The Role of Financial Institutions in The Changing International Financial Framework

(Transcript of speech delivered at Bilkent University)

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I would like to first thank Sir Alan Walters (former chief economic advisor to Prime Minister Margeret Thatcher and vice charman AIG Trading) and Mr. Augusto Lopez-Clares (Executive Director, Lehman Brothers Emerging Markets Research) to set the background. Coming from the banking sector, I will try to look at things from a different perspective. And I have the added burden of representing how things look from both İstanbul and Ankara at this moment, given the absence of our guest from Ankara.

Financial markets play an essential role in the economy. This may sound a bid cliche at this point, but events of the last few days have underscored this yet again.

Why do financial markets play an imporant role in the economy? The simplest answer is that financial markets solve the resource allocation problem in the economy, which is one of the fundemental questions of economics. Historically, this duty has been performed by different people - from kings and philosophers to merchants and central planners. Finally after thousands of years of human evalution, it is assigned to the financial system.

What exactly is the financial system that is chosen to cope with this task? I would like to first take a look at the market that forms the basis of the system, and then attempt to explore the specific working principles of the system and to relate them to the issues that we are facing today.

Financial markets in my view have four large chunks:
1. The government debt market, which have become instrumental only after 1945 when governments' role in the economies increased. This market has been revolutionized after 1980 when interest rates worldwide were set free.
2. The banks, which have been in operation roughly in their current form for over 400 years
3. The corporate bond markets, which have been in operation through the beginning of the 1800’s.
4. The equity markets, which have become an important factor since the beginning of this century.

In solving the resource allocation problem, the debt markets and the equity market fulllfill different risk and return profiles. On the debt side, we have the bond markets and the capital markets in the long term, and we have the banks in the short term. In the equity market, there is a wide range of players from venture capital and private equity to public equity, including institutional and retail players.

This whole process is what we call intermediation in the financial markets. At the end of the day, there is an end investor, which is the population of the country, and somehow through all these mechanisms the capital accumulation of the country goes into funding different projects.

On the debt side, banks and bond markets represent slightly different ways of intermediation. We can divide the intermediation process into three different parts:
1.Management of the fund flows which involves taking the funds from the end investor and bringing it into the system
2.The risk manegement element
3. The service provision element

If we examine the case of the banks, we see that the banks manage the funds and they also manage the risk. You give your money to the banks in various forms, they go and allocate it. They are responsible for the upside and downside of the investment.

In the capital markets, again some intermedieries (investment banks and funds) make certain decisions, but at the end of the day, the risk is born by the end investor directly.

There are the two kinds of intermediation that we have observed historically, but when we look at what has been happening in world market recently, we see that these two methods are converging towards each other relatively fast.

On the banks' side, the banking system and its instruments are becoming more and more liquid, aproaching the capital market products. On the capital markets, there are changes that make people’s allocations much faster. If we look at mutual funds and other players, we see more and more instruments that allow people to change allocation decisions more quickly. The two modes of intermediation are shrinking into one relatively quickly.

What trends can we observe in the global markets about intermediation? More and more of the final risk is being pushed onto the end investor. When we talk about the development of the capital markets, this means that government and the banking system are really taking more of a intermediary role and that the end risk is really born by people directly in their insurance and pension fund portfolios. But banks are still around. So what do banks do? Banks are transforming into service providers. The fund flow, risk management and service provision functions are becoming more clearly defined.

We observe two distinct models in the world banking system as to how banks deal with new development.

The Citicorp model involves one player, which itself is created from the mergers between several players, continuing to play all the parts in the intermediation game. Citicorp have been managing the fund flows, managing the risk and providing all the services ranging from insurance to credit cards. Therefore, you have a monolistic financial institution getting into every single piece of service provision as well as resource allocation in the economy.

The alternative model, which we may call the Chase-JP Morgan model, is one where the bank targets the resource allocation question only, and leave retail service provision to other institutions.

Citigroup and Chase-JP Morgan are the two more extreme examples in the world market, and there are other players in between, from Deutsche Bank and CSFB to other American banks, all of whom take roles somewhere in the middle.

When we examine these models we clearly see similarities to other sectors in the economy. For example, there is a similar debade going on in the media and telecom sector. Whether the resource allocation and service provision function should be done by the same player or seperate players is equivalent to the debate in the telecom and media sector for content and delivery, and whether it makes sense to bundle them or unbundle them.

Having reviewed the mechanism of the financial system, I would like to talk a little bit about macro elements, and then finally get into how all of these relate to Turkey now and the difficulties we are facing now .

When we look at the world from a macro perspective, we can make one observation: since 1980, there has been a great wave of liberalisation and deregulation in the world markets. But this happened in two seperate ways. We need to seperate the goods and services market and the factors markets, as deregulation happened in different forms in those two. What is the difference? In goods and services markets, producers and consumers have trade-offs. You can make CD’s or butter or TV shows. There is a great trade-off between ways that you can allocate your resources. Whereas in factor market, you are pretty much stuck with what you have in the short term. Your labor force is what you already have and capital base is what you already have and you need to do the best of it. Major changes are only possible in the long term.

What we observe in the 1980’s is that in the goods and services markets, deregulation works with very small qualifications. In the factors markets, deregulation works but with some major qualifications.

In the goods and services markets, just small adjustments like ensuring good competion and creating a reliable legal framework to limit some information assymetries are sufficient to operate a free market system. Deregulations have really provided results - quickly and on a large scale.

In the factors markets, we have a slightly different situation. Because of their nature, the factors markets need to reflect some kind of consensus in the society much more than the goods and services markets. So a different evolutionary path have been observed. I would like to give the example of US Federal Reserve, which in my view best reflects the approach of the world’s largest capitalist economy to factors markets regulation. At first there was no Fed. The Fed was invented, but didn’t do too much. Later on people decided that Fed need to do a lot more. During the Bretton Woods system, we had an environment where not only the short term interest rate but the whole interest rate curve was managed quite heavily. In 1979, a different paradigm was chosen where the Fed started to target monetary aggregates rather than setting interest rates directly – somewhat similar to the system that we are observing in Turkey these days. And finally in1983 a more sophisticated system was deviced where the Fed sets short term rates only, with an aim to regulate both to assets and goods markets with the one tool that it has.

Clearly, in the international financial market, governance and regulation have mattered quite a bit because of the very nature of the system. Let’s talk about a few details or fundementals before entering into a discussion about what is going on in Turkey.

Theoratically, the financial system is about resource allocation accross the board, but we have only one tool in our hand: money. Money performs an exchange function, a measument function and a storage function all at once so as to facilitate the resource allocation decisions accross the economy.

It is a handicap that we have one tool to regulate two seperarate markets. On one hand we have the goods and services markets which are quite stable, as they really represent the physical reality in the economy. Things can change only at such a pace that such physical reality allows. Assets markets, on the other hand, are in effect a sum of the estimation of all the future potential of the economy. Unfortunately, a huge quantity of analysis is needed to summarize this potential into a few small parameters. So because of this particular nature of the assets markets, they can move very fast, as people’s sentimenta about the future change. Modern tecnology, especially communications devices and computers have made the information flow and processing faster, and hence the assets markets have become even more volatile.

If there were only goods and services market in the world, which was more or less a good approximation 50 years ago or 100 years ago, things would be easier for central banks to regulate, as the economy would be working slowly. You can really think of ways to accomodate goods and services and demand and supply and money that result from those transactions relatively fast. But now, as the role of exchange of assets in the economy is grown, the task facing central banks and the international financial system has grown more difficult.

Why is this so? Because in the past, assets were only for rich people. Now everybody has assets, from real estate to stocks and bonds. A much larger part of society actually owns assets. Therefore changes in asset prices affect the whole economy much more than it did in the old days.

In the goods market, corresponding to a certain amount of goods changing hands, there is a certain amount of money that changes hands with a certain velocity. This quantity of money accomodates the whole exchange function. However, the assets markets are really different, because the total value of what participants are buying and selling is theoratically very large. Assets in effect represent the whole future potential of the economy. The total value of assets in an economy could be 10, 20 or 30 times the value of goods changing hands. Normally, there is a a certain money supply in the economy accomodating the exchange of both goods and assets. The implicit assumption is that a very small proportion of total assets is going to change hands at any given moment. In periods of dificulties everybody is trying to change their long term asset allocation - getting out of one kind into another, or getting out of long term assets as a whole. This brings the system into a crunch, because there isn’t enough money in the to accomodate this large shifting of asset allocation in the economy. This is the very simple explanation of asset driven crises we face in the worldeconomy today. And that is why central banks’ task is much more dificult now than 50 years ago or 100 years ago.

Having set the background both from a market perspective and theoratical perspective, I would like to talk a little about Turkey. I would like to agree on one point Sir Alan Walters made – the fact that big mistakes in the economic management generally come from misinterpretations of the fundemental realities of the economy and not from the lack of sophistication of the policy makers. In Turkey, a very interesting example of this is taking place and we can observe this very easily in the numbers.

Let me first review the background and how we got into this situation in the first place. The resource allocation profile of Turkey changed a lot in 1980. We can say that Turkey changed track completely. We adopted a free market model and reduced the government guidance in the economy. In the 1980’s things went more or less OK. Since 1990, however, if you look at the growth in the economy and the macroeconomic performance in Turkey overall, you can’t help but observe that we really done pretty badly.

What happened? The key to the answer lies in the resource allocation decisions that Turkey has been making lately. Basically, Turkey has not been able to invest enough. Turkey has not been able to adress its balance of payment difficulties and its income distribution problems. So across the board, from a resource allocation perspective, Turkey has not done well in the 1990’s. And we should note that this is despite the fact that people’s awareness of the science (or art) of economics has increased and that the sophistication and capabilities of the private sector have improved. At a first glance, a lot of things appear to have moved in the right direction, but clearly the results don’t reflect these yet.

There are two strong reactions to what happened in Turkey in the 1990’s. The criticism from the left points out that liberalization and deregulation and capitalism in general are bad. So they say “see, we told you this would happen if you leave a state-driven system”. The reaction from the right, on the other hand, is just denying that this worsening of resource allocation ever happenned. I personally disagree with both. I admit that the resource allocation in Turkey worsened in the 1990s. But I don’t think this is because of the choice of liberalism as a system.

When we look at Turkish history we see three periods of enormous success in economics. The 1923-30 period, the 1960-70 period, and the 1980-87 period. One clear common groud between all these periods, is that resource allocation question was explicitly adressed in all these periods as the essential problem in Turkey. When it was adressed explicitly, solutions were devised and we managed to have long years of prosperity afterwards.

Until the 1980s the government was the allocator of all resources in Turkey. At that point the government stopped, so someone had to come and to make these decisions for the economy. Unfortunately, this role has not been fullfilled properly. The party that is not fullfilling its role as the determining force of the resource allocation in the economy is the Turkish financial system.

Let us review the parameters of the Turkish economy and I will leave the decision to you whether the banking system or the financial system in general is doing what it supposed to do in Turkey.

In Turkey we have a base of 100 billion dollars of bank deposits, including repos. This is a respectable amount of savings. But are there any long term assets in Turkish economy? Unfortunately no. The proportion of the stock market held by individuals is very low, and there are no significant pension funds or other investment institutions. The insurance system is also very small. Therefore, there is no “buy side” or investor base to speak of. All of Turkey’s national savings are in short term instruments. Are these short term instruments somehow or by somebody transfered into long term instruments. No. Most of the deposits in Turkey are used to fund either treasury bills or the limited amound of corporate lending which is also very short term.

What does the T-bill market accomplish in Turkey? Clearly this is the central element of Turkish financial system. There is 50 billion dollars of T bills with a 20-25 % real rate on them in dollar terms even in the good days of year 2000 when the program was working well.

What do these T bills accomplish ? The government borrows this money and government spend it on transfers. Transfers from who to who? In a World Bank report in 2000, it was measured that the transfers affected by the Turkish government do not go to places that would improve the income distribution in Turkey. So we have this complex model of borrowing money from our population with 20 % real interest rate and the places we use these savings neither enhances long term prospects of economy in the form of investment nor correct income distribution. So clearly, we have a problem in the overall financial system in Turkey. Essential things that are supposed to work seamlessly do not work at all. All in all, it is difficult to say that Turkey has a financial system.

We can look at this from two perspectives. As I outlined at the beginning of my speech, there are a few different roles played by the financial system: the funds flow element, the risk management element and service provision element. Clearly, the service provision element is there. From a service prospective,Turkish banks are very good. But this is not sufficient. The second and more important element, the resource allocation element is not done at all.
Let’s continue with certain parameters in the economy .We talked about 100 billion dollars of savings in the banking system. What are these savings? Roughly sixty percent of them are in Turkish Lira (including repos) and the rest are in foreign currency. The Turkish Lira half has on average a maturity between 7 and 15 days or so. On dollar side, 3 months in good times and 1 month in bad times. So we are funding the whole Turkish economy on a deposit base which has an averege maturity of 15 days or 20 days. This is strange to start with.

Look at a second element: the Treasury is taking great effort to increase the maturity of its domestic debt. The Treasury gets very happy if maturity of its paper goes to 1 or 2 years. Unfortunately, purely from analytical perspective, you need to look at whole Turkish banking system balance sheet consolidated with the government. Why is that ? Because the government has 50 billion dollars of T-bills with maturity of 1 or 2 years that is funded by 7 day Turkish Lira repos and deposits and 1 to 3 month FX deposits. Clearly there is a phenomenal maturity mismatch in the system. This is inherently a very fragile system. There is no intermediation here whatsoever.

As the government is obliged to guarantee the deposits of the banks on one hand, as a significant portion of the assets of the banks are Turkish T-bills, just by common sense, you can conclude that the Turkish government’s real liabilities are not the domestic T-bills but the 100 billion dollars of liabilities which is sixty percent TL with 7 days maturity and forty percent half dollars with 1 or 2 month maturity. I think that is the key reason behind our problems now. This is the reality and you need to set policy according to this reality. The Turkish government unfortunately has not chosen this path. In my view, the interest rate in the T-bill market is not a relevant variable for the economy over all. It is just a transfer of wealth from one set of people to another set of people. But in terms of the consolidated balance sheet of the government and banking system it does not matter. Because the government’s real liability are the short term deposits.

We should also review a second major source of risk in the system: the FX short position of the banks. Lateky, there has been a lot of talk about reducing the short position of the banks. Let us review mathematically whether it is possible.

There are 80 billion dollars of deposits in the system. About half of it is in dollars. In addition, there is 15-20 billion dollars of bilateral borrowing and loan syndications from abroad. Clearly, there is a very large amount, around 60 billion dollars, of total foreign currency liabilities in the Turkish banking system. Where are the dollar assets? A very large proportion of the assets in system are Turkish T bills. There is only around 10 billion dollars of bonds issued by the Turkish Republic held by the domestic banks. So clearly, there is a huge mismatch. We have been hearing debates about reducing the short positions to 20 % of the capital of the banking system. (By the way, the negative capital of the government banks probably offsets any capital in the private banks completely.) The private banks’ capital in Turkey is probably around 10-15 billion dollars. 20% of it is 2-3 billion dollars. So as we are faced with 60 billion dollars of FX liabilities, there needs to be 57 billion dollars of FX assets. Is it possible to create these assets in the near future? No. It is not possible. So, is there any point in debating reducing short position of the banking system? Not really, because physically and mathametically it is not possible.

There is clearly an issue that we need to resolve in Turkish financial system, but it is not a mismanagement problem. It is not an administrative problem. It is a very fundemental problem of resorce allocation. Turkey needs long term capital. Who needs long term capital? The İşbank –Telecom Italia mobile phone venture needs long term capital. Power plants, Turkcell need long term capital. Koç and Sabancı Holdings need it. So do the many Turkish entrepreneurs across the country. If Turkey wants to be a prosperous country, the Turkish population needs to invest its money long term into these ventures. There are no ifs and buts about it. This has to happen. Period. Is this going to happen by small administrative changes? I’m very skeptical about it. As the size of transformation is so large, small administrative changes or IMF packages are not going to solve this. IMF packages are great to adress liquidity crises. But even if liquidity crises are solved, the resource allocation problem remains. Honestly, there is no Turkish financial system and such a system needs to be created. We need to sit down the representatives from all the parts of the country, from its labor, agriculture, from its banks, politicians, economic experts. We all need to come sit down, maybe including legal experts as well, and come up with a system that will channel the Turkish population’s savings into long term funds that are required by the country.

Can this happen? Let’s look from two different perspectives. One is the academic perspective represented by World Bank researches and the likes and the other from an observation of the financial markets.

From an academic perspective, when we look at different countries of the world, no great explanation has been found why some countries advance and some countries fall back. You look at countries which have the same capital accumulation, same labor, same everything else and some of them advance while others don’t. When you look at middle income countries like Turkey, you observe a great deviation in performance of these countries. Countries like Argentina have done very badly in the last 50 years, while Japan and Korea have done fundementally better. What could be behind this?

My humble but honest view is that governance does matter. One needs to look at the very basics of the economics of one’s country and solve the resource allocation problem. If you look at the system that has been succesful from Spain to Japan to Korea, you see a clear adressing of this problem and solutions to it. When you look at other models of countries that failed, you see a clear lack of it. I would like to emphasize this both in capital markets and in labor markets. In the labor markets, education is the means.

So from an emprical academic perspective, the answer is there. Now, we must check whether this theory is validated in the market? I think the answer is a solid yes. Let’s take examples from the UK, Spain and Russia. What happened in the UK? The UK chose a privatization path in the early 1980s. What made UK fundementally different from other countries who privatized? The UK, like the US, had a functioning financial market. The UK had a system into which it was going to privatize. There was a well functioning investing mechanism, which actually had been in existance much longer than the government’s economic departments. The UK private system had been allocating the resources in the economy in last 200 years, while the government had been taking part in it only for the latest 40 years. So the private sector was very strong, stronger than the government. That is why as a result of privatization, decision making improved in the UK economy. So if a country already has its market, when it privatizes, things go really well.

Let us look at the Spanish example. Spain was nowhere in 1985 in terms of markets. It lacked the instruments. There was a strong industry, but institutionally (from a financial markets perspective), it was nowhere. It had a government that was not experinced in democracy nor in the modern way of managing business. What did Spain do? In the last 20 years, Spain caught up institutionally as well as on a per capita income basis. If you look at the capital markets of Spain, you observe the benefits of creating a buy side, in your capital markets. When Spain was privatizing, liberalizing and deregulating, it took the necessary steps to create new investment regime in the country. It improved the banking system, improved the insurance system, created pension funds and other long term investors that could buy the assets that were being unloaded by the government. As a result, Spanish capital markets are examples for the whole world now, functioning at least as well, if not better than the capital markets of France or German, which are countries with significantly higher per capita income. When the Spaniards decided to reform things, they looked at the very basic fundementals of the economy and made sure that all the pieces were in place. All the necessary steps were taken in all the aspects of economy.

Russia, also liberalized and deregulated, and the result was a complete disaster. Why? There was nobody ready to take over decision making responsibilities from the government. So basically, they gave away assets to random people. When this happened, the efficiency of resource allocation of the country declined tremendously and whole system suffered. There was a fundemental mistake made at first, which was that they were privatizing in a system that did not even have the most basic ingredients to run a market system.

The financial system and the idea of capitalism in general need to be understood correctly. Capitalism does not involve an expansion of the private space at the expense of the public space. Capitalism is just a much better method of running the public space. In Turkey, we need to take some steps to institutionalize all the parts of economy so that the whole public space in Turkey is run by this new and more efficient mechanism. We also need these institutions to fill the void that the government left in 1980. That is the only way to leave our problems behind.

I would like to finish with one positive and one negative note. The positive note is that Turkey has developed the ingredients to run a good market economy in last 15-20 years. So there is definitely potential to realize this and to create a prosperous country. The main problem, on the other hand, is 50 billion dollars of government debt, paying real interest rate of 20-25% even in good days and up to 30-40% in bad days. This is clearly unsustainable with ar without an IMF program, so we need to find ways to adress this question. Until we have a good solution to this question, we are going to keep facing ups and downs in our economy.