slides

1. New Approaches to Economic Challenges
NAEC Group Meeting, 28 November 2014
SESSION 2
BETTER UNDERSTANDING
AND INTEGRATING FINANCE
Adrian Blundell-Wignall
Special Advisor on Financial Markets to the OECD Secretary General,
& Acting Director Financial & Enterprise Affairs Directorate.

2. The Rolling Bubble in Finance versus
the Need for Sustainable Demand
2
• The past decades has been characterised by rolling financial
bubbles, the complex causes of which are rooted a
misunderstanding of structural forces: technology, the rapid
growth of emerging markets, financial deregulation and
innovation.
• Financial deregulation and innovation created a mountain of
derivatives and complex counterparty relationships that
exploded into a severe liquidity crisis in 2008. These still
remain, but are shifting to non-banks.
• The bubble has likely rolled towards illiquid higher yielding
assets (especially EME’s), and matching the need for yield in a
zero rates world.
• There is no painless path to prosperity. There is instead a
need for finance for sustainable demand.

3. Derivatives Shifting From Banks to
Shadow Banks
3
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Sep-10
Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Sep-13
Mar-14
Sep-14
$US, bn Aggregate Banks Devivatives
Amounts Outstanding of OTC Derivatives

4. The Emerging Market Bubble in
Corporate Credit
4
50
100
150
200
250
300
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Feb-10
May-10
Aug-10
Nov-10
Feb-11
May-11
Aug-11
Nov-11
Feb-12
May-12
Aug-12
Nov-12
Feb-13
May-13
Aug-13
Nov-13
Feb-14
May-14
Aug-14
Nov-14
Feb-15
May-15
Index US Tsy Tot Ret 1-3y
US Tsy Tot Ret +10y
Merill Tot Ret EM Credit $
Merill Tot Ret EM Credit EUR
Merill Tot Ret EM Credit JPY

5. Investment as a per cent of Company Net Sales
5

6. Debt-to-Enterprise-Value: Japan,
EME’s, USA & Europe
6
40
35
30
25
20
15
10
5
0
% Debt / (Debt + Equity) Non-Infrastructure
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

7. Expect Banks to be More Constrained
7
• The OECD has been at the forefront of the reform of
banks—it proposed a higher leverage ratio and bank
separation long before Volcker/Vickers/Liikanen. Now
the USA have moved to a leverage ratio of 5% and 6%
(GAAP; & 3.9% and 4.6% IFRS). And with its new buffer
in the 4.05% to 4.95% range for the UK, well above 3%.
• But the game has moved on now: the next crisis will not
be like the last one. Banking will play a reduced role, and
non-banks need to play a bigger role. Asset prices will
have to play a larger role in investment decisions & the
transmission of monetary policy.
• If there is to be another crisis, expect it to look more like
1987—a liquidity crisis in securities markets if monetary
policy normalisation is not handled well.

8. Distance to Default Looking Better: New
NAEC Tool
8
10
8
6
4
2
0
-2
At 30 June 2014
DTD DTD End of 2013
DTD End of 2008
US Banks European Banks
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67

9. From Banks to Non-banks in Financing
& the Transmission of Monetary Policy
9
• As banks play a reduced role as liquidity providers,
and tend not to have the right business model for
very long-term investment, the non-banks will have
to step up to the plate in both respects.
• The crucial issue now, is that with safer more
constrained banks, who will finance long-term
investment and provide liquidity in markets where
asset prices will play a larger role in investment
decisions & monetary policy transmission.
• New NAEC issues emerge.

10. Distance to Default: the AQR Remains the
Big Issue for Europe in 2014
$US, tn Private Banks $US, tn
80
70
60
50
40
30
20
10
10
0
300
250
200
150
100
50
0
Central Banks
Insurance Companies
Pension Funds
Investment Funds
Hedge Funds & Funds of Funds
Others
Total Asset of Financial Institutions
World GDP (RHS)
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

11. New Policy Issues for NAEC
11
• The LCR & other rules mean that bank broker dealers
are pulling back, while products that promise daily
liquidity while investing in underlying illiquid assets are
rising (e.g. ETF’s). Market makers focus on core client,
and are reluctant to absorb large positions. Dealer
inventory is falling.
• Demand for yield exceeds new issues, and liquidity
premia are being driven down—they are too low now.
What happens if interest rates rise, demand slows and
exit from illiquid positions is attempted?
• Is QE undermining the role of long-term investors as
liquidity providers? they should buy at troughs and sell
at peaks, but central banks are smoothing both sides and
undermining this role.

12. More New Issues for NAEC
12
• There is need for finance for sustainable demand—QE
gives rise to demand shifting (exchange rates), low trust
in the future as normalisation lies in front of us. Sensible
expectations about the wealth effects upon exit from QE
imply no now easy transmission mechanism from low
interest rates to consumption and investment.
• Longevity is rising while terminal (after normalisation)
interest rates will be lower—posing real problems for
liability matching.
• What do we need to do to increase the sustainable role of
non-banks in financing investment and matching
liabilities, i.e. patient capital—buy and hold business
models for non-banks?

13. 1920 to Today: Real S&P500 and Real
10-year Bond
13
-20
-15
-10
-5
0
5
10
15
20
25
Jan-20
Jun-24
Nov-28
Apr-33
Sep-37
Feb-42
Jul-46
Dec-50
May-55
Oct-59
Mar-64
Aug-68
Jan-73
Jun-77
Nov-81
Apr-86
Sep-90
Feb-95
Jul-99
Dec-03
May-08
Oct-12
% int rate
Roosevelt devalues against gold
Real S&P 500
Real 10y bond

14. 1920 to Today: Nominal 10-year
Below 4% Again!!
14
0
2
4
6
8
10
12
14
16
18
Jan-20
Jun-24
Nov-28
Apr-33
Sep-37
Feb-42
Jul-46
Dec-50
May-55
Oct-59
Mar-64
Aug-68
Jan-73
Jun-77
Nov-81
Apr-86
Sep-90
Feb-95
Jul-99
Dec-03
May-08
Oct-12
% US 10-yr 1920 to Today

15. New Policy Issues are Upon Us
15
• Policy must improve liquidity in bond and derivative
markets.
• Policy must bring SME financing more towards capital
markets.
• Policy must encourage (not discourage) direct loans by
non-banks, and buying private bonds.
• Policy might encourage sale and leaseback markets.
• What policies will encourage long-term equity holding
(listed and unlisted)?
• What policies will encourage the infrastructure debt
markets?
• What policy will encourage longevity bonds and
longevity swaps?

16. 4 Sets of Issues for Policy Makers
16
• There are at least 4 sets of issues to develop investment for growth,
but in a sustainable demand framework.
• First regulatory, legal and governance impediments to long-term
investment.
--accounting, solvency II, macro-prudential, local content
requirements, ownership restrictions, capital controls; treaty
frameworks; etc.
• Second the institutions themselves are not prepared:
--credit assessment capability; underwriting framework;
origination; operational services.
• Third, public participation in resolving transparency and trust.
--market rules; longevity table benchmarks; reliability of
contracts for public utility private sector participation (legal
framework).
• Fourth, corporate governance and RBC (environment, local
communities, labour); due diligence on global supply chains, etc..