5.      FINANCIAL GROWTH

 

 

Financial markets have been subject to significant change and expansion in recent years. This may be considered in terms of size, change, transformation, innovation and trends.

 

(1)       Market Size

 

The substantial expansion in the size and scope of financial markets can be understood with reference to a number of key indicators:

 

1. The total global stock of core financial assets reached US$140tn (£70.66tn and Є104.49tn) by 2005 with the ratio of global financial assets to annual world output increasing from 109% in 1980 to 316% by 2000 (McKinsey Global Institute) – this subsequently rose to US$194tn just before the financial crisis beginning in summer 2007 following which it fell to US$172tn - it was predicted that the Chinese economy alone would grow to $123 trillion by 2040

2. Over US$5.3tn  moves round the world every day in foreign exchange markets ;

3. The total global nominal value in over-the-counter (OTC) financial derivatives has expanded from US$3.45tn in 1990 to US$286tn by 2006 and subsequently to US$838.7tn by 2009 and then US$684 by 2010. It then rose to over $700 trillion by 2013 with total exchange and OTC derivatives possibly being in excess of £1 quadrillion or £1000 trillion;

4. The ratio of bank deposits to financial securities has reduced from 42% to 27% between 1980 and 2005 as part of the larger process of securitisation of debt and growth in the importance of investment as opposed to commercial banking;

5. In terms of alternative investment, the number of hedge funds had grown from 610 in 1990 to 9,575 by beginning 2007 with a total of US$1.6tn under management at the same time as private equity funds have grown to 684 vehicles with US$432bn of commitment – these numbers fell during the crisis but hedge funds recovered to manage US$1.82 trillion by 2009 with 6,300 funds and 22,350 separate funds under management in total;

6. The amount of money placed in non-life insurance and life or pension assurance cover has also grown substantially with Lloyd’s of London alone previously earning £10bn in profit a day.

 

One of the core difficulties that have arisen with this expansion in wealth is that it is not evenly held. Total financial assets owned by residents in higher income countries has increased from 50% of GDP to 100% between 1970 and 1985 and then again to 330% by 2004.

 

Earlier US dominance has since shifted although investment spreads remain uneven. US private equity investment fell from 68% in 2000 to 40% by 2005 with a corresponding drop in funds raised from 69% to 52%. Investments grew from 17% to 43% (17-38% of funds raised) in Europe with Asia Pacific growing from 6% to11% between 2000 and 2005.

 

Some of the US banks are still among the largest financial institutions in the world. The largest in terms of tier 1 capital in 2010 were Bank of America, after its acquisition of Merrill Lynch, and JP Morgan Chase, which had earlier acquired Bear Stearns and the operations of Washington Mutual. Over 50% of US investment bank income is nevertheless now generated abroad with 75% of global growth occurring outside the US. A number of large banks and financial groups have also increasing arisen in Asia and especially in China with its ‘Big Four’ of the Industrial and Commercial Bank of China, Bank of China, China Construction Bank and the Agricultural Bank of China.

 

(2)       Market Growth and Development

 

Markets have been subject to substantial growth in recent decades. Markets benefited from the relatively stable conditions that arose after World War Two that allowed the substantial reconstruction of many European economies. International monetary stability was secured under the Bretton Woods system of managed exchange arrangements entered into in 1944 which fixed the value of the US dollar to gold and all other currencies to the dollar. Funding was made available through the US Marshall Plan and other assistance programmes.

 

Markets were disrupted with the move from fixed to floating currencies and the abandonment of the Bretton Woods exchange standard between 1971 and 1973 and again with the Third World debt crisis beginning in Mexico in 1982. The global economy was also rocked by the Asian financial crisis beginning in Thailand in July 1997 although it recovered substantially until the international credit crisis beginning in August 2007.

 

While it will take several years for the effects of the global financial crisis to be absorbed fully it, it is expected that financial markets will then continue to prosper and grow strongly again and hopefully at the same time support the real economy. A number of the responses adopted following the recent crises are intended to ensure that financial institutions and financial markets support the real economy. Financial functions and advantages are considered further in section 5 below.

 

 

(3)       Market Change and Innovation

 

Financial markets have undergone significant change especially since the early 1970s and the collapse of the Bretton Woods system. The main changes can be summarised as follows:

 

1. Liberalisation and deregulation of many market access, regulatory and capital or foreign exchange restrictions;

2. Technological advances especially in computer software and hardware and telecommunications;

3. Market integration (on a cross-border and then cross-sector basis) and globalisation more generally subsequently;

4. Advances in risk management and financial innovation and engineering including, in particular, the construction of modern finance, portfolio and investment theory with the advances that that has permitted in terms of risk identification, measurement and management;

5. The stable financial and monetary policy conditions that have generally applied since the exclusive reliance on fiat money with the collapse of Bretton Woods in 1973 (unsupported by gold) and the favourable credit conditions that have arisen since especially in the last 4-5 years.

 

(4)       Market Transformation and Trends

 

These changes have permitted a restructuring of financial products and markets. This can be seen in the emergence of a number of key factors:

 

1. There has been an explosion in the size of almost all financial market;

2. Financial markets have become increasingly trade and transaction rather than bank and relationship based;

3. There has been the emergence of a number of new complex products beginning with financial derivatives (in the mid-1970s following the collapse of Bretton Woods), the dis-intermediation of many products (especially with commercial paper), the securitisation of underlying receivables and loan-based products; subsequently packaging of outstanding debt and then the most recent expansion of new structured products including the linking and layering of exposures as well as ‘privitisation’ of the main markets and market functions).

4. A number of new institutions have emerged especially with the growth in the alternative investment market including, in particular, with hedge funds and private equity and with the corresponding expansion in the number and types of investors including pension funds, corporate treasuries, government agencies, specialist investment vehicles and individual investors more generally especially with the continued expansion of private income in a number of countries and with the growth in private pension provision.

 

A number of key trends can also be identified within financial markets more specifically:

 

1. Dis-intermediation (with the issuance and trading in debt by institutions directly without financial institution support);

2. Securitisation (with the move from inherently non-transferrable loan to transferable debt or security instruments);

3. Repackaging and structured financing (with the restructuring of debt packages and linking of product profiles including, in particular, financial derivatives especially with the growth in credit derivatives (including total return swaps (TRS), credit spread swaps (CSS) and credit default swaps) as well as credit linked notes (CLNs) and collateralised debt obligations (CDOs);

 

 

 

 

(d)  The ‘privitisation’ of debt with the use of over the counter (OTC) markets, off-exchange transactions and in-house markets (internalisation); and

(e)   The ‘deconstruction’ of risk with the layering of exposure tranches and separate trading of differently rated or graded paper created and consequent creation of a considerably higher degree of market complexity financial marketplace involving the spread or diffusion (rather than dilution) of risk across many parts of the market and counter parties.

 

It is possibly the deconstruction and separate trading of risk that creates the more significant challenges for regulators and central banks. The total amount of risk within the system is not diluted or diminished in any way. Total or aggregate exposures have increased significantly in recent years with risk simply having been broken up or parcelled and spread around with no individual financial institution or authority being able to assess or oversee the total risk created and the ability of the financial system to support that exposure.

 

This creates complex information problems especially in terms of data collection, aggregation and assessment. More fundamental problems also arise in terms of risk management with individual institutions simply purchasing and trading in risk products or exposures but with no underlying initial or original management function being undertaken. Credit tranches, where simply graded by rating agencies at the time of issuance and then sold on by financial institutions sequentially with no one party wishing to hold the debt at default.

 

The historic and original function of bank credit examination and associated personal credit relationship has been replaced by ratings and trading. As unregulated institutions, the role and function and capability of the rating agencies has also been questioned recently especially with the errors made with the pricing of debt in the US sub-prime market and the consequent global credit crisis that arose beginning in August 2007. A Regulation was adopted within the EU on Credit Rating Agencies which came into effect in December 2009 and established a registration system for agencies and harmonised approach to activity regulation. The Regulation was to be amended to include additional requirements in respect of structured products and to bring CRA within the oversight of the new European Securities and Markets Authority (ESMA) which began operations in January 2011.

 

(5)       Market Capability

 

The ability of financial markets to with stand cyclic downturns and shocks has strengthened in recent decades. This has occurred as a result of a combination of factors:

 

1. Increased market transparency within and across markets and market sectors;

2. Increased market information with growth in support services examining and presenting data effectively;

3. Increased complexity and sophistication of markets and market earnings with consequent improvement in liquidity and credit conditions;

4. Substantial improvements in model risk identification, measurement and management techniques;

The emergence of more sophisticated and specialist central banking functions which can more effectively manage monetary and credit conditions and provide liquidity or other emergency support as necessary.