political ideas.
The expression “real economy” doesn’t apply to the financial markets. But even if the
financial operations are not material in the sense of the outcome – the effects are very
real. Also the data which moves the market (like company earnings, GDP, CPI, NPL and
many other data generally called “fundamentals” in the financial market slang)
arise
from the real economy and are influenced by political decisions. In such aspect the
International Political Economy is the key foundation for the knowledgewhich is
necessary to operate on the globalised financial markets. In comparison to the knowledge
of economic theories, IPE covers not only the “the rational side of the human activity”
caused by the urge to increase the material wealth but also brings the understanding of
the ideas changing the environment for the human economic decisions and for the
future28.
If for a second we would forget about the theoretical foundations of the knowledge
spread out across the financial markets (e.g.,
market efficiency or rationality and
optimisation of decision ) then we can notice that the practice of how the financial
markets analyse the future and how the IPE does it are quite similar. We can also test the
hypothesis that knowledge delivered by both sides may be complementary.
Robert Gilpin stressed out that IPE is interested in the distribution of gains from market
activities , contrary to neoclassical economics29. He also pointed out that the logic of the
state is to capture and control the process of economic growth and capital accumulation
in order to increase the economic welfare of the nation, whereas the logic of the market is
to locate economic activities wherever they will be most efficient and profitable30. But
the financial markets – thanks to their ability to pick up a different type of risk – are
operating so as to increase the welfare of the capital owners. And in today’s world – with
its
private pension schemes, private investment funds and increasing private deposits,
the financial markets effectively manage
private capital (with a few exceptions of
managing state money e.g. Abhu Dhabi, Quatar, Saudi Arabia, Russia or Hong Kong).
28
Robert Gilpin: Global Political Economy. Understanding the International Economic Order, Princeton
University Press 2001, pp. 25-45.
29
Ibid, p. 77.
30
Ibid, p. 81.
9
Such big liquidity in private hands has been labelled by Ben Bernanke as the savings glut
and blamed to be one of the reasons of the crisis.
The forward looking view can be based on the most important similarities between the
IPE and financial markets. As an example we can use
hypothetical assumptions about
the weight of influence of macroeconomic data or political news, e.g
that the Chinese
government will change its demographic policy while keeping the market friendly policy.
We can take for granted that the political news will play the leading role in shaping future
investment decisions. Another example may be the BRIC (Brasil, Russia, India and
China) concept created in 2001 by Jim O’Neill31 – the chief economist of Goldman
Sachs. This idea has influence not only on the asset management industry but also on the
international relationships.
But what makes financial markets so volatile and alienated?
Apart from their mathematical foundations and assumptions based on expected utility
function there are factors like:
-
complexity of the financial instruments on the stock exchanges and OTC- markets
combined with high correlation between them,
-
shortage of time necessary to analyse, understand and price the new information
(economic, political, regulations)
-
simplifying the material world into the possible market actions (buy, sell, wait),
-
short horizon in the result evaluations due to market methodology ( starting from
intraday to one year valuations).
These factors are deepening the alienation due to concentration around
specific
knowledge and the short time for reaction.
Internal circle of ideas and knowledge in globalised financial markets
When discussing World View of the New Theories Robert Gilpin pointed out that new
theories have all been strongly influenced by research development in the field of
industrial organisations33. As he stressed, this research challenged the assumption that all
economic processes are characterized by constant returns and perfect competition.
31
CNN Money, For Mr. BRIC, nations meeting a milestone, by Beth Kowitt,
http://money.cnn.com/2009/06/17/news/economy/goldman_sachs_jim_oneill_interview.fortune/i
ndex.htm, accessed, 13.09.2013.
33
Robert Gilpin: Global Political Economy. Understanding the International Economic Order, Princeton
University Press 2001, p.77.
10
Financial markets are strongly influenced by the research and analysis written by research
teams with the financial institutions and disseminated to their counterparties or clients.
Such research centres have been developed since the mid 90’s in order to support internal
financial decisions and then expanded to the position which they have today34. Some of
the banks – e.g. Goldman Sachs – have established their own Global Market Institutes.
Research delivered by financial institutions has following characteristics:
-
the research comments the data almost on spot (e.g 10-15 minutes after the
economic data has been published by statistical office) or at the latest the day
after,
-
covers wide range of asset classes, countries, trade recommendations, political
events, assets pricing, story in circulations (e.g. the gossip that Bundesbank will
print Deutsche Marks in the summer of 2011), central bank activity,
-
covers the global economy and financial markets in global context and also
creates new global indicators. One of the most creative is the Goldman Sachs
Global Economics, Commodities and Strategy Research team issuing on a regular
basis their own papers, e.g. the Global Economic Papers (on the 9th of September
the 220th paper was issued: What the world wants?) or Global Leading
Indicators35.
The knowledge of financial markets is also shaped by the CFA Institute (Chartered
Financial Analyst Institute)36 and GARP (Global Association of Risk Professionals)37
both dedicated to practitioners and established in the USA. It creates the situation where,
after graduating and entering the financial market circle, the decision makers rely mainly
on their own industry view.
34
As the case study we can look at: Goldman Sachs page http://www.goldmansachs.com/what-wedo/research/ or Deutsche Bank page: http://www.dbresearch.com/.
35
www.gs.30.com but distributed only via predifined mailing list.
36
The leading motto is: Shaping an investment industry that serves the greater good,
https://www.cfainstitute.org/Pages/index.aspx, accessed 9 September 2013.
37
www.garp.org
11
Analysing the crisis nature, Brunnmermeier and Oehemke distinguish two phases that
play a role during financial crises38:
-
a run-up phase, in which bubbles and imbalances form,
-
crisis phase during which risk that has build up in the background, materialises
and the crisis erupts.
They also stress out that for most crises it is difficult to pinpoint the exact trigger which
acts as a catalyst. And very often the triggering event to which the crisis is attributed
seems relatively small in relation to the crisis that follows – like in the case of subprime
mortgage market which constituted only about 4% of overall mortgage market 39. As
another factor which plays a role in the run-up phase the moral hazard problem is raised ,
especially the principal-agent problem in conjunction with the short-run horizon (decision
making process has to take into account the potential outflow of funds being managed).40.
In order to explain the run-up phase from the financial markets point of view it’s worth
mentioning that each crisis is rational. Only the moment when the trigger goes off –
under the circumstances of combination of power and common agreement about the
asset overvaluation – may be surprising.
This is possibly why the joint knowledge about the economy and politics, shared by IPE
centers and financial markets is not adding value – e.g. Robert Gilpin is questioning the
rationality of the markets and asks how rational actors can become caught up over and
over again in investment booms or manias that almost invariably result in financial panic
and crises41. Assuming that ‘the rational agents’ means ‘states’– we can’t forget that
states themselves are causing crises – by not paying off debt, like Russia, or by
implementing
inadequate financial regulations, like South Korea Maurice Obstfeld has
shown, for example, that balance-of payment crises are rational and arise and represent
rational response to persistently conflicting internal and external macroeconomic targets
38
M.K. Brunnermeier, M. Oehmke: Bubbles, Financial Crises, And Systemic Risk, 2012, NBER Working
Paper, www.nber.org/papers/w 18398, p. 2., accessed 2 September 2013.
39
Ibid, s. 30
40
Ibid, s. 22.
41
Robert Gilpin: Global Political Economy. Understanding the International Economic Order, Princeton
University Press 2001, p. 264.
12
set by state-agents42. It shows the other side of the coin and demystifies the power of a
single man43 to move the market and cause the crisis when the fundamentals are healthy.
Financial markets simplify the crisis, distinguishing 3 phases:
1. subprime mortgage crisis in the USA – mainly caused by low rate environment
and political push to increase the affordability of the houses44 - 2006
2. Collapse of Lehman Brothers – caused by exposure to the derivatives market and
structural products like CMO, CDO and other hybrid product – September 2008
3. Sovereign debt crisis – triggered by disclosure of the swap transaction done by the
Greek government in order to show that the Maastricht criteria have been met –
the strongest wave shook up the markets in July 2011.
Each of these phases has been triggered by a different cause. But it’s difficult and not fair
to blame only the financial markets for causing the crisis.
Usually when the run-up phase of a crisis is analysed, the moral-hazard problem is
addressed in relation to market participants (generally representing a financial
institution). A further source of moral hazard could be that the governments became the
financial market players as the issuers of debt, while at the sometimes exploring market
forces to achieve political goals. As an example, Richard Ch. Wahlen pointed out three
main factors which contributed significantly tothe subprime bubble45:
- the public policy partnership – initiated in Washington and comprising companies,
association and government agencies – to enhance the availability of “affordable
housing” via the use of “creative financial techniques”,
- active encouragement by federal regulator of the rapid growth of over-the-counter
derivatives and securities by all types of financial institutions,
- the related implementation by the Securities and Exchange Commission (SEC) and the
Financial Accounting Standards Board (FASB) of fair value accounting standards.
42
M. Obstfel: Rational and self-fulfiling balance of payments crises, 1984, NBER Working Paper 1486,
http://www.nber.org/papers/w1486, accessed 3 September 2013.
43 Jeffrey A. Frieden: Global Capitalism. It’s fall and rise in the twentieth centaury, W.W Norton &
Company 2006, pp. 405-412,
44 Richard Christopher Whalen: Origins of the Subprime Collapse, GARP Risk Review,
January/February 2008, p. 13.
45Ibid, pp.12-13.
13
In the globalisation era of financial markets the ideas and knowledge are disseminated
quickly. The high competition between financial institutions and the access to the “best
available brains” – made the industry very creative. But such creativity (understood as the
constant development of assets pricing models, investment approaches and creation of the
new financial instruments) with the power expressed by growing assets under
management,
combined with technical infrastructure
and unified way of thinking –
made financial markets important but ideologically (and nationally) independent players
in a world without borders.
The real interest of decision making centres in the economic crisis
As soon as
the financial crisis transforms from the run-up phase into the crisis phase
there is a moment when it can be spotted by non-financial markets participants – central
banks, government and savings/capital owners. As it was mentioned before, the run-up
phase takes some time. But when the crisis is triggered – by a real factor – e.g. Lehman
Brothers collapse, the market reaction is very rapid. Brunnermeier and Oehmke show that
amplification may transform even a modest triggering effect into large spillover across
the financial system47. Although the spillover effect may be caused by a different source
of risks (liquidity risk, counterparty risk etc.) the financial markets react in advance. The
wave of fear is also triggered by the mathematical and statistical foundations of financial
markets. Starting from falling benchmarks, which cause the sell-off of real assets, through
high correlation between financial instruments, a much broader group of participants is
touched by one falling market and finally the volatility itself is growing which triggers
various risk measures (e.g.VAR) and deepens the effect of crisis by forcing the sale of
assets held.
Brunnermeier and Oehemke stress that a key element in understanding financial crises
and systemic risk is therefore not only the direct domino effect, but spillovers and the
endogenous response of other market participants48.
But when the crisis appears the decision making bodies responsible for security of the
society take the shortest path to understand the situation and take the typical actions. The
bodies involved in case of financial crises are: central banks, governments and regulators.
47
M. K. Brunnermeier, M. Oehmke: Bubbles, Financial Crises, and Systemic Risk, 2012, NBER Working
Paper, www.nber.org/papers/w 18398, p. 30, accessed 2 September 2013
48 Ibid, p.32.
14
In the case of crises they try to intervene – very often blaming the financial markets
(domestic or foreign) for causing the trouble.
Central Banks
The field of central bank intervention is so broad it cannot be fully covered here. But a
few steps are generally common: first, the stabilisation of domestic banking and financial
systems, followed by securing the international position. This approach has been called
macroprudential policy. The last crisis has shown that even the biggest countries have
to be ready to tackle
such problems. Same goes for group of countries, such as the
Eurozone. Figure 2 shows the Euro/USD basis swap quotation reflecting the price for
exchanging EUR for USD. Before the financial crisis it was close to zero, showing that
both currencies were enough liquid and identically accessible. But increasing liquidity
risk between the USA and the Eurozone (reflecting also FED and ECB policy goals) was
immediately priced by the market. The moment when the market went to -60 basis points
shows the riskiest moment – the threat of the break up of the Eurozone . The position of
“non-hegemonic” countries is by far more complicated. If the market participants do not
understand the rationality of central banks’ decisions they price them immediately. In the
era of globalisation the prices are reflected around the global market as soon as within 1
minute.
Figure 2. EUR/USD 5Y basis swap quotation 2008-VI 2013
Source: Bloomberg, access 9.09.2013
15
Governments
During financial crises, governments are in difficult circumstances from many points of
view. Generally, the economy is shrinking, which curbs the government income from
economic activity and increases budgetary tensions. From a political point of view it’s
even worse – the crisis shows that citizens cannot feel safe under the ruling government.
The societal expectations towards the government are very often opposite to the financial
markets’ rational point of view at this very specific moment.
Such a clash took place during the last crisis. As said above, the run-up phase of crises is
formulating in the long run and is often caused by the policy of the state. Using Greece as
the case study – we see that the government itself is prone to non-ethical behaviour, the
results of which will be paid for by society in a very long run. Although the Greek
example is rather extreme,
it has put the question toward the efficiency of constantly
increasing budget spending (and, in consequence, rising debt to GDP ratio).
The clash between the financial markets and the state policy has three dimensions:
1. The dependence of the state on the financial markets as the buyers of the
sovereign debt and, in consequence, rising dependency on rating agencies,
2. Cutting the long term wealth of society by indebting the country50,
3. The limited faith in financial markets is goes the wealth of the country. Since
the financial markets are or should multiply savings the simple statement that they
act in favour of “rich” people is not valid any more.
Regulators
Regulators play a very special role within the financial system. They deal with pure and
liberalised markets on the one hand and they try to shape and curb the market
environment in order make the system stable and less prone to financial bubbles.
However, regulators rely on ratings and mathematical models (like Basel II and III
regulations) in the same way as the financial sector does. The regulators’ actions are
based on the same knowledge and ideas. But they are more conservative and less
creative.
C. M. Reinhart, K. Rogoff : “The Forgotten History of Domestic Debt”, The Economic Journal 121
(May 2011), pp.319–350.
50
16
Regulators also play an important political role. They implement the state policy toward
the financial markets, sometimes purely in favour of the state (e.g. short-selling
regulation)52.
The last crisis has shown the complexity and strong interdependence of real economy and
the financial markets around the world. The common knowledge of financial markets has
worked not in favour this time but as amplification channel even deepening the crisis. It
shows that the financial theory didn’t prevent us from that crisis. Why did it happen?
May it happen again?
Robert O. Keohane and Jospeh O. Nye pointed out that contemporary world politics is
not the seamless web but it is a tapestry of diverse relationships. In such world, one
model cannot explain all situations. The secret of understanding lies in knowing which
approach or combination of approaches to use in analysing a situation53. And this is why
the theory is inescapable: all empirical or practical analysis rests on it. But the financial
markets dynamic has been moved rather by recent data instead of long run projection.
Crises are also a kind of reevaluation of the way
the world is seen by the financial
markets.
The probability of the next crisis is still high unless the centres of political and financial
power together with the centres of knowledge will cooperate in order not to let the run-up
phase of crises turn into the phase of real crises. Such cooperation is crucial in such
globalised
universe of finance. In such a world, prudent economic policy in a single
country doesn’t guarantee
financial stability. Cooperation and openness are key to
curbing future crises. And in this respect the IPE creates the best platform for cooperation
by combining economics and politics.
Communication channels
Effective cooperation cannot be achieved without good will and proper communication
channels. The world today is observed from dealing rooms, asset managers’ offices, or
living rooms of ordinary people – sitting in front of their screens. The qualified market
participants generally sit in front of Bloomberg of Reuters screens joining the real world
of finance. The financial institution customers are in front of TV screens or any device
transferring data from Internet. Such communication channels seem to be sufficent under
the non-crisis circumstances – e.g. as the way to observe the market reaction to the
52
53
/ec.europa.eu/internal_market/securities/short_selling/index_en.htm, accessed 14 September 2013.
R. O. Keohane, J. O. Nye: Power and Interdependence, Pearson 1997, p. 4.
17
central bank policy. But watching the long bond yield used as the reference rate for 30
years fixed mortgage rate by FED members differs from recognizing the risks arising
from dynamic the day-to-day activity.
Figure 3. US 30Y Government Bond, 2008- IX 2015, YTM
Source: Bloomberg
But direct channels of communication between the financial markets, central bankers,
regulators, government administration and researchers require openness and trust in
possible mutual benefits.
The official interconnection which can be noticed occurs within the following circles:
-
within the state circle – central banks, governments, regulators,
-
central banks and universities,
-
within the financial sector – e.g. banks are competing on the OTC markets but at
the same time they exchange the views and knowledge via research exchanges
The effect of interconnectedness can be also observed based on tracing the path of
financial careers. Personnel transfers between big financial institutions, central banks, and
regulators/supervisors show that the specific knowledge and ideas are in circulation (e.g.
the interesting career path of Mario Draghi54 from Italian Trasury via Goldman Sachs to
54
Stephen Foley: What price the new democracy? Goldma Sachs conquers Europe, The Independent, 18
Vovember 2011, http://www.independent.co.uk/news/business/analysis-and-features/what-pricethe-new-democracy-goldman-sachs-conquers-europe-6264091.html, accessed 14 September 2013.
18
ECB or Willian Dudley55 as Chairman of The Committee on the Global Financial System
(CGFS), President and Chief Executive Officer of the Federal Reserve Bank of New
York and former managing director at Goldman Sachs).
Asymmetry of knowledge
As opposed to well-educated and knowledgeable professionals, ordinary people seem to
be on the weaker side of this contract. Taking into account the complexity and direct
impact on private savings of the capital engaged in financial markets the issue of the
asymmetry of knowledge of non-qualified customers should be addressed by:
-
financial education – financial literacy issue has been addressed by G20,
-
creating the opportunities for them to get financial product more in line with their
subjective needs
Financial knowledge is crucial in navigating the financial markets. Two fields of risk
need to be better addressed in order to curb future crises:
-
asymmetry of knowledge between professional financial market participants and
non-professional investor
-
asymmetry of knowledge between the citizens and governments
In order to diminish the asymmetry of knowledge such goals could be achieved:
- the agent-principal dilemma will be better addressed and private money will be
managed in line with the goals of investor and not just
in line with the industry or
company standard (which will make the private money less model dependent),
- in case of financial crises – the voting power can be put upon the real solutions
supporting both society and private wealth and not rely on the populist promises.
When raising the issue of asymmetry of knowledge in the context of the main question
How to deal with financial markets in the globalised world?, the ethical behaviour in
relation to the asymmetry of knowledge should be stressed out. The financial industry is a
human-based activity. The regulation ( e.g. MIFID) or even industry standard (e.g. Global
Investment Performance Standards56) may not curb the dark side of human nature. The
55
http://www.newyorkfed.org/aboutthefed/orgchart/dudley.html, accessed 29 September 2013.
Global Investment Performance Standards at www.gipsstandards.org/Pages/index.aspxon web,
accessed 9 September 2013.
56
19
crisis has brought to light such scandals as LIBOR manipulation in London or
misconduct at JP Morgan in New York. But this issue is beyond any theory.
Conclusions
Financial stability is a public good. This has been proved by the severity and long lasting
negative outcomes of the last crisis. But the crisis has also shown
the power of the
financial markets and the complex interdependence between the states and globalised
international financial markets. The financial markets are unified in terms of knowledge
and ideas. The Eurozone is just a part of a global network. The statistical data shows that
global assets have stopped falling, which confirms their sustainable power but also a
potential risk of future crises. What’s most important for Europe – London is a key
centre for global finance when measured by financial globalisation metric at the level of
949% (in comparison to USA at around 225% or China at around 60%) 57. It’s not only
the privilege, it’s also big obligation.
But apart from the lower valuation of assets, other fields have been revised as well. The
financial theory and its mathematical and statistical foundations of
are now under a
strong revision process. The question is if the industry founded on the normal distribution
will really head toward behavioural direction? What will be the role of the state versus
the financial markets and what about the efficiency of government spending in the
context of increasing the wealth within the society? How can the non-financial world
deal with the financial markets to mutual benefit and who should lead such a project?
The power seems to be in hands of IPE , which can fill the theoretical hole and hunger for
knowledge and long lasting ideas. IPE may transform the shorttermism of the statisticsbased financial markets into constructing reliable and valuable ideas depicting the real
values and real threats of the world.
For both scholars and practitioners new questions are arising: e.g. the problem of the
nationality of money (if any) and the nationality of the agent – how will it shape the
national interest58? How to solve the problem of the state harming its own financial
markets? If the transaction is concluded with the maturity of 50 years from today – does
it rule out a war or maybe only an external war is accepted?
57
Global McKinsey Institute: Financial Globalisation: Retret or Reset?, March 2013, p.16,
http://www.mckinsey.com/insights/global_capital_markets/financial_globalization, accesed 14.
September 2013.
58 as the example what about British investment company managing money of a Chinese investor?
20
The answer to the question: How to deal with financial markets in the globalised world?
is: by combining knowledge and cooperation between the financial sector, the state and
society.
In 1977 Hyman Minsky wrote The Financial Instability Hypothesis. He ended with
advice to establish and enforce a “good financial society” in which the tendency by
business and banker to engage in speculative finances is constrained59. It can still be
achieved.
H. P. Minsky: “The Financial Instability Hypothesis: An Interpretation Of Keynes and an Alternative to
“Standard” Theory, Challenge, March/ April 1977, p.27.
59
21
Appendix
Chart1. Italian Government 10Y bond YTM 2008 - IX 2013
Source: Bloomberg, 9.09. 2013
Chart2. Spanish Government 10Y bond YTM 2008 - IX 2013
Source: Bloomberg, 9.09.2013
Chart3. German Government 10Y bond YTM 2008 - IX 2013
Source: Bloomberg, 9.09.2013
22
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