Glenn Stevens: The role of finance
Shann Memorial Lecture by Mr Glenn Stevens, Governor of the Reserve Bank of Australia,
at the University of Western Australia, Perth, 17 August 2010.
* * *
I would like to thank Paul Bloxham for his extensive research assistance in preparing this address.
Thank you for the invitation to deliver the 2010 Shann Lecture. It is an honour.
People are shaped by formative events, and Edward Owen Giblin Shann was no exception.
Born in Hobart in 1884, his family moved to Melbourne a few years later. Growing up in the
Depression of the 1890s - an episode that hit Melbourne particularly hard - Shann saw
firsthand the effect that financial crises could have on peoples' lives. Those memories stayed
with him and motivated much of his career's work.1
In his early adult life Shann exhibited some Fabian tendencies - and a flirtation with the Left
would be a not uncommon response by a later generation of intellectuals as a result of the
sense that capitalism had failed in the 1930s. But by the time he had become prominent as
an economist, his views had shifted in a direction that we would probably today call
Libertarian. One of his most noted works was a short pamphlet, published in 1927, that
described the lead-up to and crash of the early 1890s. It was prescient in drawing parallels
with the financial developments in the 1920s that preceded the 1930s depression.2
The 1880s were characterised by rapid population growth and increased urbanisation which
fostered an investment boom dominated by construction. There was a spirit of optimism,
which saw international capital flow in and asset prices - particularly land prices - increase.
Leverage rose and lending standards fell. As Shann's monograph noted, financial regulation
at the time abetted the excesses, including an "untimely amendment" of the Victorian
Banking Act in 1888, which allowed borrowing against a wider range of collateral.
In the 1920s, when Shann was applying this experience to contemporary issues, the problem
was not so much excessive private debt or poor regulation.3 This time the problem Shann
saw was too much public borrowing. He viewed the extensive public works popular with
State governments in the 1920s as not only increasing debt but also lowering productivity. So
it would come as no surprise that, after Australia's terms of trade collapsed in the late 1920s
and international capital markets made new borrowing much more difficult, Shann was
among the group that argued that the standard of living that could feasibly be associated with
full employment was noticeably below that to which people had become accustomed in the
boom. The Premiers' Plan of 1931, which Shann had a hand in producing, sought to
recognise this, and to spread the associated decline in incomes across the different sectors
of society.4
These two episodes had some important differences, but in a deeper sense both stories
were rather similar, and all too familiar. The sequence goes as follows. Some genuine
improvement in economic conditions leads to more optimism. It may be a resource discovery
(including the opening up of new productive land), or a technological change, or a rise in the
terms of trade, or even just greater confidence in economic policy's capacity to solve
problems. Human nature being what it is, people (or governments) are inclined to project into
the future with undue confidence and insufficient assessment of risk. They often decide to
invest more in ventures that are marginal, or even speculative, borrowing to do so. Because
their assessment of permanent income is that it has increased, they also decide to consume
more now (either privately or in the form of public services). Financial markets and
institutions - which are populated by human beings after all - help them do both these by
making capital available. Then, at some point, an event causes people suddenly to realise
they have been too optimistic. Maybe the "new paradigm" disappoints in some way or the
terms of trade decline again. The cycle then goes into reverse, usually painfully.
This pattern is fresh in our minds after the events of the past several years. But Shann was
writing about it 75 years ago, and of course he wasn't the first. Narratives like these are
peppered throughout history. The thought that "It's Different This Time" springs eternal in the
human psyche, and is a fitting title to the recent work by Rogoff and Reinhart covering eight
centuries of financial delusions. Moreover, financial instruments, markets and institutions are
always central to the way these cycles play out.
So it is fitting, given Shann's own work, to ask the question: what is the proper role of
finance? In particular, I will take up four questions:
1. What are the desirable functions of the financial system, and how did they evolve?
2. What problems are inherent in finance, and what issues do they raise for
policymakers?
3. What questions arise from the growth and change of the financial system over the
past couple of decades?
And finally,
4. What are the challenges as we look ahead?
The functions of the financial system and its origins
What is it that we need the financial system to do?
I think we can outline five key functions. We want it to provide:
i. a reliable way of making payments (that is, exchanging value);
ii. a means for pricing and pooling certain types of risks;
iii. a way of transferring resources from savers to borrowers;
iv. a way of transferring the returns back again, which requires that the savers' money
is not lost and which, in turn, requires monitoring of borrowers and managers; and
v. liquidity.
These are very valuable things for a community to have. The modern economy could not
have developed without these capabilities arising in the financial system.
We tend to think of financial activity and innovation as very recent, but in fact the history is a
long one. There is not time to do justice to that history here, and there are some fascinating
books on the subject which repay the reader generously for the investment of their time.5 But
it is clear that borrowing and lending is almost as old as civilisation itself. Evidence of such
transactions, some of them remarkably codified, go back at least to eighteenth century BC
Babylonian records.6 Some scholars suggest that the records of the Greek and then Roman
ages show considerable evidence of several activities we would associate with banking,
including taking deposits, making loans and facilitating transactions.7
Developments seemed to accelerate during the Renaissance, particularly in Italy. Bills of
exchange were by then in common use as a means to facilitate trade and also to circumvent
usury laws. Traders were able to take a deposit in one city, make a loan to someone
transporting goods to another city and then take repayment at the destination (possibly in a
different currency) - with a suitable addition to the price in lieu of interest. This activity would
appear to be a forerunner - by seven centuries - of an instrument that in our terminology
would combine elements of a zero coupon or discount security, trade credit and a sort of
foreign currency swap.
The most noted bankers of that era were of course the Medici family of Florence, who went
further than their predecessors and contemporaries in the pooling of credit risk, by having a
branch network with partners who were remunerated with a profit share.8 The development
of double-entry bookkeeping, in Genoa in the 1340s, also helped banking assume more
modern features: the receipt of deposits, maintenance of current accounts, provision of loans
and management of payments.9
This form of banking in Italy later became a model for Holland, Sweden and England, to
which further innovations were added. In Amsterdam, the Wisselbank, which was the first
exchange bank in Northern Europe, pioneered a system of cheques and direct debits
circumventing problems with different currencies.10 The Swedish Riksbank, formed in 1656
and the oldest institution recognised today as a central bank, is credited by some as having
pioneered fractional reserve banking.11
Other key innovations were joint-stock ownership and limited liability. These allowed more
capital to find its way into banking and further reduced the costs of intermediation. The Bank
of England, established in 1694, was for many years the only bank in England allowed to
operate on a joint-stock ownership basis. Walter Bagehot devotes a chapter in Lombard
Street to the virtues of joint-stock ownership, noting that while these sorts of companies "had
a chequered history", in general the joint-stock banks of Britain were "a most remarkable
success".12 The same innovations helped to develop equity markets more generally.
Meanwhile bond markets had also developed. Again the earliest forms were in Renaissance
Italy, where wealthy citizens were able to buy bonds and thereby invest their savings in one
of the few activities that was seen as providing a significant return: war. Such instruments
allowed governments (and later large corporations) to raise funds from a broader set of
sources. In time, the formation of secondary markets for these securities meant that risk had
6
Banking activities were sufficiently important in Babylonia that there were written standards of practice that
were part of the Code of Hammurabi, the earliest known formal laws (Davies 1994). These were carved on
tablets of stone, including details of how loans, interest and guarantees would operate according to a set of
standardised procedures.
7
Temin (2004).
8
See de Roover (1946). The Medici family may have learned from earlier failures of the Peruzzi and Bardi
families' banks in Florence in 1348 owing to defaults on payments when King Edward III failed to repay
borrowings taken in the beginning of the Hundred Years' War (Kindleberger 1993).
9
As an aside, it is from this era that we receive the term "bank", which derives from the merchant's bench, or
banco, in the market places of medieval Italy (particularly Lombardy; Lombard Street in the City of London is
named after this region of Italy, as King Edward I granted this piece of land to the goldsmiths of Lombardy).
10
Quinn and Roberds (2005).
11
Ferguson (2008).
12
Bagehot (1873).
BIS Review 107/2010
a price set by a market. These innovations also spread to Northern Europe and, by the
mideighteenth century, London had a well-developed bond market.13 It was trading in the bond
market that made the Rothschild family wealthy and for most of the nineteenth century its
bank was the largest in the world.14
So by the middle of the nineteenth century a quite sophisticated financial system had arisen
in major western economies. It included banks and other financial intermediaries, stock and
bond markets and insurance. It allowed transactions to be made, and mobilised pools of
savings for investment in enterprise while offering a degree of liquidity to savers. It pooled
certain risks, and served in a fashion to monitor borrowers. It allowed payments to be made
and funds invested across national borders. In the process, it facilitated the industrial
revolution, which resulted in the biggest transformation in living standards seen in the history
of western civilisation. This system did just about all the things we would want a financial
system to do today, albeit with less technological efficiency. Arguably the biggest change a
financier from much earlier times would notice today would not be the new instruments - nor
the crises! - but the effects of the silicon chip and fibre optics on the way finance is
conducted.
Incidentally, the difficulties that accompanied having only a rudimentary financial system
were nowhere better illustrated than in the early Australian colonies, as one of Shann's other
works, An Economic History of Australia, makes clear. The most commonly used means of
exchange for many years was rum.15 Indeed, he reports that in Sydney "George Street
between Brickfield Hill and Bridge Street cost four hundred gallons" of rum to build (p 49). In
today's prices for rum, this amounts to about $80,000. It is doubtful that a road of that length
could be constructed for that sum today, such has been the increase in the price of labour in
terms of rum (and indeed other commodities). The colonists began to issue "notes" or
"cards", which were forms of IOUs and which circulated as currency, although this system
soon became unworkable partly because the quality of such IOUs varied greatly and tended
to decline over time. Governor Macquarie famously sought to end the shortage of metallic
currency by punching holes in a consignment of Spanish dollar coins, giving the "ring" and
"dump" different values, and also rendering them less useful elsewhere, thereby retaining
this currency in the new colony.
However, the need for credit facilities, for pastoral expansion and short-term financing for
local and overseas trade, still required the development of a banking system. In 1817,
Macquarie granted a charter to a group of leading traders and officials to form the Bank of
New South Wales, with responsibility to issue a paper currency. As Shann points out, the
stock holders were given limited liability in the operations of the Bank of New South Wales,
which at the time in England was still an exclusive privilege of the Bank of England, and was
not granted to other British banks until 1858.16 So despite a somewhat shaky start,
Australia's own financial system was able to catch up rapidly on the other developed
economies by adopting their technologies.
13
The more market-oriented approach of British finance stood in contrast to mainland Europe, which was more
bank-oriented (and remains so today). Both approaches provide different ways of achieving the functions
listed above.
The contrast between systems has spurred much debate about their effectiveness. Some suggest a key role
in the development of German industry in the nineteenth century, for example, was the large size and scope of
the universal banks of Germany, which allowed them to develop a close relationship with industry
(Gerschenkron 1962). Others suggest that markets provide the discipline required and also led to a superior
allocation of capital.
14
Ferguson (2008).
15
Shann (1930).
16
Shann (1930) and Newton (2010).
BIS Review 107/2010
The problems of finance and development of regulation
As banking had developed, it had become more leveraged. No longer was it a case of a few
wealthy individuals risking their own money in enterprises akin to venture capital funds -
accepting the risk and illiquidity that went with it. In their more developed form, banks raised
deposits from the public - redeemable at their face value, at notice or at call.
Leverage changes the dynamics of any business. Expected returns are higher but management
needs to be on its game - which is an oft-quoted argument for having some debt in a
corporation. In the case of banks, it meant that the business of banking became even more
focused on monitoring, information gathering and risk management.
Of course the depositors had some protection in that the capital of the proprietors was at risk
before deposits. But banks also undertook maturity transformation. They offered depositors
liquidity, but held only a fraction of their own assets in liquid form - enough for normal
day-today operations. The whole thing depended on confidence - if depositors wanted their funds
back en masse, a bank could not provide them because its assets were not all in cash. If
there was a loss of confidence for some reason, the bank would be under pressure: there
could be a run. So banks themselves needed access to liquidity in situations of stress; that
is, they needed to be able to liquify assets when a shock to confidence occurred.
When such a shock was idiosyncratic, a bank might seek funding in the market. Other
institutions, mindful of the possibility of contagion if a run got going, might support one of
their competitors provided there was a reasonably held expectation of solvency. But if the
confidence shock was more systemic in nature the question was how the whole system
could be supported. This came to be seen as the proper role of a central bank and was
ultimately encapsulated in Bagehot's famous (if widely misquoted) maxim that the central
bank should be prepared to "lend freely, against good collateral at a high rate of interest".17
Of course central banking was at that time embryonic at best: the central banks in existence
in Bagehot's day mainly had been established to help sovereigns raise war finance; their
stability functions evolved later, over time.18
But while the provision of liquidity in crises left the system less vulnerable to runs, it was no
real solution to simple bad lending. Even if all the good assets can be liquified to meet a run,
if not all the assets are good, failure may still occur. Failures of individual institutions could be
allowed provided they did not damage confidence in others, but it is always difficult to know
just how small or large a failure might cross the threshold. Inevitably, since there could be
spillovers from failures, and since banks and others would accept funds from the general
public, there would end up being a degree of regulation.
And so the history of banking and finance is not just a history of financial innovation, it is also
a history of regulatory response. That regulatory response has had its own quite pronounced
cycles. Moreover, regulation prompts further innovation, and so on.
From the 1930s, regulation became much more intrusive. In the United States, fear of the
"money power" saw some large institutions (J.P. Morgan for example) broken up, much as
occurred in some other industries at the time. Yet simultaneously, competition between
banks was intentionally curtailed in some respects, for fear of irrational behaviour. Regulatory
intervention extended to interest rates, requirements for reserves, prohibitions on certain
types of business, and even lending guidelines and quotas. In the 1940s this all became part
of the war-time apparatus that essentially sought to run economies via direct intervention
rather than by relying on the price mechanism. However, it persisted in finance for many
years after the war had ended, perhaps in part to keep low the costs of servicing large war
debts. It was only really in the 1980s and 1990s that this regulatory approach had finally
passed, allowing banks to compete vigorously for all lines of business and allowing pricing to
be driven by market forces.
We can trace many of these trends in Australia. The 1937 Royal Commission argued for
greater control and regulation of the Australian monetary and banking systems, motivated by
the perceived failings of the financial system through the depressions. Legislation on many of
the recommendations from the Commission was enacted in 1945 and continued the tight
controls placed on banks during the Second World War. The focus immediately after the war
was on stability with little regard given to the efficiency of the financial system. This was
consistent with extensive government intervention and regulations in other markets.
As a result, in the early post-war period, the Australian banking system was highly
constrained. There were tight controls on interest rates for bank lending and borrowing, on
terms to maturity of different types of deposits and loans, and quantitative and qualitative
controls on banks loans in aggregate and to particular types of borrowers. These were
introduced to guard against excessive risk-taking by banks with depositors' savings and also
were regarded as serving the needs of macroeconomic policy.
Given the pervasive and restrictive nature of these controls, it is perhaps not surprising that
the banking system was very stable. In the almost five decades from the early 1930s until the
problems of the Bank of Adelaide in 1979 no Australian bank failed or even faced serious
financial problems.19 This was in a very real sense a result of the terrible 1890s depression
which had been so influential on the young Shann. As Selwyn Cornish points out, that
episode had a significant effect on the nature and form of much of Australian economic policy
throughout most of the twentieth century, including financial regulation and central banking.20
But the constrained banking system left a gap into which others stepped.21 As early as the
1960s, new, less regulated, financial institutions began to arise. The banks' share of financial
intermediation in the Australian economy steadily declined from the mid 1960s, reaching a
little over half at its lowest point in the early 1980s (Graph 1).
Graph 1
The increasing size and complexity of the system and the rise of non-bank financial
institutions made the regulatory architecture increasingly less effective. By the late 1970s,
the philosophical tide was turning against intervention as efficiency costs became more
apparent - a trend not confined to finance.
Eventually these inefficiencies led to calls for financial liberalisation and so, around 40 years
after the Royal Commission, the Campbell Inquiry laid the foundations for the intellectual and
practical shift towards liberalisation and the current system. In addition to freeing up banks,
the floating of the currency and the opening up of capital markets, a range of technological
advancements - as well as economic development and policy changes affecting other
sectors in the economy - also were important drivers of change in the financial system.
Questions arising from the growth of finance
The past 20 years has seen a major increase in the size and breadth of activity of the
financial sector in most economies, as well as an acceleration in the globalisation of finance.
Statistics abound to demonstrate this: the turnover in various markets, the real value of
assets, the amount of gross derivative positions outstanding; all have grown considerably
faster than the size of overall economic activity. Again some of these same trends are seen
in Australia. Total assets of financial institutions relative to the size of the economy have
increased from the equivalent of around 100 per cent of annual GDP in the early 1980s to
almost 350 per cent in recent years (Graph 2).
Graph 2
Noteworthy in some countries has also been a significant increase in the share of financial
activity in the economy's value added and the proportion of people employed in the financial
sector.
It is widely assumed that financial deregulation played a major role in this increase, and the
timing seems to fit. Now, in the aftermath of the crisis, there is a more questioning tone about
whether all this growth was actually a good idea: maybe finance had become too big (and
too risky). This question is certainly a live one in the United Kingdom, where the City of
London was very prominent in the economic success of the country since the mid 1980s.22
There are at least two potential problems in a world where the finance sector becomes "too
big". If it is accepted that finance has its own cycle - of risk appetite, leverage, crisis and then
de-leveraging - then a bigger financial system compared with the economy, unless
accompanied by much more capital (and it wasn't in the case of the big international banks -
the reverse was true), risks de-stabilisation of the whole economy. Because crises can be
costly, moreover, calls are inevitably placed on the public purse for support. These are very
difficult to resist. In the current episode, the direct costs to the public purse of restoring
financial stability in some of the North Atlantic countries are non-trivial. But the cost of lost
revenue in the lengthy periods of economic weakness that seem invariably to follow financial
crises is an order of magnitude larger. It is this factor really that has unleashed the recent
round of concerns about public finances in the affected countries.
Secondly, as well as making incomes and activity less stable, an overly large financial sector,
if characterised by perverse incentives that can drive extraordinary remuneration for
individuals, may draw in too many resources that could otherwise be employed at a higher
social return. To put it in practical language, too many PhD physicists, mathematicians and
engineers working on options pricing and designing structured products could lower, rather
than increase, the productive capacity of the economy.
For finance is not, for the community, an end in itself. It is a means to an end. Ultimately it is
about mobilising and allocating resources and managing risk and so on - providing the five
outputs I listed earlier. Yet people have become suspicious of the way much of the activity in
the financial system amounts to the production of "intermediate" financial services, delivered
to others within the same sector: the "slicing and dicing" of risk, re-allocating it around the
system to those who are most willing and best able to bear it (or, sometimes perhaps, and
much more troublingly, to those who least understand it).
Some commentators - among them the chair of the UK Financial Services Authority - have
openly questioned the social usefulness of much of this activity. In essence people are
asking whether the rising size and pace of transactions of the finance sector is actually a sign
of higher economic prosperity, or of something wrong. They are also questioning implicitly
whether the thrust of financial liberalisation in the 1980s and 1990s was correct, or at least
may have gone too far, if it helped to produce these outcomes.
These questions are likely to be debated intensely over the next several years. This will be a
growth sector of the conference and consulting industry. It is therefore premature to draw
strong conclusions, but a few observations may be useful.
First, a small point of measurement. In most modern economies, the share of GDP
accounted for by services generally has long been growing as agriculture and manufacturing
get (relatively) smaller. It would not be surprising for the finance sector to be part of that. So it
might make more sense to measure the financial sector as a share of the services sector,
rather than as a share of total GDP. On this basis it will still have shown a distinct rise, but
not quite as much. In Australia's case, by the way, the finance sector's share of services
sector employment peaked around 1990, thereafter declined somewhat and has changed
little for a decade.
Second, a fair bit of the growth in financial sector activity was surely bound to happen in view
of changes in technology. These dramatically lowered costs, so that the provision of news
and information became instantaneous and ubiquitous, as did the ability to respond to news.
The capacity to monitor and manage a portfolio more actively is likely a "superior good":
people will want more of it as their affluence increases. The increasing development of
financial management techniques and new instruments - another kind of technology, if you
will - also led to a lot more gross activity. For example the conceptually simple process of
keeping to a benchmark drives a good deal of transaction volume. So surely some of the
growth in the finance sector has been genuinely useful, and the technological changes mean
that much of it has been accommodated without much in the way of real resources being
used. That is not to deny that there is a very important set of questions about the price the
general public is paying for some of the services and about whether the capacity to respond
to every piece of "news" is resulting in an excessively short-term focus in management. The
latter is, of course, a question that extends much more widely than just the finance sector.
Third, the increasing integration of the global economy - itself assisted by financial
development - brought the savings of literally hundreds of millions of Asians into the global
capital market. This meant that differences between countries' policies and saving and
investment appetites became more likely to affect financial trends and market prices. These
factors were certainly one reason that interest rates, including long-term rates set in markets,
not just the ones set by central banks, were so low in the middle of last decade. Surely this
had a major bearing on the pace of growth of intermediation and, ultimately, the appetite for
risk in the global system.
Fourth, we need to be careful how much blame we ascribe to changes in regulation for
everything that went wrong. Of course it cannot be denied that the regulations had
shortcomings. But while all significant countries were operating on more or less the same
minimum standards for bank supervision, some countries had serious financial crises, but
many - in fact most - did not. Moreover, a significant part of the problems arose in the
"shadow banks" - more lightly regulated institutions which were not banks (though some of
them became banks subsequently when there was a regulatory advantage to doing so).
Many observers have concluded that in the major countries, allowing large regular
commercial banks to engage in more "shadow banking" type activity without more capital
was a mistake. But all this says that supervisory practice is as important as the formal
regulations. Moreover, if those freedoms were granted in response to the demand by the
commercial banks to get in on the action happening elsewhere, that points to the general
environment as a big part of the story. As we know from our own history, if there is an
incentive for risk-taking activity to occur (like low interest rates, for example), it will eventually
occur even if it has to migrate to markets and institutions where fewer regulatory
impediments are in place. To put this point at its most extreme, it could be argued that that
the overall environment dictates the appetite for risk-taking financial activity, and that the
nature of regulation simply determines the location of the activity. That is, as I say, extreme,
but there is some truth to it.
Looking ahead
Where then does this leave us?
The regulatory cycle has come fully around. After two or three decades of liberalisation and
allowing markets and private agents in the financial sector more sway, the international
debate has of late been consumed with issues of financial regulation: how to re-design it, and
generally increase it.
This is understandable, and it is entirely appropriate that these questions be posed in the
light of the events of the past decade. My point is simply that we have been here before. If
we think far enough back in history, there are things to learn about regulation and its cycle,
just as there would have been - had people been more inclined to look - about the nature of
private finance and its cycle.
The objective shouldn't be to suppress finance again to the extent it was for so long in the
past. There would be a cost to the economy in attempting this, and in any event the
financiers will be quicker to figure out the avoidance techniques than they used to be. The
objective should, rather, be to foster arrangements that preserve the genuine benefits of an
efficient and dynamic financial system, but restrain, or punish, the really reckless behaviour
that sows the seeds of serious instability. Such arrangements surely have to include allowing
badly run institutions to fail, which must in turn have implications for how large and complex
they are allowed to become.
There is a large reform effort under way at the international level. I have spoken about this
before on several occasions and so I will not revisit the regulation issue here. I would only
say that while no doubt regulations can always be improved - and who would say otherwise?
- it is unlikely that regulation per se, becoming more and more complex and widespread as it
is, will be the full answer. A big part of the answer must come from practice, not just
blackletter law.
The finance industry, certainly at the level of the very large internationally active institutions,
needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of
risk and more responsible about where those risks end up, than we saw for the past decade
or two. And, of course, it does have to be better capitalised.
Equally, surely regulators and supervisors in some jurisdictions need to be more intrusive
and assertive, to be prepared to go beyond minimum standards and to be a little less
concerned about the competitive position of their own banks, than they have been in the
past. It has been not uncommon, for example, for Australian bankers to complain about
APRA's relatively strict rules on definition of ca