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Prof Lawrence Rose
2 December 07
Financial Literacy:  What’s the Buzz?

What is a basis point, and what does it have to do with changes in interest rates?  Should your savings be put into Kiwi Saver or into paying off a house mortgage? Should you be worried about the recent collapse of so many finance companies over the past 18 months?  What is an exchange rate and why does the New Zealand Exchange Rate change so much? Should I sell my Warehouse shares or buy more?

The understanding by the general public of the above questions, and many more are relevant to the functioning of a healthy economy and the economic wealth of individuals in it.  Yet, recent research highlights financial literacy among New Zealanders could be better and there is a need for a wider understanding of the importance of financial literacy in its more complex forms.  The most basic elements of understanding about finance include having the ability to calculate rates of return on investments and the interest rate on debt; an understanding of the risks or benefits of their financial decisions and the importance of budgeting to achieve financial goals like purchasing a home.  The more complex issues include answers to the questions I just raised.  Here I will focus on the freedom of firms to fail. To start, one must understand some subtle issues around markets.

Markets are strange arrangements of business activity.  If someone has an idea and decides to take a risk with either their own money, or preferably someone else’s, which turns out to be valued by consumers of the good or service, that person or organisation could end up making lots of money.  If, on the other hand, consumers decide they do not rate the good or service offered, a lot of money can be lost, often very quickly.

Now, of all the characteristics of capitalism, the freedom to fail, the way the market punishes unwanted behaviour, is the most important although the consequences are the most undesirable.  If those failing, or about to fail, can exert political or economic power to avoid failing, or in the event of failure shift the cost to others, they will certainly do it.  In a sense, that is what is happening during what I would call the current turmoil in global financial markets as there is a call for governments or central bankers to bail out failing financial institutions. But if this occurs, it most likely will result in a misuse of scare resources, reducing global growth in the long run and making the next turmoil event much worse. In the shorter term such actions will result in a transfer of money from taxpayers and debt holders to equity holders which also may result in the inappropriate use of available investment funds.

I do not wish to give the impression the current turmoil is not real, or even a threat to the stability of global financial markets.  As with any disruptions in our modern economic environment, where markets are now globally linked (whether we wish them to be or not), the situation could get out of hand if ignored or another severe shock occurs before the current one is sorted out. Sometimes the sorting out happens quickly, at other times it can take much longer. But what I am calling for is to take a step back, a cup of tea if you will, to see what is going on before implementing policies which may settle markets in the short term but make things worse in the longer term by subsidising private risk-taking with public assistance.

Losses in global equity and debt markets are not uncommon.  One can point to the 2001 dot com share market collapse where globally, trillions of dollars of value disappeared quickly.  In New Zealand we just “celebrated” the twenty year collapse of the share market which had a profound impact on this country for over a decade by some estimates. And of course there was the 1997 global share market collapse starting in the Asia-Pacific which took several years to resolve in several developing countries. 

The recent sub prime market turmoil is an interesting case in point about the fear of failure by many people.  This market is where existing house loans to relatively low quality borrowers (sub prime mortgages where high quality would be designated prime) are broken into pieces and repackaged into securities which are subsequently sold off to investors seeking high returns in the financial marketplace around the world.  A benefit is the release of funds which the financial institutions selling these loans can then use to make more home loans to those in a high risk category at reasonable interest rates. 

Is there something different about the current turmoil which started in the United States sub-prime mortgage market in August 2007?   In some sense, no. This crisis was similar to those in the past where someone took excessive risk per unit of expected return. Once participants in the marketplace realised that the risks being taken were under priced and acted to raise the price of risk those organisations and individuals were made to pay the real cost of their activities.  Many failed quickly. The ones which did not fail fast began to ask for government assistance and unfortunately had receptive ears in some governments and some commentators and were not made to pay the total price for their bad decision-making or opportunism. 

However, there were characteristics which made the current turmoil different from those in the past. If we understand those differences perhaps we can make sense of the situation and perhaps reduce the chance of repeating it in the future, whereby market participants see losses and react to those creating additional market volatility (risk) without understanding the total risk picture.  This lack of financial acumen leads on to escalation of risk and leakage into other unrelated markets.

What were the characteristics that lead to the current turmoil in financial markets?  In my opinion, there are at least four.  First, there was a long history of relative market calm, low inflation and under-priced exchange rates in developing countries, which led to excess liquidity (lots of surplus money) in the marketplace.  This in turn led to artificially low pricing of risk and large opportunities to make money with innovative products. 

So, second, the marketplace responded and new complex and exotic financial products were developed and marketed to investors.  Hedge funds and private equity products were just the latest of those new products to hit the financial marketplace.  By purchasing existing debt they allowed banks and other financial institutions to diversify risk and free up capital so they could do what they do best: analyse risk and underwrite debt.  But in the rush to meet the escalating demand by hedge fund and private equity investors, these institutions started to use risk models as a proxy for credit worthiness and risk ratings from third parties (Credit Rating Agencies) instead of doing the work themselves.  Added to that is the conflict of interest, which can be present in the use of risk ratings as often the Credit Rating Agencies are paid by the very firms they are rating.

Third, government regulators and central bankers act, through prudential regulation and provision of liquidity, to stabilise markets.  However, normally it is not their responsibility to evaluate and enforce management decisions.  As a result they are often reactive not proactive to market innovations.  Additionally, government actions had the effect of putting a cork into a bottle which was just shaken up and was ready to fizz.

Fourth, institutional differences changed the impact of the turmoil as it spread through global markets.  In the United States , it appears few guarantees from Banks were made to investors in the new products and bank subsidies which invested in them.  Further, the breakdown in liquidity was relatively minor, in comparison to Europe, as many banks could access the commercial paper market for additional liquidity, a market far less developed in Europe .  Further, right or wrong, the US Federal Reserve governor moved quickly to provide liquidity to the inter bank market while in Europe it took the European Community more time to react and in the UK the Chancellor of the Exchequer tried to hold the line initially and avoid subsidising private risk taking.  Eventually the pressure to act was overwhelming as the UK experienced a large bank failure.

So, what lessons can we glean from the current financial turmoil?  That was the very question a group of academics and industry experts asked themselves when they met in Copenhagen in early September to discuss the current financial turmoil.  These academics (including me as the New Zealand representative) were members of Shadow Financial Regulatory Committees of Asia, Australia-New Zealand, Europe, Japan , Latin America and the United States .  Their joint statement, issued on 10 September, 2007 made the following observations and recommendations:

1. A key weakness in the current period of financial turmoil is the linkage – through either explicit or implicit guarantees – between either conduits or special purpose investment vehicles and sponsoring investment banks and commercial banks. The activities of these conduits and vehicles are extremely complicated and opaque. 

2. In many new forms of lending, responsibility for analyzing and pricing loan risk is shifted to credit scoring programs and outsourced to credit rating agencies. These agencies do not share in losses caused by misjudgement, however. To restore investor confidence in the securitization process, loan originators must track the long term performance of their underwriting staff and establish systems of deferred compensation that make loan officers share the losses generated by borrower defaults. The Shadow Committees urge regulators and industry study groups to immediately address the incentive problems caused by outsourcing of risk assessment.  

3. The current turmoil on financial markets raises important questions with respect to the implementation of the Basel II capital adequacy framework for banks. The Basel Committee on Banking Supervision ought to re-evaluate the heavy reliance on ratings provided by credit rating agencies in the so-called Standardized Approach of Basel II. Moreover, the advanced Internal Ratings Based approach of Basel II, which allows large and sophisticated banks to use their internal risk models, needs to be re-examined. The recent turmoil revealed that these models performed poorly and underestimated the degree of risk exposure. The Shadow Committees urged the Basel Committee to conduct another quantitative impact study (QIS) using observations from the recent turmoil.

Returning to my financial literacy theme, the recent announcement that the New Zealand Shareholders Association is planning to promote basic education in finance across the country, with the backing of some of the country’s wealthiest businessmen was good news. However, wider efforts will be needed at the school and university level if significant increases in financial literacy are to be made over the next decades. This will necessitate contributions by government and the university sector in addition to the business sector.  For, if we are truly going to address uncertainty and confusion by participants in financial markets, which has the potential to reduce our global competitiveness, we must make sure financial literacy is high enough to understand the increasing complexity of the financial marketplace.   This includes anyone from school leavers on up.  A dynamic economy cannot afford to demand less from its participants.

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