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Measuring Wealth and Financial Intermediation and Their Links to the Real Economy
By Charles R. Hulten, Marshall B. Reinsdorf The University of Chicago Press
Copyright © 2015 National Bureau of Economic Research
All rights reserved.
ISBN: 978-0-226-20443-7
CHAPTER 1
Integrating the Economic Accounts
Lessons from the Crisis
Barry Bosworth
In recent times, we have benefitted from a wealth of interesting articles and research on the institutional changes and other innovations within the financial system that contributed to the 2008–2009 crisis. Unfortunately, nearly all of that work postdates the crisis itself. It is disappointing and puzzling that so little evaluation of those changes was undertaken in earlier years. Our profession did not perform well in anticipating the risks created by many of the financial innovations. Yet, with the benefit of hindsight, many economists have written very lucid descriptions that suggest that the dangers were obvious. Many of us will comfort ourselves with the phrase, "If only I had known what they were doing...." Hence the topic of this conference on what can be done to provide a better flow of information to help prevent similar crises in the future.
However, the crisis was not so much a failure of information as it was an analytical failure to draw the appropriate conclusions. We knew what the individual agents were doing, but did not understand the linkages and the chain of reactions that would lead the system to spiral out of control. Policy-makers became excessive advocates for financial innovation and placed far too much confidence in the incentives and discipline of private markets to restrain participants from excessive risk taking. Our ability with hindsight to identify the failures that led to the past crises can also create a false optimism about our ability to prevent future crises. In effect, the inability to conduct laboratory experiments to explore directly the implications of various reforms to the system leads to an overemphasis on explaining the past rather than thinking about how various innovations might affect the future.
The focus of this chapter is on designing a flexible and robust statistical framework that could monitor an evolving financial system and assist regulators in controlling the risks. While that is an important objective, let me begin with some doubts that a new regulatory process can reduce the risks to an acceptable level; perhaps we should also consider the alternative of moving further in the direction of a plain-vanilla financial system that forgoes some of the gains from financial innovation in return for reduced risk. James Tobin was fond of observing that "It takes a heap of Harberger triangles to fill one Okun Gap." (Tobin 1977, 468). His perspective seems particularly appropriate in the present context when we try to balance the gains from financial innovations in the United States and Europe against the costs of a mistake to an even wider global economy. Our neighbor, Canada, is an example of that alternative: while the menu of financial products is more restricted and the prices for some services are higher, Canada did avoid the direct effects of the financial crisis. It suffered only through the channel of reduced trade and its position as a major trading partner of the United States.
For too long, the financial sector has been a poor cousin within the statistical system. Just as the national accounts provide the macroeconomic framework for a variety of real sector analyses, the flow of funds should be the starting point for analysis of financial developments. Traditionally, the Federal Reserve has had the major responsibility for the collection of financial statistics and construction of the Flow of Funds Accounts, but for many years the flow of funds was a neglected element, and the Federal Reserve was reluctant to devote a significant amount of resources to developing the data system. More recently, the Bureau of Economic Analysis and the Federal Reserve have made a major effort to expand the financial accounts and integrate them with the sector income and outlay statements of the national accounts. The integrated macroeconomic accounts bring the United States more in line with the international System of National Accounts (SNA) in which economic agents are organized into five major sectors (nonfinancial corporations, financial corporations, government, nonprofit institutions serving households and households). There is also a consistent set of accounts that flow from production, income and outlay, capital, financial, and ultimately a net balance sheet for each sector.
The Flow of Funds Accounts played a more significant role in financial analysis during the 1960s and 1970s, relative to recent decades. In part, the reasons might reflect the more restricted nature of the earlier financial system where various interest-rate ceilings and other restrictions created some nonlinearities in the system that created a need to observe changes in different types of credit. As those restrictions were eliminated, financial markets seemed more homogeneous, and many credit instruments were viewed as highly substitutable for one another. Interest shifted away from the composition of credit toward a greater focus on aggregates and the price of credit. There may be some shift back toward an interest in the composition of credit because of the severity of the disruptions of the past few years and a realization that they did not impact equally on all forms of credit.
The integrated accounts are an advance in providing an improved systemwide framework for analyzing macroeconomic flows and the links between the real and financial sectors, but they provide surprisingly little insight into the causes of financial crises. The traditional view of financial institutions emphasized their role in intermediating the flow of resources between savers and investors. While it is true that financial institutions continue to fulfill that function, a modern interpretation places greater emphasis on their activities in transforming financial claims in the dimensions of liquidity, maturity, and credit risk. These dimensions are not captured in the aggregate accounts because the accounts rely on purely deterministic measures of value and cannot reflect the accumulation and transmission of risk exposures. To measure these variables, the system needs to incorporate measures of the risk and volatility of key balance sheet items, and to integrate prices and quantities in the financial accounts. At the same time, the emphasis on balance sheets at the sector level highlights the role of counterparty risk in a system in which the assets of one sector are the liabilities of others. As conventionally presented, however, the accounts are too deterministic and too aggregated to serve that goal.
The primary purpose of this chapter is to review the need for new types of economic statistics in the light of the financial crisis. There has been—and will be even more—discussion of the need for an expanded reporting system to meet the needs of the financial regulators. The focus herein is more on the public side of the statistical system. It reflects a nervousness about relying on internal confidential channels of information between private firms and their regulators. While there is a need to balance the needs for a public information flow and legitimate private concerns about confidential business strategies, there may be substantial returns to outside scholars accessing the kind of data that would permit the analysis and construction of indicators that will provide realistic evaluations of the consequences of future financial innovations. Part of the argument is that the statistical system of the federal government has not evolved at a pace that matches the changes in the economy and the new technologies that can be used to monitor it. It is most apparent with respect to the financial system where the reporting structure has remained largely frozen in time despite a drastic change of financial structure. The later portions of the chapter also examine the effects of financial crises on the real economy and whether there are major gaps in the reporting system outside of the financial accounts.
1.1 Data Challenges in the Financial Sector
The Flow of Funds Accounts (the financial side of the integrated accounts) have the appearance of a well-defined system that facilitates tracing out the flow of credit and the distribution of financial assets and liabilities throughout the economy, but they are not particularly useful to identify the distribution of financial risks, and in some respects they describe a system that no longer exists. The US system has been complicated by the emergence of a shadow banking system that operates in parallel with the traditional system of commercial banks. Problems within the shadow banking system during the crisis highlighted three specific areas in which information was lacking and limited the usefulness of the aggregate financial accounts: the maturity structure of the underlying financial claims (liquidity), the lack of information on the use of leverage to support the claim structure, and the shifting of returns and risks away from the reported holders of the claims through the growth of credit derivatives. They all relate to establishing some measure of the underlying quality or risk of the financial assets and institutions. Either the economic accounts need to be expanded to incorporate increased detail or the individual entries need to be accompanied by some index or alternative measure of their risk and volatility.
1.1.1 Shadow Banking
The shadow banking system is essentially the collection of financial companies who do not have access to central bank liquidity or the government guarantees of normal banks, but who provide bank-like services. It includes money market funds, investment banks, finance companies, hedge funds, and various asset guarantors. The major funding instruments include commercial paper, repurchase agreements, and various derivatives. A significant portion of the system's growth is motivated by regulatory arbitrage, but there may be some broader economic benefits in the form of gains from specialization (Pozsar et al. 2010). The bulk of their funds are provided through short-term lenders, such as money market funds, which expect their funds to be available on demand and at par. Despite its similarity to commercial banking, shadow banking lacks deposit insurance and the ultimate backing of the state to protect itself against a run. Absent such a backstop, a general crisis of confidence can be expected to trigger a run on the system. That is what happened in the recent crisis and it resulted in a near complete, albeit temporary, government guarantee.
The official statistics have failed to adapt in the face of this change in the structure of the financial system. They maintained a focus on the commercial banking system while an increasing proportion of the activity was being conducted through other venues. Surveys of nonregulated institutions, such as finance companies, are of questionable quality—relying on voluntary participation. Information on pension funds is incomplete and subject to large revisions. The basic elements of the shadow banking system are included within the flow of funds and the integrated economic accounts. One study (Pozsar et al. 2010) used that data to estimate the size of the shadow banking system, and suggested that it exceeded the commercial banking system beginning in 1995 and peaked at $20 trillion in 2008 (figure 1.1). However, the individual elements are not grouped in a fashion that emphasizes their interrelationships. In addition, the accounts do not directly measure the activities of hedge funds, which are largely allocated to the residual household sector. The hedge funds have a big impact on the market for liquidity because they rely on short-term credit to enhance their investment strategies.
1.1.2 Maturity Structure
A major feature of the buildup to the crisis was a heavy reliance on short-term borrowing to finance long-term lending. It has also been a key element in the majority of past financial crises and is always listed among the major lessons of every postmortem; yet, somehow, those lessons are quickly forgotten. Maturity mismatches in the collapse of commercial banks in the 1930s led to the introduction of deposit insurance and an expanded regulatory system. Yet, a similar crisis emerged within the saving and loan industry in the 1980s and ultimately led to the bankruptcy of that industry. The growth of the S&L industry was a reflection of efforts to avoid the constraints of the regulated sector. In the current episode, the problem began within the shadow banking system with its emphasis on repos, but it ultimately spread to the larger commercial banks through the interbank markets.
The statistics can be expanded to differentiate among financial liabilities of varying maturity, but in the absence of explicit insurance, this form of maturity transformation is inherently unstable and subject to runs. Thus, liquidity can vanish overnight. It is particularly true when so much of the short-term lending is dependent on high-frequency repo agreements. It would help if the statistical system could measure the magnitude of the maturity mismatches and the exposures, but information is not a solution to the fundamental instability.
1.1.3 Leverage
Extensive reliance on leverage, particularly within the shadow banking system, was another important contributor to the liquidity crisis that developed in late 2008. Some firms were financing their activities with liabilities more than fifty times their own capital. Doubts about the quality of the assets being put up as collateral for short-term financing forced the sale of assets at distressed prices and quickly wiped out the firms' net worth.
A traditional measure of leverage focused on the extent to which a firm uses fixed debt to finance its activities because the highly leveraged firm would, in the absence of other factors, have a more volatile stream of income after deducting its interest expenses. In notional accounting, leverage is simply total assets divided by total assets less liabilities (net worth). In an economic context, however, the concern is more with the volatility of net worth relative to the volatility in the underlying asset values. Thus, economic leverage might be much lower than the notional level because the valuations of the assets and liabilities share a positive covariance. These computed leverage measures, however, depend upon the accuracy of the underlying model assumptions. In a regulatory context, leverage became a particularly ambiguous concept when regulators attempted to place different risk ratings on various asset classes and use those ratings in the computation of an overall leverage rate.
As pointed out in Greenlaw et al. (2008), many of the examples of excessive leverage were outside the regulated commercial banking sector. The leverage rate for commercial banks was about 10, compared to 24 for the government sponsored enterprises, 25 for brokers and hedge funds, 19 for Citibank, and over 50 for some foreign banks like Deutsche Bank and UBS.
Currently, the Flow of Funds Accounts have an incomplete treatment of leverage in that the notional measure is available for only a few sectors, such as households and nonfinancial corporations. In the integrated macroeconomic accounts, the balance sheet framework is extended to the total of all financial institutions, but we still have no balance sheet with net worth measures for subsectors of financial business. In any case, the flow of funds does not include the measures of volatility that would be needed to compute an aggregate measure of economic leverage.
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Excerpted from Measuring Wealth and Financial Intermediation and Their Links to the Real Economy by Charles R. Hulten, Marshall B. Reinsdorf. Copyright © 2015 National Bureau of Economic Research. Excerpted by permission of The University of Chicago Press.
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