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Richard Werner Centre for Banking, Finance and Sustainable Development University of Southampton Management School ESDN Workshop Brussels 22 November 2012 Centre for Banking, Finance & Sustainable Development Management School Financial Markets and Sustainable Development Concepts, Players, Challenges Richard Werner Centre for Banking, Finance and Sustainable Development University of Southampton Management School ESDN Workshop Brussels 22 November 2012 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School Financial Markets and Sustainable Development a) Financial Markets: Overview b)Financial Intermediation, Banking and ‘Growth’ c) Banking, Interest and Sustainability – or Lack Thereof d)How to Utilise the Financial System to Achieve Sustainability 1 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School a) Financial Markets: Overview • Textbook View of Financial Intermediation RR = 1% Saving Banks Investment (‘Financial Intermediaries’) (Lenders, (Borrowers) Depositors) = “indirect finance” Purchase of Newly Issued Debt/Equity = “direct financing”/disintermediation 2 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School What Makes Banks Special? But empirically, it had been found that banks are special Their function cannot be easily replaced by other financial players or markets. - Fama (1985) shows that banks must have a kind of monopoly power compared to other financial institutions. - Ashcraft (2005) shows that the closure of small regional banks significantly hurts the local economy. But economic theory could not explain why. Here is why. Richard A. Werner 2012 3 Centre for Banking, Finance & Sustainable Development Management School What is money? ¾ Where does it come from? ¾ Only about 3% of the money supply comes from the central bank. ¾ Who creates the remaining 97% of our money supply and who allocates this money? A: The commercial banks ¾ This explains why banks are special: They are not (just) financial intermediaries. They have a license to ‘print money’ by creating credit. There is no such thing as a ‘bank loan’. Banks do not lend money, they create it. Richard A. Werner 2012 4 Centre for Banking, Finance & Sustainable Development Management School Bank Credit Creation Balance Sheet of Bank A Step 1 Deposit of $100 by customer at Bank A Assets Liabilities $100 Step 2 $100 used to increase the reserve of Bank A Assets Liabilities $100 $100 5 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School Banks do not actually lend money! Step 3 Loan of $9,900 granted, by crediting borrower’s bank account with deposit. The borrower is treated as if she/he or the bank had actually deposited the money, but no money was deposited. Assets Liabilities NB: No money is $100 $100 transferred from + + elsewhere $9,900 $9,900 There is no such thing as a ‘bank loan‘. 6 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School Bank Credit Creation: Not in Economics Textbooks, but Admitted by Central Banks: “The actual process of money creation takes place primarily in banks.” (Federal Reserve Bank of Chicago, 1961, p. 3); “By far the largest role in creating broad money is played by the banking sector ... When banks make loans they create additional deposits for those that have borrowed.” Bank of England (2007) “Over time… Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs” (ECB, 2000). “Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies.” (BIS, 2003). “The commercial banks can also create money themselves… in the eurosystem, money is primarily created by the extension of credit… ….” (Bundesbank, 2009) Richard A. Werner 2012 7 / Centre for Banking, Finance & Sustainable Development Management School b) Financial Intermediation, Banking and ‘Growth’ Banks are Not Financial Intermediaries Saving Banks Investment (Lenders, (‘Financial (Borrowers) Depositors) Intermediaries’) $99 $100 =“indirect finance” RR = 1% “direct finance” They are the Creators of the Money Supply. And they decide who gets the money and for which purpose it is used. This decision shapes the economic landscape. Banks thus decide over the economic destiny of a country. Richard A. Werner 2012 8 Centre for Banking, Finance & Sustainable Development Management School The Quantity Theory of Credit (Werner, 1992, 1997): money used = value of all market transactions Money is best measured by its credit counterpart (C) which created it. Financial transactions are not part of GDP. If we want to link this to GDP, we must divide money/credit into two streams: C= CR + CF Credit used for GDP transactions, used for the ‘real economy’ (‘real circulation credit’ = C ) C R Credit used for non-GDP transactions (‘financial circulation credit’ = CF) Richard A. Werner 2012 9 Centre for Banking, Finance & Sustainable Development Management School The Quantity Theory of Credit (Werner, 1992, 1997) ∆(PRY) = VR ∆CR ∆(PFQF) = VF∆CF nominal GDP real economy credit creation asset markets financial credit creation YoY % YoY % YoY % YoY % 12 12 80 40 70 35 10 10 60 30 8 8 25 50 Nationwide Residential 20 6 6 40 Real Estate Land Price (R) Credit (L) 15 nGDP (R) 30 4 4 10 20 2 2 5 10 0 0 0 0 -5 83 85 87 89 91 93 95 97 99 -2 -2 -10 -10 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 CR (L) -4 -4 Latest: H1 2001 Latest: Q4 2000 Real circulation credit determines Financial circulation credit determines nominal GDP growth asset prices – leads to asset cycles and banking crises Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School Bank credit creation determines economic growth. The effect of bank credit allocation depends on the use money is put to Case 1: Consumption credit Investment credit (= credit for the creation of new Result: Inflation without growth goods and services or productivity gains) Case 2: Financial credit (= credit for transactions that do Result: Growth without inflation, not contribute to and are not part even at full employment of GDP): = productive credit Result: Asset inflation, bubbles creation and banking crises = unproductive credit creation Richard A. Werner 2012 11 Centre for Banking, Finance & Sustainable Development Management School Credit for financial transactions explains boom/bust cycles and banking crises ¾ A significant rise in credit creation for non-GDP transactions (financial credit CF) must lead to: - asset bubbles and busts 30% - banking and economic crises 28% 26% 24% ¾ USA in 1920s: margin loans rose CF/C from 23.8% of all loans in 1919 22% to over 35% 20% 18% ¾ Case Study Japan in the 1980s: 16% 14% CF/C rose from about 15% at the beginning of the 1980s to almost 12% 79 81 83 85 87 89 91 93 twice this share Source: Bank of Japan CF/C = Share of loans to the real estate industry, construction companies and non- bank financial institutions Richard A. Werner 2012 12 Centre for Banking, Finance & Sustainable Development Management School Warning Sign: Broad Bank Credit Growth > nGDP Growth This Created Japan's Bubble. YoY % 20 Broad Bank Credit 15 10 Excess Credit Creation Nominal GDP 5 0 -5 -10 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Latest: Q3 2011 Richard A. Werner 2012 13 Centre for Banking, Finance & Sustainable Development Out-of-control C 10 0 90 80 and Crises in Ireland & Spain 70 F Bro is the problem, creating the Bubbles 60 ad B 50 ank C red 40 it a nd G 30 DP 20 (Ireland 10 ) 0 -10 -20 1998/Q1 1998/Q3 1999/ Q1 1999/Q3 2000/Q1 Management School 2000/Q3 2001/Q1 Richard A. Werner 2012 2001/Q3 30 2002/ Q1 Broad Bank Credit and GDP (Spain) 2002/Q3 25 2003/Q1 2003/Q3 20 2004/Q1 3 2004/Q 15 2005/Q1 Q3 nGDP 2005/ 10 2006/Q1 2006/Q3 Broad Bank Credit2007/Q1 Growth > nGDP Growth5 2007/Q3 2008/Q1 0 2008/ Q3 2009/Q1 -5 2009/Q3 -10 1987/Q1 1988/Q1 1989/Q1 1990/Q1 1991/Q1 1992/Q1 1993/Q1 1994/Q1 1995/Q1 1996/Q1 1997/Q1 1998/Q1 nGDP 1999/Q1 2000/Q1 2001/Q1 2002/Q1 2003/Q1 2004/Q1 2005/Q1 2006/Q1 2007/Q1 2008/Q1 2009/Q1 14 Centre for Banking, Finance & Sustainable Development How to Avoid Asset Bubbles & Home-Grown Banking Crises - and ensure ample funding for small firms 15 10 Broad Bank Credit and GDP Growth (Germany) 5 0 -5 Richard A. Werner 2012 -10 1997/Q2 1997/Q4 Management School 1998/Q2 1998/Q4 1999/Q2 1999/Q4 2000/Q2 2000/Q4 2001/Q2 2001/Q4 2002/Q2 2002/Q4 2003/Q2 2003/Q4 2004/Q2 nGDP 2004/Q4 2005/Q2 2005/Q4 2006/Q2 2006/Q4 2007/Q2 2007/Q4 2008/Q2 2008/Q4 2009/Q2 2009/Q4 15 Centre for Banking, Finance & Sustainable Development Management School Bank credit creation is a public privilege ¾ It is not a law of nature that commercial banks should be the institutions creating and allocating the money supply. ¾ It is a public privilege granted to banks, on the implicit understanding that they will not use it against the public interest. ¾ However, governments and regulators have failed to ask banks to create and allocate credit mainly for productive purposes and transactions that are part of GDP. Only productive credit creation is sustainable. ¾ Banks have responded by using the privilege to create the money supply for their own short-term (speculative) gains. ¾ This creates unsustainable asset bubbles and costly banking crises and subsequent recessions. 16 Richard A. Werner 2012 Centre for Banking, Finance & Sustainable Development Management School Banking in Germany Regional, foreign, other banks Local cooperative 17.8% banks (credit unions) Large, nationwide Banks 12.5% 26.6% Local gov’t-owned Savings Banks 42.9% 70% of banking sector accounted for by hundreds of locally- controlled, small banks, lending mostly to productive SMEs 17 Richard A.
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