Joseph E. Stiglitz Beijing May 13, 2009

1. Joseph E. Stiglitz Beijing May 13, 2009 Keys to Future Stability and Growth: Institutional Investors and Regulation

2. Outline • Some basic concepts/lessons from the current crisis • Traditional roles of institutional investors and asset managers • New roles of asset management in the new regulatory framework?

3. The current crisis and where the system failed • Incentives • Market participants had incentives to engage in excessive risk taking/short sighted behavior • Conflicts of interest • Transparency • Market participants had incentives and instruments for non-transparency • But failure was more than that of transparency: complexity • Competition • Too big to fail institutions had incentives to engage in excessive risk taking • Competition didn’t work—race to the bottom

4. Failures of America’s Financial System • Didn’t manage risk—created risk • Misallocated capital • Too much into housing, too little to real investment, innovative sector, improving environment • High transaction costs • Resisted creation of an efficient electronic transfer system • Predatory lending practices

5. Failures of America’s Financial System • Innovations directed at regulatory, accounting, and tax arbitrage • Little innovation at meeting society’s real needs • Failed at both micro and macro level • Major social problems—devastation of the poor in America • Global macro-problem

6. “Model” didn’t work • Self-regulation didn’t work • Perverse incentives • Self-regulation can’t work—externalities • Model of risk diversification (securitization) didn’t work • Increased information asymmetries • Systems of market checks and balances failed (credit rating agencies) • Regulatory checks and balances failed • Ideology • Capture

7. What are the key factors in the design of a new regulatory structure and system ? • Asymmetries and imperfections of information • Moral hazard • Human fallibility/  “behavioral” economics • Externalities

8. Key features of new regulatory system • Regulation has to be comprehensive • Globally, domestically • Products, Institutions • Restrictions on incentives • Restrictions on size • Restrictions on risk taking • Transparency/complexity • Financial product safety commission

9. Key principles to be safeguarded/ put in place • Mark-to-market—best information available • Care in regulatory use of information • Care in design of mark to market system • Restrict or inhibit the use of over-the- counter derivatives • Restrictions on leverage, countercyclical provisioning/capital adequacy • Have the voice of those whose interests are likely to be hurt be well represented in the regulatory structure

10. A good regulatory system can contribute to a more dynamic, innovative economy, a more efficient economy, a more stable economy, and a more “harmonious” society • Can’t return to the world as it was before the crisis

11. Outline • Some basic concepts/lessons from the current crisis • Traditional roles of institutional investors and asset managers • New roles of asset management in the new regulatory framework?

12. A distinctive feature of this financial crisis versus previous ones • It has occurred in highly securitized and institutionalized context • Theory was that risk would be spread/diversification would make economy more stable • Banks didn’t move as much risk off their balance sheet as they pretended • Securitization worsened problems of information asymmetry • Securitization worsened problems of ex post resolution • Increasingly important role of institutional investors • Pension funds • Life insurance • Mutual funds • Sovereign and other government-sponsored funds

13. Household and Sovereign portfolios – The flip-side of securitization • Securities are increasingly held by households, either directly or indirectly through institutional investors • Pension funds and life insurance mean an increasing number of households access securities markets • Recently sovereign funds and other government-sponsored funds have gained increasing relevance and become important investors

14. 70% 60% Netherlands 50% UK 40% Share of institutional investors Germany US Austria France 30% Japan 20% Spain Italy 10% 40% 50% 60% 70% 80% 90% Securities in household portfolios (%) Households are, to varying degrees, exposed to securities and to institutional investors • The degree of institutionalization refers to the share of family financial assets in pension funds, life • insurance policies and mutual funds, which e usually considered institutional investors. • With the term securitization, we refer to the transferability of the assets in the financial market, • and specifically all financial products excluding deposits. Source: PGAM Research elaboration on Central bank statistics

15. The effect of the current crisis on household financial wealth has been dramatic In terms of net wealth/GDP, the crisis has brought us below the 1995 levels and significantly so for the UK. which seems to have missed most of the equity market rebound after 2003 and also to have sufferedmore in the downturn USA: Flow of funds figures as of December 2008, Italy, UK : National accounts data as of 3rd quarter 2008, PGAM Research estimates for fourth quarter

16. Outline • Some basic concepts/lessons from the current crisis • Traditional roles of institutional investors and asset managers • New roles of asset management in the new regulatory framework?

17. Challenges facing institutional investing… • Securitization, for all the virtues of diversification, has introduced new asymmetries of information • Some institutional investors also act in short sighted manner, exhibiting “herding” behavior • Increased reliance on 3rd party valuations—power of credit rating agencies

18. The new regulatory frameworkWhat institutional investors want • Institutional investors’ interests coincide broadly with social objectives of a good regulatory system • Marginalize over-the-counter transactions • Increased transparency, lower transactions costs, better risk management—at a slight loss of ability to “tailor” products • Use exchanges that are also hubs for full information on the origin and evolution of securities, reduce scope for counterparty risk, reduce scope for hidden leverage • Enforce high levels of product standardization and transparency in transactions/pricing

19. The new regulatory frameworkWhat institutional investors can offer • Portfolio diversification • Continuous monitoring of securities in the portfolios through fundamental analysis • Mark-to-market and mark-to-maturity

20. The new regulatory frameworkWhat should institutional investors look like • With independent governance, independence from “sell side”: reduce scope for conflicts of interests • Main mandate: avoid potential negative impacts of information asymmetries on final investors (households/governments) • Provide effective diversification • Low transactions costs • Offer simple and understandable “default solutions”

21. The new regulatory frameworkHow institutional investors would fit in a 21st Century Regulatory Framework • A good alternative to the “too big to fail” institutions- they basically decentralize risk • Have limited or non-existent leverage • Appropriate to represent a vast array of final interests (employees, retirees, governments, plan sponsors) • Help think through appropriate risk analysis • Help improve corporate governance? • Have a culture of transparency

22. Rethinking our Financial System • America’s financial system failed—at great cost to America and the world • It is important for America and all other countries to learn the right lessons • Securitization can/will be an important part of 21st century financial markets • But for securitization to work, there has be much better regulations of all aspects of the financial market

23. Rethinking our Financial System • With appropriate regulatory structures, institutional investors can play an important role in enhancing the ability of ordinary citizens to manage the risks they face • And can contribute to a more efficient and stable economy