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

2 H OW IS THE CRISIS UNFOLDING — DIFFERENT STAGES

The Origins of the Crisis in 2007-08 3 Weak oversight/infrastructure Macro Inadequate regulation (K, L) Very low interest rates Insufficiently wide perimeter Abundant liquidity Poor supervision/disclosure Poor risk management Micro Lack of resolution tools Managerial incentives Weak market infrastructure Implicit guarantees Financial System Radical reforms needed to Highly complex and opaque strengthen stability and TBTF institutions resilience of the global financial system Overleveraged Reliant on short-term funding Funding activities of dubious quality Global financial crisis Heavily interconnected Shadow banking activities

Changing Nature of the Crisis and Policy Response 4 Solvency problems for Liquidity crisis Subprime weak financial institutions crisis globally (US, EUR) Large scale Negative feedback loop official support Debt crisis (between sovereign, bank, to weak (as fiscal deficits real sector risks) institutions and and debt/GDP combined w/ policy and ratios ballooned policies to revive political uncertainty economic growth Confidence • Bank recapitalization plan Contagion in and • Greek debt write-down crisis in outside Europe • EFSF/ESM firewall countries with Spillover to • Large scale ECB support fiscal problems emerging markets • (ECB facilities; SMPP) and weak banks • LT economic-fiscal EU coordination measures • ST EU stability measures

Where we are today? 5  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 of 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 6 Regional EMBI Spreads Regional Stock Market indices (Change from a year ago, basis points) (change from a year ago, % change) 0 250 -5 200 -10 150 -15 100 -20 50 -25 0 -30 Europe Africa Middle East Asia Latin Europe & Eastern Euro Stoxx Latin Asia ex America Middle East Europe 50 America Japan Source: Bloomberg and staff computations

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

Key Risks and Vulnerabilities 8  Euro area sovereigns and banks remain highly exposed to each other (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 of 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 9  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 10  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 11 Funding needs* (Total of € 1.3 trillion) (EUR billion) 400 350 300 250 200 150 100 50 0 France Italy Germany Spain Greece Portugal Ireland * Including bills, bonds, deficit and others. Source: UBS Investment Research, European Weekly Economic Focus, January 2012

(2) Transmission via further bank solvency risks 12  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 13 Change in Holdings between July and Dec 2011 (EUR million) 450,000 400,000 Own Core Periphery Eastern Europe UK 350,000 300,000 250,000 200,000 150,000 100,000 50,000 - (50,000) 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 Source: EBA and staff computations

(3) Transmission through banks’ deleveraging 14  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 o Asset quality/solvency problems  recap needs  gov. support o Further rise in debt/GDP ratio at a time of high borrowing costs

(4) Transmission through a more challenging environment for debt management 15  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

16 E XTRA S LIDES

European Banking Systems More Leveraged than Other Regions 17 140 (Loan to Deposit Ratios, in percent) 120 100 80 60 40 20 0 Adv EUR Europe Central Advanced Other Latin America High Non OECD South Asia East Asia Pacific Sub Saharan Middle East Asia Caribbean Africa NAfrica Source: Finstats, 2010, the World Bank.

Both in EU and Non-EU Countries (Loan to Deposit Ratios) 18 250 (in percent) 200 150 100 50 0 Source: Finstats, 2010, the World Bank.

Source: Bankscope staff computations. 20.0 30.0 40.0 50.0 60.0 80.0 10.0 70.0 0.0 CredAg Deutsche UBS Svenska Dependence on Wholesale Funding Esp San DexiA Barclays EUR average = 39% RBS Danske BNP Popular Commerz Swedbank SocGen Nordea ISP EUR M Paschi UniCred Santander BBVA Lloyds ( 2009 data, in percent) BCP CredSuisse HSBC DnB Nor 19 SEB Alpha KBC StanChar Raiffeisen Erste Piraeus NBGr MS US average = 31% GS BAC Citi JPM US Bancorp WFC SunTrust PNC Branch Regions CBA Asia average = 20% Mizuho NAB Woori Asia Sumitomo Shinhan Bank of China CCBC ICBC