Survival of the Fittest: An Evolutionary Theory of Financial History. Turin, December 14, 2007

Transcription

1 Survival of the Fittest: An Evolutionary Theory of Financial History Turin, December 14, 2007

2 Tony Ryan said it Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others." (Assistant Secretary of the Treasury for Financial Markets Anthony W. Ryan before Congress in September 2007)

3 Goldman Sachs said it The Evolution of Excellence conference in London, November 2005

4 Thorstein Veblen tried it the economic life process [is] still in great measure awaiting theoretical formulation Why is Economics Not an Evolutionary Science? Quarterly Journal of Economics (1898)

5 Some economists have tried it Alchian, A.A. (1950) Uncertainty, evolution and economic theory. Journal of Political Economy 58: Nelson, R.R. and Winter, S.G. (1982) An evolutionary theory of economic change. Harvard University Press, Cambridge, MA

6 But Hilferding still rules The legacy of Rudolf Hilferding s Finanzkapital (1910) Concentration and consolidation in financial services as an inexorable process of exploiting economies of scale and scope

7 An evolutionary process? Evolution as seen by Citigroup

8 A real evolutionary process Evolution as seen by Nature

9 The evolutionary analogy Genes institutional memory of business practices Potential for spontaneous mutation innovation Competition for finite resources customers, clients Mechanism for natural selection through the market allocation of capital and human resources and possibility of death in cases of under-performance (differential survival) Scope for speciation and hence sustained biodiversity Scope for extinction

10 The differences (part 1) When one organism ingests another in the natural world, it s just plain eating; in finance mergers and acquisitions can lead directly to mutation In finance, there s no counterpart to the role of sexual reproduction in the animal world mergers aren t sex In finance, most mutation is conscious innovation, rather than random change (so it s a Lamarckian not a Darwinian process)

11 Commercial banking Internet/direct banks Telephone/direct banks Shareholder owned private banks High-end private and merchant banks Commercial banks Full service retail and commercial banks ` Bancassurance Monoline consumer finance and mortgage Subsidiaries of major conglomerates Shareholder owned savings and loans Not for profit savings and loans Government owned deposit takers

12 Investment banking Boutique / specialist investment banks Universal bank divisions Shareholder owned investment banks Privately owned merchant banks Boutique investment managers Alternative investment managers Private equity houses Marketplace / exchange

13 A decade of financial innovation Instruments Mortgage-Backed Securities Other Asset-Backed Securities Collateralized Debt Obligations Collateralized Loan Obligations Derivatives Institutions Hedge funds Private equity Sovereign wealth funds Conduits Strategic Investment Vehicles (SIVs) Bond insurers

14 Asset backed securities 4,000 3,500 Mortgage-backed and asset-backed securities in the U.S. 3,000 2,500 2,000 1,500 1, ,500 Ginnie Mae Fannie Mae Freddie Mac 2,000 1,500 1, Auto Credit Card Equipment Home Equity Manufacturing Student Other

15 450, , , , , , , ,000 50,000 0 Derivatives Over-the-counter derivatives outstanding Interest rate contracts Foreign exchange contracts Equity-linked contracts Commodity contracts CDS Other 1987 Notional Amount Outstanding($ BN)

16 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 New entrants Number of financial institutions in selected developed countries Commercial Banks Savings Banks Mutual & Cooperative Banks Mutual funds Hedge funds

17 The first hedge fund was set up in the 1940s to allow savvy investors to bet against stocks by taking socalled short positions. The Long Term Capital Management debacle didn t stem the rise

18 The environmental analogy Exogenous shocks can radically alter the evolutionary environment, rendering certain evolved traits disadvantageous where previously they had been advantageous, and vice versa Financial disruptions (like the Great Depression of the 1930s or the Great Inflation of the 1970s) are like the asteroid strikes and ice ages that periodically intervened in the evolutionary story of life on earth

19 200, , ,000 Deposit insurance US$ 5,000 4,500 4, , , ,000 80,000 60,000 40,000 20, ,500 3,000 2,500 2,000 1,500 1, The last great dyings Bank failures in the United States : The Great Depression : Savings & Loans Number of bank failures Deposit insurance limit Bank failures

20 Is it happening again?

21 The American crisis $60bn of write-downs so far acknowledged by world s leading banks But total subprime-related losses could exceed $300bn Total risky debt losses could exceed $800bn* Collapse of issuance of ABS, CDOs Commercial paper outstanding declined $10.2bn last week; asset-backed CP declined $23bn Losses worst for US bond insurers (48% of paying resources), insurance cos. (2.4% of total assets) and US commercial banks (2.2%) *Subprime assets+other MBS+Leveraged loans+other ABS+Corporate liabilities (Bridgewater)

22 Survival of the fittest Estimated gross investments of the five largest funds amount to around $100bn Altogether, hedge funds now account for between one-third and a half of all trading in the US and UK equity and bond markets Example: Citadel buys E*Trade s $3.1bn ABS portfolio for cents on the dollar

23 The differences (part 2) In the natural world, there are no regulators; in finance there is intelligent design (?) Regulators focus on consumer protection and systemic risk but may impede natural selection by their actions

24 A penultimate word from Joe This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted. Creative destruction means the disappearance of those firms which are unfit to live. (Joseph Schumpeter)

25 It really is Darwinian (or, rather, Lamarckian) out there The key to survival lies not just in being able to eat the weak, but in being prepared to mutate and even to speciate The possibility of extinction should not be removed by excessively precautionary regulation Conclusions