Monetary Circuit Theory has two roots – France and Italy.
From FRENCH CIRCUIT THEORY
The concept of the circuit was first used in economics by the Physiocrats of 18th century France. They viewed production as a cycle beginning with advances, that is, capital expenditure, and ending when the goods that had been produced were sold. To that extent, the late 20th century revival of the circuit concept by Bernard Schmitt (1960, 1966, 1984), Jacques Le Bourva (1962), Alain Barrère (1979, 1990) and Alain Parguez (1975), was a salute to a French tradition. This is not the whole story, though. Circuitist thinking, although usually unsung, has in fact underpinned many approaches to economics from Marx to Keynes by way of Wicksell,1 Schumpeter, Kalecki and J. Robinson.2 Indeed, today’s French circuit school owes much to Keynes, to whom Schmitt, Barrère and Parguez all referred extensively. And it is Keynes’s heterodoxy, as opposed to the conventional neo-classical view of Keynes’s economics, that was their source of inspiration. Hence the affinities of French circuitists with post-Keynesians (for a detailed review of common ground and differences, see Deleplace and Nell, 1996, Arena, 1996, Rochon, 1999a).
Circuit theory also counts an Italian branch which emerged in the 1980s on Graziani’s (1989, 2003) initiative and which explicitly focuses on Keynes’s monetary theory of production (cf. Fontana and Realfonzo, 2005). French and Italian circuitist approaches have also inspired post-Keynesians outside Europe, especially in Canada (Lavoie, 1984; Rochon, 1999; and Seccareccia, 1996). This affinity between circuit theory and Keynes’s heterodoxy and now post-Keynesian theory will be a recurrent theme in this paper. It should help readers familiar with post-Keynesian literature to grasp the significance of the circuit approach and help also to confirm its veracity.
Circuitists see the economy, meaning the present-day monetary economies of production, as being based on an asymmetrical (hierarchical) relationship between firms (or entrepreneurs) and workers. Firms employ workers and pay them money wages. In spending their money wages, workers gain access to a fraction of the output, the size of that fraction varying according to the price they pay for goods in markets. Symmetrically, firms earn profits formed by the surplus of the price received for the goods sold over the wage-bill the firms paid out, allowing them and their backers to appropriate the complementary part of the output.
First, it shall be seen that the features outlined here set circuit theory apart from the neoclassical view inherited from Smith (1776) and extended by Walras (1926), by which the economy is composed of individual agents who simultaneously supply their productive services on a first set of markets and create demand on a second set for the goods produced. To be clear, circuitists do not of course deny the existence of markets and the correlated role of supply and demand in determining wages and prices. What they refute, by reference to Keynes’s notion of the entrepreneur economy, is the idea that market transactions may ultimately be seen as mere exchanges of productive services and goods for one another, with the terms of trade supposedly being determined through adjustments taking place in interdependent markets in conformity with the agents’ preferences. Secondly, it will be confirmed that the circuitist approach, as its proponents argue, implicitly underpins Keynes’s principle of effective demand to which circuitists therefore subscribe.
Key Sources of Research:
Circuit and Coherent Stock-Flow Accounting
FRENCH CIRCUIT THEORY
Some Simple, Consistent Models of the Monetary Circuit
Finance and Crisis: Marxian, Institutionalist and Circuitist approaches
Financialisation and the Limits of Circuit Theory
THE MONETARY CIRCUIT APPROACH: A STOCK-FLOW CONSISTENT MODEL
October 28-29, 2005,
FINANCIALIZATION AND THE MONETARY CIRCUIT: A MACRO-ACCOUNTING APPROACH
The Dynamics of the Monetary Circuit
The theory of the monetary circuit and economic policy in Augusto Graziani. An assessment from an early Italian circuitist perspective, and a first comparison with Alain Parguez
NIPA – Simon Kuznets, Wesley Mitchell, Richard Stone, James Meade
Flow of Funds Accounts – Morris Copeland
Input Output Tables – Wassily Leontief
Social Accounting Matrix – Richard Stone, Graham Pyatt, Erik Thorbecke
Morris Copeland and Financial Accounts
From THE ORIGINS OF FINANCIAL ACCOUNTS IN THE UNITED STATES AND ITALY: COPELAND, BAFFI, AND THE INSTITUTIONS
In 1944, Copeland was commissioned by the National Bureau of Economic Research (NBER) to create a statistical framework for the money circuit. The project was carried out in collaboration with the Federal Reserve, in particular the Board’s Division of Research and Statistics. After the First World War, Wesley Mitchell had built annual estimates of national income while working at the NBER.2 Copeland started from an unpublished memo that Mitchell had written in 1944, in which the economy was divided into four groups of units. Each group makes payments to and receives payments from the others. In double-entry accounts, the payments made by each group are recorded on one side and the payments received on the other. All payments appear among the liabilities of one group and the assets of another.
Copeland’s work was first published in 1947, in an article in the American Economic Review. His principal work, published in 1952, analysed the moneyflows of U.S. institutional sectors from 1936 to 1942.3 The initial project envisaged two sectors – households, and an aggregate of the other sectors – and six types of moneyflows. The analysis was later extended to eleven sectors: households; farms; industrial corporations; business proprietors and partnerships; the federal government; state and local governments; banks and US monetary funds; life insurance companies; other insurance carriers; other financial intermediaries not included in the above categories; and the rest of the world.
Copeland identifies four origins of moneyflows, or motivations: households’ distributive shares, households’ product transactions, secondary distribution (i.e. transfer payments), and flows through financial channels. There are fourteen types of moneyflows, all of which can be traced to one of these four motivations. Four moneyflows can be attributed to households’ distributive shares: wages and salaries, cash dividends, cash interest, and net owner take-outs. A further four are the result of production transactions: customers’ payments to firms for goods and services; rents; instalments to contractors; payments for real-estate sales. Five moneyflows – insurance premiums, insurance benefits, taxes collected, tax refunds, and public purpose expenditures – fall into the category of transfer payments. The fourteenth moneyflow consists in financial transactions and constitutes the fourth motivation.
The statistics built by Copeland provide information on the distribution of moneyflows between production transactions, transfer payment transactions, and transactions through financial channels. Every sector has its own balance sheet, with its own assets and liabilities. A distinction is maintained throughout between aggregates measured on a cash basis and those on an accrual basis, although Copeland himself prefers the first method. Moneyflows are presented as an extension of the national accounts, on which Copeland had written extensively since the end of the 1920s; moneyflows are constantly compared with the concept of national income, underlining analogies and differences. Copeland states that both his approach and the national income one are based on the notion of the economy as a circuit. The moneyflows approach makes it possible to analyse debit and credit movements that are not part of the concepts of production and income distribution.
Copeland describes his work as an extension of ‘social accounting to moneyflows measurement’,4 highlighting the advantages of his approach over the equation of exchange. In particular, the disaggregate approach produces ‘money inflows’ and ‘money outflows’ for each sector. Despite the different definition given to the institutional sectors, Copeland maintains that Leontief’s work is similar to his own.5 Moneyflows go from one sector of the economy to another, with liabilities financing assets. Leontief talks of inputs producing outputs. There is a visual similarity between the two approaches, as the phenomena are measured by constructing large double-entry matrices.
In addition to moneyflows, Copeland also considers stocks, which are measured by loanfunds, that is financial assets and liabilities of institutional sectors. He cites Irving Fisher’s The Nature of Capital and Income of 1906, which draws a distinction between stocks and flows. Copeland stresses the importance of using financial statements in economics, following an approach already adopted by Robertson, Mitchell, Hawtrey, Lutz, Hicks and others.6 He recalls the difficulty of communication between accounting and statistics, principally because of the different conventions they employ.
Copeland makes a sharp distinction between consolidated statements, in which positions between sectors are net of reciprocal transactions, and combined statements, which include all transactions between sectors. He examines issues on which economists and statisticians are still working, such as the differences between real accounts and financial accounts, and, in the case of business proprietors, the distinction between assets belonging to the business and assets of the proprietor’s family. He points to the difficulties of ‘balancing’ the total assets and liabilities of the economy caused by three differences: in the timing of entry of transactions; in their classification of identical items; and in the evaluation criteria applied to assets and liabilities.
As mentioned earlier, Copeland’s work ties in with various lines of analysis, which are themselves linked to one another. The first connection is with the developments in national accounts that followed Keynes’s General Theory. As Federico Caffè recalled, Keynes invented not only a discipline, but also the words to describe it, setting the national accounts on a new basis. The process was not an easy one. Blanchard described macroeconomics before the Second World War as ‘an age of confusion’. After Keynes, progress in national accounts can be attributed mainly to Kuznets, Stone, and Hicks (the first edition of The Social Framework is dated 1942); a major effort of organisation produced the United Nations’ System of National Accounts (SNA) of 1947. Copeland had already studied the national accounts before the Second World War, publishing papers in the NBER series Studies in Income and Wealth. His essays of 1935 (‘National Wealth and Income – An Interpretation’) and 1937 (‘Concepts of National Income’) were cited by Richard Stone in the preparatory work for the SNA. Afterwards, when the concepts of real national accounts had been codified, it was a natural step to move on to the notion of financial accounts.
Another inspiration for moneyflows was the debate on the business cycle, in particular Mitchell’s efforts to collect relevant statistics. Mitchell and Copeland were very close and the moneyflows project was the last Mitchell undertook before retiring. Moneyflows are part of the American tradition of institutionalism – stretching from Veblen to Commons and from Ayres to Mitchell himself – which stresses the importance of an empirical approach to the interpretation of economic phenomena and the need to build statistics based on time series.10 It is not an obvious approach: Koopmans’s cutting verdict, ‘measurement without theory’, appeared in 1947 in a review of Burns and Mitchell’s book on the measurement of economic cycles.11
Copeland’s approach was also predominantly empirical. He reproaches Keynes that the latter’s theoretical approach was one of the reasons the General Theory had been assimilated in the Neoclassical Synthesis.12 Copeland had already attacked the abstraction of the neoclassical approach in 1931, causing Frank Knight to express several reservations.13 However, it would be wrong to classify Copeland’s contribution as empirical only, and to level against him the same accusation that Koopmans made against the Burns-Mitchell duo. Copeland has in mind not only the work of Keynes, but also that of Hicks, notably Value and Capital, which was first published in 1939, and in particular Chapter 14 on the difficulties of defining and measuring an economy’s income, and Chapter 19 on the demand for money. He asserts that a similarity exists between his ideas and those put forward in Value and Capital, underlining that Hicks focuses only on households and firms. Basically, Copeland has a vision of an economic system with a wealth of specialised and interconnected activities that is co-ordinated by institutions of the law: property rights, regulations governing contracts and negotiable instruments, rules on compensation and bankruptcy, and freedom of association. Money and other ‘pecuniary institutions’ are further elements that allow an economy to function.14 After the essays on moneyflows he remained interested in money, particularly the origin of monetary economies and the development of bank money. His interest in all the institutional sectors of the economy led him to study the US general government debt, with strong emphasis on relations between the federal government, on one side, and state and local bodies, on the other.15
Key Sources of Research:
FLOW-OF-FUNDS ANALYSIS AT THE ECB
FRAMEWORK AND APPLICATIONS
by Louis Bê Duc and Gwenaël Le Breton
Balance Sheets, Transaction Matrices and the Monetary Circuit
Lavoie and Godley 2007
Book of Monetary Economics chapter 2
The Flow-of Funds Approach to Social Accounting: Appraisals, Analysis, and Applications
According to Pyatt and Round (1985), a Social Accounting Matrix (hereafter, SAM) is a particular representation of the macro, meso, and micro economic accounts of a socio-economic system, which capture the transactions and transfers between all economic agents and institutions in the system1. However, a complete SAMs also can provide both descriptive and prescriptive analysis of a regional economy. In common with other economic accounting systems, it records transactions taking place during an accounting period, usually one year. Since 1960s, the initial SAM is proposed by Sir Richard Stone based on the United Kingdom and some other industrialized countries2. Where it’s further developed by the economists and policymakers from early 1970s onward and employed to analyze the poverty and income distribution issues in developing countries (Pyatt and Thorbecke, 1976).
The construction and use of SAMs was closely related to the growing dissatisfaction with the results of growth policies in developing countries (Jan, 1991). To examines these problems of government policies distributional impact, data would be required that would enable a comprehensive analysis of these aspects of the economic process. Therefore, SAMs applies together the standard macro-economic data sets summarized in the national accounts and data systems that have been designed to analyze production relations (such as Input-output tables) and income and consumption patterns (household income and expenditure surveys). On the other hand, a solid accounting and data compilation methodology to underlie both macro- and micro-economic analyses were proposed by the quality of social accounting framework (Jan, 1991). Hence, SAM was designed to combines successfully indicators of growth, income distribution and poverty into one coherent accounting framework.
History of SAM
From A Financial Social Accounting Matrix (SAM) for Luxembourg
The use of social accounting matrices (SAMs) to record the main transactions that took place in a national economy during a specific period (e.g. one year) can be traced as far back as Quesnay (1694-1774) in 1758 with his Tableau économique. In the twentieth century, social accounting was heavily influenced both by the work on national income accounts by Kuznets (1937) and that on input-output matrices by Leontief (1941). The development of SAMs such as they are used today began with the work by Meade and Stone (1941) by developing the first logically complete set of double entry national income accounts. Subsequent work by Stone (1947) resulted in the conventions for social accounting embodied in the United Nations‟ System of National Accounts (United Nations, 1953 and 1968), which is currently used throughout the world.
Usefulness of SAM
However, the widespread use of SAM started in the 1980s as a result of efforts to integrate the “social” with the “economic” dimension in policy analysis. The SAM provides a framework that integrates detailed data on production, income and expenditure, thereby allowing a systematic recording of economic transactions for the study of growth and its distribution in a particular country (Mohora, 2006). Further, a SAM also enables inter alia the identification of structural relationships between the economic agents. In the SAM the economic agents are usually classified according to the main institutional sectors3: non-financial corporations sector, financial corporations sector, households sector, government sector and the rest of the world (external) sector. The performance of each institutional sector is analysed in terms of, e.g. its contribution to net value added, expenditure, disposable income and net saving. In addition, the current external balance of the economy can be derived within the SAM. More important, the SAM represents a consistent framework, which gives a “snapshot” of the economy. It provides a clear picture of the structure of the economy at a particular point in time as well as the core data for a general equilibrium model.
what are FSAM?
Economic and social systems, subject to an increasing complexity and interdependence, require policy analysts to have high quality and reliable observations in order to properly explain, conceptualise, understand and make meaningful the underlying dynamics of the scientific material. Otherwise, unreliable and biased data can result in seriously distorted (if not altogether wrong) policy recommendations. The SAM is the framework that challenges (most of) these constraints.
In order to have a complete picture of transactions taking place in an economy, real accounts are not sufficient and need to be complemented with financial accounts.
Financial accounts form an important tool for analysing financial flows taking place between well-defined institutional sectors within the economy (non-financial corporations, financial corporations, government and households), between institutional sectors and the rest of the world, and for assessing financial interrelationships within the economy and vis-à-vis the rest of the world at a particular point in time. Because of their link to capital and use of income accounts, financial accounts are an important instrument to monitor the transmission process of monetary policy. The completeness of financial accounts enables the analysis of monetary aggregates as well as the analysis of longer-term financial investments and sources of finance. Consequently, the financial accounts provide a way of examining the financial effects of economic policy and assistance for decisions regarding future policy. The accounts can be used to investigate factors influencing the transactions in different types of financial instruments (i.e. changes in interest rates). For financial institutions, these accounts show the large amounts of funds which are channelled through them as financial intermediaries. The scale of this makes it important to be aware of changes in their sources of funds and in the use of those funds. The transactions of the financial institutions reflect the liquidity, current and capital expenditure of other sectors, and the financing of the government sector net cash requirement (EC and Eurostat, 2002).
Further, the financial balance sheets (another tool of financial accounts), show the financial wealth of each sector of the economy at a particular point in time. The changes from previous balance sheets illustrate both the change in the valuation of different instruments as stock markets move and as currency exchange rates change, but also the changing portfolios resulting from the financial transactions of the sectors. This allows measuring “wealth effects” through the change in assets‟ market prices. Regarding the structure of financial markets, the balance sheets can be used to measure: the share of different financial instruments for different sectors, the share of different sectors for different financial instruments, the degree of marketability of financial instruments and the degree of financial intermediation (EC and Eurostat, 2002).
A SAM usually encompasses a somewhat less detailed supply and use table or input-output (IO) table. A clear distinction must be drawn between the IO table and the SAM. The essence of the IO table is the way industries are interrelated through transactions, while the SAM also presents the transaction and the transfers between the different types of economic agents such as firms, government, households and the rest of the world (Pyatt, 1999). In other words, a SAM is a comprehensive, economy-wide-data framework, typically representing the economy of a nation and also providing the link between the economy and the rest of the world in terms of trade flows. A SAM has two principal objectives. The first is concerned with the organisation of information, usually information about the economic and social structure of a country in a particular year, though it could just as well be about the region of a country, a city, or any other unit one might be interested in. The unit of time is arbitrary but is usually a year. It is recognised as a sound descriptive and synoptic framework of an economy (Pyatt and Round, 1985). Furthermore, the structure and disaggregation of the SAM depends on the national socio-economic structure, modelling needs, and availability of data and resources.
Once the data in a particular country for a particular year have been organised in the form of a SAM, it presents a static image which can reveal much about the country‟s economic structure. Even so, the image is only a “snapshot”. In order to analyse how the economy works and to predict the effects of policy interventions, more is needed than just a static image. A model of the economy has to be created. This is the second objective of a SAM: to provide the statistical basis for the creation of a plausible model.
Historically, the design of a statistical information system such as SAM has evolved from the combination of two ideas: the matrix presentation of national income accounts, reflecting the Keynesian model of the markets for goods and services, and the input-output model of the structural interdependence of production in the economy. The Keynesian model divides economic activity into three categories: production; income and expenditure; and accumulation.
Accounts involved in a SAM may be real and/or financial. Real accounts are used to depict the circularity of real flows of the economy capturing all transfers and real transactions between sectors and institutions. Six major types of accounts headings are distinguished in a real SAM: (i) production activities, (ii) commodities, (iii) factors of production, (iv) current account of domestic institutions, (v) capital account of institutions (savings-investment) and (vi) external sector. Depending on analytical requirements, availability of disaggregated data, challenging problem raised in the analysis or analytical requirements, some additional accounts can be introduced and each account can be disaggregated or aggregated.
The SAM can be classified as real SAM and financial SAM, where the former records only the transactions of the real activities of the economic institutions and the latter not only records the real transactions but also the transactions taking place in the financial markets. Therefore, in the financial SAM, non-financial and financial corporations, government, households and agents from the ROW engage in transactions related to the real-side of the economy but they also own assets and incur liabilities. In this section, these additional rubrics of accounts – financial accounts – to be associated with the real accounts are presented, and this so as to obtain a complete set of accounts that represent financial SAM. Financial accounts described in this section follow ESA95 classification and accounting rules.
In general, financial accounts are an integral part of the system of national accounts. The primary function of the system of national accounts is to schematically dissect the complex workings of the economy and its basic components and thereby to facilitate the task of economic analysis. The financial flows account supplements this picture by adding those transactions which occur in the financial sphere (Deutsche Bundesbank, 2010). The consistent, homogenous and comprehensive set of financial accounts provides a useful overview of the main financial flows in the economy, as well the main risks and interdependencies between sector and financial instruments (Bê Duc and Le Breton, 2009).
The financial account deals with the financial transactions (in financial assets and liabilities) taking place between institutional units (non-financial corporations, financial corporations, government and households), and between them and the rest of the world (Eurostat and European Commission, 1996). It shows on its left side acquisitions less disposals of financial assets, while its right side shows the incurrence of liabilities less their repayment6. In other words, the financial account shows how the surplus or deficit on the capital account is financed by transactions in financial assets and liabilities. Thus, the balance of the financial account (net acquisition of financial assets less net incurrence of liabilities) is equal in value to net lending/net borrowing, the balancing item of the capital account (European Commission and Eurostat, 2002). The financial transactions are summarised and recorded systematically in the financial account. The financial account also indicates how net borrowing sectors obtain resources by incurring liabilities or reducing assets, and how net lending sectors allocate their surpluses by acquiring assets or reducing liabilities. The account also shows the contributions to these transactions of the various types of financial assets, and the role of financial intermediaries (European Commission and Eurostat, 2002). Finally, its purpose is also to provide figures on the net worth – i.e. assets minus liabilities – of institutional sectors (Lequiller and Blades, 2006).
Key Sources of Research:
Financial social accounting matrix: concepts, constructions and theoretical framework
Kai Seng Kelly Wong and Azali M. and Chin Lee
Identifying Sectoral Vulnerabilities and Strengths for the Philippines: A Financial Social Accounting Matrix Approach
Francisco G. Dakila, Jr., Veronica B. Bayangos and Laura L. Ignacio
The Financial Social Accounting Matrix for China, 2002, and Its Application to a Multiplier Analysis
Construction of Financial Social Accounting Matrix for Tunisia
When did economists start thinking systematically?
Where do we find it now in Economics?
From Structural Interdependence in Monetary Economics: Theoretical Assessment and Policy Implications
Acknowledgment of the existence of structural interconnections in a sufficiently developed country is not a novelty in the literature of economics. It has been present since its very beginning, in Quesnay’s Tableau Économique and Petty’s and Cantillon’s descriptions of production and consumption as a circular flow. Significant evidence of structural interdependence is provided by Walras’s general equilibrium model, by Marx’s reproduction schemes and by his circuit of capital, by Keynes’s dismissal of the ‘classical’ assumption of a dichotomic economic system, by Leontief’s inter-industry input-output analysis, and by other analytical approaches (von Neumann and Morgenstern strategic game theory, Copeland’s flow-of-funds tables, Koopmans’s activity analysis of production and allocation).
Relevant contributions to the literature on structural interdependence in economics have been made by Tobin, Davidson, Meade and Stone, Godley and Cripps, Lavoie, Lance Taylor and others, with reference to specific institutional frameworks. In the last decades this branch of research has attracted increasing attention. Sectoral flows of funds connecting balance sheets have been analyzed. Some controversial issues, however, regarding the integration of money and finance in the theory of value and the structural relations between stock and flow variables, are still partially unsettled.
From ‘Classical’ Roots of Input-Output Analysis: A Short Account of its Long Prehistory
According to Wassily Leontief, ‘Input-output analysis is a practical extension of the classical theory of general interdependence which views the whole economy of a region, a country and even of the entire world as a single system and sets out to describe and to interpret its operation in terms of directly observable basic structural relationships’ (Leontief, 1987, p. 860).
The key terms in this characterisation are ‘classical theory’, ‘general interdependence’ and ‘directly observable basic structural relationships’. In this overview of contributions that can be said to have prepared the ground for input-output analysis proper, ‘classical theory’ will be interpreted to refer to the contributions of the early classical economists from William Petty to David Ricardo; further elaborated by authors such as Karl Marx, Vladimir K. Dmitriev, Ladislaus von Bortkiewicz and Georg von Charasoff; and culminating in the works of John von Neumann and Piero Sraffa. ‘General interdependence’ will be taken to involve two intimately intertwined problems, which, in a first step of the analysis, may however be treated separately. First, there is the problem of quantity for which a structure of the levels of operation of processes of production is needed in order to guarantee the reproduction of the means of production used up in the course of production and the satisfaction of some ‘final demand’, that is, the needs and wants of the different groups (or ‘classes’) of society, perhaps making allowance for the growth of the system. Secondly, there is the problem of price for which a structure of exchange values of the different products or commodities is needed in order to guarantee a distribution of income between the different classes of income recipients consistent with the repetition of the productive process on a given (or increasing) level. It is a characteristic feature of input-output analysis that both the independent and the dependent variables are to be ‘directly observable’, at least in principle. The practical importance of this requirement is obvious, but there is also a theoretical motivation for it: the good of an economic analysis based on magnitudes that cannot be observed, counted and measured is necessarily uncertain.
From ‘Classical’ Roots of Input-Output Analysis: A Short Account of its Long Prehistory
We shall see that input-output analysis can indeed look back at a formidable history prior to its own proper inception, which is often dated from the early writings of Wassily Leontief. These include his 1928 paper ‘Die Wirtschaft als Kreislauf’ (The economy as a circular flow) (Leontief, 1928) and his 1936 paper on ‘Quantitative input-output relations in the economic system of the United States’ (Leontief, 1936); because of its applied character, the latter is occasionally considered ‘the beginning of what has become a major branch of quantitative economics’ (Rose and Miernyk, 1989, p. 229). The account of the prehistory of input- output analysis may also throw light on wider issues which played an important role in the past, but are commonly set aside in many, but not all modern contributions to input- output analysis. This concerns first and foremost the subject of value and distribution. While in earlier authors and also in Leontief (1928) that issue figured prominently, in modern contributions it is frequently set aside or dealt with in a cavalier way. This raises a problem, because production, distribution and relative prices are intimately intertwined and cannot, in principle, be tackled independently of one another. Scrutinizing the earlier literature shows why.
Key Sources of Research:
‘Classical’ Roots of Input-Output Analysis: A Short Account of its Long Prehistory
By Heinz D. Kurz and Neri Salvadori
Who is Going to Kiss Sleeping Beauty? On the ‘Classical’ Analytical Origins and Perspectives of Input–Output Analysis
HEINZ D. KURZ
Wassily Leontief: In appreciation
William J. Baumol and Thijs ten Raa
Wassily Leontief and L ́eon Walras: the Production as a Circular Flow
Akhabbar, Amanar and Lallement, J ́eroˆme Lausanne University, Centre Walras-Pareto, Centre d’Economie de la Sorbonne
Input–Output Analysis from a Wider Perspective: a Comparison of the Early Works of Leontief and Sraffa
HEINZ D. KURZ & NERI SALVADORI
Impact Studies without Multipliers: Lessons from Quesnay’s Tableau Economique
Albert E. Steenge and Richard van den Berg
Causality and interdependence in Pasinetti’s works and in the modern classical approach
by Enrico Bellino and Sebastiano Nerozzi
Three centuries of macro-economic statistics
The Circularity of the Production Process
Modeling the Economy as a Whole: An Integrative Approach
By FREDERIC S. LEE
Structural Interdependence in Monetary Economics: Theoretical Assessment and Policy Implications
The agents of production are the commodities themselves On the classical theory of production, distribution and value
Integration of Real and Financial sectors of economy.
Balance-sheet accounting approach
From Post-Keynesian Stock-Flow Consistent Modeling: A Survey
PK-SFC models are a specific kind of Post-Keynesian macro model that follows distinctive accounting rules, ensuring the consistent integration of the stocks and flows of all the sectors of the economy. The models have three important methodological innovations: first, the consistency of the overall economy is maintained, since one sector’s outflows are always another sector’s inflows just as one sector’s liability is always another sector’s asset; second, the integration of the real and the financial side of the economy; third, the construction of the long run as a chain of short run periods. Nothing is lost, neither in space nor in time. These constraints are crucial in modeling modern macroeconomies which are highly complex, integrated systems.
The roots of PK-SFC models can be identified in the work of Morris A. Copeland (1949), who, with his study on “money flows,” is the father of the flow of funds approach. His intuition was to enlarge the social accounting perspective to the study of money flows. Copeland laid the foundations for an economic approach able to integrate real and financial flows of the economy. A concrete example of his legacy is represented by the quadruple-entry system: since someone’s inflow is someone else’s outflow, the standard double-entry system of accounting is doubled in a quadruple-entry system.
Copeland’s work certainly had a great influence on economics -mainly as a source of financial data- but its potential disruptive impact on the study and modeling of the interdependences between real and financial flows failed to occur. It was only in the 1980s, with the work of Nobel Laureate James Tobin, that these efforts culminated in the organizing theory advocated by Cohen. The article Tobin wrote with co-authors (Backus et al., 1980) perhaps best represents his path-breaking contribution in the foundation of PK-SFC models. Indeed, in developing an empirical model of the US economy in both its financial and non- financial sides, Backus et al combined the theoretical hypothesis on the behavior of the economy with a rigorous accounting framework based on the flow-of-funds social account developed by Copeland. The result is a stock-flow consistent model that includes some of the characteristics still peculiar in the literature, such as the matrices-based accounting approach and discrete time and other features, such as the stock- flow identity, which are fundamental in any model of this type.
Next to Tobin, the other scholar who played an essential role in the development of this family of models is Wynne Godley. Godley, head of the New Cambridge school in the 1980s, started developing models coherently integrating stocks and flows. His efforts culminated in the organized framework he developed in his more recent publications, with which he collected the legacy of Tobin. Godley’s contribution probably finds its peak in the seminal book he wrote together with Marc Lavoie (Godley and Lavoie, 2007), which is still the main reference for current PK-SFC practitioners. This paper focuses on the tradition descending from the work of Wynne Godley, hence the choice of talking of PK-SFC models rather than just SFC models.
Key Sources of Research:
Bezemer, Dirk J.
“The economy as a complex system: the balance sheet dimension.”
Financial markets have become increasingly integrated over the past ten years. In many countries, foreign borrowing has helped to finance higher levels of investment than would be possible with domestic savings alone and contributed to sustained periods of growth. But the opening of capital markets has also placed exceptional demands on financial and macroeconomic policies in emerging market economies. Private capital flows are sensitive to market conditions, perceived policy weaknesses, and negative shocks. Flows of private capital have been more volatile than many expected. A number of major emerging economies have experienced sharp financial crises since 1994.
The financial structure of many emerging markets economies—the composition and size of the liabilities and assets on the country’s financial balance sheet—has been an important source of vulnerability to crises. Financial weaknesses, such as a high level of short-term debt, can be a trigger for domestic and external investors to reassess their willingness to finance a country. The composition of a country’s financial balance sheets also helps to determine how much time a country might have to overcome doubts about the strength of its macroeconomic policy framework, and, more generally, how effectively a country can insulate itself from volatility stemming from changes in global market conditions.
This paper seeks to lay out a systematic analytical framework for exploring how balance sheet weaknesses contribute to the origin and propagation of modern-day financial crises. It draws on the growing body of academic work that emphasizes the importance of balance sheets. It pays particular attention to the balance sheets of key sectors of the economy and explores how weaknesses in one sector can cascade and ultimately generate a broader crisis.
What Is the Balance Sheet Approach?
Unlike traditional analysis, which is based on the examination of flow variables (such as current account and fiscal balance), the balance sheet approach focuses on the examination of stock variables in a country’s sectoral balance sheets and its aggregate balance sheet (assets and liabilities). From this perspective, a financial crisis occurs when there is a plunge in demand for financial assets of one or more sectors: creditors may lose confidence in a country’s ability to earn foreign exchange to service the external debt, in the government’s ability to service its debt, in the banking system’s ability to meet deposit outflows, or in corporations’ ability to repay bank loans and other debt. An entire sector may be unable to attract new financing or roll over existing short-term liabilities. It must then either find the resources to pay off its debts or seek a restructuring. Ultimately, a plunge in demand for the country’s assets leads to a surge in demand for foreign assets and/or for assets denominated in foreign currency. Massive outflows of capital, a sharp depreciation of the exchange rate, a large current account surplus, and a deep recession that reduces domestic absorption are often the necessary counterpart to a sudden adjustment in investors’ willingness to hold a country’s accumulated stock of financial assets.
An economy’s resilience to a range of shocks, including financial shocks, hinges in part on the composition of the country’s stock of liabilities and assets. The country’s aggregate balance sheet—the external liabilities and liquid external assets of all sectors of the economy—is vital. But it is often equally important to look inside an economy and to examine the balance sheet of an economy’s key sectors, such as the government, the financial sector, and the corporate sector.
Our framework for assessing balance sheet risks focuses on four types of balance sheet mismatches, all of which help to determine a country’s ability to service debt in the face of shocks: (i) maturity mismatches, where a gap between liabilities due in the short term and liquid assets leaves a sector unable to honor its contractual commitments if the market declines to roll over debt, or creates exposure to the risk that interest rates will rise; (ii) currency mismatches, where a change in the exchange rate leads to a capital loss; (iii) capital structure problems, where a heavy reliance on debt rather than equity financing leaves a firm or bank less able to weather revenue shocks; and (iv) solvency problems, where assets—including the present value of future revenue streams—are insufficient to cover liabilities, including contingent liabilities. Maturity mismatches, currency mismatches, and a poor capital structure all can contribute to solvency risk, but solvency risk can also arise from simply borrowing too much or from investing in low-yielding assets.
An analytical framework that examines the balance sheets of an economy’s major sectors for maturity, currency, and capital structure mismatches helps to highlight how balance sheet problems in one sector can spill over into other sectors, and eventually trigger an external balance of payments crisis. Indeed, one of the core arguments that emerges from this approach is that the debts among residents that create internal balance sheet mismatches also generate vulnerability to an external balance of payments crisis. The transmission mechanism often works through the domestic banking system. For instance, broad concerns about the government’s ability to service its debt, whether denominated in domestic or foreign currency, will quickly destabilize confidence in the banks holding this debt and may lead to a deposit run. Alternatively, a change in the exchange rate coupled with unhedged foreign exchange exposure in the corporate sector can undermine confidence in the banks that have lent to that sector. The run on the banking system can take the form of a withdrawal of cross-border lending by nonresident creditors, or the withdrawal of deposits by domestic residents.
Many of the characteristics of a capital account crisis derive from the adjustment in portfolios that follows from an initial shock. Underlying weaknesses in balance sheets can linger for years without triggering a crisis. For example, a currency mismatch can be masked so long as continued capital inflows support the exchange rate. Consequently, the exact timing of a crisis is difficult to predict. However, should a shock undermine confidence, it can trigger a large and disorderly adjustment, as the initial shock reveals additional weaknesses and a broad range of investors, including local residents, seek to reduce their exposure to the country. Massive flows are the necessary counterpart of a sudden move toward a new equilibrium of asset holdings stemming from rapid stock adjustments. If these flows cannot be financed out of reserves, the relative price of foreign and domestic assets has to adjust. An overshooting in asset prices (including the exchange rate) is likely, as investors rarely have access to perfect information and may be prone to herding.
Information about sectoral balance sheets is most useful if it is available in time to allow policymakers to identify and correct weaknesses before they contribute to financial difficulties. In practice, however, balance sheet information is often only partly available and can be obtained only with significant time lags, which limits its utility for all but ex post analysis. Balance sheet analysis starts with in-depth analysis of sector vulnerabilities; the first step is to identify gaps in country data and to develop the sources needed to provide this data. There is an obvious case for better data collection and enhanced external disclosure of key balance sheet data.
The balance sheet approach also focuses attention on policies that can reduce sectoral vulnerabilities—particularly the vulnerability to changes in key financial variables. It reinforces the importance of (i) sound debt management by the public sector to minimize the risk that weaknesses in the public sector’s balance sheet will be a source of financial difficulty and to preserve the public sector’s capacity to cushion against shocks originating in the private sector; (ii) policies that create incentives for the private sector to limit its exposure to various balance sheet risks, particularly the explosive combination of currency and maturity risks created by short-term foreign currency denominated borrowing; and (iii) the need to maintain a sufficient cushion of reserves. Flexible exchanges rates can help to limit exposure to currency risk and encourage ongoing hedging as well as facilitating adjustment to external shocks. But the balance sheet approach also underscores some of the risks that can continue to arise in a floating exchange rate regime, particularly if the public sector is the source of the financial instruments that help the private sector hedge against currency risk. While the balance sheet approach directs attention to indicators of financial strength rather than more classic macroeconomic indicators, it in no way diminishes the importance of sound macroeconomic policies. Large debt stocks emerge from persistent flow imbalances (fiscal and current account deficits), and underlying macroeconomic weaknesses are often the reason why countries can borrow only in foreign currency or with short maturities.
There are five strands in development of Balance sheet Economics.
A) Work of Prof. K Tsujimura and Prof. Mizoshita and Prof. M Tsujimura on asset-liabilities Matrices (ALM).
B) IMF’s Balance sheet Approach (BSA)
C) Prof. N Zhang’s work on the Global Flow of Funds accounts
D) Post Keynesian Economists – Mark Lavoie, Dirk Bezemer, Wynne Godley, Hyman Minsky, Steve Keen
E) Money View – Perry Mehrling, Zoltan Pozsar
Key sources for Research:
Compilation and Application of Asset-Liability Matrices: A Flow-of-Funds Analysis of the Japanese Economy 1954-1999.
A notable feature of the modern Financial world is its high degree of interdependence. Banks and other Financial institutions are linked in a variety of ways. The mutual exposures that Financial institutions adopt towards each other connect the banking system in a network. Despite their obvious benefit, the linkages come at the cost that shocks, which initially affect only a few institutions, can propagate through the entire system. Since these linkages carry the risk of contagion, an interesting question is whether the degree of interdependence in the banking system sustains systemic stability.
From Contagion Risk in Financial Networks
Recently, there has been a substantial interest in looking for evidence of contagious failures of Financial institutions resulting from the mutual claims they have on one another. Most of these papers use balance sheet information to estimate bilateral credit relationships for different banking systems. Subsequently, the stability of the interbank market is tested by simulating the breakdown of a single bank.
From Contagion in Financial Networks (PG and SK)
In modern financial systems, an intricate web of claims and obligations links the balance sheets of a wide variety of intermediaries, such as banks and hedge funds, into a network structure. The recent advent of sophisticated financial products, such as credit default swaps and collateralised debt obligations, has heightened the complexity of these balance sheet connections still further, making it extremely di¢ cult for policymakers to assess the potential for contagion associated with the failure of an individual financial institution or from an aggregate shock to the system as a whole.
The interdependent nature of financial balance sheets also creates an environment for feedback elements to generate amplified responses to any shock to the financial system.
From Contagion in Financial Networks (PG and SK)
The interactions between financial intermediaries following shocks make for non-linear system dynamics, and our model provides a framework for isolating the probability and spread of contagion when claims and obligations are interlinked. We find that financial systems exhibit a robust-yet-fragile tendency. While greater connectivity reduces the likelihood of widespread default, the impact on the financial system, should problems occur, could be on a significantly larger scale than hitherto. The model also highlights how a priori indistinguishable shocks can have very different consequences for the financial system. The resilience of the network to large shocks in the past is no guide to future contagion, particularly if shocks hit the network at particular pressure points associated with underlying structural vulnerabilities.
From Contagion in Financial Networks (PG and SK)
The intuition underpinning these results is straightforward. In a more connected system, the counterparty losses of a failing institution can be more widely dispersed to, and absorbed by, other entities. So increased connectivity and risk sharing may lower the probability of contagion. But conditional on the failure of one institution triggering contagious defaults, a higher number of Financial linkages also increases the potential for contagion to spread more widely. In particular, greater connectivity increases the chances that institutions which survive the effects of the initial default will be exposed to more than one defaulting counterparty after the first round of contagion, thus making them vulnerable to a second-round default. The impact of any crisis that does occur could, therefore, be larger.
Key Sources of Research:
Kiyotaki and Moore
Credit Chains and Sectoral Comovement: Does the Use of Trade Credit Amplify Sectoral Shocks?
A flow network analysis of direct balance-sheet contagion in financial networks
Contagion in Financial Networks
Paul Glasserman H. Peyton Young
October 20, 2015
Contagion in Financial Networks
Prasanna Gai and Sujit Kapadia
The Effect of the Interbank Network Structure on Contagion and Financial Stability
Contagion Risk in Financial Networks
Financial Fragility and Contagion in Interbank Networks
Complexity, concentration and contagion
Prasanna Gai , Andrew Haldane , Sujit Kapadia
Contagion in financial networks : a threat index
May 23, 2011
Liquidity and financial contagion
TOBIAS ADRIAN HYUN SONG SHIN
Financial globalization, financial crises and contagion
$ Enrique G. Mendoza Vincenzo Quadrini
The International Finance Multiplier
How Likely is Contagion in Financial Networks?
Paul Glasserman,1 and H. Peyton Young
Capital and Contagion in Financial Networks
S. Battiston G. di Iasio L. Infante F. Pierobon
Contagion in the Interbank Network: an Epidemiological Approach
Complex Financial Networks and Systemic Risk: A Review
Spiros Bougheas and Alan Kirman
Systemic Risk, Contagion, and Financial Networks: a Survey
Matteo Chinazzi∗ Giorgio Fagiolo†
June 4, 2015
Systemic Risk and Stability in Financial Networks†
By Daron Acemoglu, Asuman Ozdaglar, and Alireza Tahbaz-Salehi
The payment system – which includes financial market infrastructure for payments, securities and derivatives – is a core component of the financial system, alongside markets and institutions. If modern economies are to function smoothly, economic agents have to be able to conduct transactions safely and efficiently. Payment, clearing and settlement arrangements are of fundamental importance for the functioning of the financial system and the conduct of transactions between economic agents in the wider economy. Private individuals, merchants and firms need to have effective and convenient means of making and receiving payments. Moreover, funds, securities and other financial instruments are traded in markets, providing a source of funding and allowing households, firms and other economic actors to invest surplus funds or savings in order to earn a return on their holdings. Active markets facilitate price discovery, the efficient allocation of capital and the sharing of risk between economic actors.
Public trust in payment instruments and systems is vital if they are to effectively support transactions. In financial markets, market liquidity is critically dependent on confidence in the safety and reliability of clearing and settlement arrangements for funds and financial instruments. If they are not managed properly, the legal, financial and operational risks inherent in payment, clearing and settlement activities have the potential to cause major disruption in the financial system and the wider economy.
Banks and other financial institutions are the primary providers of payment and financial services to end users, as well as being major participants in financial markets and important owners and users of systems for the processing, clearing and settlement of funds and financial instruments. The central bank, as the issuer of the currency, the monetary authority and the “bank of banks”, has a key role to play in the payment system and possesses unique responsibilities. It is therefore no coincidence that one of the basic tasks of the ESCB and the ECB is to promote the smooth operation of payment systems. A safe and efficient payment system is of fundamental importance for economic and financial activities and is essential for the conduct of monetary policy and the maintenance of financial stability.
From The Payment System
The complexity and – in particular – importance of market infrastructure for the handling of payments and financial instruments has increased greatly in recent decades, owing not only to the tremendous increases observed in the volume and value of financial transactions, but also to the wealth of financial innovation and the advances seen in information and communication technologies. Bilateral barter trade is now largely a thing of the past, and instead economic agents buy and sell goods and services (including financial instruments) in markets, making use of the transfer services made available by market infrastructure.
Payment, clearing and settlement systems may differ from country to country in terms of their type and structure, both for historical reasons and on account of differences between countries’ legal, regulatory and institutional environments. Furthermore, rather than being static, payment, clearing and settlement systems and arrangements are dynamic constructions which have evolved over time and will continue to do so in the future. A key priority for central banks is to contribute to the development of modern, robust and efficient market infrastructure which serves the needs of their economies and facilitates the development of safe and efficient financial markets.
All transactions are exposed to a variety of risks, and this is particularly true for financial transactions. Thus, in order to facilitate enhanced risk management, many countries have introduced real-time gross settlement systems for the handling of critical payments. Progress has been made in the implementation of safer and more efficient systems and procedures for the clearing and settlement of securities. Modern securities settlement systems offer delivery-versus-payment mechanisms and allow the effective management of collateral, while foreign exchange transactions are increasingly being settled on a payment-versus-payment basis. In parallel, stronger international trade links, the increased integration of international financial markets (including global derivatives markets) and large migrant flows have all contributed to increased demand for arrangements allowing the cross-border handling of wholesale and retail transactions, raising new issues from a policy and risk perspective.
From The interdependencies of payment and settlement systems
The global payment and settlement infrastructure has changed significantly over the last decade. The myriad of domestic and cross-border systems that make up the global infrastructure are increasingly interconnected through a web of direct and indirect relationships. Through these relationships, the smooth functioning of a single system often becomes contingent on the performance of one or more other systems. In addition, individual systems are often reliant on common third parties, financial markets or other factors. Consequently, the settlement flows, operational processes and even risk management procedures of individual systems are often materially interdependent with those of other systems. As a result, the numerous systems that make up the global clearing and settlement infrastructure have become more tightly interdependent.
This increasing interdependence is driven by several interrelated factors, including technological innovations, globalisation and financial sector consolidation. In addition, a number of initiatives by the financial industry and by public authorities to reduce the costs and risks of settlement have purposely promoted greater integration among the numerous components of the global payment and settlement infrastructure. For example, the 1989 G30 recommendations for T+3 securities settlement, central bank policies encouraging the development and reliance on systems with intraday finality, and the CPSS focus on reducing foreign exchange settlement risk have provided incentives for more straight through processing and tighter relationships among individual systems.3 While these explicit initiatives explain one aspect of tightening interdependencies, institutions’ profit-seeking and cost management incentives also foster interdependencies.
Interdependencies have important implications for the safety and efficiency of the global payment and settlement infrastructure. Some forms of interdependencies have facilitated significant improvements in the safety and efficiency of payment and settlement processes. At the same time, interdependencies increase the potential for a given disruption to spread quickly to many different systems. This potential was noted in the 2000 G10 report on Financial sector consolidation (the Ferguson report), which suggested that interdependencies might accentuate the role of payment and settlement systems in the transmission of disruptions across the financial system, and is further analysed in this report.
The potential for interdependencies to reduce key sources of risk, and yet create new sources of risk, highlights the numerous trade-offs faced by payment and settlement systems, their participants and public authorities. The reduction of one form of risk often comes at the expense of increasing another source of risk, or of increasing costs.
From Congestion and Cascades in Interdependent Payment Systems
The report identifies three different types of interdependencies. System-based interdependency, which includes payment versus payment (PvP) or delivery versus payment arrangements (DvP)4 as well as liquidity bridges between systems. Institution-based interdependence which arises when, for example, a single institution participates in, or provides settlement services to, several systems. The third type is environmental-based interdependency which can emerge if multiple systems depend on a common service provider, for example the messaging service provider SWIFT.
From Illiquidity in the Interbank Payment System following Wide-Scale Disruptions
At the apex of the U.S. financial system are a number of critical financial markets that provide the means for both domestic and international financial institutions to allocate capital and manage their exposures to liquidity, market, credit and other types of risks. These markets include Federal funds, foreign exchange, commercial paper, government and agency securities, corporate debt, equity securities and derivatives. Critical to the smooth functioning of these markets are a set of wholesale payments systems and financial infrastructures that facilitate clearing and settlement.1 Operational difficulties of these entities or their participants can create difficulties for other systems, infrastructures and participants. Such spill overs might cause liquidity shortages or credit problems and hence potentially impair the functioning and stability of the entire financial system.
Key Sources of Research:
The interdependencies of payment and settlement systems
The Payment System
Interdependencies of payment and settlement systems: the Hong Kong experience
HONG KONG MONETARY AUTHORITY QUARTERLY BULLETIN
Congestion and Cascades in Interdependent Payment Systems
Fabien Renault, Walter E. Beyeler, Robert J. Glass, Kimmo Soramäki, Morten L. Bech
March 16, 2009
Eurozone payment and securities settlement systems interdependence:
Will consolidation initiatives lead to contagion; who is accountable?
Recent developments in intraday liquidity in payment and settlement systems
Payment systems and Market Infrastructure Directorate
Precautionary Demand and Liquidity in Payment Systems
Gara M. Afonso and Hyun Song Shin
Banque de France – European Central Bank: Liquidity in interdependent transfer systems
Large banks have grown significantly in size and become more involved in market-based activities (those outside traditional bank lending) since the late 1990s. The advance of information technology and deregulation, which has led to a proliferation of financial markets, may have been the key driver of this process.
Large banks tend to have lower capital, less-stable funding, more market-based activities, and be more organizationally complex than small banks. This suggests that large banks may have a distinct, possibly more fragile, business model.
Large banks are riskier, and create more systemic risk, when they have lower capital and less-stable funding. Large banks create more systemic risk (but are not individually riskier) when they engage more in market-based activities or are more organizationally complex.
Failures of large banks tend to be more disruptive to the financial system than failures of small banks. The failures of large banks generate liquidity stress in the banking system, their activities that rely on economies of scale and scope cannot easily be replaced by small banks, and the marginal cost of taxpayer support may increase in the volume required.
Traditional bank regulation, which focuses on individual bank risk, may be insufficient for large banks. Additional regulation, based on systemic risk considerations, is needed to deal with the externalities of distress of large banks. This may include capital surcharges on large banks and measures to reduce their involvement in market-based activities and their organizational complexity.
Banks may operate at a size that is too large from a social welfare perspective due to “too- big-to-fail” subsidies and corporate governance shortcomings. However, the potential for economies of scale in large banks cannot be dismissed. As a result, “optimal” bank size is uncertain.
From Matching Collateral Supply and Financing Demands in Dealer Banks
Broker-dealers are firms that participate in markets by buying and selling securities on behalf of themselves and their clients. They must register with the Securities and Exchange Commission (SEC), and are often a subsidiary of a larger bank holding company. Any securities purchased by the firm for its account can be sold to clients or other firms, or can become part of the firm’s own holdings. Our definition of dealer banks includes activities performed by broker-dealers, but also includes OTC derivative dealing activities, which are often conducted in the affiliated depository institution subsidiary of the parent holding company (rather than the broker-dealer subsidiary).
From Matching Collateral Supply and Financing Demands in Dealer Banks
Dealer banks are active in the intermediation of many markets, either in their role as dealers or in their role as prime brokers where they provide financing to investors. Dealer banks are financial intermediaries that make markets for many securi- ties and derivatives by matching buyers and sellers, holding inventories, and buying and selling for their own account when buyers and sellers approach the dealer at different times, for different quantities, or are clustered on one side of the market. Many banks with securities dealer businesses also act in the primary market for securities as investment banks, underwrit- ing issues to sell later to investors. Services typically provided by dealers include buying and selling the same security simul- taneously, extending credit and lending securities in con- nection with transactions in securities, and offering account services associated with both cash and securities.
From Matching Collateral Supply and Financing Demands in Dealer Banks
Many dealers carry out their activities in a broker-dealer subsidiary of a bank holding company. For most derivatives trades, dealers are one of the two counterparties, with many dealers recording their derivative exposures at their affiliated bank, the depository institution subsidiary of the parent com- pany. Prime brokers are the financing arm of the broker-dealer, offering advisory, clearing, custody, and secured financing services to their clients, which are often large active investors, especially hedge funds. Prime brokers can conduct a variety of transactions for their customers, including derivatives trading, cash management, margin lending, and other types of financ- ing transactions.
From Broker-Dealer Finance and Financial Stability
Broker-dealers were at the epicenter of the financial crisis. Their reliance on collateralized borrowing in the form of repurchase agreements was assumed to insulate them from runs, perhaps because many viewed collateralized lending as providing little default risk. This proved wrong. Many of their creditors did not want to take possession of the collateral backing the repurchase agreements in the event of default of a broker-dealer. As a result, there were widespread runs on broker-dealers, particularly those experiencing acute financial problems. This was not, however, just a problem for broker-dealers. Because of broker-dealers’ crucial role as market-makers, liquidity in markets was severely impaired.
Importantly, these broker-dealers fund their holdings in uninsured short-term credit markets, which makes them inherently more subject to runs than institutions that finance their holdings with longer-term or insured borrowing. As the crisis showed, when investors lose confidence in broker-dealers, short-term funding “runs” from them, and as a consequence the broker-dealers lose their ability to effectively serve as middlemen in markets, which in turn can impair the ability of investors to buy or sell a wide variety of stocks and bonds.
Perhaps the defining event of the 2008 financial crisis was the failure of Lehman Brothers, one of the largest broker-dealers in the United States. However, the collapse of Lehman was not an isolated failure of a single broker-dealer – but rather one of a string of crises for multiple broker-dealers. Bear Stearns had failed earlier that year, Merrill Lynch experienced significant funding difficulties and was eventually acquired, and Goldman Sachs and Morgan Stanley opted to become bank holding companies. Foreign broker-dealers did not fare much better: several large foreign broker-dealers operating in the United States experienced very substantial losses that required a significant rebuilding of capital.
While there have been significant reductions in some broker-dealers’ holdings of highly risky assets, and some improvements in capital and liquidity positions (and collateral quality), their reliance on a wholesale funding model that is subject to runs remains surprisingly unchanged.