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  1. 1. STD/NA(2002)19 TABLE OF CONTENTS Background................................................................................................................................................3 Introduction................................................................................................................................................3 Recent changes on financial markets.........................................................................................................4 Identifying financial corporations..............................................................................................................5 What are the services rendered by financial corporations?.........................................................................9 Measuring financial services: main points...............................................................................................13 Open questions.........................................................................................................................................20 In conclusion............................................................................................................................................21 0 Boxes Eurostat FISIM: an operational definition................................................................................................14 0 2
  2. 2. STD/NA(2002)19 Background At the 2001 OECD Meeting of National Accounts Experts, the Swiss Delegation raised the issue of measurement of financial services in the national accounts (Stauffer and Meier, 2001) in the light of structural changes in the core activities of financial corporations. National Accounts Experts confirmed the relevance of this topic and the OECD Secretariat proposed to put in place a small task force to examine the issue at greater depth. Switzerland expressed its readiness to act as a lead country in the process. In preparation of the work, several meetings involving Swiss commercial banks, representatives of Statistical Offices, and Central Banks took place during the first half of 2002. These meetings led to a background and discussion paper that was discussed at the first meeting of an OCDE Task Force on Financial Services in the National Accounts in June 2002. The present document reviews the main issues raised in the meeting and summarises the various discussions. It constitutes a progress report rather than a document that presents final results. The Task Force continues with its work and has scheduled its next meeting in the beginning of 2003. Introduction At the heart of this project lies the question: “Do current SNA prescriptions fully account for the services provided by financial intermediaries?”. Recent developments on financial markets have significantly changed the way in which financial corporations operate and the answer to the question may well be negative. While the nature of the services provided by these institutional units may not have changed radically, their relative importance may have shifted as well as the way by these services are provided and paid. For example, new financing patterns have reduced the importance of interest incomes, which traditionally constituted a major feature of financial corporations’ business. Innovation has produced new financial instruments, often remunerated indirectly, that did not exist when the SNA was debated. The SNA uses the concept of FISIM – financial intermediation services indirectly measured - to put a value on financial services that are not explicitly priced. However, measurement is often narrowly defined around the traditional deposit/loan business, thereby leaving out other financial instruments that may be carriers of financial services with implicit prices. The central idea of the present paper is not to modify the notion of FISIM but to extend the use of output indirectly measured so as to obtain as complete as possible a measure of the services produced by financial corporations. Failing to do so may lead to an under- estimation of value added of these units. If structural changes in the industry continue, national accountants might be faced with consistency problems and potentially biased analyses. We will proceed as follows. The third chapter highlights major changes on financial markets and their impact on financial corporations1. Chapter 4 reviews the definition of financial corporations in SNA93 and proposes a working definition. The following chapter introduces the distinction between financial services, financial instruments and financial activities, and discusses financial services in greater detail. Chapter 6 sums up measurement issues and the remaining points for further discussion. 1 In this document, the notion of “financial corporations” normally excludes insurance corporations in their main activity as poolers of risks. This is due to the fact that (i) parallel work on insurance output is currently undertaken by OECD; (ii) the pooling of risk as undertaken by insurance companies may be different in nature from the risk assumption services provided by other financial corporations. 3
  3. 3. STD/NA(2002)19 Recent changes on financial markets During the past decade financial markets experienced important changes that affect the way financial corporations operate. The following list illustrates some of the changes: - Enhanced role of the equity and bond markets for financial corporations. These markets were traditionally important for rich households and large firms. Financial corporations often intervened as counsellors but they hardly held large portfolios. In some countries legal prescriptions prohibited them from holding equities, but this pattern was found in most regions of the world. Today financial corporations hold large portfolios of securities and are major actors on the markets. In Switzerland for example the share of trading portfolios of big banks rose from about 5% of their total assets in 1990 to a peak of 15,5% of total assets in 1998. - New channels and institutional forms for financial services. Liberalisation, financial innovation and the opening-up of frontiers led to new channels and institutional arrangements for financial intermediation. New separate establishments have been set up whose characteristics often differ from those of traditional banks. On the one hand their resources consist mainly of assets other than deposits. For example some units are set up to manage the liquidity of some large parent company, which therefore is the sole provider of funds and the sole beneficiary of the actions undertaken. Some of these units, like Renault Finance in Switzerland, now manage large amounts of money and must be fully accounted for. On the other hand, these new actors often invest all their funds in bonds and securities. Their main function is therefore the management of portfolios. This is for example the case of mutual funds. This pattern differs from that of traditional financial corporations, which are still more involved in deposit taking and loan granting activities. - Increasing importance of intra-sectoral transactions. Financial innovation has led to the creation of new instruments. Their complexity often restricts their use to the financial sector itself. Moreover, it encouraged “traditional” financial corporations to set up specialised institutions or to outsource the management of such instruments. As a consequence, the share of bank assets and liabilities with a counterpart in the same sector (that is intra-sectoral) has increased significantly during recent years. In Switzerland for example the share of intra-sectoral assets has risen from around 21% in 1990 to about 34% of total assets in 1999. The complexity of the new instruments, combined with the new funding patterns, have let to a “splitting-up” of the different stages of the production process. Processes that used to be carried out within the same institutional unit now tend to be split in “elementary units” which can be performed by various corporations. The importance of the market as a “transaction centre” has increased. The traditional pattern that relied on a long-standing relationship between banks and customers, where financial corporations offered a wide range of instruments, has lost in importance. “Single-purpose providers” have gained in importance. - Increased liquidity of assets and liabilities. By establishing standard procedures for the evaluation of assets and liabilities financial corporations have been able to “securitize” substantial parts of their balance sheets. ‘Securitization’ describes the transformation of non-marketed assets or liabilities such as deposits or loans into tradable financial instruments, securities. A striking example is mortgage loans. Financial corporations used to hold these loans in their balance sheets until the capital was fully reimbursed. The new evaluation standards now allow active and systematic trading of mortgage loans. Basset and Carlson (2002) report that in the United States, at year-end 2001, the outstanding principal balance of single-family residential loans that banks had sold or securitized was about equal to the value of such assets that remained on their books. Today, most assets and liabilities are tradable and their value may therefore change sharply with time. 4
  4. 4. STD/NA(2002)19 These changes may have consequences for national accounts. On the one hand, these activities often generate forms of remuneration which are not fully accounted for in the current prescriptions. On the other hand they may generate efficiency gains leading to a change in the behaviour of financial corporations. For example, the improvement in their income and cost structure could drive them to lower prices for the provision of various services or to distribute higher dividends. As the initial element of remuneration is not accounted for this may lead to interpretation problems and challenge the robustness of results. Identifying financial corporations Current treatment in the SNA From the start the SNA 93 chooses an approach based on the analysis of institutional units and emphasises the aspect of economic activity. In this context financial corporations are defined as “…all resident corporations or quasi-corporations principally engaged in financial intermediation or in auxiliary financial activities which are closely related to financial intermediation” (Paragraph 4.77). Financial intermediation itself is defined as “…a productive activity in which an institutional unit incurs liabilities on its own account for the purpose of acquiring financial assets by engaging in financial transactions in the market. The role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. They collect funds from lenders and transform, or repackage, them in ways that suit the requirement of borrowers. They obtain funds by incurring liabilities on their own account, not only by taking deposits but also by issuing bills, bonds or other securities. They use these funds to acquire financial assets, principally by making advances or loans to others but also by purchasing bills, bonds, or other securities. A financial intermediary does not simply act as an agent for other institutional units but places itself at risk by incurring liabilities on its own account.” (Paragraph 4.78). Besides units that incur liabilities on their own account the sector of financial corporations includes units engaged in auxiliary financial activities which are closely related to financial intermediation. These units do not acquire financial assets and put themselves at risk by incurring liabilities on their own account2. Several points are noteworthy: First, the definition of financial corporations puts particular emphasis on financial intermediation, that is, on an activity. The SNA does not specify particular services provided by financial corporations. Two elements characterise the description of the activity put forward in the SNA, namely “risk-taking” and “repackaging”. It will be useful to examine whether risk-taking and repackaging activities have changed in nature over the past years and if so whether that could affect the analysis. This point is discussed more extensively in the section below. Second, the definition in paragraph 4.78 is quite general in that it does not prescribe any particular composition of assets or liabilities in the identification of financial corporations. For example, a unit that exclusively collects funds for investment by issuing interest-bearing securities would clearly qualify as a 2 . SNA 93 explains the inclusion of these financial auxiliaries by saying that it “(…) is becoming (…) increasingly difficult to draw a clear distinction between true intermediation and certain other financial activities. (…) However this is not the only reason for classifying financial auxiliaries in the System (…) Corporations whose principal function is financial intermediation also tend to provide a wide range of auxiliary services themselves as secondary activities. As a corporation as a whole has to be allocated to a sector, the auxiliary activities of financial corporations would fall within the financial corporate sector of the System anyway, even if financial auxiliaries themselves were to be excluded”(SNA 93, paragraph 4.80/ 4.81). Securities brokers, flotation companies and loans brokers are typical examples of these financial auxiliaries that have to be included. 5
  5. 5. STD/NA(2002)19 financial corporation. Involvement in the loan-deposit business is not a necessary condition for identification as a financial corporation. Third, there is some ambiguity about the role of ‘own funds’ as a source for the provision of financial services. Paragraph 4.78 allows for funds to be obtained by issuing all kinds of securities, and by implication this includes shares and therefore part of equity which can reasonably be equated with ‘own funds’. However, a different paragraph (6.125) of the SNA explicitly excludes own funds as a source for intermediation activity and the associated services. Furthermore, the SNA indicates that the exclusive use of a unit’s own funds as a source of lending and investment does not give rise to financial intermediation. The task force felt that the exclusion of own funds was not desirable conceptually and difficult empirically. Fixler (2002), expresses exactly this point when he states: “Because money is fungible, it is not possible to say that the funds available for a loan derive from deposits or a firm’s own funds. More importantly, it makes no difference where the funds come from because a service is being provided; the granting of a loan based on deposit funding is indistinguishable from that funded with own funds – all of the credit related services are the same.” In this view own funds3 are thus part of the production process of financial corporations. A similar conclusion had been drawn earlier by Hill (1996). The changing nature of financial activities The SNA puts forward “risk taking” and “repackaging” as key elements of intermediation activity. This section examines how these activities have changed in recent years, and how such changes may affect our perception of the sector. We start out by re-labelling “risk taking” as “risk management” and “repackaging” as “liquidity transformation”. This seems to describe better the activities of financial corporations, as is explained below. “Risk-taking” enters our considerations as a financial service provided, rather than as an activity (see section 5). Risk management Risk management is at the heart of the activities of financial corporations. Changes on financial markets have, however, modified this activity with possible implications for its measurement. Traditionally, financial corporations have managed risks by (i) extending lines of credit (the financial corporations accepts a counterpart risk); (ii) accepting deposits (there is a risk in the sense that depositors may withdraw their assets at short notice while financial assets are usually less liquid); (iii) accepting a mismatch of terms between assets and liabilities, which often implies an interest rate differential. In such a world financial corporations are mainly concerned with the creditworthiness of counter-parts and strive to establish stable relations with depositors. They also develop expertise in monitoring enterprises that benefit from loans. If funding appears to be stable financial corporations can make long-term commitments. The accumulation of short-term liquid assets which often characterises banks can then be seen as a “buffer” that can be increased when times are good and decreased when times are bad (Allen and Santomero 1999). In this situation, risk management can be analysed as a spread over time of risks which cannot be diversified by other means. This intertemporal smoothing of risks (Allen and Gale 1996) is mainly remunerated by the difference between interests received and interests paid. It does not entail significant trading in securities or securitization. This “traditional” risk management has lost in importance. Deregulation, globalisation and increased capital mobility have sharpened competition. Investors have moved substantial parts of their funds from banks into non-bank financial corporations and accumulated assets with new features. Rather 3 “Own funds” can be identified with the more widely used notion of ‘equity’, i.e., the unit’s assets less its liabilities (where, in the case of a joint stock company, the latter exclude the ordinary share capital). Thus, “own funds” comprise the value of ordinary shares, retained earnings and other reserves. 6
  6. 6. STD/NA(2002)19 than carrying “buffer” reserves over from period to period banks became major innovators in an effort to facilitate risk transfer and allocate it to those most able to bear it. “New” risk management uses complex financial instruments to bundle and unbundle the different components of risk. Risks are now traded so that more risk-averse agents bear less risk than those who are risk-friendly. This kind of risk trading is therefore achieved through exchanges of risk among individuals at a given point in time. Risk-sharing and risk-shifting are the main features of the new risk management. The concerns about creditworthiness of counterparts not only exist for assets but also for liabilities due to rapidly expanding securitization. Ultimately financial corporations offer liabilities with unit-specific risk- profiles on the one hand and acquire assets with other unit-specific risk-profiles. The development of off-balance sheet transactions can partly be seen as the result of this risk-shifting process, as complex contingent liabilities are created to offset the outcome of other transactions. It is important to note that this permanent reshuffling of risks does not mean that financial corporations themselves bear no risk. On the contrary – they remain the ultimate bearers of certain types of risks. In this respect, they are different from insurance corporations, who can alter conditions of contract and/or tariffs at short notice when the risk evaluation changes as contingencies rise. Off-balance sheet operations are often seen as constructs to counterbalance various types of transactions, but ultimately the risk remains within the sector. Financial corporations thus assume some kind of “ultimate” net risk. The changes in risk management presented above have far-reaching consequences in terms of remuneration. “New” risk management implies active trading in securitized assets and liabilities and often involves holding gains or losses. These do not only reflect the exogenous and unexpected movement of prices of assets permanently held in the balance sheet but are also outcomes from systematic reshuffling of all positions of the balance sheet. The latter used to be a “static” working tool for financial corporations with deposits and loans held up to maturity. More recently, the balance sheet has become a ”dynamic” working tool as all financial assets and liabilities can enter the risk management process through trading. Liquidity transformation “Liquidity transformation” shares common features with risk management and in practice it is difficult to distinguish between the two. Nevertheless liquidity transformation is an important activity of financial corporations and its delivery has changed over time so that a separate description appears worthwhile. Investors, on the one hand, have always been concerned with liquidity because they are uncertain about the time at which they may want to increase or reduce their holdings of a financial asset. Borrowers, on the other hand, are concerned with liquidity because they are uncertain about their ability to raise added funding in the future. An interesting feature of “traditional” liquidity transformation is that it is “demand- driven: deposits and credits fluctuate according to the needs of bank customers. Moreover for a long time credits and deposits were not traded on financial markets, and remained in the balance sheet of the original bank. Again, this “traditional” liquidity transformation was mainly remunerated with the interest rate differential. A “new” liquidity transformation has risen in importance with financial liberalisation and capital markets integration. Its satisfies needs of different customers. Bernard and Bisignamo (2000) list the following factors that contributed to the growing demand for this “new” liquidity: “(…) The relative increase in short-term liabilities of intermediaries, reflected in the greater degree of short-term international lending during the 1990s; the securitisation of assets (…); the enormous increase in domestic and cross-border trading volumes of financial assets; the move to real-time gross settlement systems (…); the demand for liquidity to support derivatives activities (e.g. margining), by both end-users and market-makers; and the greater proprietary trading of financial intermediaries. Also 7
  7. 7. STD/NA(2002)19 important has been the trend to provide contingent lines of credit to potential borrowers, both as backup for the issuance of commercial paper and as alternative lines of credit to capital market borrowing (…). Liquidity demands can also increase as a result of the use of over-the-counter derivative instruments to provide leverage to market participants” (p.5). Arbitrage activities, counterpart activities and underwriting facilities have a common feature: they provide market liquidity. By creating new assets and liabilities with different liquidity profiles financial corporations provide services on both sides of their balance sheets. Here again the remuneration of this “new” liquidity is different: while commissions remunerate some of these actions, others –like arbitrage- are remunerated through holding gains or losses. A distinctive feature of this new liquidity transformation is that it is initiated by the financial corporation itself and is not as much demand-driven as before. Moreover it gives greater weight to the interaction between corporations and markets rather than on the “one to one” relation that prevailed earlier. Using their substantial portfolio assets (“proprietory trading”) financial corporations take advantage of opportunities arising on given sub-markets, thereby contributing to a smooth functioning of the overall structure. A working definition In light of the above points, the Task Force prefers a broader definition of financial corporations. The working definition of the Task Force is along the following lines: Financial corporations are all resident corporations or quasi-corporations principally engaged in providing financial services4. The production of financial services is the result of risk management, liquidity transformation and/or auxiliary financial activities. Risk management and liquidity transformation are productive activities in which an institutional unit incurs financial liabilities for the purpose of acquiring mainly financial assets. Corporations engaged in these activities obtain funds, not only by taking deposits but also by issuing bills, bonds or other securities. They use these as well as own funds to acquire mainly financial assets by making advances or loans to others but also by purchasing bills, bonds, or other securities. Auxiliary financial activities facilitate risk management and liquidity transformation activities. Financial auxiliaries – the units that are primarily engaged in auxiliary financial activities – typically act on behalf of other units and do not put themselves at risk by incurring financial liabilities or by acquiring financial assets. This definition: − Defines financial corporation foremost via the nature of their output (financial services) instead of their activity (intermediation). Thereby, it extends the logic of the production indirectly measured to other elements of the balance sheet of financial corporations. 4 . Some further discussion may be needed to examine whether financial services have to be provided to other units or whether they may also constitute ‘own account production’. For example, do portfolio management services associated with the management of a financial institution’s own funds constitute production in this sense and if so, whether such production is recognised by the SNA? 8
  8. 8. STD/NA(2002)19 − Emphasises “Risk Management” and “Liquidity transformation” activities rather than “Intermediation” activities. This semantic change seems to better capture the nature of the business of today’s financial corporations. − Treats all sources of funds symmetrically, in recognition of the fact that financial services are produced by taking and investing funds, independently of their origin. In particular, there is no reason to exclude the financial services produced by the investment of financial corporations’ own funds. − Allows for investment in non-financial assets. Parts of the non-financial assets that financial corporations own are simply one alternative form of investment. It may occupy a small share of (non-insurance) financial corporations’ assets, but should not be excluded on an a-priori basis. Further discussion will be needed concerning the treatment of such assets in the measurement of financial services. What are the services rendered by financial corporations? To start with: a clarification of terminology The working definition of the Task Force puts forward financial services. This is more than a semantic issue because measuring the production of financial corporations means measuring the services that they produce. The Task Force stressed the need for identifying these services. Before doing so, a distinction must be made for clarity of discussion between financial services and financial instruments. Figure 1 provides an illustration of the whole process discussed so far. Financial services constitute the output of financial corporations. It is the services that users value and that are provided – implicitly or explicitly – on the market. What makes them somewhat different from other services is that they are often provided implicitly. 9
  9. 9. STD/NA(2002)19 Figure 1 Production process of financial unit Output=Services •Liquidity provision service •Monitoring service Inputs •Financial information service Activities •… •Labour •Other services •Non-financial goods/services •Non-financial capital services •Risk management •Liquidity transformation •… Financial capital •Other activities Output-Support= Financial Instruments •Deposits •Loans •Securities •… •Other instruments Financial instruments are the catalysts by which financial corporations sell bundles of financial services. They constitute the observable form of the transaction in which financial corporations and their clients engage. For example, liquidity provision is a financial service, as is record keeping. Both services are produced by banks but sold as a bundle to customers who purchase the financial product ‘current account’. Of course, there may be financial instruments that consist of only one type of financial service in which case ‘financial service’ and ‘financial product’ coincide. The sale of financial market information by a credit rating agency is a case in point. One notes that some financial instruments function as inputs into the production process of financial services. For example, deposits may be necessary to provide the funds for loans – the product by which liquidity services are delivered to borrowers. Thus, financial instruments cannot be easily classified into categories of inputs or outputs. However, there is no specific need to do so, as long as it is clear that financial services constitute the output of financial corporations. Given that financial instruments are only a tangible form by which some financial services are provided and considering that financial services can only be provided by institutions classified as financial corporations, it follows that loans or deposits are not as such production. There may be no production at all (e.g., if a loan agreement is made between two households). A service and production in a national accounts sense only exists because there is a financial corporation that collects funds and transforms them into financial instruments that suit preferences of customers. ‘Intermediation’ does not very well capture the breadth of services Financial services constitute the output of financial corporations and are thereby an object of considerable interest to national accountants. To identify them, it is useful to turn to the literature on the economics of finance, and more particular to those strands of research that provide explanations why financial corporations exist in the first place. There is a body of literature focussing on the theory of intermediation, built around the idea that transaction costs and asymmetric information are important in understanding the role of financial corporations (see, for example Gorton and Winton 2002) for a comprehensive overview of 10
  10. 10. STD/NA(2002)19 this literature). Gorton and Winton conclude, “financial intermediaries are producing services that are not easily replicated in capital markets” and identify several of the services mentioned below, including monitoring services. However, a number of other services springs to mind that appear to be insufficiently described by intermediation services. The elements in the following list aims at being broader in scope but it should be pointed out that the services mentioned are neither mutually exclusive, nor is every type of service always clearly separable from the others. Monitoring services: monitoring of potential borrowers is costly and it is efficient to delegate the task to a specialised agent, the bank. Thus, faced with a choice of going out and screening potential borrowers on the financial market, an investor buys this service from a financial corporation by depositing his funds with the intermediary. Somewhat akin, Allen and Santomero (1998) focus on participation costs in financial markets. The authors deviate from the idea that all financial market participants are equally informed and introduce participation costs that need to be incurred to become an informed market participant. Financial corporations help avoiding participation costs – they create financial instruments with relatively stable returns, allowing investors to monitor their asset holdings on a relatively infrequent basis. In return, financial institutions use their knowledge to invest on the financial market to finance the income due to investors. Avoidance of participation costs applies also to potential borrowers: financial institutions monitor depositors on behalf of borrowers to identify for example those who are willing to commit to long- term deposits. Generally, monitoring services or services to avoid participation costs are a way of bringing together potential borrowers and investors who otherwise would have to incur search costs on financial markets. Convenience services: these services comprise, for example, bookkeeping, safeguarding, automatic payments, money transfers and the provision of cheques. Liquidity provision services: for depositors, liquidity provision services relate to the capacity to finance unforeseen expenditure due to the possibility to withdraw deposits at short notice and at small cost. For borrowers, liquidity provision services are provided when a financial institution offers contingent credit lines to potential borrowers. Some models stress the role of financial intermediaries as vehicles for consumption smoothing: by providing liquidity, financial corporations offer insurance against shocks to a consumer’s consumption path. A similar function applies to corporations whose credit lines allow them to carry out investment whenever this appears promising from a business perspective. Risk assumption services: in the absence of financial corporations, individual (non-financial) economic agents would bear the full risk of financial operations. For example, a unit with financial surplus would bear the risk involved in lending to individual borrowers5. Or a borrower dealing with a lender on an individual basis would bear the risk of the lender withdrawing his/her loan. Financial corporations, by making use of scale economies, can offer to accept part of the risks that would otherwise accrue to units with financial surpluses and units seeking finance. The following table provides several examples of financial instruments, the type of risk associated with it as well as the unit who bears it. 5 . Of course, potential lenders can always choose low-risk government bonds as investment but as long as there is demand for funds for more risky projects and as long as surplus holders supply is not entirely inelastic, there will be a market and a price for loans with non-zero risk. 11
  11. 11. STD/NA(2002)19 Table 1 Examples of risks associated with financial instruments Financial instrument Type of risk Risk borne by Loan Default of borrower Financial corporation Loan with fixed interest rate Change in market interest rate Financial corporation Default of borrower Deposit Withdrawal by depositor Financial corporation Deposits Run on bank Depositors (or insurer when there is deposit insurance) Portfolio management on behalf Misjudge market trends; Client of clients Sub-optimal investment decisions Sale of financial advice to client Misjudge market trends Client Sub-optimal investment decisions Portfolio management of own Misjudge market trends Financial corporation funds invested Sub-optimal investment decisions Fixed interest-bearing securities Misjudge market trends Financial corporation issued by financial corporation Sub-optimal investment decisions Securities held by market maker Price changes of securities or Financial corporation absence of demand for them Financial information services: when information about investment opportunities is costly, then there is value in producing it. Financial information services can, however, be sold in very different forms: a) As a separate product as is for example the case with credit rating agencies. Another example is investment banks that offer after-issuance advice to corporations after a security has been underwritten. Such advisory services will be all the more requited when advanced financial tools are involved such as callable bonds or convertible bonds where a corporation often relies on the investment bank to determine the optimal moment for exercise. Typically, there is an explicit price for this service. b) Embedded in portfolio management activities: this occurs, for example, when financial corporations manage portfolios on behalf of third parties: although the financial corporation does not expose itself to risk, it makes investment decisions, thereby selling financial information implicitly. A mutual fund would be an example of implicitly sold information services. 12
  12. 12. STD/NA(2002)19 Underwriting services: these are core activities of investment banks and involve the issuance of a security by a corporation or by government. The investment bank acts as a consultant during the entire process and finally enters a contract with the client to purchase the security for a specified price (Roll 1992). Underwriting services are typically compensated by a margin that the investment bank takes on the price of the security. Securization services are a special type underwriting services and entail packaging individual (fixed-income) assets into pools. Ownership claims to various portions of the cash flow from the pool are then sold to the public in the form of transferable securities. Securization increases the liquidity of the underlying assets and therefore implies the provision of liquidity services to the initial owners of the underlying assets. Inventory, trading and market making services: due to their reputation and cumulative knowledge, certain financial institutions, in particular investment banks, occupy a particular place as traders who bring together buyers and sellers of securities or who hold inventories of stocks so as to satisfy demand as it arises. Such market makers play a central role in many equity markets by buying and selling shares to service the public’s demand to trade immediately (Schwartz 1992). Thus, market makers supply ‘immediacy’: buyers and sellers arrive at the market at different times and the market maker stands ready to trade from his or her own inventory of shares. The service is not free; the dealer sells to buyers at higher ‘ask’ prices and buys from sellers at lower ‘bid’ prices. This bid-ask spread is the market maker’s compensation for inventory services. But the bid-ask spread also compensates the market maker for accepting risk due to uncertainty concerning future prices and future transaction volume in the asset. Measuring financial services: main points This section briefly describes the measurement towards the production of financial corporations as currently recommended by the SNA and implemented in many OECD countries. The text then goes on and points out how the present approach could be extended and what the issues and obstacles are that arise in this context. Measurement: what the SNA prescribes Many of the financial services produced by financial corporations are implicitly priced. Although market transactions take place, their value, price and volume is not directly observable. Financial corporations defray their expenses and have an operating surplus by receiving rates of return on the funds they lend that are higher than the rates they pay on the funds they borrow. The SNA which subsumes this activity as ‘financial intermediation’, foresees an indirect way of measuring the value of financial services implicit in the business of lending and borrowing and uses the net receipts of interest as an indirect measure for production. This gives rise to financial intermediation services indirectly measured (FISIM) that are defined as “the total property income6 receivable by financial intermediaries minus/ their total interest payable, excluding the value of any property income receivable from the investment of their own funds, as such income does not arise from financial intermediation” (SNA 93, paragraph 6.125). When financial services are explicitly transacted, their value is directly observable and their measurement poses no particular conceptual problem. The SNA 93 (paragraph 6.123) mentions currency exchange services, or advice about investments, the purchase of real estate, or taxation as examples of such explicitly priced financial services. The value of these services is straightforward to measure, and typically corresponds to the fees or commissions involved. 6 . Property income comprises interests, distributed income of corporations (such as dividends), reinvested earnings on foreign direct investment, property income attributed to insurance policy holders and rent. For financial corporations, the main items in this list are interest payments and distributed income of corporations. 13
  13. 13. STD/NA(2002)19 Eurostat FISIM: an operational definition Eurostat, in a regulation on FISIM, uses a reference rate method (Eurostat 2002) and derives the total value of financial services as the sum of the services rendered to borrowers and to depositors. The value of these services is measured as the “difference between the actual rates of interest payable and receivable and a reference rate of interest. The latter represents the pure cost of borrowing funds – that is a rate from which the risk premium has been eliminated to the greatest extent possible and which does not include any intermediation services”(SNA 93, paragraphs 6.127 and 6.128). Eurostat FISIM is then calculated as = (rr-rDD)yD+(rLL-rr)yL where rDD is the actual rate of interest paid to depositors, rLL the rate charged to borrowers, rr is the reference rate and yD and yL are the values of deposits and loans, respectively. By its very nature, a key advantage of this method is that it implies a way of allocating FISIM among users. The choice of the reference rate is an important issue that can influence results and which has been the object of considerable discussion. The Eurostat Regulation stipulates the use of a computed rate based on interbank loans. Deposit/loan case When financial services are provided implicitly – with instruments as carriers – a useful strategy to identify financial services is to imagine a world without financial corporations. This idea is best illustrated with the figures below. Figure 2 presents a situation without financial intermediaries: there is a loan market and non-financial units with surpluses of funds enter in direct contact with non-financial units with a demand for funds. Every market participant incurs his own search costs, bears the full risk of the operation but no financial services are provided. Only property income exists on this market in the form of interest payments between non-financial units. Figure 2: Loan market without financial corporation Interest paid Financing Non-financial units Non-financial units with demand Financial with surplus for funds Markets of funds Next, consider a case with financial corporations: some of the funds from non-financial units are now deposited with financial corporations at a rate that is determined on the newly created market for deposits. Financial corporations, in turn, channel funds to the loan market where they become available to other non- financial units. As the added institution and the new market for deposits exists, there must be value in it, and this value corresponds to the value of financial services. 14
  14. 14. STD/NA(2002)19 Figure 3: Deposit/loan market with financial corporation Interest paid Financing Non-financial units Non-financial units with demand Financial with surplus for funds Markets of funds Deposit (Y D) Loan (YL) rL rD Interest rate Interest rate for loans Financial for deposits corporations Assets Liabilities Deposit/loan case: three interpretations but the same outcome Measurement of the value of financial services can only be done residually, given that they are priced implicitly. What can be observed is the remuneration of loans and deposits. A residual computation of the value of services could then proceed along three avenues: (a) First, take all interest payments on loans and subtract interest payments on deposits but allow for the fact that own funds of the financial corporation are also used in the production process. This implies that some minimum remuneration has to be introduced for own funds when the value of services is computed residually. It could also be argued that there are opportunity costs to funds being invested in a financial corporation and these opportunity costs need recognition. Thus, a first approach towards calculating the value of financial services is to use net interest corrected for minimum remuneration of own funds (or for their opportunity costs). It is not difficult to argue that the opportunity cost is well captured by a rate that reflects the safe return on an alternative investment such as government bonds. This rate can easily be identified with the ‘reference rate’ alluded to elsewhere in the SNA and in Eurostat’s FISIM calculation (see box). (b) Second, start out with a situation where there are no financial corporations and where loans are again granted at a rate rL but this time by individual (non-financial) units. rL is a rate that reflects, among other things, the degree of risk involved in the loan. The risk premium for the lender is given by r L-rr, where rr is again an alternative investment (say in government bonds) at minimum risk7. The amount of the loan is yL. Now let there be a financial corporation that intermediates between the two non-financial units: it takes a deposit at the rate r D and lends it out at the rate r L. Under this new situation, the depositor only accepts risk that is valued at (rD-rr)yD. The difference with the total value of risk (rL-rr)yL is the service rendered by the financial institution. This risk differential8 corresponds therefore to (rL-rr)yL-(rD-rr)yD. 7 . Although not necessary identical, this rate is again close to the ‘reference rate’ referred to in the SNA and used in Eurostat’s FISIM calculations. 8 . Note that rD is the interest rate that would prevail if there are no added convenience or advisory services to the depositor. The reference rate rr has to be defined around the same conditions (availability of funds etc.) except for 15
  15. 15. STD/NA(2002)19 On the asset side, banks act as investors and put the deposited funds at the disposal of those seeking liquidity on the financial market. Thereby, financial corporations will typically accept risks beyond those from an opportunity (low-risk) investment and require a higher rate of return as a risk premium. In the simplest case where banks invest in loans, the risk premium can be measured as (rL-rr)yL. In the simple deposit/loan case it could then be said that the value of risk assumed by the financial corporation corresponds to the difference between the total risk inherent in the loan and the value of risk left to the owners of deposits. (c) Third, the above results also join in with the user cost of financial capital approach in the economic literature, based on Barnett (1978), and applied for example by Hancock (1985), Fixler and Zieschang (1991, 1999) and Fixler (1993). Under this approach, financial corporations produce financial instruments to which bundles of services attach: “The user cost measures the economic return to the financial corporation for providing a financial product. The economic return is the difference between the financial corporation’s opportunity cost of money and the holding revenue in the case of an asset or the holding cost in the case of a liability.” (Fixler and Zieschang 1991). More specifically, the (simplified) user cost per currency unit of a financial instrument is uD=[rr-rD] in the case of a liability, and uL=[rL-rr] in the case of an asset, where rr is the corporation’s opportunity cost of money, rDD and rLL are again the interest rates paid on deposits and on loans. Total user costs and the value of financial services are then measured as the product of the user cost price times the amount of deposits and loans, i.e., as uDyD+uLyL. This yields: user costs in the deposit/loan case = uDyD+uLyL=[rr-rDD]yD+[rLL- rr]yL. This expression corresponds again to the one derived under (a) and (b). To conclude on the deposit/loan case First, for the simple deposit/loan case, we have derived an expression for the value of financial services with a double interpretation: as assumption of risk by the financial corporation or as a measure of net interest income with consideration of opportunity costs of investment. Both formulations yield the same result and are also consistent with the calculation of FISIM as foreseen by Eurostat. Furthermore, they are consistent with the user cost approach. Second, while the overall value of financial services in the deposit/loan case has been established on economic principles, there are no straightforward implications for the partition of the total value between borrowers and depositors. This is different in Eurostat’s formulation which provides such a split. Third, no restrictions were imposed on the use of own funds as a source of funds for the provision of loans. This is counter to SNA prescriptions but intuitively and economically plausible. Fourth, the question arises why the measurement of financial services should be limited to those that are associated with deposits and loans when other financial instruments that form parts of the balance sheet potentially involve the provision of financial services. The following section will thus extend the present approach to cover other parts of the financial corporation’s balance sheet. a difference in risk. It may well be that an investor considers a deposit in a bank just as safe as an alternative investment in, say, government bonds. In this case, the risk premium becomes zero. 16
  16. 16. STD/NA(2002)19 Beyond the deposit/loan case Whereas the simple deposit/loan case is convenient for presentational purposes, it is unsatisfactory from an analytical point of view. It was argued earlier in this document that the financial services industry has seen a structural shift away from the traditional deposit/loan business towards more diverse strategies to attract funds as well as to invest them. It is therefore relevant to extend earlier considerations to other types of liabilities and to other types of assets. To illustrate the importance of security trading in the business of financial corporations, consider Figure 4. It presents the evolution of total revenues and of revenues from security trading by Swiss banks and shows the increasing importance of this item. Thus, the question whether there is any production or income generation associated with this revenue is of significant interest, given its rising importance. Figure 4 Total and security trading revenues in Switzerland All banks, 1985=100 800.0 Revenues from 700.0 trading in 600.0 securities 500.0 400.0 300.0 200.0 Total revenues 100.0 - 85 87 89 91 93 95 97 99 01 19 19 19 19 19 19 19 19 20 Source: Schweizerische Nationalbank (2002); Die Banken in der Schweiz; Zürich; Table 40.12. For this purpose, consider the balance sheet below that distinguishes three main types of financial liabilities (deposits, shares issued and other securities issued) and three main types of financial assets (loans, shares owned and other securities owned). It should be noted that this balance sheet follows SNA prescriptions and has a different format from commercial balance sheets. For example, the SNA balance sheet recognises financial derivatives as part of the balance sheet of a financial corporation. At the same time, commercial balance sheets are the main statistical source to measure the assets and liabilities of financial corporations. Certain items, in particular financial derivatives are treated as off-balance sheet. Also, rules for valuation of assets and liabilities may vary between the two types of balance sheets. While it would be natural to derive a national accounts measure for the production of financial services in conjunction with a national accounts type balance sheet, the empirical limits of such an undertaking would soon become apparent. Thus, commercial balance sheets would remain a primary source for any empirical efforts towards services measurement. 17
  17. 17. STD/NA(2002)19 Table 2 SNA-type balance sheet of financial corporation Assets Liabilities Non-financial assets Financial assets Financial liabilities Monetary gold and special drawing rights Currency and deposits Currency Securities other than shares, including Securities other than shares, including financial derivatives financial derivatives Shares and other equity Loans Other accounts payable Shares and other equity owned Other accounts receivable Net worth Financial services associated with securities For the measurement of the value of financial services associated with securities it is again instructive to first think about an economy without financial corporations. Ignoring, for simplicity, deposits and loans, such an economy would feature only one market for securities issued by non-financial units. Demand for these securities and supply of funds would also come exclusively from non-financial units. This is illustrated in the figure below. Individual investors have to incur costs to choose between securities offered on the market and they have to engage in portfolio management activities. As each investor operates on his own, he or she bears the full risk of the operation. Figure 5: Securities market without financial corporation Return on investment Securities issued by non-financial firms Non-financial units Non-financial units with demand Financial with surplus for funds Markets of funds 18
  18. 18. STD/NA(2002)19 Now let there be a financial corporation that issues securities (bonds or shares) to attract some of the funds from agents with surplus and invests them on the market for securities issued by non-financial units. In doing so, an additional market is created: the market for securities issued by financial corporations (Figure 6). Non-financial units buy these securities because they generate property income but, contrary to a direct investment on the market for securities issued by non-financial units, agents do not have to incur portfolio management costs and search cost to obtain costly information about non-financial corporations. Thus, the financial corporation provides portfolio management services, embedded in a financial product, the securities issued by the bank. Such portfolio management services may be sold with an explicit price, for example a service fee. The most clear-cut case of such an arrangement is mutual funds that undertake collective investment in securities against a service charge. No risk is assumed by the financial corporation, and the measurement of production at current prices is straightforward, as it equals the value of the service fee. Things are more difficult when portfolio management services are sold implicitly, typically in conjunction with some risk assumption service. As an example take the case where a financial institution issues a fixed interest bearing bond and uses the proceeds to invest in a portfolio of financial assets. Here, no explicit price exists for the combined portfolio management and risk assumption service, and an indirect measurement is called for. Figure 6: Securities markets with financial corporations Return on investment Securities issued by non-financial firms Non-financial units Non-financial units with demand Financial with surplus Securities issued (Y SI) for funds of funds Securities owend (Y SO) Markets reSO reSI Rate of return Rate of return on securities Financial on securities corporations Assets Liabilities Valuation of services with implicit prices To measure the value of services that are implicitly priced, a residual calculation could be envisaged as a natural extension to the deposit/loan case. Thus, the value of financial services implicitly priced would equal the returns generated by the financial corporations’ investments minus the returns that accrue to holders of the financial corporation’s securities. Further, a minimum return could again be deducted for the equity invested. On the face of it, this suggests calculations that are quite similar to the ones in the deposit/loan case. However, there are some added complications associated with the nature of returns to 19
  19. 19. STD/NA(2002)19 securities. In particular, the treatment of asset price changes and holding gains and losses has to be addressed both conceptually and empirically. Open questions An extension of the indirect measure of financial services to other parts of the balance sheet has to take account of a number of complications and the task force has only started to address these questions. Consequently, the present section states the issues but does not yet supply any answers. Should all securities be included? The task force spent considerable time on discussing whether all securities are potential carriers of financial services and whether returns from all types of securities should be included in an estimate of the total value of financial services. Particular attention was paid to shares. Equity can be seen as one particular way of providing liquidity provision and risk assumption services to non-financial units who use equity as one particular way of financing (investment) projects. It is more difficult to make this case for equity held by financial institutions with a view to achieving short-term trading gains. However, even in this case, there may be a portfolio management service rendered, for example to holders of securities issued by the financial corporation. In the event, such a service may also be considered one for the financial corporation’s own shareholders who bought equity of the financial corporation in expectation of returns following successful portfolio management services. And if so, how does one treat holding gains and losses? The SNA 93 draws a distinction between property income and holding gains and losses. The latter are changes in value of an asset due to changes in its price that constitute neither transactions nor income. Holding gains or losses are recorded by the SNA independently of whether they are realised or not through subsequent financial transactions. In the eyes of the SNA, holding gains can never be compensation for a service. Yet, from an economic perspective it could be argued that sometimes (expected) holding gains might be part of the price at which some financial services are exchanged. For example, the value of risk assumption services could be measured by a risk premium, itself the difference between the expected return on a risky asset over the expected return on a risk-free asset. There is no easy way out here, although Fixler and Moulton (2001) put forward a suggestion to distinguish between different types of holding gains. They stress the fact that expectation of a holding gain may provide an incentive for a unit to engage in a productive process, and reason that “the SNA acknowledges the possibility that a change in the price of an asset may be associated with ‘transforming’ or a process of production, rather than simply representing a pure holding gain. For such cases, it is generally necessary to separate ‘pure’ holding gains from changes in price that represent productive activity”. If it were possible to separate ‘expected’ from ‘pure’ holding gains, the former could be redefined as compensation for a financial service. The task force identified one case where holding gains could enter the value of production without changes to the SNA. Management of portfolios on behalf of clients may involve service fees that are linked to holding gains. In this case, parts of holding gains could be used as a proxy to value the financial service provided by the financial institution with actually including holding gains into a measure of income or changing their nature as defined by the SNA. 20
  20. 20. STD/NA(2002)19 Any discussion about holding gains has to consider the case of holding losses. If parts of the former could be considered payment for a service, this certainly does not apply to the latter. Again, the distinction between expected and actual price changes might help here but more discussion will be needed. How about financial derivatives? Financial derivatives are assets based on or derived from a different underlying instrument – usually another financial asset but also a commodity or an index. Derivatives have gained in scope and importance as financial instruments. They also appear as balance sheet items in the national accounts. If the principle applies that all financial assets and liabilities are potential carriers of financial services, this would mean that derivatives should not be a priori excluded. The task force agreed that some services are attached to derivatives. However, identification of the financial service is not straightforward and may depend on the type of derivative. For example, option prices include an explicit service element which provides a way of measuring financial services. Also, marketable derivatives have fees attached which permits direct measurement of at least parts of the financial services that come with the handling of derivatives. In other cases such as swaps, the identification of the service element turns out to be even more difficult. Empirically, a large proportion of trading in derivatives is internal to the financial sector. This would reduce their importance for the measurement of financial services as delivered from the financial sector to the rest of the economy. Lastly, mention is made of the virtual impossibility to trace back empirically derivatives to other items on the balance sheet. Can we identify the units that buy financial services? Whenever a flow of production is recorded in the national accounts, it has to be allocated to users. For several reasons, this is a difficult task in the case of financial services. First, the total value of the financial service has to be allocated to the various financial instruments. Second, even if the financial service can be allocated between different items on the bank’s balance sheet, it is necessary to know which type of institutional unit holds certain assets or has engaged in liabilities. Thus, assets and liabilities need cross- classification by type of institutional unit. Only then can the important distinction between final and intermediate consumption be made which has a direct impact on overall GDP. Volumes, values and prices: much work left The measurement of output of financial corporations at current prices may be a difficult undertaking but the statistician cannot stop there: splitting values into a price and a volume component is just as important as getting the current price values right. The price/volume split is far from obvious and concerns implicitly priced services just as much as explicitly priced ones. For example, it cannot at all be taken for granted that an explicit ‘price’ of a financial service such as a percentage rate on which commission fees are based are useful measures of prices of the underlying services. Here, the measurement questions for financial services share many features with those for other business services. Identifying the volume component of implicitly priced services is challenging as well. However, a discussion and identification of the nature of the financial services that are sold implicitly and explicitly should provide guidance to the measurement of their volume and prices. In conclusion The purpose of the present document is to outline some of the reasoning that the task force has followed in its attempt to review the measures of production for financial corporations. As this is a progress report and 21
  21. 21. STD/NA(2002)19 not a final document, reflections are necessarily incomplete and will require further conceptual and, importantly, empirical work. It is hoped that the discussion at the national accounts expert meeting will provide additional insights and suggestions for avenues to pursue as well as an opportunity to test ideas with a larger and well informed constituency. 22
  22. 22. STD/NA(2002)19 BIBLIOGRAPHY Allen, Franklin and Anthony M. Santomero (1999); “What Do Financial Intermediaries Do?”, Wharton Financial Institutions Center Working Papers 99-30-B. Allen, Franklin and Anthony M. Santomero (1998); “The theory of financial intermediation”, Journal of Banking and Finance 21, p. 1461-1485. Allen, Franklin and Douglas Gale (1996); “Financial markets, intermediairies and intertemporal smoothing”, Wharton Financial Institutions Center Working Papers 96-33. Baltensperger, E.(1980); “Alternative approaches to the theory of the banking firm”, Journal of Monetary Economics 6, pp. 1-37. Barnett W.(1978); “The User Cost of Money”; Economics Letters, 2, 145-49. Basset, William F. and Mark Carlson (2002); “Profits and Balance Sheets Developments at U.S. Commercial Banks in 2001”; Federal Reserve Bulletin June. Bernard, Henri and Joseph Bisignano (2000), “Information, liquidity and risk in the international interbank market: Implicit gurantees and private credit market failure”, BIS Working Papers n° 86. Bournay, Jacques (1998); “Repartition du service d’intermédiation financière indirectement mesuré (SIFIM)”; paper presented at the 7th Colloque de l’Association de Comptabilité Nationale; Paris. Fixler, Dennis (1993); “Measuring financial service output and prices in commercial banking”; Applied Economics, Vol 25, 983-993. Fixler, Denis and Kimberley Zieschang (1991); “Measuring the nominal value of financial services in the National Income Accounts”; Economic Inquiry 29, 53-68. Fixler, Dennis and Kimberley Zieschang (1999); “The Productivity of the Banking Sector: Integrating Financial and Production Approaches to Measuring Financial Services Output”; Canadian Journal of Economics, Vol 32, No 2, 547-569. Fixler, Dennis J., Brent R. Moulton (2001); “Comments on the treatment of holding gains and losses in the national accounts”; Paper presented at the OECD Meeting of National Accounts Experts, October. Fixler, Dennis J. (2002); “Identifying Bank Financial Services in the US”; Paper prepared for the OECD Task Force on Financial Services. Gorton, Gary and Andrew Winton (2002); “Financial Intermediation”; NBER Working Paper Series 8928. Hancock, Diana (1985); “The Financial Firm: Production with Monetary and Nonmonetary Goods”; Journal of Political Economy, vol 93, no 51, 859-880. Harrison, Anne (1996); “Rethinking FISIM”, unpublished manuscript. Harrison, Anne (2002); “Defining and measuring financial services”; Paper prepared for the OECD Task Force on Financial Services. 23
  23. 23. STD/NA(2002)19 Hill, Peter (1996); “The Services of Financial Intermediaries of FISIM Revisited”; unpublished manuscript. Moulton, Brent R. (2000); “Measurement of banking services in the U.S National Income and Product Accounts: Recent changes and outstanding issues”. Rajan, Raghuram G. (1996); Is there a future in banking? Towards a new theory of the commercial bank, Northwestern University and the University of Chicago. Roll, Richard (1992); “Investment Banking”; The New Palgrave Dictionary of Money and Finance; 143-145. Santos, Joao A. C. (2000); “Bank capital regulation in contemporary Banking theory: a review of the literature”, BIS Working Papers n° 90. Schmidt, Reinhard H., Andreas Hackethal, and Marcel Tyrell. (1998); “Disintermediation and the role of banks in Europe: an international comparison”, Johann Wolfgang Goethe-Universität, Working Paper Series: Finance & Accounting N°10. Schreyer, Paul and Philippe Stauffer (2002); “Measuring the production of financial intermediaries”; Paper prepared for the OECD Task Force on Financial Services, June. Schwartz, Robert A. (1992); “Market Makers”; The New Palgrave Dictionary of Money and Finance; 143-145. Stauffer, Philippe and Ruth Meier (2001); “What services for what society? How should the services provided by financial intermediaries in a modern society be measured?”; paper presented at the 2001 OECD National Accounts Experts Meeting [STD/NA(2001)13], Paris.Thakor, A.V. (1996), “The design of financial systems: An overview.” Journal of Banking & Finance Vol. 20, pp. 917-948. 24