HOW TO MAKE FINANCE WORK

- Robin Greenwood and David S. Scharfstein

Y.V.S.KALYAN PGDM-BIFAAS 1/22 B616

• 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 the Review 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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households and firms • The sector’s performance has been beneficial to some. financial sector’s share of GDP grew from less than 5% in 1980 to more than 8% in 2007—the 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.S.• The U. in particular the US Corporations. 3/22 . • Simultaneously the Industry resulted in unhealthy ways which had a negative impact on US economy.

4/22 3) .There are 3 main problems: 1) 2) The financial system is less stable than was 30 years ago The financial sector has steered trillions of dollars into real estate. away from more productive investments The cost of professional investment management is simply too high.

• Recent research has shown that economies with well developed financial systems grow reliably faster than those in which finance plays a smaller role. 5/22 . to allocate those funds to most productive use.Successes • The key functions of a financial system is to facilitate household and corporate saving. • Venture-capital-backed entrepreneurs have also put pressure on existing firms to adapt their business models and to innovate. • In US corporations got easy access to debt and equity markets. manage and distribute risk.

• Example: Financing R&D • Forty years ago. capital markets suggests that • The percentage of firms that go public with negative earnings has jumped dramatically.S. government and private industry made roughly equal contributions to R&D. the U. 6/22 . • Now private industry funds approximately four times as much R&D as the government—an indication that the financial sector is steering capital toward new ideas. demonstrating the willingness of the U. capital markets to bet on new ideas.S.S.With the development of U.

FINANCIAL FAILURES 7/22 .

S. the U.Failures—and How to Address Them • Despite the successes outlined above. financial system has had difficulties in • Managing and distributing risk • Allocating capital • Facilitating low-cost savings 8/22 .

FINANCIAL INSTABILITY 9/22 .

insurance companies. • The critical functions of banking were provided by players other than traditional deposit-taking banks. 10/22 . Freddie Mac. and money market mutual funds—created a “shadow” banking system. hedge funds. which resulted in a breakdown in the quality of securitized loans.Financial instability What changes made the financial system so vulnerable? • Growth of securitization • This was fueled by significant flaws in the credit ratings process. • The growth of nonbank financial firms and investment vehicles— from Wall Street broker-dealers to Fannie Mae.

The financial crisis revealed at least three significant weaknesses of shadow banking and the broader financial system. The entities involved in shadow banking were tightly connected to one another and to the traditional banking sector. The shadow banking system turned out to be vulnerable to the same kind of bank runs that plagued traditional banks prior to the 11/22 establishment of deposit insurance. 3. 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. Those links created considerable risks that were poorly understood before the crisis. 2. 1. .

• Placing stronger safeguards on the largest financial institutions would be an important measure to promote stability. 12/22 . • Limiting the extent to which financial firms can fund long-term assets with short-term liabilities. would go a long way in stabilizing the Financial Status.• Increasing capital requirements. which regulators have agreed to do.

HOUSING FINANCE 13/22 .

and the Federal Housing Administration implicitly or explicitly guaranteed more than half of all outstanding home mortgages in the years before the financial crisis.Housing finance • The United States has been an outlier in its support of homeownership through both government policy and private-sector activities • Fannie Mae. Freddie Mac. • When home values appreciated. • The excess allocation of capital toward housing diverted resources from potentially more productive uses. households borrowed against their equity to finance consumption. 14/22 .

and consumer advocates—focus on keeping mortgage credit cheap and available and call for government to play a critical role in achieving that goal.• Rising house prices put a damper on homeownership rates. and left households vulnerable to economic adversity • The leading proposals for housing finance reform—supported by a coalition of the financial services industry. the real estate industry. 15/22 . reduced household savings rates.

How to address this problem? • The long term goal of Housing finance reform should be to promote financial stability and proper allocation of capital. • The details of how to regulate housing finance are to be worked out. 16/22 . private securitization of mortgage credit can and should return. • The industry should focus on designing securities that deliver the fundamental promise of securitization—enhanced liquidity and diversification of risk—and not on those that arbitrage gaps in regulation. • Once the government steps back from guaranteeing most new mortgage credit.

INVESTMENT COSTS 17/22 .

18/22 .S. Among employed 2008 graduates of Harvard College. 28% went into financial services. compared with about 6% from 1969 to 1973.4% of GDP in 1980 to 1.Investment costs • The asset management and securities industry grew from 0. • Fees are assessed on the basis of a fund’s overall performance rather than on relative risk-adjusted performance.9% in 2006. • High investment fees affect U. It also reflects the industry’s high fees. • This reflects growth in financial assets and in the share of those assets that are managed professionally. competitiveness chiefly by distorting the allocation of talent.

• This gives brokers a degree of pricing power. where prices are quoted by individual brokers and getting information can be expensive. • But if investment fees is too high.• According to a study by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia. 19/22 . by 2006 he was earning 70% more. allowing them to command higher spreads from trading. and financial firms pay high costs to trade in many over-the-counter markets for corporate bonds and derivatives. in 1980 a financial services employee typically earned about the same wages as his counterpart in other industries. then finance is inefficiently draining talent from other industries. hampering overall productivity growth • Institutional investors. corporations.

20/22 . they can be reduced by making fees more visible so that financial firms can better compete on them. asset management should be a utility—low cost and reliable.• Investment costs are unlikely to fall overnight • Nevertheless. • For most households. • The broad principle underlying both proposals is that asset managers should compete on the true value of the services they provide.

more competitive economy over the long term. utmost care has to be taken in order to see that Financial Sector is performing well without any loopholes.• Aspects of the financial sector have distorted the allocation of talent and capital and have left the economy vulnerable to crisis. • In the end. • Since Financial Sector’s contribution to the GDP plays a significant part. 21/22 . the financial sector should be judged not on its profitability and size but on how well it promotes a healthy.

Thank You 22/22 .

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