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| Author: | Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance |
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September 3, 2003
Council on Foreign Relations
Practicum of Columbia University
Roger M. Kubarych
Senior Economic Advisor, HVB Group;
Henry Kaufman Adjunct Senior Fellow, Council on Foreign Relations
September 3, 2003
Americanization of Finance is shorthand for a straightforward, but powerful, transition: from a financial system centered around traditional commercial banks to a system that is centered on the open capital markets. Many, whether or not they are Americans, embrace this shift because they know from the experience of the past few decades that conventional banking systems are vulnerable to shock and something else might work better. Whether we recall the savings and loan crisis in the United States that broadened to infect leading commercial banks, or the huge problems encountered by the Scandinavian banks that led to their nationalization in the 1990s, or numerous failures within the banking systems of emerging markets, or the mother of all banking crises, that of post-bubble Japan, it is clear that old system didn’t work well enough. Banking can be a tough business, especially when banks are unprotected from unforeseen risks.
But strong economies need strong financial underpinnings, so there is an understandable yearning for creation of a set of institutions that can provide the payments facilities, credit creation and allocation, and risk taking functions of traditional banks but with less systemic fragility. Americanization of Finance is the main method by which this diversification has been carried out in the past 25 years. It has generally served most borrowers and creditors well but has not been trouble-free. All in all, it poses substantial challenges for many countries, either by threatening entrenched financial elites or by exposing weaknesses in the existing regulatory structure.
The building blocks of Americanization of Finance
The building blocks of Americanization of Finance consist of a number of elements that collectively lead the financial system toward the capital markets and away from traditional deposit-taking and bank lending.
Securitization
Central to this evolution is securitization – the process of gathering existing loans into a bundle and issuing a security based on those bundled loans. It started out primarily in the US mortgage market in response to a conventional structure that essentially failed when interest rates rose sharply in the late 1970s. The mortgage function had always been thought of as a single business: banks and thrifts originated, serviced and held mortgages in their portfolios financed primarily by short-term sources of funding. But some clever investment bankers realized that the business could be separated into three separate businesses, each capable of being operated profitably by specialist firms. So some firms could specialize in originating mortgages, others could specialize in servicing them, and others could specialize in holding them. But the final investors wouldn’t hold the mortgages themselves, but rather securities that would represent a basket of mortgages. After some nasty back-office problems were solved, the new idea worked reasonably well at first. But it really took off by the end of the 1980s, as two government-sponsored entities, Fannie Mae and Freddie Mac, standardized the process of creating mortgage-backed securities. The mortgage securities market in the US is now the biggest bond market in the world. At over $4 trillion of the $6.6 trillion in total home mortgages, it far eclipses the US Treasury market.
Since then, all types of loans have been securitized: car loans, credit card receivables, education loans, home equity loans, and more recently commercial loans (collateralized loan obligations) and even bonds (collateralized bond obligations). Outstanding issues of asset-backed securities were negligible as recently as 1990. They amounted to $2.5 trillion as of the end of March 2003.
Securitization has become a familiar technique throughout Europe and Japan, and is even making headway in many emerging markets. Naturally to do the business you need a lot of computer power and software. But that has become cheaper and more available, so that in the future there is no doubt that securitization will be a feature of financial life practically everywhere.
New types of financial institutions
What should be obvious is that securitization can only be truly successful if there is an active “buy-side”. There is no use in bundling loans into securities if no one wants to buy the securities. So the process of Americanization of Finance is conditioned on there being financial institutions predisposed to buying such securities.
In the US the major development that provided the buy-side was the prodigious development of the private pension system. This took shape in three phases: the creation of large defined-benefit pension funds in the large, usually heavily-unionized industrial sector; the establishment by state and local governments of retirement funds for public employees (teachers, policemen, firemen, local government staff); and in recent years the emergence of defined-contribution pension plans that are employee owned and directed (the famous 401k accounts are the most familiar).
The defined benefit pension plans became the single-most important acquirer of securitized assets, either directly or through the wide variety of outside investment managers that were set up to manage these funds.
Performance-based portfolio management
The emergence of specialized institutions to take risks only just began with pension fund management. It soon broadened out into whole new areas. Venture capital funds, leveraged buy-out firms, and hedge funds were the product of this evolution. They did far more than invest in relatively conservative fixed-income securities. Their whole reason for being was to achieve extraordinary performance by taking significant risks. And performance-based risk taking has become an integral element of Americanization of Finance, whether conducted by US institutions or competitors in Europe, Asia and elsewhere.
Financial Innovations
As market participants got more and more involved in seeking superior performance, they demanded new and more sophisticated methods of both taking and managing risks. So financial derivatives, which have existed in primitive forms literally for centuries, blossomed in the late 1980s and early 1990s. Organized futures markets multiplied. Forward transactions swelled in number and magnitude. Complex interest rate and currency swaps and options were perfected, and then supplemented by even more complex equity swaps and options. By the beginning of this decade, the total size of outstanding derivatives – now over $100 trillion worldwide— far exceeds the total size of traditional “cash” markets.
The derivatives markets have their champions – Fed Chairman Alan Greenspan is a leading proponent. – and detractors – noted investor Warren Buffett is the most forceful. But nobody can conceive of a modern financial system without them.
Development of an equity culture
An equity culture has two ingredients. One is broad public participation, nurtured by a energetic broker-dealer community, comforted by comprehensive disclosure of company financial information, and kept informed by an investigative free press. In 1950 about 18% of Americans had exposure to the stock market. Today it is over 50%, even after the collapse of the high-tech bubble of the late 1990s.
Two is a relatively free and active market in corporate control. In the US mergers averaged about 500 a year from the mid 1970s through the mid-1990s, with a brief upsurge during the junk-bond financed hostile takeovers of the late 1980s. But from 1995 on, merger and acquisition activity soared, reaching a peak over 2500 a year at the beginning of this decade, before receding.
Democratization of risk-taking
What really brought the average American into the stock market, however, was not cheap transactions fees of discount brokers nor e-trading over the Internet. It was the explosive growth of the mutual funds. At the time of the October 1987 stock market break, mutual funds were thought to be important, but they only amounted to $250 billion. Today that number is over $3.5 trillion. About half of that is pension-related, the defined contribution or 401k plans mentioned above. Almost half of American families are invested in mutual funds. There are over 4000 of them to choose from, although the top ten funds account for almost 50% of the market.
Globalization
Americanization of Finance and globalization go hand in hand. Many of the innovations, especially in the area of options trading, have been pioneered by European institutions. Many of the key players in the US financial markets are affiliates of European or Japanese institutions. The trading markets are global. The counterparties come from every continent. The US capital markets are a magnet for all types of participants. And the huge and growing current-account deficit couldn’t be financed, at least not as cheaply as it is, without that global presence. So Americanization of Finance isn’t entirely American.
The Dark Side of Americanization of Finance
The main plusses are evident. Borrowers gain from more competitive markets. Just ask any of the 50 million-plus American families who have been able to refinance their mortgages more cheaply in the past two years. Investors gain from a plethora of choice among assets in every risk category and from the ability to manage those risks far better than in the past. Corporations gain from the easier access to credit, too. And the rate of inflation has secularly declined throughout the era in which Americanization of Finance has evolved, suggesting that a capital-markets based financial system is more readily responsive to central bank anti-inflation policies.
But there are some important downsides. Americanization of Finance is associated with greater volatility in asset prices, interest rates and exchange rates than in most prior historical periods. And it is subject to abuses, whether of excessive zeal, or of morality, or occasionally of the law.
The collapse of the high-tech bubble and its aftermath illustrate many of the dangers. Corporate malfeasance is widely cited as one of the main reasons why equity markets have stayed well below their past peaks. You can’t trust the numbers anymore, people say. To be sure, there have to be some important broad economic forces at work, as well. But the impact of the corporate scandals in the US is not negligible, either. And it may leave a lasting wound that never quite heals and so is vulnerable to being opened up in the future.
I would identify four areas where there have been significant impacts. Each of these areas requires attention, fixing, and continuing scrutiny. They are: corporate governance, Wall St. behavior, the role of professionals who are supposed to provide checks & balances in the private sector, and public policy. So far there has been considerable movement in two of these areas, but much to be done in the other two. Americanization of Finance requires a radical rethinking of the balance between formal regulation and more sophisticated, but also more informal supervision. We in the United States are still struggling to strike that balance effectively.
Corporate governance
In too many instances there has been a complete failure by members of corporate boards of directors to exercise their prescribed “duty of care”. They were too often servants of a powerful, or at least bullying, CEO, too rarely servants of investors. Members of Audit and Compensation Committees were especially subservient to inside management. But all board members seem to have shown no sense of personal accountability for the misdeeds of the companies which they governed. There was no formal lead director to provide leadership. Too many board members were other CEOs, with much dirty linen of their own to hide. Too many were simply pals of the CEO, without allegiance to any other stakeholder. Fixing this will require many changes. The supervisory board concept, long scorned in the US, needs to be reconsidered. The successful example of FIRREA, which legislated personal accountability for directors of depository institutions, needs to be emulated for all public companies. Some have proposed separate elections for Audit Committee members to enhance their independence from the rest of the board. So far, little or nothing useful has been done voluntarily by corporate America, apart from some brave souls who have decided to expense options. But that just scratches the surface and deals with a symptom, not the disease, which is a lack of incisive questioning of CEO behavior. After all that is the most important thing a board does: choose the CEO and evaluate his/her performance – not just to be a cheering section or public relations image-maker.
Financial institutions practices
Booms lead to diminished vigilance, complacency, sloppy thinking, hero worship, and subservience. More so on Wall St. than anywhere else, except perhaps Washington DC. Wall St. analysts are not to be trusted. Maybe once they were, but they have lost that respect. They became mainly the channel for creating buying clubs. They are just the most visible and highly publicized part of a system that has serious flaws.
But the institutional investor community has no cause for self-righteousness. They either knew and were willing to play along for the big ride or didn’t know and were either ignorant or lazy. This carelessness aggravated the problem and allowed the securities industry to lose its integrity. Who was criticizing the analysts when 98% were publishing buy recommendations? A few grumpy old men who were ridiculed as has-beens.
Naturally the investment banking connections with companies assessed by what should be objective critics created questionable conflicts of interest. Maybe even illegal conflicts, but that has yet to be proved in court.
Meanwhile, lenders also failed to do appropriate due diligence. There was poor stress testing, although many patted themselves on the back for their superior risk management systems, which in retrospective were primarily backward-looking and sterile. They certainly didn’t catch many of the huge looming bankruptcies. [Half of the largest US bankruptcies in the past quarter-century have been in the past three years.]
When an analyst or investor really doesn’t understand how a company makes money, the implication is don’t invest/lend. Rarely were they humble enough to admit they didn’t understand. Plus, when companies say they make money but then don’t pay any taxes, most people would raise a red flag: somebody is being deceived. But too many times such an anomaly was handwaved away. By the way, the old guard predicted what would happen when Glass-Steagall was abolished – the competitive pressures that would emerge as commercial banks strived to get into the lucrative investment banking business and the lowering of standards and forbearance that would result. Naturally those critics were dismissed as out-of-date or out-of-touch. But they were prescient.
Inadequate Checks and Balances
Who are the providers of checks and balances? Outside auditors. Lawyers. Journalists. All those who are professional critics, the people who are supposed to ask the tough questions. Many failed miserably, as now admitted by senior partners of accounting and law firms, and top editors of the business press.
One of the lessons from the scandals is that consulting and auditing don’t mix well. But few examples have been given to prove how sordid it had become. Consultants are highly paid. Auditors aren’t. So they aspire to be consultants in their firms. Does that make them more or less eager to raise questions about a device, gimmick, or accounting judgment that their consulting division colleagues have crafted for an important client? By the way, this is a weakness of the human condition, not a deformity in US or English-speaking character.
Of course, behind it in the US case is the entire edifice of GAAP accounting, once praised (perhaps a eulogy would have been more appropriate) as one of the bedrock strengths of the US capitalism by a former high US Government official. It may have some virtues, compared to other systems. But it is too complicated and too easily gamed. And too dependent on experts to referee the games. What’s worse is when the partners of the referees are drawing up the plays.
What must be done to fix all this? Simplify. And clarify the role of the legal community and the SEC in overseeing the overseers. At least that much will be done because it is now mandated. But a lot more has to be done to stop companies, even basically honest ones, from hiding behind highly legalistic footnotes and arcane explanations that are so ambiguous that even the experts disagree on what they mean. The SEC has mandated plain-language prospectuses for the mutual funds industry, which deals every day with the average citizen-investor. It can do no less for public financial reporting.
Public policy
Congress has been dismal in its performance over the past decade. It probably wouldn’t have done anything after Enron, except for the WorldCom travesty. That scandal couldn’t even be dignified under the category of “complex”. They simply capitalized expenses that freshmen accounting students at the lowliest community college are told is forbidden. Several of their executives entered guilty pleas and are already in jail. Out went the silly argument that Enron was a special case and that most companies are Simon pure. But it took an unknown state attorney general in NY by the name of Elliot Spitzer to blow the lid on Wall St. corruption. After he went after Merrill Lynch and soon after Salomon Smith Barney [now entitled Citigroup Capital Markets] and others, he was ridiculed by many in an organized campaign to impugn his motives and his IQ. But he persevered. It set the stage for Sarbanes-Oxley, which would have never passed in anything like its present form. Now of course that legislation is being ridiculed for not changing much. What a preposterous notion! If it was so limp, why did the industry virtually fall all over itself trying to stop it?
Market implications
Investors believe, rightly or wrongly, that all participants – companies, their boards, their auditors, their legal counsel, their government regulators – will push for more conservatism in defining and reporting earnings. That means profits forecasts will be scaled back. And, according to Fed Chairman Greenspan’s analysis, that has kept the stock market from mounting a dynamic recovery and also deterred the executives of many corporations from increasing their capital expenditures. There is no way of proving whether this analysis is correct. But the one thing many agree on is that in time, stronger corporate governance, more honesty in the numbers, and the return of adequate checks and balances are all investor friendly. Getting there has not been trouble-free, however.
In The Closing of the American Border, Edward Alden goes behind the scenes to tell the story of the Bush administration’s struggle to balance security and openness in the wake of the September 11, 2001, terrorist attacks.
In Termites in the Trading System, Jagdish Bhagwati reveals how the rapid spread of preferential trade agreements endangers the world trading system.
America Between the Wars explores how the decisions and debates of the years between the fall of the Berlin Wall and the collapse of the Twin Towers shaped the events, arguments, and politics of the world we live in today.
Complete list of CFR Books.
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