GOST razgledi.net

dr. Simona Bovha Padilla
svetovalka v uradu za evropske politične analize pri evropski komisiji
simona.bovha.padilla@ec.europa.eu

The most recent financial turmoil started more than a year ago and unfolded rapidly. Although the re-pricing of credit risk was not surprising event, given the prolonged period of compressed credit spreads, a securitisation crisis and its effect on money markets hit some of the most prominent financial institutions in the world. Both the business cycle downturn and the on-going financial turmoil were triggered by the correction in the US Housing Market. House price cycles have a prominent effect on the economy. As banks usually hold the biggest part of mortgage loans in their balance sheets, it is not surprising that historically housing busts have impacted the banking sector significantly. Decline in house prices increases delinquency rates and at the same time reduces economic activity through negative effects on construction sectors and related activities.

The roots of the on-going financial turmoil lie in imbalances that accumulated in recent years. The turmoil itself may be seen as part of the adjustment process association with the resolution of such imbalances. The main drivers of imbalances were the following:

1. Over-expansionary monetary and fiscal policies. Although some had been warning for several years that the global economy was awash in liquidity, but these calls were ignored.

Loose monetary policy in most countries, but particularly in the USA, has led to an excess liquidity in international financial markets well above the needs of real transactions in the economies (see Figures 1 and 2).¹ Global excess liquidity has endorsed long-term world interest rates to historically low levels, reduced savings, caused asset price inflation and a high demand for the US assets, which resulted in a growing US current account deficit (see Figure 3). As US external imbalance has been mainly financed through foreign official lending, it led to the build up of reserves (which were invested in the US Treasuries) and current account surpluses in Asian countries, particularly in China. These operations might have reduced long-term interest rates in the USA by 30-60 basis points.²

Figure 1: Annualized growth rates of M2 and loans and bank leases in the USA, January 2005-September 2008

^{Source: Federal Reserve}

Figure 2: Annualized growth rates of M2, credit to non-financial corporations and credit to households and individual enterprises in the Euro area, January 2005-August 2008

^{Source: ECB}

Figure 3: Current account balances as a share of GDP in the USA and China, 2000-2007 (% of GDP)

^{Source: International Financial Statistics}

2. Related housing-market bubbles in many countries (USA, in Europe, the most prominent cases were Ireland and Spain) were also accompanied with some early warning signs that were ignored (see Figures 4 and 5). Real estate bubble spilled into a financial sector and caused inflated financial-asset prices with associated compressed premia on credit- and liquidity-risk. Clearly, the originate-and-distribute model of finance created has been poorly implemented by global banks and investment banks.

Figure 4: Annualized growth rate of new house prices in the USA, January 2000-September 2008

^{Source: Office of Federal Housing Enterprise Oversight}

Figure 5: Annualized growth rates of housing prices in Spain and Ireland, January 2000-August 2008

^{Source: Central Statistical Bank of Ireland, Bloomberg}

3. Financial innovation (such as securitisation products, credit derivatives and structured finance products) was supposed to reduce banks’ exposure to mortgage loans and prevent them from a house prices decline. However, it turned out that the securitisation process could not isolate banks from the adverse impact on housing markets price corrections.

4. Failed risk management, control, and governance structures in the global institutions had its toll on the current crisis and were accompanied with inadequate regulatory, supervisory, and surveillance frameworks in the global financial centers and many other advanced financial systems.

The current situation

This present credit crisis has the following key features:

1. Capital shortage among global banks

Reported write downs so far have totaled $750 billion, of which $580 billion have been reported by banks. Loss making banks have been able to raise new capital amounting to $420 billion. This creates a capital gap of some $160 billion.

In its October Global Financial Stability Report, the IMF has raised its projection of total loses to some $1,400 billion implying that the globally active banks are expected to report additional write downs and losses totalling between $145-$240 billion.

2. Money and credit markets are still dysfunctional

In global inter-bank money markets, the cost of short-term funds – liquidity – has risen to historically high levels, although some easing has been observed: on October 23, 3-month LIBOR has eased to 3.54% compared with 4.06% on Monday and 3-month EURIBOR fell to 4.92% from 5% on Monday.

The root cause is concern about the creditworthiness of counterparts among the set of financial institutions that make of the global inter-bank money market (that is, the global banking system). As a result, key interest rate spreads have risen to historically high levels. The TED spread (between interest rates on 3-month US treasury bills and the LIBOR rate) has risen to 400 basis points - on October 23 it eased to 249 basis point-whereas in normal conditions it trades close to 10-20 basis points. The European equivalent measure of perceived credit risk among the money-center banks has also risen sharply – see Figure 6.

Credit spreads have risen in all important credit market exposures such as household mortgages, credit-card receivables, commercial paper markets, corporate debt markets, as well as emerging-market sovereign and corporate debt. These funding pressures show an inability and/or unwillingness to lend due to mistrust about creditworthiness. Therefore, there is a real threat of continued funding problems in global money markets and further ‘runs’ on key systemically important financial institutions in the United States and Europe.

Figure 6: Differential between the 3-month interbank rate and the 3-month indexed swap rate (daily data, 2 January 2006- 22 October 2008)

^{Source: Bloomberg}

3. Rising likelihood of a global recession

The U.S. economy appears already to be in recession and the European economy may not be far behind. The IMF’s October 2008 World Economic Outlook paints a bleak and uncertain picture about current economic developments and prospects for the world economies and especially for the industrial countries. It is clear that the growth revisions relative to the July 2008 WEO projections are all in one direction, lower and by significant amounts. World economic growth, at 3.9% Y/Y in 2008 and 3.0% in 2009, is revised down by 0.2 and 0.9 percentage points, respectively. Economic growth in the US is projected to be 1.6% Y/Y in 2008; no growth is expected in 2009. Compared to the July 2008 WEO, these are 0.3 percentage points higher and 0.7 points lower, respectively.
Economic growth in the euro area is expected to slow from 1.3% Y/Y in 2008 to 0.2% in 2009, down by 0.4 percentage points and 1.0 points, respectively, relative to the July WEO. Among the major EU economies, Italy, Spain and the UK are projected to have negative growth in 2009.
Economic growth in the European Union is expected to be 1.7% Y/Y in 2008 and 0.6% in 2009, down by 0.4 and 1.1 percentage points, respectively. Central and Eastern Europe is now projected to see growth of 4.5% in 2008 and 3.4% in 2009, respectively. Finally, economic growth in the newly industrialized Asian economies will moderate from 4.0% Y/Y in 2008 to 3.2% in 2009, also considerably down compared to the July 2008 WEO.

What policy actions have been taken so far?

1. Insuring banks’ liabilities. Given the systemic nature of funding pressures, it is likely that key institutions will continue to face the potential for ‘bank runs.’ Continued funding pressures will severely reduce the ability of institutions to raise needed capital to remain viable through normal market sources of funding. New debt issuance is one way of proceeding. However, such measures do open the possibility of excessive risk taking on the part of banks.

2. Recapitalizing banking system. Many financial institutions are under funding pressures because their potential counterparts are not able to evaluate their assets; the markets in which these assets are valued are not functioning. This is creating widespread uncertainty about the value of banks’ net worth or capital. Until assets can be properly valued, otherwise viable financial institutions could face insolvency and financial systems will have difficulties to provide necessary credit to finance economic activity. Therefore, authorities should provide capital to those institutions that seem to be viable and help restructure non-viable ones.

Actions needed after the crisis has been halted

1. Short-term emergency measures must be revised. Once global financial markets begin functioning more-or-less normally, and the global banking system is providing credit to finance the recovery in economic activity, it is necessary to foresee a well ordered exit strategy.

The massive liquidity provided to restore market functioning will have to be ‘mopped up.’ Otherwise, we could face rising inflationary pressures and over-expansionary monetary conditions. The portfolio of assets purchased by governments – including toxic securities and shares in financial institutions – will need to be liquidated in an orderly fashion. Government guarantees on bank liabilities will also need to be removed. Private funding should substitute for public money in banks’ capital. Taxpayers should get a fair return on their investments.

2. Longer-term structural reforms are needed to restore global financial stability. The objective of reforms should be to enhance the ability of the global financial system to prevent the build-up of the kind of imbalances (discussed above) that could threaten global financial systemic stability and the global economy again in the future.

Achieving these broad objectives requires the creation of a new global financial architecture. Among other objectives, the architecture should be designed to significantly enhance the ability of private market discipline to prevent the kind of imbalances from arising that could threaten systemic stability.

***
¹ _{For a detailed discussion, see Dedola, Luca (2006), “Global Imbalances and “Excess Liquidity: Is There a
Link?”, ECB Research Bulletin, No. 4, April 2006, pp. 5-7.}
² _{See Bernanke Ben, Vincent Reinhart, Brian Sack (2004), “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment”, FEDS Working Paper No. 2004-48.}

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