Financial Integration and Global Financial Turmoil

Hamid FaruqeeAssistant to the Economic Counsellor

Research Department, IMFJune 25, 2008

Overview

Financial Integration

Financial Stability

Europe’s Road to a “Single Market” in Financial Services

Integrating Europe’s Financial Markets

Europe’s Road to a “Single Market” in Financial Services

Treaty of Rome (1957)

EMU (1999)

FSAP (2005)

Banking Directive (1989)

Capital Flows (1988)

Single European Act (1986)

Internal Market (1993)

Financial Integration: Concepts, Benefits & Risks

Autarky

“Single Market”

Interdependent Markets

Competition & Arbitrage

Scale Economies & Innovation

Completeness & Risk Sharing

“As Europe’s system of financial markets continues to evolve, so to will the risks... integration will introduce risks that are not yet known and that are more likely to spread...” (p. 40)

Evolving Risks from Integrating Financial Markets

Global Financial Turmoil Epicenter — U.S. Subprime Mortgage Crisis

Tremors — Credit Squeeze & Rising Spreads, Liquidity Strains in Term-Funding (ABCP / Interbank)

Wider Aftershocks and Fault Lines —Frozen Markets in ABS/CDO, Valuation problems, Bank Capital, Monoline Insurers, Liquidity “run”

Policy Issues — “Front-end” (mortgages) and “Back-end” policy reactions (liquidity)

7U.S. Subprime Delinquencies(in percent of total subprime loan amount; 2007Q1)

0% to 9%10% to 14%15% to 19%20% or more

8

0% to 9%10% to 14%15% to 19%20% or more

U.S. Subprime Delinquencies(in percent of total subprime loan amount; 2007Q2)

9U.S. Mortgage Resets and U.S. Mortgage Resets and DelinquenciesDelinquencies

Housing Market Delinquencies(percent of total residential loans

outstanding)

0

2

4

6

8

10

12

14

16

18

20

98 99 00 01 02 03 04 05 06 07 08

ForeclosuresPrimeSubprime

0

5

10

15

20

25

30

35

40

45

50

J un-07

Dec-07

J un-08

Dec-08

J un-09

Dec-09

Option adjustable rate mortgage

Subprime

Alt-A

Prime

Agency

Monthly Mortgage Rate Resets

(in billions of U.S. dollars)

Months to first reset

10

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

30

0 10 20 30 40 50 60

Months after origination

0.0

0.5

1.0

1.5

2.0

2.5

0 10 20 30 40 50 60

Subprime Prime

2003

2006

2000

2002

2005

2001

2004

20072003

2004

2002

20052000

2001

2006

2007

Mortgage Delinquency by Vintage year(60+ days delinquencies; in percent of balance)

11U.S. House Prices and Mortgage Delinquencies

Sources: Moody's Economy.com, Equifax, Case-Shiller and OFHEO.1/ Delinquency rate defined in percent of outstanding mortgages (in dollar amounts).

-2

0

2

4

6

8

-30% -20% -10% 0% 10% 20%

House Price Changes, 06Q2 - 07Q3(in percent)

Ch

ang

e in

Mo

rtg

age

Del

inq

uen

cy R

ate

, 05Q

4 -

07Q

4(i

n p

erc

en

t p

oin

ts)

1/

MidwestWest

SouthNortheast

12

0

10

20

30

40

50

60

70

80

90

100

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

failed acquired

Virtual Shutdown of Subprime Lending

Mortgage-Related Company Failures and Acquisitions

13

0

50

100

150

200

250

300

350

400

450

500

550

600

650

Jan-06 Aug-06 Mar-07 Oct-07 May-08

A-rated

BBB-rated

BB-rated

Corporate Spreads(basis points)

6/6

0

50

100

150

200

250

300

350

400

450

500

Jan-06 Aug-06 Mar-07 Oct-07 May-080

200

400

600

800

1000

1200

1400

1600

1800

2000Conforming

Jumbo

Subprime ABS (RHS)

Mortgage Spreads(in basis points; rel. to 1-m

LIBOR)

6/9

U.S. Interest Rate Spreads and Credit U.S. Interest Rate Spreads and Credit SqueezeSqueeze

14

0

100

200

300

400

500

600

700

97 98 99 00 01 02 03 04 05 06 07 08

0

2

4

6

8

10

12

Default rates—Total (RHS)

Default rates—Speculativegrade (RHS)

AA (LHS)

BBB (LHS)

BB (LHS)

Corporate Default Rates and Bond Spreads 1/

(default rates in percent; bond spreads in basis points)

1/ Speculative grade defaults based on Moody’s data through end-March.

15

-20

-10

0

10

20

30

40

50

60

2005 2006 2007 2008

Loans to small/ medium-sized companiesLoans to large companies

Consumer credit

Housing loans

Bank Surveys and Tighter Lending Conditions

(Change in credit standards over past 3 months; in percent 1/)

1/ Change in the balance of respondents between the “tightened considerably and tightened somewhat" and the "eased somewhat and eased considerably.“

ECB’s Lending Survey

-80

-70

-60

-50

-40

-30

-20

-10

0

10

20

30

40

50

60

70

80

2005 2006 2007 2008

C&I loans to firmsCommercial real estateResidential mortgagesResidential mortgages: primeResidential mortgages: subprimeConsumer loans (excl. credit cards)

Fed’s Lending Survey

16

-20

0

20

40

60

80

100

120

Jan-07 May-07 Sep-07 Jan-08 Jun-08

UnitedStates

Euro area

Japan

UnitedKingdom

0

20

40

60

80

100

120

140

160

180

200

220

240

260

Jul-07 Sep-07Nov-07 Jan-08Mar-08May-08

Liquidity and Credit Strains

3-Month LIBOR Spreads to OIS

(Overnight index swap; in basis points)

Bank CDS Spreads(5-years; in basis points; Median)

Europe

U.S.

6/6 6/6

17

0

25

50

75

100

125

150

175

200

225

250

275

300

325

350

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

0

50

100

150

200

250

300

350

400

450

500

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

Global CDS Spreads(5-years; in basis points)

Investment Grade

United States Major Economies 1/

World 1/ 2/

Source: IMF staff estimates.1/ Consolidated series based on investment grade entities from various sectors. Asia ex. Japan includes some non-investment grade entities.2/ Median based on U.S., Europe, Japan, Asia ex. Japan. Shaded area represent (+/-) one standard deviation.

InvestmentBanks

Commercial Banks

U.S.

Europe

Japan

Below Investment

Grade

0

25

50

75

100

125

150

175

200

225

250

275

300

325

350

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

Asia ex. Japan

6/9 6/9 6/9

18

0

100

200

300

400

500

600

700

Writedowns 1/ Capital Raised

US Europe Asia

Global Bank Writedowns and Capital Infusion

(in billions of U.S. dollars)

1/ Includes writedowns due to asset valuation, yet to be passed through income statement.

392.4

291.7

19

-10

-5

0

5

10

15

20

25

30

35

House “Price Gaps” and Monetary Policy Rates

Source: IMF staff calculations.

0

1

2

3

4

5

6

7

8

Jan-06 Aug-06 Mar-07 Oct-07 May-08

House “Price Gaps”(in percent of real house prices)

Monetary Policy Rates(in percent)

U.K.

Australia

U.S.

Japan

ECB

Key Lessons and Policy Issues Incentives and Standards — Oversight & Agency Problems in “Originate-to-Distribute” / Securitization

Credit Risk Transfer — ”Boomerang” from SIVs back to Banks; off-balance sheet transparency

Liquidity Fragility — at times of market stress, Complacency Problem & Counterparty Implications

Complex Products — Valuation Problems, Reliance on Rating Agencies, Breakdown of Due Diligence