symposium on financial stability april 14, 2011 aula magna, romanian-american university...

SYMPOSIUM ON FINANCIAL STABILITY April 14, 2011

Aula Magna, Romanian-American University

Macroeconomics of Crisis: Borrowing Time Adrian Mitroi, Secretary General, CFA Romania

unusual uncertain times?

Macroeconomics of CrisisMacroeconomics of Crisis Buying timeBuying time

Decreased correlation

•Correlation: stocks, growth, inflation, deficits, exchange and interest ratesCorrelation: stocks, growth, inflation, deficits, exchange and interest rates•Cyclical vs. countercyclical; conventional vs. non conventional policiesCyclical vs. countercyclical; conventional vs. non conventional policies•Financial sector, a pro cyclical indicator of real economyFinancial sector, a pro cyclical indicator of real economy•Lending to negative equity; solvability vs. liquidityLending to negative equity; solvability vs. liquidity•Real estate market; LT real assets vs. ST financial liabilitiesReal estate market; LT real assets vs. ST financial liabilities

A PsiFinance Perspective into A PsiFinance Perspective into the New Normal Economicsthe New Normal Economics

Borrowing timeBorrowing time

Change in paradigm

•Propensity to spend, save or invest in highly volatile marketsPropensity to spend, save or invest in highly volatile markets•Risk aversion vs. loss aversion in economic recessionRisk aversion vs. loss aversion in economic recession•Decrease in bear markets correlation; only local black swansDecrease in bear markets correlation; only local black swans•Net wealth effect can be substituted for net income effectNet wealth effect can be substituted for net income effect•Ultralow/easy money leads always to bubblesUltralow/easy money leads always to bubbles

SYMPOSIUM ON FINANCIAL STABILITY, April 2011, Romanian-American University 2

Macro policies and marketsMacro policies and markets Learning by doingLearning by doing

Conventional •Cyclical: pro cyclical, correlated with overall state of the economy; ex. Cyclical: pro cyclical, correlated with overall state of the economy; ex. tightening monetary policy in recession (hawkish); higher than equilibrium-tightening monetary policy in recession (hawkish); higher than equilibrium-appropriate exchange rate, fiscal tightening (VAT increase)appropriate exchange rate, fiscal tightening (VAT increase)

•Conventional: monetary rate, (ex. strong Ron = tightening but decreased Conventional: monetary rate, (ex. strong Ron = tightening but decreased MRR = softening), open market; higher bound for repo interest = dovishMRR = softening), open market; higher bound for repo interest = dovish

•Countercyclical: activist (vs. laissez faire), against current economic Countercyclical: activist (vs. laissez faire), against current economic tendency, lower monetary rate (dovish), simulative in economic downturn; tendency, lower monetary rate (dovish), simulative in economic downturn; ex: progressive tax, unemploymentex: progressive tax, unemployment

Terra Incognita in MacroeconomicsTerra Incognita in Macroeconomics Trial and errorTrial and error

Ron appreciation

limited effect on inflation

Unchartered territory

Non conventional: easing cost and availability of funds; fiscal monetization: Non conventional: easing cost and availability of funds; fiscal monetization:

•aimed at reduced risk spreads, affecting longer term rate across the aimed at reduced risk spreads, affecting longer term rate across the board, independently of their liquidity and credit risk, affecting the market for board, independently of their liquidity and credit risk, affecting the market for risk free assets, government bonds (QE- ‘quantitative easing’); BCE reposrisk free assets, government bonds (QE- ‘quantitative easing’); BCE repos

•targeted on the risk spread across assets classes, between those whose targeted on the risk spread across assets classes, between those whose markets are particularly impaired (PIGs junks as collateral) and those that markets are particularly impaired (PIGs junks as collateral) and those that are more functioning (CE- ‘credit easing’); EU/IMF/EC Stability Fundare more functioning (CE- ‘credit easing’); EU/IMF/EC Stability Fund


One size monetary without fiscal policyOne size monetary without fiscal policy Not sure workingNot sure working

Combination of reasons

•CCommon to all major ommon to all major crisescrises, , is ais a combination of reasons: overleverage, real combination of reasons: overleverage, real estate boom, loose fiscal estate boom, loose fiscal aand monetary policiesnd monetary policies, overspending - debt d, overspending - debt difficult ifficult decisionsdecisions: h: higher tax igher tax oror lower spending lower spending/expenses?/expenses?

•ECB: one size fits all monetary policy has drawbacks, mostly in a downturn ECB: one size fits all monetary policy has drawbacks, mostly in a downturn economy. economy. FFrontront runners runners (G) (G) in recovery would rather enjoy an in recovery would rather enjoy an % % increase once increase once the growth picks up, but laggards the growth picks up, but laggards (P, S)(P, S) would rather see very low would rather see very low %% for a longer for a longer term term

From 2 big to fail to 2 big to bailFrom 2 big to fail to 2 big to bail Probably workingProbably working

Bail outs equals bail ins

•MMoral hazard introduced oral hazard introduced byby EU EU/IMF/EC/IMF/EC stand by stand by PIGs PIGs bailout bailout was a necessary was a necessary evil (write off). Probably, restructuring would have been better, but EU is not yet evil (write off). Probably, restructuring would have been better, but EU is not yet prepared to accept, manage, convince; China capitalizes Spanish Banksprepared to accept, manage, convince; China capitalizes Spanish Banks

•Europe’s financial tribulations reflect investors concern that governments have Europe’s financial tribulations reflect investors concern that governments have borrowed too much to revive their economies; how do US manage?borrowed too much to revive their economies; how do US manage?

•No matter how smart and big is the bailout (EU Stabilization Fund), most No matter how smart and big is the bailout (EU Stabilization Fund), most important stakeholders have to buy in: population (to sacrifice) and private important stakeholders have to buy in: population (to sacrifice) and private investors (to roll over next debt, at reasonable prices)investors (to roll over next debt, at reasonable prices)


Conventional vs. nonconventional Conventional vs. nonconventional policiespolicies Which one is better? Which one is better?

Debt transportation

•Too much debt is dangerous. During boom, central banks, investment bankers Too much debt is dangerous. During boom, central banks, investment bankers and politicians all signed up to the cult of debt; and politicians all signed up to the cult of debt; SE Asia is the least levered, SE Asia is the least levered, best prepared for sustained economic growth (financial and commercial)best prepared for sustained economic growth (financial and commercial)

•Companies went for balance-sheet "efficiency" - and homeowners, piled on Companies went for balance-sheet "efficiency" - and homeowners, piled on huge mortgages, were caught out, then discover that it is much harder to huge mortgages, were caught out, then discover that it is much harder to deleverage than to leverage up; deleverage than to leverage up; basically, only rented home from the bankbasically, only rented home from the bank

•When the Fed stops buying Treasuries, does the private sector take the baton When the Fed stops buying Treasuries, does the private sector take the baton and run the last leg of the relay race?and run the last leg of the relay race?

New Normal Global EconomicsNew Normal Global Economics Crisis or recession?Crisis or recession?

Change in paradigm

•Globalization doesn't work smoothly by itself. Free movement of capital has Globalization doesn't work smoothly by itself. Free movement of capital has facilitated rapid shifts in cross-border capital flows, currency values and prices of facilitated rapid shifts in cross-border capital flows, currency values and prices of commodities; insufficient financial depth (savings and investments/GDP) makes a commodities; insufficient financial depth (savings and investments/GDP) makes a country vulnerable; first: save; then: invest; only then: spendcountry vulnerable; first: save; then: invest; only then: spend

•Most probable we all, insufficiently saved, inadequately invested and irrationally Most probable we all, insufficiently saved, inadequately invested and irrationally spent future cash flows (governments, corporations, individuals)spent future cash flows (governments, corporations, individuals)


Central Banks matterCentral Banks matter Armada of measures, inflated BSArmada of measures, inflated BS


•During a normal recession, the Fed, ECB and During a normal recession, the Fed, ECB and otherother central banks central banks responded with non conventional monetary policies by buying short-term responded with non conventional monetary policies by buying short-term governmentgovernment/quality (except for PIGs junks) /quality (except for PIGs junks) debt from banksdebt from banks

•ProcessProcess drives rates on government debt down; investors seeking a drives rates on government debt down; investors seeking a higher rate move into other assets, driving other rates down; normally higher rate move into other assets, driving other rates down; normally these lower rates these lower rates will will lead to economic bouncebacklead to economic bounceback; in recession, fiscal ; in recession, fiscal also mattersalso matters

Interchangeable fiscal, monetaryInterchangeable fiscal, monetary Borrowing time; how/when to exit?Borrowing time; how/when to exit?

Change in paradigm

•AA lower bound to rates advocate lower bound to rates advocatess higher government spending: when higher government spending: when monetary policy is ineffective and private sector can’t be persuaded to monetary policy is ineffective and private sector can’t be persuaded to spend or borrow more, the public sector must take its place in spend or borrow more, the public sector must take its place in supportingsupporting the economythe economy

•Probably the fProbably the fiscal stimulus is Keynesian answer to iscal stimulus is Keynesian answer to current current economic economic situation situation and a good mix with monetary policy. New normal recession and a good mix with monetary policy. New normal recession requires CBs to be less concerned on inflation? Milton Friedman for requires CBs to be less concerned on inflation? Milton Friedman for growth and John Maynard Keynes for recession? growth and John Maynard Keynes for recession?


Central banks do matter since monetary and fiscal policies Central banks do matter since monetary and fiscal policies look interchangeable, latelylook interchangeable, lately

7

FED (Apr. 2011):FED (Apr. 2011): •Discount rate (charged to banks, Discount rate (charged to banks, refinancing, psychological): 50 bprefinancing, psychological): 50 bp•Fed Funds (o/n, benchmark, Fed Funds (o/n, benchmark, target, main policy rate): 0-25 bptarget, main policy rate): 0-25 bp

ECB (Apr. 2011): ECB (Apr. 2011): •Marginal lending facility: 1.75 % Marginal lending facility: 1.75 % •Main refinancing operations: 1.25 % Main refinancing operations: 1.25 % •Deposit facility: 0.5 %Deposit facility: 0.5 %

NBR (April. 2011): NBR (April. 2011): •Deposit facility: 2.25%Deposit facility: 2.25%•Policy rate: 6.25%Policy rate: 6.25%•Lend facility: 10.25%Lend facility: 10.25%•MRR FX: 20%MRR FX: 20%

SYMPOSIUM ON FINANCIAL STABILITY, April 2011, Romanian-American University

Hold rates, strengthen Ron, prop solvabilityHold rates, strengthen Ron, prop solvability

8SYMPOSIUM ON FINANCIAL STABILITY, April 2011, Romanian-American University

Sovereign debt pressureSovereign debt pressure no pain all gain solutionno pain all gain solution

2nd generation of structural

reforms

•Actual rate probably lower with 100 -150 bp than neutral Actual rate probably lower with 100 -150 bp than neutral •6.25% vs.~7% current neutral (5% historical) - need to tighten (100 bp) 6.25% vs.~7% current neutral (5% historical) - need to tighten (100 bp) but output gap is negative (-4%). M. Finance % rate < LT GDP g %but output gap is negative (-4%). M. Finance % rate < LT GDP g %•VAT added (1VAT added (1stst and 2 and 2ndnd) round 2.5%-3% fiscal inflation) round 2.5%-3% fiscal inflation•Permanent increase in the inflation risk premiumPermanent increase in the inflation risk premium•Economic contraction positive countercyclical effect (March poor 8%)Economic contraction positive countercyclical effect (March poor 8%)

Systemic riskSystemic risk Old answers to new questionsOld answers to new questions

Monetary medication plus fiscal dietMonetary medication plus fiscal diet


•A bubble in government bonds has been deflated but yields will rise, A bubble in government bonds has been deflated but yields will rise, inflation, oversupply. inflation, oversupply. •Need to print money to pay interest on new debt; result: a slower Need to print money to pay interest on new debt; result: a slower recovery; growth is a key determinant for deficitsrecovery; growth is a key determinant for deficits•Add corporate and private debt to government debt / GDP, the prospect Add corporate and private debt to government debt / GDP, the prospect of economic growth paying all that off is moving further in timeof economic growth paying all that off is moving further in time

Sovereign debt pressureSovereign debt pressure Public loss private gainsPublic loss private gains

Change in paradigm

•Debt restructuring, could be the new currency devaluation in the euro Debt restructuring, could be the new currency devaluation in the euro zone if not proper measure taken;zone if not proper measure taken;•Higher borrowing cost (LT) could lead to higher deficits; EU Higher borrowing cost (LT) could lead to higher deficits; EU Stabilization Plan targets MT/LT ratesStabilization Plan targets MT/LT rates•Creditors are also massive debtors. If the value of their assets Creditors are also massive debtors. If the value of their assets declines, the only way they can stay solvent is by reducing their debt, declines, the only way they can stay solvent is by reducing their debt, sell assets, pushes price down further, exacerbating and spreading it to sell assets, pushes price down further, exacerbating and spreading it to other securities/currency (€)other securities/currency (€)


Real vs. financial/virtual economyReal vs. financial/virtual economy Wealth effect vs. income effectWealth effect vs. income effect

Commercial vs.

Financial

•Governments have borrowed too much to revive economies, causing Governments have borrowed too much to revive economies, causing (2011) volatility, pushing the limits of fiscal and monetary stimulation; (2011) volatility, pushing the limits of fiscal and monetary stimulation; financial prosperity, however, takes timefinancial prosperity, however, takes time

•Banking and financial sector, a lagging, pro cyclical indicator of real Banking and financial sector, a lagging, pro cyclical indicator of real economy; although economy hoped to clearly rebound in 2011, GDP economy; although economy hoped to clearly rebound in 2011, GDP growth is not enoughgrowth is not enough

•Banks will not give loans on concerns of negative equity; pro cyclical Banks will not give loans on concerns of negative equity; pro cyclical attitude: the more credit you need, less able you are. Unemployment is attitude: the more credit you need, less able you are. Unemployment is a key indicatora key indicator

The weak Dollar syndromeThe weak Dollar syndrome Easy FED takes $ from saversEasy FED takes $ from savers

Bernanke's floor and putBernanke's floor and put

$ 15% yoy decrease - big loss for China

•Post real estate boom market: real assets vs. financial liabilities Post real estate boom market: real assets vs. financial liabilities

•Financial stability: Financial stability: bail out countries (PIGs) is to keep financing bail out countries (PIGs) is to keep financing banks sovereign exposure solvable; banks sovereign exposure solvable; money-printing is just another money-printing is just another way for governments to silently default on their debt way for governments to silently default on their debt

•ChIndia, ChIndia, probably best market capitalists have socialist ideology and probably best market capitalists have socialist ideology and US will not make it easier for EU; EU does not make it easier for EUUS will not make it easier for EU; EU does not make it easier for EU


Liquidity Liquidity Bail outBail out


•Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not inter changeable. Interest rate risk vs. credit/counterparty riskinter changeable. Interest rate risk vs. credit/counterparty risk

•Liquidity provided by CBs can make a difference on ST but not on a LT; Liquidity provided by CBs can make a difference on ST but not on a LT; markets are becoming completely dependent on Central Banks. Dark markets are becoming completely dependent on Central Banks. Dark side of Euro: side of Euro: one size fits all could be suboptimal in times of crisisone size fits all could be suboptimal in times of crisis

•Negative equityNegative equity: market value of assets < present value of liabilities. : market value of assets < present value of liabilities. Deleveraging is a must Deleveraging is a must (7/91 stressed European Banks w/ Tier1 < 6%)(7/91 stressed European Banks w/ Tier1 < 6%)

SolvencySolvency Bail inBail in

Change in paradigm

•Solvability (LT, renewable ability to borrow) vs. liquidity (short term) Solvability (LT, renewable ability to borrow) vs. liquidity (short term) •High debt/GDP, high deficit/GDP, low growth – LT endangered High debt/GDP, high deficit/GDP, low growth – LT endangered speciesspecies•An absolute economic pecking order:An absolute economic pecking order:

1: recovery 1: recovery 2: growth 2: growth

3: expansion 3: expansion 4: prosperity4: prosperity

•What if Oil does not decrease till Q4? What when FED stops buying?What if Oil does not decrease till Q4? What when FED stops buying?•Bail out: €B 865 (EFSF: 440, IMF: 280/US 50, EFSM: 60, Bilateral: 85) Bail out: €B 865 (EFSF: 440, IMF: 280/US 50, EFSM: 60, Bilateral: 85)


Carry trade the easy moneyCarry trade the easy money Ultralow monetary for net wealthUltralow monetary for net wealth


•Then (2009): reverse correlation; when the dollar would fall, stocks Then (2009): reverse correlation; when the dollar would fall, stocks would rise and vice versawould rise and vice versa; euro was strong, EM currencies, including ; euro was strong, EM currencies, including Ron, were under pressureRon, were under pressure

•Why: CTWhy: CT investors were using a currency that cost almost nothing to investors were using a currency that cost almost nothing to borrow borrow ($,¥) ($,¥) to buy undervalued stocks, with a bias toward emerging to buy undervalued stocks, with a bias toward emerging marketsmarkets; c; combination ombination llift stocks off their 2009 March lows ift stocks off their 2009 March lows

Currencies and stocksCurrencies and stocks Competitive re(de)valuationCompetitive re(de)valuation

Change in paradigm

•NowNow (2011) (2011): stocks and the dollar are moving : stocks and the dollar are moving up up in tandem againin tandem again, but , but not down (weak Euro from B/Outs?); not down (weak Euro from B/Outs?); a signal for investors to put more a signal for investors to put more money into $ denominated assetsmoney into $ denominated assets? a signal to sell Euro denominated ? a signal to sell Euro denominated assets and buy into emerging markets (Ron?)assets and buy into emerging markets (Ron?)

•Countercyclical Dollar and Yen are now less favorite CT currencies, Countercyclical Dollar and Yen are now less favorite CT currencies, due to strengthening and overall volatility; with $, ¥, and volatility up due to strengthening and overall volatility; with $, ¥, and volatility up


DollarDollar Cyclical tailwindCyclical tailwind


•TTypical paradigm for an export oriented Europe was that a strong dollar ypical paradigm for an export oriented Europe was that a strong dollar // weak euro is good for trade, weak euro is good for trade, forfor both US and China. both US and China. AA weakening euro weakening euro (a political not economic currency) (a political not economic currency) is of benefit to is of benefit to PIIGSPIIGS, alleviating , alleviating some excessive deficits and making their products more competitivesome excessive deficits and making their products more competitive

•RRaw materials, mostly denominated in dollars are making inputs prices aw materials, mostly denominated in dollars are making inputs prices more expensive adding additional strain on expected growth differential more expensive adding additional strain on expected growth differential vs. US. This will lead probably to an earlier interest rate hikevs. US. This will lead probably to an earlier interest rate hike, , make make now now dollar assets attractivedollar assets attractive; ; now: strong CHF, J¥, €; undervalued C¥now: strong CHF, J¥, €; undervalued C¥

EEurouro Structural headwindStructural headwind

Cyclical or countercyclical

•DDuring the toughest part of recession, the dolar weakend against most uring the toughest part of recession, the dolar weakend against most of other currenciesof other currencies. . A A ddepreciatiepreciatingng currency is a good antirecessonary currency is a good antirecessonary tooltool; ; aa low $ exports recession and a strong $ imports growth low $ exports recession and a strong $ imports growth

•Banks are a lagging economic conditions. Banks are a lagging economic conditions. CBsCBs, trying to protect , trying to protect currency stability and debtorscurrency stability and debtors,, would rather sacrifice future, potential would rather sacrifice future, potential debtorsdebtors/present depositors/present depositors than curent debtors solvability than curent debtors solvability positionposition

•MMain risks to fiscain risks to fiscaal consolidation stem from l consolidation stem from too too optimistic assumptions optimistic assumptions and lack of specificationand lack of specification; if EU didn’t have common currency, it would ; if EU didn’t have common currency, it would have bigger problems or vice versa? have bigger problems or vice versa?



15

Diversification along sectors, assets, managersDiversification along sectors, assets, managers Economy (2011-2012) Probability A (energy sector) B (financials sector)

Boom 0.25. 20% 5%

Normal 0.50 10% 10%

Recession 0.25 0% 15%

•Ra = (0.25) (0.20) + (0.50) (0.10) + (0.25) (0.00) = 0.10

•Rb = (0.25) (0.05) + (0.5) (0.10) + (0.25) (0.15) = 0.10

•Σ2a = (0.25) (0.20-0.10)2 + (0.5) (0.10-0.10)2 + (0.25) (0.00-0.10)2 = 0.005

•σ2b = (0.25)(0.05-0.10)2 + (0.5)(0.10-0.10)2 + (0.25)(0.15-0.10)2 = 0.00125

•σa = (0.005)1/2 = 0.07071 = 7.071%

• σb = (0.00125)1/2 = 0.03536 = 3.536 %

•Covab = (0.25)[(0.20-0.10)(0.05-0.10)]+ (0.50)[(0.10-0.10)]+ (0.25)[(0.00-0.10)(0.15-0.10)]=

- 0.0025

•ρ(a,b) = cov (a,b) / σ2a σ

2b = - 1


Risk appetite increases at the wrong moment and for the Risk appetite increases at the wrong moment and for the wrong reason, just when risk capacity decreases; net wealth wrong reason, just when risk capacity decreases; net wealth effect (market) compensates for net income effect (lower wage)effect (market) compensates for net income effect (lower wage)


2011 P2011 Portfolio diversificationortfolio diversification: : 50% stocks + 50% bonds50% stocks + 50% bonds

Probability Equity fund % Bond fund % 50% equity +50 % bond

Recession 1/3

- 7 17 + 5

Normal 1/3

+ 12 + 7 + 9.5

Boom 1/3

+ 28 - 3 +12.5

Expected return 11 7 9

Variance 204.7 66.7 9.5

Standard deviation 14.3 8.2 3.1

•Cov(s,b) = 0,3333(-7-11)(17-7)+0.3333(12-11)(7-7)+0.3333(28-11)(-3-7) = -116.67•ρ(s,b) = cov (s,b) / σaσb= -116.66 / [(14.3) (8,2)] = - 0.99


Emotional Phases; case study: PIGS Emotional Phases; case study: PIGS

Phase 2 Phase 4 Phase 5

Emotions and guts do matter

Emotions and guts do matter

▪ Individuals make mistakes

▪ Pain is a strong evolutionary trick that quads us against dangers

▪ Individual learn, adapt (heuristic) but make a lot of mistake in the process

▪ Residual risk aversion▪ Overconfidence

Survival of the able planner

Survival of the able planner

▪ Behavioral biases create bubble and bust phases that are hard to predict

▪ Contrarian strategy needs steadfastness

▪ Even best strategies wax and wane over time

▪ If the market is efficient, what is the use of stock picking ability?

▪ A 95% perfect strategy is a non performing strategy

▪ Do the right thing only after had exhausted every other alternative

Markets are not always rational

Markets are not always rational

▪ Both markets and investors evolve and adapt

▪ Frame dependence▪ Mental accounting

▪ Financial education is a necessity; manage assets and liabilities

▪ Think long term▪ Make sacrifices▪ Can do attitude

▪ Greed makes crisises unavoidable; humans are kind, generous,

▪ Econs are unscrupulous, have a limited span of interest and attention

ConfidenceConfidence

▪ Risk is rewarded, in general, by higher return, but not necessarily

▪ Risk is seriously punished during crises, rational or not

▪ Progress in finance is cyclical

▪ Economic creativity is key to human development

▪ Inertia is a very powerful force

▪ Most of the decisions we make in our lives is based on our level of confidence

Phase 3

▪ Survival is all that matters

▪ Pain is temporary, quitting is permanent

▪ Regret aversion

▪ Pace of change in business is faster than ever

▪ Representativeness

▪ Save more tomorrow▪ People do not react

well to bans or mandates; they react best at nudging

Phase 1

▪ Individuals always act in their own best interest, economic

▪ Success and prosperity are strong anesthetics

▪ Biological rigor prevails▪ History is written by

winners ▪ Right decision feels,

right, investor sentiment

▪ Unstable balance between fear and greed

▪ People have noneconomic reasons and irrational behaviors

▪ Achievement begets success

▪ Success begets confidence

▪ Confidence begets opportunities

▪ Individuals act feasibly, and always try to satisfice

▪ People consumed to much and invested too little

▪ Competition imposes continuous adaptation

▪ Adaptation, flexibility, innovation and compromise are key to survival

OverallOverall Denial Anger BargainingDepression Acceptance

1

3

2

4


Too big to fail but fit enough to carry trade the easy money

20

Paper out the crisis to the future


What if: 1% (end of 2011, ECB) increase in short-term ratesWhat if: 1% (end of 2011, ECB) increase in short-term rates

Assets Yield Liabilities CostRate sensitive 500$ 9.0% 600$ 5.0%Fixed rate 350$ 11.0% 220$ 6.0%Non earning 150$ 100$

920$ Equity

80$ Total 1,000$ 1,000$

GAP = 500 - 600 = -100

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NIM = 40.3 / 850 = 4.74%NII = 83.5 - 43.2 = 40.3

Expected Balance Sheet for Hypothetical Bank

With a negative GAP, more liabilities than assets reprice higher; hence NII and NIM fall

ECB tightening will pressure banks, lending, growth


Adjust Rate Sensitivity of a Bank’s Assets and Liabilities Adjust Rate Sensitivity of a Bank’s Assets and Liabilities ((core EU: more fixed rates vs. periphery EU: more variable rates)core EU: more fixed rates vs. periphery EU: more variable rates)

Objective Approaches (core vs. periphery Europe)

Reduce asset Reduce asset sensitivitysensitivity

• Buy longer-term securitiesBuy longer-term securities• Lengthen the maturities of loansLengthen the maturities of loans• Move from floating-rate loans to term loansMove from floating-rate loans to term loans

Increase asset Increase asset sensitivitysensitivity

• Buy short-term securitiesBuy short-term securities• Shorten loan maturitiesShorten loan maturities• Make more loans on a floating-rate basisMake more loans on a floating-rate basis

Reduce liability Reduce liability sensitivitysensitivity

• Pay premiums to attract longer-term depositPay premiums to attract longer-term deposit• Issue long-term subordinated debtIssue long-term subordinated debt

Increase liability Increase liability sensitivitysensitivity

• Pay premiums to attract short-term depositPay premiums to attract short-term deposit• Borrow more via non-core purchased liabilitiesBorrow more via non-core purchased liabilities



Oil vs. Euro; higher Euro or lower Dollar?Oil vs. Euro; higher Euro or lower Dollar?

23


Gold vs. Euro; higher Euro or lower Dollar?Gold vs. Euro; higher Euro or lower Dollar?EU: prosperity by austerityEU: prosperity by austerityUS: assumption and consumptionUS: assumption and consumption

24


DJIA vs. BET; Dollar weakening (15%) - no procyclical decorrelationDJIA vs. BET; Dollar weakening (15%) - no procyclical decorrelation

25

The Black EyrarThe Black Eyrar

Global insolvency of current benefits; need to transfer/lower standard of living

• A pension that has to pay A pension that has to pay €10,000 in 50 years (@4 €10,000 in 50 years (@4 %) in today’s money, %) in today’s money, €1,400; use of 7 % reduces €1,400; use of 7 % reduces that to €340 today, but that to €340 today, but €10,000 remains €10,000 remains

• IFRS: “IFRS: “discount rate discount rate should reference to market should reference to market yields on high quality yields on high quality corporate bonds with similar corporate bonds with similar durations to those of benefit durations to those of benefit obligationsobligations” ”

• Where a deep market of Where a deep market of corporate bonds do not corporate bonds do not exist (CEE), pension exist (CEE), pension companies discount at yield companies discount at yield on TBs on TBs

Yield curve bet vs. credit quality bet

Portfolio managers time level Portfolio managers time level of interest rates relative to of interest rates relative to cycle, adjust maturities:cycle, adjust maturities:

• time interest rate peaks, time interest rate peaks, counter-cyclical strategy: the counter-cyclical strategy: the changes in loan demand and changes in loan demand and the yield curve’s shapethe yield curve’s shape

• at top of cycle, expanding at top of cycle, expanding portfolio, when interest rates portfolio, when interest rates and loan demand are high and loan demand are high lengthening maturitieslengthening maturities

• yield curve generally yield curve generally inverts when rates are at inverts when rates are at peak prior to recession peak prior to recession

• at bottom interest rates and at bottom interest rates and loan demand are low, bank loan demand are low, bank contracts portfolio, shortens contracts portfolio, shortens maturitiesmaturities

Mrs. Market infinite energy to prove us wrong

• Solvability and liquidity are Solvability and liquidity are not interchangeablenot interchangeable

• Cannot transform liquidly Cannot transform liquidly into solvability except by sale into solvability except by sale at loss at loss

((S = L - Current LossS = L - Current Loss))

• An investor/debtor (An investor/debtor (TheThe Real Real Estate Inc.Estate Inc.) can’t get rich by ) can’t get rich by buying an overvalued asset buying an overvalued asset except by miracle or luck; luck except by miracle or luck; luck is non recurrentis non recurrent

• Deficit of competitiveness Deficit of competitiveness and and Black EyrarBlack Eyrar::


The same old sun: easy to be smart on hindsightThe same old sun: easy to be smart on hindsight

OOverver optimism is a optimism is a basic tenet of basic tenet of human human sspeciespecies

In general, people do In general, people do

not spend time not spend time looking and looking and understanding bad understanding bad newsnews

IInvestors would rather nvestors would rather prefer to focus on prefer to focus on the bright side of the bright side of the moon and they the moon and they do not see things do not see things that they do not that they do not expect to seeexpect to see

In the war b/w upper In the war b/w upper and lower class, it and lower class, it is the middle class is the middle class that pays the pricethat pays the price

Where are we now? Where are we now?


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