Y.V.S.KALYAN ARS

7/27/2019 Y.V.S.KALYAN ARS

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HOW TO MAKE FINANCE

WORK

- Robin Greenwood and

David S. Scharfstein

Y.V.S.KALYAN

PGDM-BIFAASB6161/22


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Robin Greenwood is the George Gund

Professor of Finance and Banking. He is a

Faculty Research Associate at the National

Bureau of Economic Research and an

associate editor at theReview of Financial

Studies.

David S. Scharfstein is the Edmund

Cogswell Converse Professor of Finance

and Banking at Harvard Business

School. Scharfstein is a Research

Associate of the National Bureau of

Economic Research.

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The U.S. financial sectors share of GDP grew from less than 5% in 1980

to more than 8% in 2007the largest share in any advanced economy

The industry was transformed from a sleepy old boys club to a dynamic

business that attracts the best and the brightest.

The financial sector exists to serve the needs of U.S. households and firms

The sectors performance has been beneficial to some, in particular the US

Corporations.

Simultaneously the Industry resulted in unhealthy ways which had a

negative impact on US economy.

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There are 3 main problems:

1) The financial system is less stable than was 30 years ago

2) The financial sector has steered trillions of dollars into real estate,

away from more productive investments

3) The cost of professional investment management is simply too

high.

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Successes

The key functions of a financial system is to facilitate household andcorporate saving, to allocate those funds to most productive use,

manage and distribute risk.

Recent research has shown that economies with well developedfinancial systems grow reliably faster than those in which finance

plays a smaller role.

In US corporations got easy access to debt and equity markets.

Venture-capital-backed entrepreneurs have also put pressure on

existing firms to adapt their business models and to innovate.

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With the development of U.S. capital markets suggests that

The percentage of firms that go public with negative earnings has

jumped dramatically, demonstrating the willingness of the U.S.

capital markets to bet on new ideas.

Example: Financing R&D

Forty years ago, the U.S. government and private industry made

roughly equal contributions to R&D.

Now private industry funds approximately four times as much

R&D as the governmentan indication that the financial sector is

steering capital toward new ideas.6/22


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FINANCIAL

FAILURES

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Failuresand How to Address Them

Despite the successes outlined above, the U.S. financial system has had

difficulties in

Managing and distributing risk

Allocating capital

Facilitating low-cost savings

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FINANCIAL

INSTABILITY9/22


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Financial instability

What changes made the financial system so vulnerable?

Growth of securitization

This was fueled by significant flaws in the credit ratings process,

which resulted in a breakdown in the quality of securitized loans.

The critical functions of banking were provided by players otherthan traditional deposit-taking banks.

The growth of nonbank financial firms and investment vehiclesfrom Wall Street broker-dealers to Fannie Mae, Freddie Mac,insurance companies, hedge funds, and money market mutualfundscreated a shadow banking system.

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The financial crisis revealed at least three significant weaknesses of

shadow banking and the broader financial system.

1. The amount of capital that regulators required the shadow banking

system to hold against securitized credit risk was lower than the

amount banks were required to hold.

2. The entities involved in shadow banking were tightly connected to

one another and to the traditional banking sector. Those links

created considerable risks that were poorly understood before the

crisis.

3. The shadow banking system turned out to be vulnerable to the same

kind of bank runs that plagued traditional banks prior to the

establishment of deposit insurance. 11/22


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Increasing capital requirements, which regulators have agreed to do,

would go a long way in stabilizing the Financial Status.

Limiting the extent to which financial firms can fund long-term

assets with short-term liabilities.

Placing stronger safeguards on the largest financial institutions

would be an important measure to promote stability.

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HOUSING

FINANCE

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Housing finance

Fannie Mae, Freddie Mac, and the Federal Housing Administrationimplicitly or explicitly guaranteed more than half of all outstanding

home mortgages in the years before the financial crisis.

The excess allocation of capital toward housing diverted resources

from potentially more productive uses.

When home values appreciated, households borrowed against their

equity to finance consumption.

The United States has been an outlier in its support ofhomeownership through both government policy and private-sector

activities

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Rising house prices put a damper on homeownership rates, reducedhousehold savings rates, and left households vulnerable to economic

adversity

The leading proposals for housing finance reformsupported by a

coalition of the financial services industry, the real estate industry,

and consumer advocatesfocus on keeping mortgage credit cheap

and available and call for government to play a critical role in

achieving that goal.

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The long term goal of Housing finance reform should be to promotefinancial stability and proper allocation of capital.

The industry should focus on designing securities that deliver the

fundamental promise of securitizationenhanced liquidity anddiversification of riskand not on those that arbitrage gaps inregulation.

Once the government steps back from guaranteeing most new

mortgage credit, private securitization of mortgage credit can andshould return.

The details of how to regulate housing finance are to be worked out.

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How to address this problem?


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INVESTMENT COSTS

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Investment costs

The asset management and securities industry grew from 0.4% of

GDP in 1980 to 1.9% in 2006.

This reflects growth in financial assets and in the share of those

assets that are managed professionally. It also reflects the industrys

high fees.

Fees are assessed on the basis of a funds overall performance rather

than on relative risk-adjusted performance.

High investment fees affect U.S. competitiveness chiefly by

distorting the allocation of talent. Among employed 2008 graduates

of Harvard College, 28% went into financial services, compared

with about 6% from 1969 to 1973.18/22


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According to a study by Thomas Philippon of New York University

and Ariell Reshef of the University of Virginia, in 1980 a financialservices employee typically earned about the same wages as hiscounterpart in other industries; by 2006 he was earning 70% more.

But if investment fees is too high, then finance is inefficiently

draining talent from other industries, hampering overall productivitygrowth

Institutional investors, corporations, and financial firms pay highcosts to trade in many over-the-counter markets for corporate bonds

and derivatives, where prices are quoted by individual brokers andgetting information can be expensive.

This gives brokers a degree of pricing power, allowing them tocommand higher spreads from trading.

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Investment costs are unlikely to fall overnight

Nevertheless, they can be reduced by making fees more visible so

that financial firms can better compete on them.

For most households, asset management should be a utilitylow

cost and reliable.

The broad principle underlying both proposals is that asset managers

should compete on the true value of the services they provide.

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Aspects of the financial sector have distorted the allocation of talentand capital and have left the economy vulnerable to crisis.

Since Financial Sectors contribution to the GDP plays a significant

part, utmost care has to be taken in order to see that Financial Sector

is performing well without any loopholes.

In the end, the financial sector should be judged not on its

profitability and size but on how well it promotes a healthy, more

competitive economy over the long term.

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Thank You22/22

Y.V.S.KALYAN ARS

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