and Implications FPD Financial Systems Practice January 2012 2 H - - PowerPoint PPT Presentation

Global Financial Crisis, Key Risks, and Implications

FPD Financial Systems Practice January 2012

HOW IS THE CRISIS

UNFOLDING—DIFFERENT STAGES

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The Origins of the Crisis in 2007-08

Weak oversight/infrastructure Inadequate regulation (K, L) Insufficiently wide perimeter Poor supervision/disclosure Poor risk management Lack of resolution tools Weak market infrastructure Financial System Highly complex and opaque TBTF institutions Overleveraged Reliant on short-term funding Funding activities of dubious quality Heavily interconnected Shadow banking activities 3 Global financial crisis Macro Very low interest rates Abundant liquidity Radical reforms needed to strengthen stability and resilience of the global financial system Micro Managerial incentives Implicit guarantees

Changing Nature of the Crisis and Policy Response

4 Subprime crisis Liquidity crisis globally Solvency problems for weak financial institutions (US, EUR) Large scale

• fficial support

to weak institutions and policies to revive economic growth Debt crisis (as fiscal deficits and debt/GDP ratios ballooned Confidence crisis in countries with fiscal problems and weak banks Negative feedback loop (between sovereign, bank, real sector risks) combined w/ policy and political uncertainty Contagion in and

• utside Europe

Spillover to emerging markets

• Bank recapitalization plan
• Greek debt write-down
• EFSF/ESM firewall
• Large scale ECB support
• (ECB facilities; SMPP)
• LT economic-fiscal EU

coordination measures

• ST EU stability measures

Where we are today?

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 Euro zone debt crisis continues to deepen, spreading from the periphery

to the core euro zone (given uncertain future of the euro zone, and lack

• f credibility of EFSF as an effective firewall to prevent contagion)

 Market tensions spill over to EMs (esp. CEE) on growing concerns about

European bank retrenchment and its impact on domestic economies

 Rating agencies take massive number of sovereign & bank rating actions

as economic/financial conditions worsen—add to negative feedback loop

 Bond yields remain elevated at levels inconsistent w: fiscal sustainability  Cost of insurance against sovereign/bank defaults surge  Funding and equity markets remain under pressure across the board  Record levels/persistent use of ECB facilities suggest continuation of

acute liquidity problems—implications for banks’ ability to lend

Emerging Europe Under Most Pressure

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50 100 150 200 250 Europe Africa Middle East Asia Latin America

Regional EMBI Spreads

(Change from a year ago, basis points)

• 30
• 25
• 20
• 15
• 10
• 5

Europe & Middle East Eastern Europe Euro Stoxx 50 Latin America Asia ex Japan

Regional Stock Market indices

(change from a year ago, % change)

Source: Bloomberg and staff computations

KEY RISKS AND VULNERABILITIES AND POSSIBLE TRANSMISSION CHANNELS TO DOMESTIC DEBT MARKETS

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Key Risks and Vulnerabilities

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 Euro area sovereigns and banks remain highly exposed to each

• ther (via banks’ bond holdings and contingent liabilities held by gov)

 Delays in policy implementation to break the negative feedback

loop between bank/sovereign/real riskscontinued funding difficulties

 Weak bank solvency and liquidity conditions  risk of acceleration

• f the deleveraging process by banks

 Deterioration in growth prospects in euro area  spillover to RoW  Further deterioration in fiscal positions/narrowing fiscal room  Slowdown in EM economies that were the engine of global growth

and reversal of capital inflows (incl. through reduced cross-border presence of WE banks)

Key Channels of Transmission to Debt Markets

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 Transmission through funding needs

(CEE, LAC, Asia)?

 Transmission through further bank solvency risks

(CEE, LAC)?

 Transmission through banks deleveraging

(CEE, Asia, AFR)?

 Transmission through a more challenging debt

management environment (CEE, LAC)?

(1) Transmission to debt markets via funding needs

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 Rating actions may feed the negative feedback loop between banking,

sovereign, and real sector risks: reduced ratings raise risk premium and borrowing costs for sovereigns and banks  further downgrades as economic prospects and financial condition of affected banking systems further deteriorate (including those of EMs with euro area links)

 Continued increase in sovereign bond yields in the euro area would

then spread to EM bond yields, raising borrowing costs for EM governments, as investors seek to avoid risky investments (EMBI spreads already rising in tandem)

 Crowding out of EM sovereigns by the large refinancing needs of

advanced country sovereigns and banks in 2012  risk of reduced availability of funding for EM debt (€1.3 trillion euro sovereign

refinancing need—Figure)

 Shortening of the maturity profile of debt (as investor risk aversion

increase)  heightened interest rate and maturity risks

Euro Area: Large Sovereign Financing Needs, 2012

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50 100 150 200 250 300 350 400 France Italy Germany Spain Greece Portugal Ireland

Funding needs* (EUR billion) * Including bills, bonds, deficit and others. Source: UBS Investment Research, European Weekly Economic Focus, January 2012

(Total of €1.3 trillion)

(2) Transmission via further bank solvency risks

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 Euro area banks have been selling peripheral and own sovereign debt to

counter market concerns about their solvency and counterparty risks, and to meet the higher capital requirements (Figure)  Pressure on sovereign euro area debt markets  Potential spillover of pressures to EM debt holdings

 Higher capital needs of weaker euro area banks may require public

support for recapitalization, if banks fail to raise equity in the market or deleveraging plans are deemed inappropriate by EBA and supervisory authorities  financing needs of euro sovereigns would rise in tandem with crowding out effects on EM sovereigns

 Contagion from distressed parent banks to affiliates in EM countries

may raise recapitalization needs of EM banks, affecting the borrowing needs of EM sovereigns

Net Direct Exposures of European Banks to European Sovereigns—Still high but reduced

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(50,000)

• 50,000

100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec Jul Dec AT BE CY DE DK ES FI FR GB HU IE IT LU NL NO PT SE SI

Change in Holdings between July and Dec 2011 (EUR million) Own Core Periphery Eastern Europe UK Source: EBA and staff computations

(3) Transmission through banks’ deleveraging

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 Many European banks are in the process of deleveraging and adjusting

their business strategies (either to shrink balance sheets as mandated by state aid rules, or to build capital buffers at an environment of low valuation and very limited investor interest)

 Deleveraging by euro area banks could result in:

 credit crunch in Europe and other EM’s, where euro area banks are

present or

 asset fire sales and lower equity/bond valuations around the world

• Prospects for economic growth further decline in Europe and RoW
• Asset quality/solvency problems  recap needs  gov. support
• Further rise in debt/GDP ratio at a time of high borrowing costs

(4) Transmission through a more challenging environment for debt management

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 The current market conditions provide a challenging

environment for sound management of risk in public debt portfolios, especially for EM economies:

 Fiscal room may be narrowing with rising fiscal deficits, higher

public debt, high borrowing costs, and a weak global economy

 Risk of rising inflation, associated with loose monetary policies

(hence, low interest rates), and rising debt burden

 Risk of currency depreciation associated with a reversal of

capital inflows as investors fly to quality  EMs with FX denominated public debt may be particularly at risk

EXTRA SLIDES

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European Banking Systems More Leveraged than Other Regions

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20 40 60 80 100 120 140

Adv EUR Europe Central Asia Advanced Other Latin America Caribbean High Non OECD South Asia East Asia Pacific Sub Saharan Africa Middle East NAfrica

(Loan to Deposit Ratios, in percent) Source: Finstats, 2010, the World Bank.

Both in EU and Non-EU Countries

(Loan to Deposit Ratios)

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50 100 150 200 250

(in percent)

Source: Finstats, 2010, the World Bank.

Dependence on Wholesale Funding

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0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 CredAg Deutsche UBS Svenska Esp San DexiA Barclays RBS Danske BNP Popular Commerz Swedbank SocGen Nordea ISP M Paschi UniCred Santander BBVA Lloyds BCP CredSuisse HSBC DnB Nor SEB Alpha KBC StanChar Raiffeisen Erste Piraeus NBGr MS GS BAC Citi JPM Bancorp WFC SunTrust PNC Branch Regions CBA Mizuho NAB Woori Sumitomo Shinhan Bank of China CCBC ICBC EUR US Asia

( 2009 data, in percent)

EUR average = 39% US average = 31% Asia average = 20%

Source: Bankscope staff computations.

Global policy response to the crisis:

Manage the crisis and reform the financial system

Microprudential regulations– Globally coordinated Intensive proactive supervision Robust national & cross-border resolution frameworks Macro-prudential dimension for systemic risk Expanded regulatory perimeter

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FSB BCBS BIS IMF/WB

Massive liquidity support by CBs Capital injections by national governments

Euro Area Bond Spreads over Bund Reached Unprecedented Levels

21

500 1000 1500 2000 2500 3000 3500 100 200 300 400 500 600

Basis points France Italy Spain Greece (Right) Portugal (Right) Source: Bloomberg

Global EMBI Spreads Rising since Summer 2011

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100 150 200 250 300 350 400 450 500 550 600

Basis points

Africa Asia Europe Latin America Middle East Gobal Composite

Source: Bloomberg

So are Regional CDS Spreads esp. for Europe

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50 100 150 200 250 300 350 400 450

Basis points

CEEMEA Western Europe Asia Pacific

Source: Bloomberg

Regional Equities Falling Across the Board

24

25 45 65 85 105 125 145 165 185 205 FTSE All World $ Asia ex Japan Europe & Middle East Latin America Eastern Europe

Index date = 1/1/2010 Source: Bloomberg

Correlation between Bank & Sovereign Risk has been Increasing since September 2011

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TARP/Cap. Purch. Program 1st Greek Support Greek PSI US Downgrade ITL/ESP Bond Purch

• .5

.5 1 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Europe-Core Europe-Peripheral

Correlations are Europe-Core: Sovereign vs Bank CDS and Europe-Peripheral: Sovereign vs Bank CDS (356 day rolling window)

Source: Staff computations

European Bank Exposure to Peripheral Sovereigns

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217% 153% 138% 137% 132% 130% 57% 51% 32% 24% 13% 11% 7% 4% 2% 1% 0% 0% 0% 0% 0% 50% 100% 150% 200% 250%

BE IT CY PT LU ES DE IE FR NL SI AT UK FI DK SE HU MT NO PL

(as percent of Core Tier 1 Capital)

Source: EBA and staff computations

European Banks Capital Shortfalls

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15.3 8.0 6.3 6.3 5.3 3.7 3.3 3.2 2.7 2.6 2.5 2.1 2.1 2.1 2.0 1.8 1.6 1.6 1.5 1.5 2 4 6 8 10 12 14 16 18

Top 20 bank with biggest capital shortfalls - Dec 2011 (EUR billion) Source: EBA and staff computations