The New Era of Financialisation
“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a 400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody”
James Carville, Advisor to Bill Clinton in The Wall Street Journal
James Carville, Advisor to Bill Clinton in The Wall Street Journal
The rise of the markets as one of the most important foundation of the liberal state in the late twentieth and early twenty first century will probably be seen by posterity as one of the interesting chapters in economic history for a number of reasons. The recurring crisis in the financial markets is but one of them. The financial crisis has led to a general increase in interest about the functional dynamics and nature of the financial world. The crisis has not only spawned widespread interest among the members of the academia but also among the general populace, who hitherto were not well versed in the intricacies of the global and national financial systems and processes. While this interest in an important component of our social and economic mortar deserves to be welcomed, a large part of the debate about issues related to finance are increasingly concentrated on issues related to its complexity as well as the triggers that led to the immediate collapse of the financial system in the western world. Increasingly, popular media seems to believe that the financial meltdown was a mere arrhythmic event rather than a structural malaise that has its origins in the nature and development of the financial system over the past three decades. Academic scholarship has often (though not always) overlooked the process of financialisation over the past three decades.
The precipitous fall and the unprecedented swiftness in the collapses in financial markets that occur with amazing monotony are symptomatic of the consequences of the process of financialisation. The events of the past three years clearly indicates that the regulatory framework may be either too slow to react to the challenges of the process of financialisation or may lack the ability to effectively police an increasingly complex system. The new financial order is marked by business models of financial institutions that are built on assuming ever larger amounts of leverage in order to increase returns. This paper attempts to analyse this process and the problems that it poses for the future for policy makers as well as the investment community.
As a generalisation, the process of financialisation may mean to refer to the growing spread and power of finance and esoteric financial products that have accompanied the growth of the market economy which lays greater emphasis on monetisation of various segments of our economic and everyday life. This growth of finance encompasses the world of corporate finance, national finances and personal finance. The business world has moved away from an era when the production of goods and exchange of commodities provided the greatest source of profits. Financialisation has led to a paradigm shift that now generates profits from the growing circuits of financial circulation rather than the traditional mode of corporate profits. The International Swaps and Derivatives Association (ISDA) has been observes that nearly 94 percent of the World’s Largest 500 companies now use derivatives of various hues.
Nation states are not far away in their use of complex financial instruments for a variety of purposes. The spread of the market has been aided by the growing deployment of advanced computing technologies in the financial markets.
The process of monetisation is now a part of everyday life in a large number of countries including India. Financialisation has enabled speculators to speculate not on real assets (as in the past) but instead on products that derive their value from an underlying asset which they may or may not own. Speculators can now buy tonnes of copper or most other commodities without actually taking physical possession of those commodities through financial derivative products. However, it is only in the last three years that the non-financial world seems to have learnt about some of its functional dynamics.
Origins and Growth of Financialisation
The origins of the process of financialisation may be re-constructed to the 1970s with the process gaining greater acceptance since the 1980s, especially with the growth of the process of asset securitisation. Asset Securitisation or structured finance, is used by the larger financial institutions to repackage their mortgage loan portfolio to free up their capital and increase lending. The first securitisation transaction undertaken in February 1970 when the US Department of Housing and Urban Development sold a securities backed by a portfolio of mortgage loans through the Government National Mortgage Association (that is now popularly referred to as Ginnie Mae). LiPuma and Lee trace the development of a new culture of financial circulation back to 1973 (Edward LiPuma and Benjamin Lee, Financial Derivatives and the Globalisation of Risk, Duke University Press, Durham, 2004).
The process of securitisation was in the early days largely confined to the housing (mortgages) loans. This process revolutionised the banking business, which for centuries was either considered ‘dull’ because banks essentially functioned as either lenders of money or at the most as money changers. The banks could profit only when they lent their capital cautiously and collected the interest and principle on these loans, thereby limiting the profit potential of the banks. That changed with the process of securitisation at it created a system where a loan (debt) is transferred from a lender (‘originator of the loan’ in finance parlance) to a special purpose vehicle (or SPV) and the originator issuing tradable debt securities to the buyers. These instruments are traded in the market place. The interest collected from the loan is deposited by the originator to the SPV at prearranged intervals. A natural corollary was the extension of the securitisation process from housing loans to various other loans that now includes commercial property, credit card debt, student loans, personal loans as well as all and sundry type of loans. The securities created through the process of securitisation now form the most important category of the debt markets – asset backed securities. The growth of the Asset Backed Securities (herein referred to as ABS) market was aided because often these securities though risky when the economic cycle turns down, carried a higher interest rate than the government bonds or other instruments in the markets.
The most significant advantage of the process of securitisation is that it enabled banks to free up their capital as the loans were securitised to investors leading to the availability of ever greater quantities of capital. Thus freed up capital was channelled to make further loans that enabled the creation of a culture of consumerism based on assuming more debt or to financial speculators. Since debt could be easily raised, the major beneficiaries were financial speculators who found that they could compound their returns many times by leveraging their own capital to make ever larger bets in the markets. This was clearly reflected in the gigantic proportions that the financial sector came to occupy in its contribution to the economy. In the USA (the largest economy in the world) the GDP share of the financial sector increased from 23 percent in 1990 to 31 percent in 2006 while, the share of the financial services industry in the corporate profits increased around 10 percent in the early 1980s to about 40 percent in 2006-07.
The most significant advantage of the process of securitisation is that it enabled banks to free up their capital as the loans were securitised to investors leading to the availability of ever greater quantities of capital. Thus freed up capital was channelled to make further loans that enabled the creation of a culture of consumerism based on assuming more debt or to financial speculators. Since debt could be easily raised, the major beneficiaries were financial speculators who found that they could compound their returns many times by leveraging their own capital to make ever larger bets in the markets. This was clearly reflected in the gigantic proportions that the financial sector came to occupy in its contribution to the economy. In the USA (the largest economy in the world) the GDP share of the financial sector increased from 23 percent in 1990 to 31 percent in 2006 while, the share of the financial services industry in the corporate profits increased around 10 percent in the early 1980s to about 40 percent in 2006-07.
The following chart provides an overview of the growth of the financial sector in various OECD countries:
The exponential growth in the financial sector was aided by the helping hand of a benign or even lax regulatory environment globally, especially the US Federal Reserve under Alan Greenspan. These new esoteric financial products are better known by their generic term, derivatives. One of the most successful investor in the contemporary period, Warren Buffett, who with prescience warned in 2003 that these derivatives as ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’. However, not all the derivative products are disastrous or lethal. Among the products that enabled rise of the financial sector are swaps, asset backed securities of various genres, collateralised debt obligations (CDOs), Credit Default Swaps and the most recent- Exchange Traded Funds (or ETFs). The importance of each of the above-mentioned product is that they have progressive enabled financial investors to gain ascendancy in almost all the segments of the economy. The rise of these extremely powerful money management firms which control large amounts of liquid capital have not only led to greater volatility in the marketplace but often threatens national governments at a time their greatest vulnerability. At its peak in 2007, the top 500 money management firms controlled US$64 trillion in assets.
The rise of new financial institutions over the last three decades aided the process of financialisation. During the early 1980s, there were very few financial institutions. They included registered Pension Funds, Developmental Financial Institutions, Endowments, and Mutual funds. Financialisation was accompanied by the rise of new types of financial players. By the end of the 1990s, Hedge Funds of various genres and Private Equity Funds were a part of the growing list of financial player. By the end of the last century, Sovereign Wealth Fund completed the cycle.
The growth of the derivatives has been exponential over the past three decades. Their growth was enabled in a large measure various American and European Governments decided that they due to their financial resource constraints increasingly forced many provincial and local governments to fend for their in order to meet their financing requirements since the 1990s. The need to reduce fiscal deficit, especially after the agreement to form the European Monetary Union with a common currency meant that these local and provincial governments increased turned to the banks or the bond markets in order to raise funds. The banks and financial institutions embraced derivatives, initially to hedge their credit and default risk, and later to expand their non-fee based trading incomes.
New Financial Instruments Compound the Power of the Market
A cursory glance at the statistics of the total market size of different components of the financial markets would is clearly instructive of the exponential growth of financialisation and the growing power of the market. However, it is a fallacy to claim that financial institutions form a closed oligopoly that work in tandem scouring the planet, destroying sovereign states and trampling upon national rights. While conspiracy theories abound, it is essential to understand the nature of the market: for every buyer there is a seller and in the end participation in the financial markets is always a zero sum game where for every winner there are one or more losers. However, the nature of capitalism is inherent in that for every winner there is often more than one loser. Financial sector funds are too incoherent as rarely work as organised syndicates because of investment/trading philosophy of a fund may differ substantially. The only commonality that they may have is their urge to profit under any circumstance, which however is motive that is common to every private enterprise.
The Bank of International Settlements (BIS) has pointed out that by June 2009, the global derivatives market boasted of a notional value of about US$605 trillion, down from their peak national value of US$683 trillion in June 2008. Interestingly, the total GDP of the world’s 191 countries by the end of 2008 was about US$60.5 trillions (World Bank estimate). The five biggest dealers (all commercial banks) earned nearly US$28 billion from the largely unregulated derivatives market in 2009. The global market for Swaps market comprised of the largest segment within the derivatives market. The aggregate notional value of the all forms of swaps increased from US$8.133 trillion in 1994 to US$414.09 trillion at the end of June 2009. with interest rate swaps accounting for the largest component.
The growth in the other segments of the financial markets is equally impressive, especially in the USA. The US 401(k) retirement plans now account for approximately US$2.7 trillion and is expected to increase to US$3.7 trillion by the end of 2014. while the mutual fund industry manages assets worth nearly US$10.97 trillion at the end of February 2010. The assets managed by the Global Pension fund industry (in the major 13 markets) had reached US$23 trillion and pension assets account for nearly 70 percent of the global GDP. The statistics for all the countries in the world are difficult to come by.
The growth of the derivatives has been exponential over the past three decades. Their growth was enabled in a large measure various American and European Governments decided that they due to their financial resource constraints increasingly forced many provincial and local governments to fend for their in order to meet their financing requirements since the 1990s. The need to reduce fiscal deficit, especially after the agreement to form the European Monetary Union with a common currency meant that these local and provincial governments increased turned to the banks or the bond markets in order to raise funds. The banks and financial institutions embraced derivatives, initially to hedge their credit and default risk, and later to expand their non-fee based trading incomes.
New Financial Instruments Compound the Power of the Market
A cursory glance at the statistics of the total market size of different components of the financial markets would is clearly instructive of the exponential growth of financialisation and the growing power of the market. However, it is a fallacy to claim that financial institutions form a closed oligopoly that work in tandem scouring the planet, destroying sovereign states and trampling upon national rights. While conspiracy theories abound, it is essential to understand the nature of the market: for every buyer there is a seller and in the end participation in the financial markets is always a zero sum game where for every winner there are one or more losers. However, the nature of capitalism is inherent in that for every winner there is often more than one loser. Financial sector funds are too incoherent as rarely work as organised syndicates because of investment/trading philosophy of a fund may differ substantially. The only commonality that they may have is their urge to profit under any circumstance, which however is motive that is common to every private enterprise.
The Bank of International Settlements (BIS) has pointed out that by June 2009, the global derivatives market boasted of a notional value of about US$605 trillion, down from their peak national value of US$683 trillion in June 2008. Interestingly, the total GDP of the world’s 191 countries by the end of 2008 was about US$60.5 trillions (World Bank estimate). The five biggest dealers (all commercial banks) earned nearly US$28 billion from the largely unregulated derivatives market in 2009. The global market for Swaps market comprised of the largest segment within the derivatives market. The aggregate notional value of the all forms of swaps increased from US$8.133 trillion in 1994 to US$414.09 trillion at the end of June 2009. with interest rate swaps accounting for the largest component.
The growth in the other segments of the financial markets is equally impressive, especially in the USA. The US 401(k) retirement plans now account for approximately US$2.7 trillion and is expected to increase to US$3.7 trillion by the end of 2014. while the mutual fund industry manages assets worth nearly US$10.97 trillion at the end of February 2010. The assets managed by the Global Pension fund industry (in the major 13 markets) had reached US$23 trillion and pension assets account for nearly 70 percent of the global GDP. The statistics for all the countries in the world are difficult to come by.
Any discussion on financialisation requires a special mention of two important ‘financial innovations’ of the recent years require special mention due to their profound impact on not only the financial world but also the real economy. These two recent innovations are (a) Credit Default Swaps and, (b) Exchange Traded Funds (ETFs). These are among the most important financial products that have the ability (and actually have) intimidated even national governments are Credit Default Swaps (CDS). Though they were designed as a form of insurance protection against default by companies and countries, they are increasingly used by those who have no ‘insurable interest’ to take speculative directional calls on companies/countries. A Credit Default Swap pays the buyer insurance coverage (usually on a contract covers a tranche of US$10 million of debt issued by a company or a country) in case of default, while the buyer gains an annual payment (like an insurance premium). A CDS contract is valid for five years. These Credit Default Swaps, like most of the other esoteric products are not exchange traded and are instead traded privately among two parties based on a written agreement. However, the one party can demand additional collateral in case it is deemed that the counter party’s balance sheet has materially altered. Those who purchase a CDS have an interest in the underlying company or country sink as they would get paid off in case of bankruptcy. It is akin to buying insurance on your neighbour’s house, thereby giving the buyer of the insurance an interest in the destruction of the neighbour’s house.
An Exchange Traded Fund (ETF) is yet another recent financial innovation. It is more of a modification of existing financial investment products. It would not be far from the truth to claim that these ETFs are partly responsible for the price volatility in a number of commodities, including food products. The first ETF was created in 1989 in Canada. The first ETF in USA was created in 1993 and they have grown exponentially since then. In the United States, the assets of these funds had grown to about US$890 billion by the end of October 2010. while they are one of the fastest growing categories amongst the financial assets in almost all parts of the world, including India. The benefit of an ETF is that it enables investors to bet on a particular commodity without actually taking physical possession of the commodity/security. The physical products are in turn held by trustees for a fee. In the more advanced markets, there are ETFs for almost any commodity and asset class, from abstruse products that represent nuclear energy to more common base metals or agricultural products.
Significance of Financialisation
Financialisation has changed the landscape of the world economy over the past decade. It would be a mistake to construe that the phenomenon a developed world feature and India is insulated from this trend. It has been pointed out that the trading on the Indian commodity exchanges has now reached nearly US$2.1 trillion – more than the Indian GDP, an indication that financialisation is an ongoing process even in India. ETFs are one of the fastest growing segments in the asset management business in India. It has been pointed out that exchange traded funds that trade in gold currently manage about Rs.2000 crores in India, while all the ETFs in India are estimated at approximately Rs.5,000 crores. The variety of the exchange traded funds is such that investors can trade in Hong Kong stocks by buying and selling on the Indian markets.
Technological change has only added to the significance of process of financialisation as it has led to an exponential increase in the participation in the financial markets leading to new challenges. Controlling activity in the financial markets has now become extremely difficult even for the regulators of nation states. Financialisation means that it has now become common place to take extremely large directional bets, often running into billions of dollars. This has resulted in billions of dollars of profits or losses . Large scale losses invariably lead to bankruptcy of not only the firm(s) involved but also systemic losses.
Financial derivatives are now a big source of income for most of the major banks thereby limiting the scope for government’s to regulate them. It has been pointed out that the biggest derivatives dealers generate revenues of US$40 billion a year from over-the-counter derivatives . Such profits for the big banks mean that they would be specially protective and would bring pressures on any government that intends to regulate the business. This growth of the unregulated derivatives market poses the single biggest systemic risk for the world economy. The collapse of Lehman Brothers and AIG in September 2008 was largely due to their bets in the derivatives market.
An Exchange Traded Fund (ETF) is yet another recent financial innovation. It is more of a modification of existing financial investment products. It would not be far from the truth to claim that these ETFs are partly responsible for the price volatility in a number of commodities, including food products. The first ETF was created in 1989 in Canada. The first ETF in USA was created in 1993 and they have grown exponentially since then. In the United States, the assets of these funds had grown to about US$890 billion by the end of October 2010. while they are one of the fastest growing categories amongst the financial assets in almost all parts of the world, including India. The benefit of an ETF is that it enables investors to bet on a particular commodity without actually taking physical possession of the commodity/security. The physical products are in turn held by trustees for a fee. In the more advanced markets, there are ETFs for almost any commodity and asset class, from abstruse products that represent nuclear energy to more common base metals or agricultural products.
Significance of Financialisation
Financialisation has changed the landscape of the world economy over the past decade. It would be a mistake to construe that the phenomenon a developed world feature and India is insulated from this trend. It has been pointed out that the trading on the Indian commodity exchanges has now reached nearly US$2.1 trillion – more than the Indian GDP, an indication that financialisation is an ongoing process even in India. ETFs are one of the fastest growing segments in the asset management business in India. It has been pointed out that exchange traded funds that trade in gold currently manage about Rs.2000 crores in India, while all the ETFs in India are estimated at approximately Rs.5,000 crores. The variety of the exchange traded funds is such that investors can trade in Hong Kong stocks by buying and selling on the Indian markets.
Technological change has only added to the significance of process of financialisation as it has led to an exponential increase in the participation in the financial markets leading to new challenges. Controlling activity in the financial markets has now become extremely difficult even for the regulators of nation states. Financialisation means that it has now become common place to take extremely large directional bets, often running into billions of dollars. This has resulted in billions of dollars of profits or losses . Large scale losses invariably lead to bankruptcy of not only the firm(s) involved but also systemic losses.
Financial derivatives are now a big source of income for most of the major banks thereby limiting the scope for government’s to regulate them. It has been pointed out that the biggest derivatives dealers generate revenues of US$40 billion a year from over-the-counter derivatives . Such profits for the big banks mean that they would be specially protective and would bring pressures on any government that intends to regulate the business. This growth of the unregulated derivatives market poses the single biggest systemic risk for the world economy. The collapse of Lehman Brothers and AIG in September 2008 was largely due to their bets in the derivatives market.
Unlike in the past, trading activity now has a major impact on the real economy. The onset of instruments such as Credit Default Swaps tends to magnify problems, often due the changing perceptions of the traders rather than due to actual underlying fundamentals. The role that CDS’ played during the recent sovereign credit crisis in Greece has come under special scrutiny as speculators as well as others followed the prices in the CDS market. Unfortunately most of these markets are very thinly traded thereby amplifying their supposed impact. Infact during the recent Greek Crisis, on a number days the volume traded were less than US$100 million but a sharp rise in the cost of insurance meant that investors started panicking as they believed that Greece was on the verge of default. Hence in the present highly financialised world, there need not be an actual default, any perception of default is sufficient to create a run on a company or a country.
The New Year will witness the rise of new Exchange Traded funds in various base metals and agricultural products. The role of CDS in the recent Euro Zone problems is instructive of the future, where perceptions of problems will be enough to send the financial markets and with it the real economy into a tail spin. Increasingly the policy makers have to deal with the fast changing financial flows, which has emerged as the single most important segment. A lament by Jose Pablo Arellano (CEO, Codelco, the largest copper producer in the world owned by the government of Chile quoted in Reuters) sums it all: “Demand and supply of copper ... are not the only ones playing a role we have financial investors having an impact in the price. For that reason we are going to expect more volatility than we are used to in the short to medium term. Unfortunately, it is a long-term trend that may be hard to reverse.
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