Factors affecting the adoption of cryptocurrency

This paper examines factors affecting the adoption of cryptocurrency across 158 countries worldwide. To this end, we collected cryptocurrency adoption data from Chainalysis’s reports and macroeconomic data from the World Development Indicators platform. Đề tài Hoàn thiện công tác quản trị nhân sự tại Công ty TNHH Mộc Khải Tuyên được nghiên cứu nhằm giúp công ty TNHH Mộc Khải Tuyên làm rõ được thực trạng công tác quản trị nhân sự trong công ty như thế nào từ đó đề ra các giải pháp giúp công ty hoàn thiện công tác quản trị nhân sự tốt hơn trong thời gian tới.

Technology and Finance analyses the dramatic implications of technology for today’s

financial sector, for productivity growth and for monetary policy A wide range offinancial market activities are now technology driven; technology is also crucial inretail, private and corporate banking, and it has lowered entry barriers to the sector

New participants are flourishing as they are strongly supported by their technology

Distinguished keynote speeches in this volume were initially featured in the

latest highly-respected SUERF (Société Universitaire Européenne de Recherches

Financie`res) Colloquium The articles cover the following topics:

● The impact of technology on financial institutions – evolution or revolution?

● The relationship between technology and financial markets, including theimpact of ‘electronification’ on financial markets and deposit insurancesystems

● The real and potential impact of technology on productivity growth, and sible implications for economic growth, monetary policy and markets

pos-This volume represents the cutting edge of informed thinking on the implications

of, and possible problems with, modern technology on contemporary finance

Morten Balling is Professor of Finance at the Aarhus School of Business, Denmark.

He was president of the ASB from 1993–2001 and has been a council member of the

Société Universitaire Européenne de Recherches Financie`res (SUERF) since 1994.

Frank Lierman is Chief Economist at DEXIA Bank, Belgium A council

mem-ber of SUERF since 2000, he is also president of the editorial board of the Revue

Bancaire et Financie`re/Bank – en Financiewezen.

Andy Mullineux is Professor of Global Finance, and Director of the Global

Finance Research Group in the Department of Accounting and Finance at theBirmingham Business School, University of Birmingham His most recent publi-

cations include co-editing Finance, Governance and Economic Performance in

Pacific and South East Asia, and Economic Performance and Financial Sector Reform in Central and Eastern Europe.

Technology and Finance

1 Private Banking in Europe

Lynn Bicker

2 Bank Deregulation and Monetary Order

George Selgin

3 Money in Islam

A study in Islamic political economy

Masudul Alam Choudhury

4 The Future of European Financial Centres

Kirsten Bindemann

5 Payment Systems in Global Perspective

Maxwell J Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard, Francisco Solis and John Trundle

6 What is Money?

John Smithin

7 Finance

A characteristics approach

Edited by David Blake

8 Organisational Change and Retail Finance

An ethnographic perspective

Richard Harper, Dave Randall and Mark Rouncefield

9 The History of the Bundesbank

Lessons for the European Central Bank

Jakob de Haan

Routledge International Studies in Money and Banking

10 The Euro

A challenge and opportunity for financial marketsPublished on behalf of Société Universitaire Européenne de Recherches Financie`res (SUERF)

Edited by Michael Artis, Axel Weber and Elizabeth Hennessy

11 Central Banking in Eastern Europe

Nigel Healey

12 Money, Credit and Prices Stability

Paul Dalziel

13 Monetary Policy, Capital Flows and Exchange Rates

Essays in memory of Maxwell Fry

Edited by William Allen and David Dickinson

14 Adapting to Financial Globalisation

Published on behalf of Société Universitaire Européenne de Recherches Financie`res (SUERF)

Edited by Morten Balling, Eduard H Hochreiter and Elizabeth Hennessy

17 Technology and Finance

Challenges for financial markets, business strategies and policy makersPublished on behalf of Société Universitaire Européenne de Recherches Financie`res (SUERF)

Edited by Morten Balling, Frank Lierman and Andy Mullineux

Edited by Morten Balling, Frank Lierman

and Andy Mullineux

Technology and Finance

Challenges for financial markets, business strategies and policy makers

London and New York

29 West 35th Street, New York, NY 10001

Routledge is an imprint of the Taylor & Francis Group

 2003 editorial matter and selection, Morten Balling, Frank Lierman and Andy Mullineux; individual chapters, the contributors

All rights reserved No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photcopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

Technology and finance: challenges for financial markets, business strategies, and policy makers / edited by Morten Balling, Frank Lierman, and Andrew Mullineux.

p cm.– (Routledge international studies in money and banking ; 17) Includes bibliographical references and index

HG2974.T434 2002 332.1–dc21

2002026937

This edition published in the Taylor & Francis e-Library, 2004.

ISBN 0-203-22261-X Master e-book ISBN

ISBN 0-203-27707-4 (Adobe eReader Format)

(Print Edition)

M O RT E N BA L L I N G

PART I

GUY QUADEN

C H A R L E S G O O D H A RT A N D J O N DA N I E L S S O N

3 Technology and finance: challenges for financial markets,

D I D I E R R E Y N D E R S A N D J E A N - PAU L S E RVA I S

PART II

Contributions on technology and financial institutions 49

4 Technology and the new economics of banking:

DAV I D T L L E W E L LY N

5 The effects of technology on the costs and risks of

viii Contents

6 Consumer behaviour and the usage and adoption of remote

9 Competition and consolidation in the European

O L I V I E R L E F E B V R E

H A N S D E G RY S E A N D M A R K VA N AC H T E R

11 Where traders go when stock exchanges go virtual

V I V I E N L O A N D M I C H A E L H G ROT E

12 Electronic trading and its implications for financial systems 204

H E L E N A L L E N, J O H N H AW K I N S A N D S E T S U YA S ATO

PART IV

16 Market structure, innovation and the development of

P E T E R D S P E N C E R

PART V

A N T J E S TO B B E

S I E G F R I E D U T Z I G

19 International productivity differences: explanations

J O H A N VA N G O M P E L

2.1 Productivity growth: the long view 20

2.10 VaR on a 100mn Portfolio of the Hang Seng Index 1997 272.11 Real UK house prices and estimated loan-to-value ratios 312.12 Growth in real lending and simulated capital adequacy ratios 322A.1 Real lending and simulated capital adequacy ratios 38

5.1 Average spending per branch: big, small and medium-sized banks 735.2 Average spending per branch: savings banks and credit cooperatives 74

6.2 Six-cluster solutions and consumer behaviour matrix 102

7A.4 Expected development of employment in the coming five years 128

8.2 Kernal density estimation for GVA in European regions, 1980–95 1418.3 Kernal density estimation for population-weighted 144–145 RGVA in European regions, 1980–92

8.4 Centres, adjoining regions and the periphery, 1980–95 146

List of figures

List of figures xi

8.7 Kernel density estimation for employment in European 150 regions, 1980–92

8.8 Kernel density estimation for population-weighted employment in 151European regions, 1980–92

8.9 Employment in centre, adjoining and peripheral regions, 1980–92 1528.10 Correlation of employment across borders, 1980–92 1538.11 Kernel density estimation for efficiency in European 154 regions, 1980–92

8.12 Efficiency in centre, adjoining and periperal regions, 1551980–92

9.2 Integration and openness within the ‘Euronext’ view 169

11.2 Changes in the relative importance of pull factors 198

13.2 The market for overnight balances in a cashless society 25114.1 Non-cash payment instruments across countries (1999) 262

14.3 Cost of a giro transaction (constant 2000 a prices) 271

19.2 Productivity trend (private sector, average annual 353 increase, in %)

19.3 International differences in labour productivity 355 (total economy, per worker, in PPP)

19.4 Relative level of labour productivity (total economy, in 356PPP, USA = 100)

19.7 Regulation of the product and labour market (1998) 362

2A.1 Testing for the randomness of economic downturns: Poisson test 352A.2 Testing for the randomness of economic downturns: exponential test 35

6.1 Consumers’ acquisition of financial product by type of 94delivery channel

6.4 Measuring agreement between Ward’s method and the 100 K-means method

6.5 Six-cluster solution of the K-means cluster analysis with 101initial seed points from Ward’s method

7A.2 Extent to which changes in employment are caused by 125 increasing use of ICT

7A.3 Own-wage elasticities (mean of estimated elasticities 126 over time)

7A.4 Negative impact of ICT use on employment in the coming 126five years (in %)

8.1 Key characteristics of real gross value added and 139 employment in the financial sector, per country, 1980–95

8A.1 Description of Eurostat data for gross value added 157

at market prices (GVA mp) or at factor cost (GVA fc), per country,1980–95

1990–95

10.3 Impact of electronic trading systems on trading costs in 175Europe

List of tables

List of tables xiii13.1 Comparison of seigniorage and central bank expenses 247(1994) (% of GDP)

13.2 Consolidated balance sheets of the Eurosystem and of 250the MFIs in Euroland (May 2000)

13.3 Reserve deposits held at the central banks as a share 256

of total bank liabilities14.1 Critical mass for giro adoption in The Netherlands: 273alternative assumptions

14.2 Share of international transactions for selected EU countries 274

15.1 The estimated cost function and cost-share equations 29615.2 Own- and cross-price elasticities calculated at the overall 297 empirical mean of the cost shares

15.3 The elasticity of scale and elasticity of costs with respect 298

to electronic payments

explanatory variables in the analysis17.1 Growth sources in the EU and contribution of ICT sector 32517.2 Decomposition of euro area labour productivity growth 326

19.1 Acceleration in growth of labour productivity and 357 contributions in the USA

Helen Allen Adviser, Market Infrastructure Division, Bank of England, UK Morten Balling Professor, Department of Finance, Aarhus School of Business,

Denmark

Cláudia Costa Storti Economist, Banco de Portugal, Lisboa, Portugal Jon Danielsson Lecturer in Finance, Financial Markets Group, London School

of Economics, UK

Paul De Grauwe Professor, Centrum voor Economische Studiën, Katholieke

Universiteit Leuven, Belgium

Hans Degryse Economics Department, KU Leuvew, Belgium Marieke Donker Researcher, De Nederlandsche Bank, Amsterdam, The

Netherlands

Ignacio Fuentes Egusquiza Senior Analyst, Servicio de Estudios, Banco de

España, Madrid, Spain

Charles Goodhart Professor, Banking and Finance, London School of

Olivier Lefebvre Executive Vice-President, Member of the Managing Board,

Euronext NV, Brussels, Belgium

Gottfried Leibbrandt McKinsey and Company, Amsterdam, The Netherlands Frank Lierman Chief Economist, DEXIA Bank NV, Brussels, BelgiumList of contributors

List of contributors xv

Kjersti-Gro Lindquist Senior Advisor, Research Department, Central Bank of

Norway, Oslo, Norway

David T Llewellyn Professor, Department of Economics, Loughborough

University, UK

Vivien Lo Research Assistant/Lecturer, Institute for Economic and Social

Geography, Goethe-University, Frankfurt/Main, Germany

Andy Mullineux Professor of Global Finance, Department of Accounting and

Finance, University of Birmingham, UK

Ralf-Henning Peters Assistant Professor, Department of Economics,

Otto-von-Guericke, University of Magdeburg, Germany

Guy Quaden Governor, National Bank of Belgium, Brussels, Belgium Didier Reynders Minister of Finance, Brussels, Belgium

Teresa Sastre de Miguel Senior Economist, Servicio de Estudios, Banco de

España, Madrid, Spain

Setsuya Sato Head of Special Meetings, Bank for International Settlements,

Siegfried Utzig Director Economics, Capital Markets, Bundersverband

Deutscher Banken, Berlin, Germany

Mark Van Achter Economics Department, Katholieke Universiteit Leuven,

The editors and the publishers gratefully acknowledge permission to reproducecopyright material from the following:

Nomos-Verlag, Baden-Baden, for permission to reprint several graphs from

vol-ume 58 of the ZEW-Wirtschaftsanalysen in Chapter 7 of this volvol-ume:

‘Employment perspectives in the German financial services industry and theimpact of information technology’ by Ralf-Henning Peters and Peter Westerheide

Ralf-Henning Peters acknowledges financial support by DeutscheAusgleichsbank Bonn

Journal of Financial Regulation and Compliance Volume 10, Number 1

(2002) for permission to reprint Guy Quaden, ‘Central banking in an evolvingenvironment’ as Chapter 1 of this volume This article is reproduced with the per-mission of Henry Stewart Publications (HSP), 25 Museum Street, London WC1A1JT

Every attempt has been made to obtain permission to reproduce copyright ial If any proper acknowledgement has not been made, we would invite copyrightholders to inform us of this oversight

mater-Acknowledgements

The papers in this volume were presented at a colloquium jointly organized in

Brussels 25–27 October 2001 by the Société Universitaire Européenne de

Recherches Financières (SUERF) and the Belgian Financial Forum (BFF) The

theme of the colloquium was ‘Technology and Finance: Challenges for FinancialMarkets, Business Strategies and Policy Makers’ The authors illuminate a largenumber of important aspects of this theme Technology has important implica-tions for the earnings, costs, risks, competitiveness and location of financialinstitutions It affects the way securities transactions are carried out, the trans-parency of the markets, settlement activities and the structure of the exchangeindustry Technology changes payments systems and the framework for strategicdecisions in the financial industry and for monetary policy Financial supervisionand regulation must be adapted to new risks and new risk management methods

The book is organized in five parts Part I consists of three lectures from plenarysessions, Part II of contributions on technology and financial institutions, Parts IIIand IV contain respectively contributions on technology and financial markets and

on technology and payments Part V deals with technology and productivity

In the first chapter in Part I, Guy Quaden (Governor of the Bank of Belgium)

analyses the changes caused by technological innovation to the macroeconomicenvironment and in the financial sector Integration of new technology and dereg-ulation have both contributed to a reshaping of the financial landscape A moreopen, competitive and globalized financial market has emerged Not all financialinstitutions have understood how to take the new uncertainties and risks for finan-cial sectors into account Central banks have to provide monetary stability

Maintaining price stability is the primary objective of monetary policy The opment of e-money is now so important that e-money issuers should not escapereserve requirements Technological and financial market changes make it neces-sary for central banks to reassess the information content of many economicindicators An increasing number of central banks now complement their tradi-tional annual reports centred on monetary policy and macroeconomicdevelopments by another report focused on the theme of financial stability Newtechnology is also playing a crucial role in the development of secure and effi-cient payment and settlement systems Oversight of these systems has become akey function in modern central banking Finally, the more globalized financial

devel-Introduction

Morten Balling

market calls for a more globalized approach to supervision The monetary ity and the financial stability wings belong to the same bird.

stabil-In the second chapter, Professor Charles Goodhart and Jon Danielsson look at

risk from a time perspective Risk must be understood in the context of a shiftingand unpredictable world Credit risk of financial institutions and the need for pro-visioning for bad debts are affected by largely unpredictable business cycles

Indeed the term ‘cycle’ may be a misnomer Technology has an important impact

on trends in productivity, asset price movements and economic activity It is, ever, very difficult for private market participants and for financial regulators toestablish at which stage in the so-called cycle they are and when the next reces-sion will come Historically, there is very little sign of any constant regularity, orperiodicity, in the onset of recessions It is equally difficult for regulators or any-one else to determine quantitatively the extent of asset price misalignment

how-Hence, regulators should – in spite of these macroeconomic measurement lems – try to develop a system with counter-cyclical movements in the regulatoryvariables such as collateral requirements, loan-to-value ratios and minimum capi-tal requirements

prob-In Chapter 3, Minister of Finance Didier Reynders and Deputy Director of Cabinet Jean-Paul Servais look at the new challenges for European and national

regulations relating to financial markets The Belgian presidency of the EuropeanCouncil has decided to continue its work for the implementation of the proposals

in the Lamfalussy Report and the drafts concerning the prospectus directive, theprudential supervision directive, the insider trading directive and the draft regula-tion concerning mandatory use of IAS – International Accounting Standards, atleast as far as consolidated accounts are concerned The proposed directive oncollateral and financial guarantees is considered important in derivatives markets

Technological innovation has induced the development of a new licensing systemfor settlement and clearing institutions and formulation of rules concerning alter-native trading systems Finally, the Belgian presidency is in charge of preparing adraft directive concerning money laundering, considered as urgent since the ter-rorist attack of 11 September 2001

Part II consists of Chapters 4 to 8 and deals with the impact of technology onfinancial institutions

In Chapter 4, Professor David T Llewellyn argues that the new technology

causes changes in the underlying economics of banking in a rather fundamentalway New types of competitors enter the market for banking services Technologyaffects entry conditions, management methods, production processes and distrib-ution channels In response, banks will have to adjust the way they conduct theirbusiness, to make their delivery systems more efficient and to revise their organi-zational structures Appropriate responses can also be formation of joint ventures,outsourcing and subcontracting of some services One of the implications of thenew technology is that it has become unclear what the optimal financial organisa-tion and structure are Plurality can be expected in the financial industry Smallbanks are not condemned to disappear Technology offers alternatives to realizeeconomies of scale and creates the possibility to unbundle processes

In Chapter 5, Ignacio Fuentes Egusquiza and Teresa Sastre study the effect of

technology on the costs and risks of Spanish banks The spending on informationtechnology and telecommunications had a slightly different time pattern in com-mercial banks, savings banks and credit cooperatives respectively Due to theirstrong involvement in the interbank and government bonds markets, the Spanishcommercial banks had to adapt quickly to the new technical possibilities and tothe requirements derived from the implementation of a single currency

Investment in new technology and a trend towards remote banking reduces theweight of personnel costs in total operating costs of the commercial banks Costpatterns in savings banks and credit cooperatives have been somewhat different

These institutions have in fact increased their branch networks and the number ofemployees has grown Spanish banks have worked for some time to develop andimplement new risk control systems The new risks arising from electronic bank-ing is taken into consideration This work will continue in cooperation with theSpanish authorities

In Chapter 6, Professor Barry Howcroft investigates consumer behaviour in

connection with remote and direct banking He applies a two-dimensional matrix

of consumer behaviour in which the consumer’s confidence and involvement arecross-classified The data from a survey based on a questionnaire are analysed withapplication of cluster analysis The respondent customers are grouped in six clus-ters with different degrees of confidence in their financial institution and differentinvolvement in financial transactions An interesting result is that bank customerswith a relatively low income tend to prefer to use branch networks rather than tech-nology-driven and remote delivery channels This suggests that the least profitablesegments of the bank’s customer base have a predisposition to use the most expen-sive delivery channel In contrast, the most efficient and profitable customers arepredominantly using the most cost effective delivery channels

In Chapter 7, Ralf-Henning Peters and Peter Westerheide assess the

determi-nants and perspectives of employment in Germany’s financial services industry

In 1997, about 1.25 million people worked in the industry Their analysis showsthat employment in the financial services industry can be expected to decrease inthe coming years The decrease will in particular affect employees with a lowdegree of education For highly qualified personnel, growing employment can beexpected In an econometric time series analysis it is demonstrated that the differ-ent skill groups have been influenced in different ways by increasing use ofinformation and communication technology The results correspond with theresults of a survey among financial market experts

In Chapter 8, Iman van Lelyveld and Marieke Donker study the effects of new

information and communication technology on the location of financial activity

They investigate what they call the ‘Geography Doesn’t Matter’ hypothesis,which says that the production of financial services could take place anywhereand that the easier and cheaper communication means that geography has becomeirrelevant Financial activity is measured at the regional level as gross value addedand employment in the financial sector If the hypothesis is true, the distribution

of financial activity should become more even across regions during the period

(1980–95) covered by the data The authors find that, with some minor tions, there have not yet been large shifts in the regional distribution of productionand employment in financial services in Europe.

excep-Part III consists of Chapters 9 to 12 which consider the impact of cal change on financial markets

technologi-In Chapter 9, Olivier Lefebvre draws on his experiences from Euronext and

presents his views on competition and consolidation in the European exchangeindustry National exchanges compete in the primary market for listings, but thecompanies have so far been most interested in listing on the home marketexchange In the secondary market, exchanges compete for liquidity Since thedirect exchange cost represents a relatively small part of total transaction cost, it

is difficult for the individual exchanges to attract trading activity from otherexchanges In addition, the relative performance of the national exchanges is pri-marily explained by the performance of their national blue chips and not by thecompetitiveness of the exchanges as such In-house matching between the cus-tomers of big banks is potentially the most serious threat to the organizedexchanges in Europe Euronext recommends the establishment of a regulatoryenvironment in Europe with true pan-European exchanges and a level playingfield as objectives There should be a ‘single passport’ for exchanges giving themaccess to all fifteen jurisdictions Regulation should be carried out ‘by function’

All kinds of order matching services including in-house matching should be ulated according to the same rules A regulatory environment according to theseprinciples will provide the best framework for investor protection

reg-In Chapter 10, Hans Degryse and Mark Van Achter analyse the impact of

alterna-tive trading systems on transaction costs and liquidity Their paper was awarded theMarjolin Prize 2001 Alternative trading systems are defined as trading mecha-nisms developed independently from the established marketplaces and designed tomatch buyers and sellers on an agency basis In the USA, such systems have beensuccessful in attracting trade, in particular in the NASDAQ dealer market

Electronic communication networks have helped to lower trading costs cantly They have also improved the quality of markets Alternative trading systemshave not been as successful in European financial markets The authors explain this

signifi-by referring to the fact that traditional exchanges in Europe have created efficientelectronic trading facilities themselves earlier than their US counterparts Theymention also that several European markets are organized as auction markets

In Chapter 11, Michael H Grote and Vivien Lo look at the geographical

loca-tion of stock market trading Network externalities are remarkable features ofstock exchanges For each actor the utility of using the market increases when newparticipants join the market The larger the market share of a stock exchange, thehigher the probability that a new user will choose it Consequently, network exter-nalities and liquidity considerations have provided strong reasons for traders toconcentrate spatially, close to stock exchanges and financial centres The authorscall this ‘agglomeration effects’ The implementation of new information andcommunication technologies transform these centripetal forces Spatial proximity

to the market can be substituted by virtual proximity Agglomeration of traders and

exchange of market information can take place within electronic networks There

is, however, an important difference between straightforward information, which isreadily transferable via telecommunication, and complex information that is not

Location of traders has therefore not become irrelevant Face-to-face contact withanalysts has value Closeness to other traders and company insiders is important

Informal meetings can increase understanding It is consequently not easy to ject where traders will go when stock exchanges go virtual

pro-In Chapter 12, John Hawkins, Helen Allen and Setsuya Sato consider the

trans-formation of the economic landscape of trading venues caused by the adoption ofelectronic trading systems The new systems have implications for the architectureand quality of financial markets Ultimately, there are broader welfare implicationsrelated to efficiency and financial stability There are multiple, possibly compet-ing, public policy objectives along with uncertainties about the net effect ofchanges in markets and their transmission to broader welfare Regulatory agendasall over the world deal with issues related to electronic trading It must for instance

be decided whether or not the frameworks for regulation should continue to entiate between exchanges and non-exchange trading systems Another importantissue is the degree of detail and enforcement in transparency rules Authoritiesresponsible for financial system stability should adapt their policies to the fact thatnew and different firms are involved in the operations of financial markets withpossible implications for systemic risks

differ-Part IV consists of Chapters 13 to 16 which analyse the impact of cal change on payments systems

technologi-In Chapter 13, Cláudia Costa Storti and Paul De Grauwe analyse the

implica-tions of a cashless society for the conduct of monetary policy They try toestablish whether there will be a mechanism that ties down the price level and pre-vents systematic inflation Furthermore, they analyse whether and how the centralbank can be transformed so that it can maintain price stability in a cashless soci-ety They conclude that the central bank will lose its traditional instruments ofmonetary policy It might be relevant to redefine the role of the central bank Itssupervisory role could be strengthened The quality of the loan portfolios of pri-vate money-issuing institutions could be controlled by the central bank This kind

of supervision should also be expanded to issuers of e-money

In Chapter 14, Gottfried Leibbrandt studies trends in the use of payment

instruments There are still large differences among countries between the relativeroles of automated clearing, giro, credit cards, debit cards and cheques, respec-tively The differences have to a large extent historical reasons Electronicpayment instruments are significantly cheaper than paper-based instruments Thefee structure has a strong impact on the customers’ choice of payment instrument

In most of continental Europe, banks have a long tradition for cooperation in ters of payment networks The author tries to evaluate whether Europe will adopt

mat-a single compmat-atible giro- mat-and cmat-ard-system His expectmat-ation is thmat-at differencesbetween payment systems will persist for some years A pan-European paymentnetwork may be further off than most people think In spite of the introduction ofthe euro, for the time being ‘one size will not fit all’

In Chapter 15, Kjersti-Gro Lindquist analyses the importance of new payment

systems for the development in banks’ scale properties and input demand in theirproduction of loans and deposits The author estimates a four-factor translog costfunction and estimates the corresponding cost-share equations using Norwegianunbalanced bank-level panel data for the period 1987–98 The inputs are labour,physical capital, materials and funding The sum of loans and deposits is treated

as an aggregate output The results show that the increase in electronic paymentshas increased the elasticity of scale and decreased average variable costs in bank-ing The move towards electronic payment systems has affected input demandasymmetrically, i.e non-neutral, causing the cost-shares of both labour, physicalcapital and materials to increase, while the cost-share of funding has decreased

New electronic payment systems have particularly substituted out paper-basedand labour-intensive methods

In Chapter 16, Peter D Spencer tries to answer the question: Why have digital

cash systems failed to penetrate the payments market while electronic trading ofsecurities has been a success? The author compares different payment instrumentswith respect to their costs and risks The convergence of Internet, television andtelephone systems means, according to the author, that there is a huge digital mar-ket to be exploited Market contestability and customer switching costs play asignificant role Presently, entry, exit and switching costs are high in markets forpayment systems He criticizes the banks’ fee structures for being out of line withthe cost structure Zero-interest transaction accounts with low transaction chargesare common In the author’s view, regulators should pay careful attention to thepricing of transaction media The regulator should also try to ensure open marketsand minimization of switching costs in order to foster the development of digitalmoney

Part V consists of Chapters 17 to 19 which investigate the impact of logical change on productivity

techno-In Chapter 17, Antje Stobbe looks at the ‘new economy’ in a European context.

Different studies of US data have tried to explain the growth of labour ity partly as a reflection of spillover effects from increasing use of informationand communication technology The effect of higher investment in the new tech-nology on total factor productivity is, however, uncertain The author useshousehold data in order to illuminate the degree to which diffusion of informationand communication technology varies from country to country within Europe

productiv-The evidence shows that use of information technology correlates positively with

GDP per capita PC and Internet penetration is higher in the Nordic countries

than in the southern European region An empirical study from ECB based onEuropean data suggests that positive spillover effects from the use of informationand communication technology have only been limited if present at all

Significant new economy effects cannot be observed for the EU as a whole So farthe ‘new economy’ in Europe is more mirage than reality

In Chapter 18, Siegfried Utzig evaluates the role of innovations in information

technology for growth in productivity Researchers have to deal with difficultmeasurement problems How should one define output which involves a quality

dimension without reference to innovation? What exactly are the units of output

in banking? Unless the nature of the output can be defined precisely, it is sible to determine its rate of growth or to answer questions about the impact ofquality-enhancing innovations like those of communications technology The suc-cess of the new economy can only be assured by economic policy It should createentrepreneurial room and avoid conservation of existing structures that tend toobstruct the transition to the new economy In the USA confidence in marketforces led to deregulation in telecommunications and the flourishing of communi-cations technology companies Europe lags behind in this area The new economydoes, however, not require a new economic policy Both overestimation andunderestimation of productivity growth can lead to mistakes in economic policy

impos-What is really important, however, is to improve the general conditions for vation and entrepreneurship so that they can meet the challenges posed by thetechnological transition to the information society

inno-In Chapter 19, Johan Van Gompel discusses the extent to which the utilization

of technological progress in the production process is influenced by the tural-institutional characteristics of a country and which policy measures thegovernment can take (or must avoid) to allow innovating economic activities todevelop to the full He looks at productivity trends since 1960 In spite of a mas-sive increase in investment in the application of new technologies, the meanannual growth of total factor productivity fell in the OECD area from 1960–73 to1973–95 This so-called ‘Solow Paradox’ has several explanations One possibleexplanation is that it takes a considerable amount of time before new computertechnologies are fully disseminated Other possible explanations have been given:

struc-higher tax rates, stricter environmental regulations, and the development of socialsecurity systems have led to a more unfavourable business climate There are sig-nificant differences among countries In the 1990s, the growth in productivity wasrelatively rapid in the USA Some researchers explain this with a high level ofinvestment in information and communications technology, while otherresearchers estimate that a considerable part of the growth since 1995 is of acyclical nature The flexibility of the labour market is also important for macro-economic performance The EMU countries tend to lag behind the USA in terms

of dynamism and technological innovation

Part I

Survey lectures from plenary sessions

Ladies and gentlemen,

I am particularly pleased to speak before this eminent forum and to have theopportunity of addressing the topic ‘Technology and Finance’ from a centralbanker’s point of view

Technology and the challenges it raises for financial markets is a most priate theme for this colloquium On the one hand, technology is closelyintertwined with the evolution of many other factors affecting financial marketsand so allows coverage of a wide range of issues On the other hand, it has far-reaching consequences for all market participants, and this certainly includescentral banks In the first part I propose to briefly recall how technology hasimpacted on our macroeconomic and regulatory environment In the next twoparts I would like to sketch the main consequences of these developments on what

appro-my colleagues at the Bank of England have described as the two wings of centralbanking, i.e monetary and financial stability

Technology is a powerful factor of change in our macroeconomic environment.

So, a few years ago, our colleagues of the Federal Reserve had to recognize thatsomething new was happening in the US economy: a persistent higher growth andlower unemployment without the emergence of inflationary strains This wasrelated, at least partly, to the revolution in the information and communicationtechnologies, which increased productivity growth and fostered efficiency in thelabour market too A third feature of the so-called new economy, the reduction inthe variability of output growth, obviously proved to be short-lived! But a wave ofover-pessimism should not submerge the previous wave of over-optimism Thequestion whether the American economy is still on a higher trend productivitygrowth path remains open, as well as what the prospects for the European econ-omy are in this respect Europe will benefit from a specific driving force, thecompletion of the single market with the new single currency, which should trig-ger further structural reforms and hence foster innovative energies

Technology also radically transformed the financial sector, which by the way

greatly contributed to the new technological wave by financing it New techniques

environment*

Guy Quaden

* Keynote speech given at 23rd SUERF Colloquium, Brussels, 27 October 2001.

in the treatment, the storage and the transfer of information exerted profoundeffects on a sector which is largely an information-based industry

In a first stage, information technologies made it possible to develop moresophisticated products, to build up a better market infrastructure, to implementmore accurate and reliable techniques for the control of risks, to reach more dis-tant and diversified markets, and to multiply the value and the volume ofoperations In short, new technology has radically transformed all three majorfunctions performed by banks, i.e access to liquidity, transformation of assetsand monitoring of risks

A new phase is presently at work with the emergence of e-money, e-bankingand e-finance It is clearly this new development which will represent the greatchallenge of the coming years The speed of adoption of these new productsremains difficult to forecast Contrary to the preceding phase, this new wave isnot limited to professional operators but involves all customers, including theretail market Many of the scenarios suggested by IT firms or consulting groupshave proved to be overly optimistic At the same time, it would be wrong tobecome complacent Most new technology is spreading following an S-shapedcurve The base section of the S can be quite long and practically horizontal; how-ever, it will sooner or later be succeeded by a steep section The example ofNordic countries, and more specifically Finland, shows how quickly e-financecan develop, once circumstances are ripe

It is important to emphasize that the integration of new technology into the

financial sector did not take place in isolation Rather, it is the interaction of

tech-nology with another major development, deregulation, that contributed to

reshaping the financial landscape True, the pressure of the market to fully exploitthe new technologies was strong, probably even irresistible However a receptiveenvironment had also been created by a lifting of the rather strict financial andbanking regulations which were still prevalent at the end of the 1970s

The increased awareness of the wide-ranging possibilities offered by newtechnologies illustrated that a lot could be gained through the removal of distor-tions in competition, directly linked to excessive regulation or intrusion from thegovernment

In combination, these two evolutions contributed to the emergence of a moreopen, competitive and globalized financial market, which obviously improvesefficiency in the world economy The transition, however, has not been a smoothone It was not easy for the authorities who had to cope with the more frequentarbitrages operated by market participants between the various currencies andfinancial instruments or even between different legal, regulatory or tax regimes

Neither was it easy for financial intermediaries that had to work in a much morecompetitive environment where traditional protection and barriers to entry wereprogressively lifted In short, the shift toward a more liberalized system togetherwith the quick expansion of new products and markets has greatly increaseduncertainties and risks for financial sectors

This was not immediately recognized by many market participants who hadpreviously been sheltered by the existing regulation As a result, individual bank

failures and banking crises, quasi non-existent between the end of the 1940s andthe early 1970s, became all too frequent during the past two decades In this con-text, the absence of significant problems within the Belgian banking sector duringthe recent period must be considered more an exception than a rule.

Despite deregulation there is still a major role to be played by public

authori-ties, among others in the field of competition rules, consumer protection, fight

against money laundering – and, of course, central banking Central banks indeedhave to provide stability, which certainly does not mean ‘no change’ but, on thecontrary, building the best foundations for a sustainable dynamism In doing so,central banks will cope with the evolving environment shaped by technicalprogress, by deregulation and globalization and, last but not least in Europe, bythe single currency

As regards the first wing of central banking, monetary stability, central banks

have to provide a durable anchor in order for the price system to appropriatelyguide economic decisions A stable value of money is all the more necessary forpreserving the information value of relative prices in a changing world, wheredecisions have to be taken rapidly Maintaining price stability is the primaryobjective of monetary policy, not only for the Eurosystem – according to theTreaty of Maastricht – but also for every central bank

Nowadays the only regulations central banks rely on in designing the

opera-tional framework of monetary policy are the monopoly of banknote issuance and

reserve requirements The Eurosystem fully respects the principle of an open ket economy with free competition, as enshrined in the Treaty Its main instrument

mar-is the weekly allotment of credit by euro area-wide tenders Minimum reserves,which are remunerated, have a stabilization function, thanks to an averaging provi-sion, and are enlarging the structural liquidity shortage of the money market

As the development of e-money is liable to weaken the leverage of theEurosystem and in order to provide for a level playing field, e-money issuers shouldnot escape reserve requirements A European directive of last year rightly broadensthe definition of credit institutions in order to include e-money institutions

Technological change and financial market developments do not only affectmonetary policy instruments but also the whole transmission process and conse-

quently the strategy of monetary policy In this complex and changing world the

Eurosystem was right in rejecting any simple rule and adopting an passing two-pillar strategy Central bankers have to continuously reassess theinformation content of many economic indicators Let me pick out some of them– output, money, stock prices and bond market indicators – not because othervariables, like wage developments and the fiscal policy stance, are less important,but because the former are most affected by technological and financial marketchanges

all-encom-Central bankers, even in the Governing Council of the ECB, are not insensitive

to growth and employment prospects, as some critics argue But they are well

aware of two limitations: first, growth should not be stimulated to the detriment ofprice stability, because such a stimulus would be short-lived and would imply

longer-term costs; second, as ‘à la plus belle fille du monde on ne peut demander

que ce qu’elle a’, monetary policy may exert some influence on the demand side

of the economy but cannot solve structural problems, like persistent ment Central banks may nevertheless contribute to output stabilization, as far asthe risks to price stability are linked to the business cycle

unemploy-A central concept in this respect is the output gap, but its measurement, cially in real time, is surrounded with a large degree of uncertainty Potentialoutput growth, which is an ingredient of both pillars of the Eurosystem’s strategy,

espe-is not known with precespe-ision Should the new economy materialize, higher rates ofgrowth could become sustainable In the absence of any firm evidence of a neweconomy in the euro area – although some driving forces are to some extent inplace – and since the emergence of a new economy is not driven by monetary pol-icy, the Eurosystem did not take the risk of pre-emptively accommodating it

Nevertheless it monitors a wide range of indicators in order to periodicallyreassess the ‘speed limit’ of the euro area economy

Needless to say, in the present circumstances growth is unfortunately evenbelow the old economy speed limit, and the associated decrease in inflationarypressures has already prompted a 100 basis points interest rate cut in three stepssince the spring

The first pillar of the strategy of the ECB gives a prominent role to money It is

based on the conviction that inflation is a monetary phenomenon in the long runand underlines the medium-term orientation of monetary policy and the inheri-tance in this respect from the Deutsche Bundesbank Recognizing that the demandfor money can be subject to short-term fluctuations which are harmless for pricestability, the ECB has not announced an ‘intermediate objective’ but rather a ‘ref-erence value’ for the growth of a broad monetary aggregate The recent rise in M3growth is up to now interpreted as being such a short-term fluctuation, caused bythe relatively flat yield curve and the weakness in stock markets

Technology and financial market changes obviously affect the first pillar Theymight increase the volatility of the income velocity of monetary aggregates and, asthey are blurring the frontiers of ‘moneyness’, they complicate the definition of keyaggregates To paraphrase a former Governor of the Bank of Canada speaking aboutM1 twenty years ago, I would say that while the ECB is not planning to abandonM3, I cannot rule out that, some day, M3 could abandon us, but you already noticedthat the first pillar is much more than the reference value It encompasses a broadmonetary analysis which will duly take into account such developments

The first pillar also rests on the fact that credit institutions remain major ers in the transmission process of monetary policy The development of euro areacapital markets could however increase the weight of financial market indicators

play-in the second pillar

The stock market is still a much less important channel of transmission in the

euro area than in the USA, but the holding of shares is spreading, for examplethrough mutual funds I would not attempt to summarize the vast debate about theappropriate monetary policy reaction to asset price movements I am inclined tosay that central banks have not to put on these variables more emphasis than war-ranted by their effects on demand and should avoid asymmetric reactions –

benign neglect in the case of irrational exuberance, intervention in the case ofsharp downward correction – which could pose a moral hazard problem.

The bond market provides indicators which are probably more important

within the second pillar of the Eurosystem’s monetary policy Technical progressand European integration lead to more sophisticated and liquid markets whichsupply useful information about market expectations Incidentally I notice that,while many central banks looked disapprovingly on indexed bonds prior to mone-tary union, the Eurosystem now welcomes the opportunity to extract information

on inflation expectations from the comparison of yields on indexed and nominalbonds Despite the upsurge in inflation in the euro area resulting from oil priceand food price shocks, inflation expectations appear to remain very moderate,showing that the Eurosystem benefits from a high degree of credibility Such acapital of credibility has to be preserved

About the second wing of central banking, the safeguarding of financial

sta-bility, I would like to adopt a chronological approach First, how are central banks

currently adapting to the new environment by reconsidering the role they are ing in the financial market? Second, how could new technology affect therelations in the coming years between market participants, central banks and othersupervisory and regulatory authorities?

play-Financial market developments and the heightened risks associated with these

rapid changes led central banks to reconsider the role they had to play to preserve

financial stability For those central banks that were in charge of the surveillance

of individual credit institutions, the implications were straightforward They had

to adapt the modalities of their microprudential activities However, the need to

proceed to macroprudential monitoring was also strongly felt by central banks,

like the NBB, which were not vested with the microsupervision

First, at an analytical level, central banks were induced to enlarge the scope of

their research The use of new technologies has caused a spectacular expansion inthe volume of financial operations, certainly in comparison to the growth of realactivities This has required reconsidering the direction of the links between thesetwo fields Central banks had traditionally focused on the consequences thatchanges in financial conditions could have on the real economy If such analysesremain essential, central banks are also increasingly concerned by the vulnerabil-ity of the financial system to fluctuations in real activities So, the causalities alsohave to be reversed and due attention must be given to the impact that evolution ofthe real economy could have on the stability of the financial system It is no coin-cidence that an increasing number of central banks now complement theirtraditional annual reports centred on monetary policy and macroeconomic devel-opments by another report focused on the theme of financial stability This is adevelopment that the NBB will also actively embrace through the publication,possibly starting in 2002, of a new yearly Financial Stability Report

At a more operational level, central banks contribute directly to strengthening

the stability of the financial system by the development of secure and efficientpayment and settlement systems Here also new technology is playing a crucialrole Real time gross settlement systems, delivery versus payment mechanisms,

cross-border connections between various clearing or settlement institutions,instant world transmission of information would be in practice unmanageablewithout the possibilities offered by IT technologies These multiple layers of net-works are too often considered as mere plumbing However, this so-calledplumbing is in many respects as spectacular and sophisticated as the more glam-orous Internet or mobile phone networks.

The oversight of these modern payment and settlement systems has become akey function in modern central banking and this certainly applies to the NBB, asBelgium is hosting two major international institutions, SWIFT and Euroclear

The second step in our chronological approach is also the most uncertain as it

implies speculating about the impact of new technology on the future

organiza-tion of financial markets.

It must be recalled from the outset that the introduction of new technology inthe banking sector is not a one-shot phenomenon On the contrary, it is proceed-

ing by waves As already said, the development of e-money, e-banking and

e-finance will represent a great challenge

Whatever its speed, this new wave will strongly modify the nature of relationsbetween market participants Distant access to financial products is substitutingfor close individual contacts Brand loyalty, while still a key asset in a businessbuilt on trust, is increasingly associated with cherry picking Banks themselvestend to shift from an approach based on long-term and stable relations to a strat-egy where each deal is individually appreciated on its own merits

The various financial institutions are also redefining what should be their corebusiness The technological wave of the 1980s and early 1990s allowed theunbundling of most financial products into their various components To theunbundling of products is now associated, thanks to the second wave of innova-tion, an outsourcing of the production and also of the distribution process Backoffice functions, distribution networks and IT infrastructures can now easily besubcontracted, creating a new web of connections between various categories ofmarket participants

There are also important changes in the relations between monetary and

pru-dential authorities, on the one hand, and financial institutions on the other First

the authorities will have to rely, much more than in the past, on the markets selves for the surveillance of financial stability One may legitimately feelconcerned by such an evolution, which sounds like asking the fox to watch over thehens However we must realize that financial markets are not only a major factor ofchange, they are also potentially a powerful factor of discipline They are forcingcredit institutions to be more transparent and to communicate more reliable infor-mation The development of new, more sophisticated, risk management techniques,under the form of internal models, has been, at its roots, a private initiative frommarket participants In order to integrate this modelling approach in the monitor-ing of banks’ solvency, the Basel Committee on Banking Supervision is notdesigning a new system from scratch On the contrary, it is referring to the bestpractices of the market itself as a benchmark against which to calibrate its own pro-posals

Now, the authorities should not delude themselves Best practices are whatthey are, easier to respect by strong institutions and in favourable circumstances,but much harder to maintain when the situation deteriorates Far from being light-ened, the burden of prudential authorities is becoming heavier The necessarilylimited human and financial resources of these authorities will be called upon allthe more by the new Basel proposals which will require a more individualized anddetailed surveillance of these new internal risk management systems.

The resource constraint will finally also strongly determine the relations that the various monetary and supervisory authorities will have to maintain among

themselves A more globalized financial market calls for a more globalized

approach to supervision

At the international level, several cooperative bodies and mechanisms havebeen established, either in the form of multilateral forums bringing together thecompetent authorities in the fields of prudential control and financial stability, or

by means of bilateral protocols concluded between the supervisory bodies of ferent countries or sectors

dif-At each national level, the authorities also have to carry out an in-depth ination of their supervisory structure and procedures I will not dwell here on thesubject of the devolution of prudential tasks Different models exist across theworld bearing witness to the trade-offs which have to be made to adapt to markettrends while also taking account of the specific national context

exam-Finally, this existing national and international framework needs to be cally reviewed and adjusted Whatever its form, the prevailing structure will have

periodi-to fulfil two major conditions On one hand, it must be efficient in preventingeither loopholes or redundancy in supervision On the other hand, it must be all-encompassing by combining the microprudential control of individual institutionswith macroprudential monitoring of the systemic risks faced by the global finan-cial market

To conclude, let me stress that central banks are fully aware of the close

con-nection and the large convergence existing between the two goals of financial

stability and monetary stability Keeping inflation under control, which is the

ulti-mate goal of every central bank, has proved to be the best way to reduceuncertainties on the market, to alleviate distortions and, so, to eliminate one of thefundamental sources of financial instability

Conversely, central banks need sound and efficient banking systems for ing rapid transmission, to the whole economy, of the impulses of their monetarypolicy This is all the more important given that the assets at the disposal of cen-tral banks – the monetary base in our jargon – is becoming increasingly tinycompared to the total assets managed by credit institutions and, beyond that, byfinancial market operators

ensur-In this context, the monitoring of financial stability may certainly not be sidered as a by-product or a mere extension of the traditional monetary stabilityobjective of central banks The two functions are closely related but distinct Inother words, the monetary stability and financial stability wings belong to thesame bird

Risk arises primarily from two essential, and interrelated, factors: lack of mation and the passage of time With more time available, one can garner moreinformation, for example from repeated experiments, and so risks woulddecline With more information available, the future should become less unpre-dictable However, what we want to concentrate on today is some aspects of theinter-temporal element of risk, rather than that which arises from lack of infor-mation As Andrew Crockett, the General Manager of the BIS, stated in aspeech at Basel last year (21 September 2000) (and previously in his keynotespeech at the last Colloquium in Vienna, April 2000), that

infor-we think of risk evolving through time The received wisdom is that riskincreases in recessions and falls in booms In contrast, it may be more helpful

to think of risk as increasing during upswings, as financial imbalances build

up, and materialising in recessions The length of the horizon here is crucial.1

Even if outcomes did follow policy decisions almost immediately, risks would, ofcourse, still occur, arising for example from lack of knowledge, failure to appre-ciate the context, principal/agent problems, and perhaps from instantaneouslyoccurring shocks of one kind or another But it should be much easier to holddecision-makers accountable for their decisions, because the outcome wouldbecome apparent while they were, by definition, still on the watch (and beforeconditions could, perhaps, change that much – though the world can change in aflash, as it did on the morning of Tuesday, 11 September)

Even so, any particular good outcome could not only be due to luck, but to

an interaction between luck and a high level of risk-tolerance by the individualdecision-maker In this case the problem is that the principal, say a loan officer’sboss or the bank’s shareholder, does not have enough information on the agent’s(i.e the loan officer, the bank) characteristics, e.g effort, ability and risk aver-sion If each period’s activity reaches its final outcome within that same period,and each period’s game is independent from that of the previous and next game,then information on such characteristics will build up over time This suggests,

Charles Goodhart and Jon Danielsson

* Paper presented at 23rd SUERF Colloquium, Brussels, 27 October 2001.

for example, that incentives should be designed to reward average success over

a long period of time rather than short-run extraordinarily good results Thiswould not suit those who do not expect or plan to be staying put in a single job

or with a single firm for the long haul, but are these short-term characters thekind of agents that firms should want to hire?

In this respect we must confess to some puzzlement why the conventional dom regards it as acceptable for regulators to intrude upon, and to constrain,decisions relating to commercial banks’ capital structure, but to abstain from anyovert, or generalised, controls upon the design of such banks’ bonus and pay-ments’ systems After all it is the prospect of direct personal pecuniary reward thatlargely drives our decisions to expend effort and take risks, not the level of (oper-ational) capital prescribed by the Basel Committee.2

wis-As a generality, however, it appears to be remarkably difficult to make agentsaccept deferment of payment until the results of their actions become clearer Onecan understand why It can be difficult for a principal to commit credibly to adeferred payment, especially when the agent may have left the firm or even havedied Moreover the time lag before outcomes are finally revealed is uncertain, andsome large part of such results will have been due to chance or to the decisions ofothers whom the agent cannot affect Be that as it may, the convention is for therewards of agents to be based on this period’s outcome, even if that outcome islargely the result of decisions taken well beforehand

Such outcomes in any period will also, of course, be due to the general ness conjuncture Profits rise and bad debts fall when the economy is strong, andwhen asset prices have been rising At such times capital is easier to raise So, typ-

busi-ically, capital controls do not bite during booms By the same token, during

periods of weak growth and falling asset prices, profits fall and bad debts rise;

capital is harder, sometimes impossible, to raise Capital requirements are, bytheir nature, procyclical, and to some large extent, as exemplified by the last set ofBasel Committee proposals, the more sophisticated is the measurement of indi-vidual firm risk the greater the consequential procyclicality in the aggregate

While it has been generally accepted that additional sophistication in riskassessment at the individual bank level will add to greater aggregate procyclicality(see for example Kupiec, 2001 and Reisen, 2001), it is difficult to provide rigorousquantification, particularly when the necessary large-size databases are not avail-able to the academic community One on-going exercise, being undertaken at theBIS and using Mexican bank data, does confirm that the Basel proposals will lead

to an increase both in required capital levels and in the procyclical variations ofsuch requirements in that country (Lowe and Segoviano, 2002)

There is inevitably a conflict between the micro-level and the macro concerns inthe operation of financial regulation (see Crockett, 2000 and Borio, Furfine andLowe, 2001) At the micro-level there is no doubt that commercial banks and otherfinancial intermediaries will tend to be more fragile, closer to insolvency, duringrecessions Yet the real concern, the major externality, in banking lies in the possi-bility of contagious (and/or correlated) failure for a significant part of the system

as a whole.3If a large number of banks are constrained by regulatory pressures to

reduce their loans during a recession either to all (private sector) borrowers or to asignificant subset (which may now be reclassified as higher risk), then the prospect

of contagious collapse may even be enhanced (see for example Danielsson et al.,

2001; Danielsson and Zigrand, 2001; Danielsson, Shin and Zigrand, 2002)

Is it possible for the regulators, and indeed for the firms themselves, to aim off,

to adjust, somehow for the stage in the cycle in which they currently happen tobe? Could some kind of cyclically adjusted capital requirement, or provisioningfor bad debts, for example, be contemplated? In our view this may be extremelydifficult What one can tell is whether the rate of change of output, or of assetprices, has been greater, or less, than recent trends; but one can never be surewhether such trends may themselves be changing, as they do from time to time, asevidenced in productivity, equity prices, output, etc For example, we have taken adiagram from a speech made by Laurence Meyer of the F.R Board (Meyer, 2001)indicating that there were quite long periods of productivity growth both above

The inter-temporal nature of risk 21and below the long-run average of two per cent (Figure 2.1) He stated that to hiseye, ‘the charts suggest a sequence of waves in labor productivity, periods of rapidgrowth followed by periods of more sluggish growth’, when ‘the high-productiv-ity periods reflect the influence of a bunching of technological innovations’

Similarly one can decompose overall growth into periods of faster, and slower,growth Take the UK, for example, though we have done similar exercises for theUSA, Germany and Japan (not shown here) The most obvious interruption ofgrowth came between the two World Wars, but even outside that interval, one canobserve longer periods of faster and slower growth (Figures 2.2 and 2.3)

0 0.5 1 1.5 2 2.5 3

Moreover, there have been much more marked longer-term variations in thegrowth rates of equity prices in real terms, i.e deflated by the CPI See, for exam-ple, data for the UK and USA (Figures 2.4 and 2.5).

-10 -8 -6 -4 -2 0 2 4 6 8 10

The inter-temporal nature of risk 23From that, it appears that the equity premium puzzle, the excess return to hold-ing shares, is primarily a post-war phenomenon, a feature of the last two or threedecades, and could, perhaps, now disappear as fast as it arose.

Even when the trends may be assumed, or taken, to be constant, so that ations around them are stationary, with reversion to the mean in deviations aroundthat trend, there is no good way to predict when the reversal will take place

fluctu-Cycles do not have a constant periodicity, if indeed one can talk about cycles atall, rather than intermittent shocks which tend to have prolonged effects as aresult of subsequent interactions within the economy If one takes the availablehistorical data, quarterly time series since about the 1950s, or annual data goingback into the last century, there is very little sign of any constant regularity, orperiodicity, in the onset of recessions We have tried to formalize this assertion intwo ways First, if cycles have a regular periodicity, we should be able to reject theclaim that the probability of a new recession aborting the recovery/boom is iden-tical in each period following the initial onset of that recovery, irrespective of thepreceding length of that recovery If the occurrence of a new recession is indepen-dent of the length of the preceding recovery, i.e the event is memoryless, then thenumber of such events in any fixed-length interval ought to follow a Poisson dis-tribution, whereas if there was any cyclical regularity we should be able to rejectthe null of there being such a distribution In our tests, using quarterly data with afixed five-year window for the UK and Germany and a ten-year window for the

US using data from the NBER ‘Business Cycle Dates’ database, we could notreject the null hypothesis that downturns did follow such a Poisson distribution,for any of these countries This work is set out below in more detail in theAppendix, Part I, for which we thank Ryan Love

Second, if the timing of a recession is independent of the length of the previous

boom, then the time interval between the onset of the initial recovery and the sequent next occasion of recession should follow an exponential distribution

sub-Again we tested whether such time intervals did follow an exponential tion, and over our data period could not reject that null hypothesis for the UK andGermany We could, however, reject it for the USA, which does suggest that therethe timing of recessions is not entirely independent of the length of the priorboom, which in our view is a pre-condition for belief in any cyclical regularity

distribu-Again this is set out below in more detail in the Appendix, Part II, by Love

So the bulk of our historical evidence leads us to believe that one cannot dict the length of any upturn, or the likely future dating of the onset of a recession

pre-One simply does not know where one might be in a cycle of indeterminate length

Moreover, the fact that, say, output or real equity or housing prices have beenrising faster than their previous trend will be taken by some as a consequence of achange in the fundamentals leading to a new higher trend, and by others as a sign

of disequilibrium, or of misalignment Even those who recognize a developingmisalignment will have little, or no, idea when the so-called bubble may burst, or

a bottom be formed after a burst Economists, who by training try to find order in

a complex system, are prone to see signs of misalignment early on; AlanGreenspan talked about ‘irrational exuberance’ as early as December 1996 If