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Financial Markets’ Future Framework

Whereas the goal of MIFID I was predominantly to protect the consumers, at the one hand, and the professionals at the other hand, in case consumers overruled their advice, the second set of directives, aims at the full integration of the financial markets and create a workable market transparency. Furthermore, the directive aims at avoiding a systemic collapse as almost encountered following of the Lehman Brothers bankruptcy. Read more

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Investment Strategies

Whilst finishing writing the first version of my course on INVESTMENTS, “The Economist” in its May 15th 1999 issue, highlighted the unprecedented level of the stock exchanges in the United States and in Western Europe. The Dow Jones (the N.Y stock exchange index) was heading towards 10.000!

The article started as follows:


“Stock prices have reached what looks like a permanent high plateau”. So thought Irving Fisher, a great American economist, in 1929, shortly before the stock market fell into a ravine! (At that time the Dow Jones index indicated 381 and fell to 41 in three years). The explanation for current share prices is that investors are indeed being irrational. Economists who believe this point to evidence from psychology that, for instance, people give too much weight to recent experience – share prices have been going up, so investors expect them to go on doing so”.

“High share prices attract again the attention of academic economists. New theories abound, though old ones still had their defenders. But would any prove more prescient that Fisher’s ill-fated observation?

“Combined with demographic factors – such as the baby-boomer generation investing for retirement – this could send share prices soaring even further above “rational” levels. If so, the academics should not be surprised. John Maynard Keynes, another economist who knew about the stock market, once noted that “there is nothing as dangerous as the pursuit of a rational

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investment policy in an irrational world”.

Another thought crossed my mind whilst writing this course. Look at these two pictures hereafter. They are scanned from a remarkable book “The

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principles of corporate finance” by Brealey and Meyers, published at Mc Graw Hill, revised in 2013.

Which one represents the Standard and Poor’s Index for a 5-year period and which one represents a coin that is being tossed over and over again? Can you tell which is which? The SP index represents 75% of all shares quoted on the New York stock exchange.

Investment Strategies

Top chart shows the real Standard and Poor’s Index for the years 1980 through 1984. The bottom chart

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is a series of cumulated random numbers. The difference is matter of trend. The trend is related to inflation!

Another introductory observation: a sentence found in Brealy and Meyers book:
”The patron saint of the Bolsa (stock exchange) in Barcelona, Spain, is Nuestra Senora de la Esperenza – Our Lady of Hope. She is the perfect patron, for we all hope for superior returns when we invest in an “efficient and rational market”! THE question is: are they rational?

However, since than the index tumbled to 6.500 after the collapse of Lehman Brothers and stands over 16.000 in early 2014!

What should be our conclusion?

The message is: know your asset classes well, and stick to the proven principles of asset allocation and diversification, in order to weather likely significant fluctuations that few, maybe none, will forecast correctly. In all modesty, let us not forget that our investment- strategies are, whatever we do, always based on the assumption that the future will not be dramatically different from the past. All our theories and means are based on statistics, i.e. on the analysis of the past.

We are permanently extrapolating.

For sure, the better your grip on all the subjects covered in my course, the greater the probability that you will extrapolate in the right direction.

In addition, it needs to be stressed that most Principles covered in this course are valid in a mature economic environment with large markets and high liquidity. The reader should consider that it may or may not be applicable to his own environment dependent upon the fact his market is closely, or not, related to the US environment, which we consider as the best possible case study. The reason the US markets are the best case study is the wealth on statistics over a long period of time as well as the cheer size and volume of the market.

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Banking Supervision


Presentation by Frankfurter School of Finance & Management GmbH (max 30 min) related to your suggested topic for Day 3 “Banking Supervision” and to detail in particular:
• your proposed learning activities related hereto including your proposed pedagogical methods and models, theories and exercises as well as
• to provide the ECB, through a concrete example, the planned granularity/level of details of your proposed training session related to this topic.

Training lay out – workshop approach (Participants should be connected to internet for all trainings).

  1. This part of the program should be introduced with the film “INSIDE JOB” which shows why there is an increased need for regulation. It speaks more than a thousand words.
  2. Debriefing should cover the following questions
    1. Why more supervision?
      1. A bank could always be seen as a portfolio of assets financed by a portfolio of liabilities. Assets generate in income, liabilities a cost. The structure of the liabilities has a major impact on profitability; hence the tendency for banks to minimize the proportion
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        of funding by equity as it is the most expensive way to finance their assets. The result thereof is the leverage issue that took, before the collapse of Lehman Brothers, far from prudent proportions (1 to 30) for investment banks.

      2. The internationalization of banking operations and their sheer seize versus their home base economies have shown that the collapse of a major bank in a given country (example Iceland) has catastrophic consequences.
      3. The deregulation has encouraged undue risk taking. After the big depression bank activities were compartmented as stipulated in the USA with the Glass-Steagall act. The Dodd-Frank act addressed only to certain extends the consequences of deregulation. Europe has followed the same pattern.
      4. The Basel Committee on Banking supervision has increasingly put the accent not only on proper regulation but also on “good practices” and “codes of conduct” along the many recommendations, more particularly related to capital structure known as Basel I, subsequently II and III.
      5. The main danger zone is related to capital adequacy and liquidity
    2. Why Euro wide supervision?
      1. The introduction of the Euro entails a common monetary policy.
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        Participants will have seen what it means in the other parts of the program. Common rules are essential for a single currency. The recognized weakness and danger zone is the absence of a common fiscal policy.

      2. The sub-prime crisis has shown how exposed certain major financial institutions can be
      3. Profit remains the key motivating factor of executives
      4. All EU countries had national supervision, apparently not sufficiently diligent (example RBS)
    3. Stress test
      1. The review of what the premises are of a stress test and likely consequences
      2. The impact of economic cycles, interest rate fluctuations on the balance sheet of a bank
    4. Basel III (Source BIS) Basel III” is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:

      The reforms target:

      • Bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.
      • macro prudential, system wide risks that can build up across the banking sector as well as the pro-cyclical amplification of these risks over time.

      These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.

    5. The Basel Committee on Banking Supervision (BCBS) – (Source BIS)
      1. Standards implementation
      2. Policy development
      3. Accounting standards
    6. Case study – The balance sheet of, for instance, RBS as of 2008 till 2013.
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Price stability and recent trends in monetary policy


Inflation, deflation related to economic growth

Graph image

Source: Eurostat. Data prior to 1996 are estimated on the basis of non-harmonised national Consumer Price Indices

Amongst many definitions for economics, my preferred definition is this one by Todd Bucholz, in: «An introduction to modern economic thought”, Plume, 1989, “Economics is the study of choice. It does not tell us what to

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choose. It only helps us understand the consequences of our choices.” and I might add of our decisions and their consequences”. This brought me to study and teach “Decision Making” by Daniel Kahneman, “Thinking fast and slow”, Allen Lane, 2011. People make decisions, in whatever position they are, on intuition – system 1- or after analysis -system 2. The key issue is the expectation or the vision of what is in front of the decision maker, allowing for a prudent, or not, extrapolation. Key decisions are based on what we have retained from the past, and this is usual very little, how we see the present, this is usual fragmental and what we expect in the very near future.

Economic policy is about analysing and influencing decision making by the economic agents, i.e. consumers, producers, market makers, investors and governments. All agents require an environment that is relatively stable. Uncertainty, volatility is discouraging the average decision maker. One of the elements of this uncertainty is the evolution of the prices. Price fluctuations do impact on the decision making process.

Economic theory underlines that in a free market economy the market price reflects interaction between supply and demand: the price is set to equate the quantity being supplied and that being demanded. In reality the price may be distorted by other factors, such as tax and other government or central bank intervention through monetary policy.

Inflation is a situation whereby prices increase or to put it differently the purchasing power of money decreases. More precisely, Inflation refers to a general increase in consumer prices and is measured by an index which has been harmonized across all EU Member States: Harmonized Index of Consumer Prices (HICP). The HICP is the measure of inflation which the Governing Council of the ECB uses to define and assess price stability in the euro area as a whole in quantitative terms. The main headings of the Index are: food, alcohol and tobacco, clothing, housing, household equipment, health, transport, communications, recreation and culture, education, hotels and restaurants and miscellaneous (see Eurostat).

Deflation is the opposite. Extremes in both situations are pervasive. As shown above price levels fluctuate. The target (the red line) is to have an inflation of two (2) percent. The discussion in the Eurozone, today is rather avoiding deflation. See article at the end of this paper. A low inflation encourages the economic agents to act, consume or invest. A deflation does the opposite and may encourage major actors to postpone decisions, purchase later or invest later. It is a state of mind.

Inflation is slowing in the Eurozone, raising the risk of a slide into deflation and stagnation with the incapacity to generate jobs to bring down unemployment. Inflation is now less than half the central bank’s target level. Recently, the IMF (the International Monetary Fund) has expressed concern that weak prices mean there is little room for improvement of the economic situation. Besides, quite a few European banks are still very cautious about lending to households and businesses, or to each other, putting a downwards pressure on the economic recovery.

Quantitative definition of price stability (Source ECB)

The ideal situation would be “price stability” with an inflation rate of two percent. The definition of price stability according to the ECB is as follows:

While the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability. The ECB’s Governing Council has announced a quantitative definition of price stability as “Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%.” The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.

Benefits of the announcement by the ECB on price stability

The announcement makes the monetary policy more transparent, provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable and provides guidance to the public for forming expectations of future price developments.

Focus on the euro area

The ECB’s definition of price stability makes clear that the focus of its monetary policy is on the euro area as a whole. This reflects its euro area-wide mandate. Therefore, price stability is assessed on the basis of price developments in the euro area economy.


By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Reasons for aiming at below, but close to, 2%

Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability.

It also underlines the ECB’s commitment to

Key interest rates (Source ECB)

The Governing Council of the ECB sets the key interest rates. The key interest rates for the euro area set by the Governing Council are:

Unconventional monetary policy or pragmatic monetary policy (source ECB)

Since the intensification of the financial crisis in September 2008, the ECB has introduced a number of non-standard monetary policy measures that are unprecedented in nature, scope and magnitude with the aim to safeguard the primary objective of price stability and ensure an appropriate monetary policy transmission mechanism. They consist of:

  1. Enhanced Credit Support
  2. The Euros
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    system purchase of euro denominated covered bonds issued in the euro area.

  3. The EIB to become an eligible counterparty in the Euro system’s monetary policy operations
  4. Securities Markets Programme
  5. A fixed rate tender procedure
  6. The reactivation in coordination with other central banks, of the temporary liquidity swap lines

Comments by the ECB related to above measures (2010)

The Governing Council considers the above measures essential in order to ensure the effectiveness of the monetary policy transmission mechanism. In particular, above measures should help to mitigate the spillover of increased financial market volatility, liquidity risks and market dislocations in the access to finance in the economy. The sterilization of the interventions in the euro area public and private debt securities markets will ensure that the Securities Markets Program does not affect prevailing levels of liquidity and money market rates.

For further information do not hesitate to consult the source of this document

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Decision making and economics

Decision Making or Irrational Perseverance applied to the Euro Issue

By Roger Claessens, prof UBI, Brussels on

This first part of the text is based on: “Thinking fast and slow” by Daniel Kahneman[1].

It is by a happy coincidence that a friend mentioned I should be reading the book of Nobel Prize winning economist, Daniel Kahneman on “Decision Making”. My only regret is that this book was not published years ago and that I did not benefit earlier from the remarkable observations of the author, reason why I want to share this with you and the students who follow my courses.

“This book is a tour de force by an intellectual giant; it is readable, wise and deep. Buy it fast. Read it slowly and repeatedly. It will change the way you think, on the job, about the world, and in your own life.” (Richard Thaler, professor of behavioural science and economics, University of Chicago) Read more

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Paper Promises

Paper Promises book cover

Paper Promises book cover

I would like to draw your attention to the excellent book of Philip Coggan with the title “Paper Promises – Money, debt and the New World Order“, Allen Lane, 2011. I quote the last paragraph of his conclusions.

“In the past forty years, the world has been more successful at creating claims on wealth than it has at creating wealth itself. The economy has grown, but asset prices have risen faster, and debts have risen faster still. Debtors, from speculative home buyers to leading governments, have made promises to pay that they are unlikely to meet in full. Creditors who are counting on those debts to be repaid

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will be disappointed.”

“Clearing up the mess will be a long, slow process. It will involve many false starts, as occurred during the banking crisis of 2008 and as we have already seen in the European sovereign debt crisis. The debts may be repaid in inflated money, or devalued currency; they may be passed on to other governments with a greater capacity to repay; or they may result in outright default.”

“Breaking those paper promises will result in economic turmoil, as both debtors and creditors suffer. This is a crisis as severe as those that resulted in the end of the gold standard in the 1930s or the end of the fixed exchange rates in the 1970s. The global economy is changing; for many in the West, it will not be for the better.”

Sadly so, I have to agree with the author of this great book, which I strongly recommend reading.

Image source: Ebay

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Back to Marx?

Karl Marx

Karl Marx

Do we see the end of capitalism? This was the subject of a brief interview seen on the website of the Financial Times. There is a Russian proverb which says that if you

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you do it with the knowledge of the past, you look with one eye.


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do not know why we all have such a need to look at the past but what is sure is that it is of no great help at this stage. The future will mean – please refer to Future “Files” by R. Watson, published with Nicolas Brealey, 2010 – a global connectivity and GRIN technologies not to mention the environmental challenges. GRIN stands for Genetics, Robotics, Internet and Nanotechnology. It is all new and requires no hindsight but foresight, imagination and creativity.

We should spend our time and energy thinking about coping with this trend. It might mean the end of capitalism as it was perceived by Marx but what has our economic environment in common with the one of 1850?

Honestly, I never read Marx, just studied abstracts like most students in economics in Western Europe. I never really understood this author whom I would qualify more as a philosopher than an economist. A much better use of our time would be to see why winds of optimism or pessimism are blowing through our economies. On what grounds do consumers and producers make decisions that affect us all, irrespective where we live?

Rather than wondering about Marx, I would recommend an excellent book on decision making, i.e. to understand how people make decisions and their consequences: “Thinking, fast and slow” by Daniel Kahneman, Nobel laureate in Economics, published with Allen Lane, 2011.

What is sure is that the future will have

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very little in common with Marx’s time and thinking. Will capitalism survive is in my view the same question as will greed survive!

Wish you a pleasant reading.

Image source
Roger Claessens No Comments

I would like…

I would like to draw your attention to a recent article published by Ernst & Young in PERFORMANCE (preview) underlying the fact we move towards a reputation economy. Having a good reputation has always been necessary but the fact that we seem to attach even more importance to it and qualify a new economic environment with it is quite new. It comes as a sort of natural consequence of the “knowledge economy and the accent on the knowledge worker”.
What does it mean?

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stay. Most products and services have been evaluated one website or the other. Consumer reviews are familiar on line tools.

“The more we trade on line the more important it will become to establish our credentials.” The reputation economy is likely to save us time in the future by building trust across platforms. It will act as quality labels or ratings. “Managing our reputations online is shaping up to the cornerstone of the 21stcentury economy.” In all likelihood, in the future,

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Indeed, reputation systems are emerging as a valuable form of capital. Gradually power and influence might well shift to those people who have the best reputations and trust networks.