World Economic OutlookWorld Economic OutlookPresentation by Subir LallPresentation by Subir Lall

October 2008October 2008

Chapter IVChapter IV

Financial Stress and Financial Stress and Economic DownturnsEconomic Downturns

Prepared by:Prepared by:Subir Lall, Roberto Cardarelli,Subir Lall, Roberto Cardarelli,

and Selim Elekdagand Selim Elekdagwith support from Angela Espirituwith support from Angela Espiritu

and Gavin Asdorianand Gavin Asdorian

Key FindingsKey Findings

•• Financial turmoil more likely to be followed by Financial turmoil more likely to be followed by severe and protracted downturns when severe and protracted downturns when

•• characterized by banking sector distresscharacterized by banking sector distress•• preceded by rapid increases in credit, a runpreceded by rapid increases in credit, a run--up in house prices, and up in house prices, and

heavy borrowing by households and nonheavy borrowing by households and non--financial corporatesfinancial corporates

•• Banks still key in transmitting financial shocks, Banks still key in transmitting financial shocks, especially in armespecially in arm’’s length financial systems s length financial systems

•• Current conjuncture bears some resemblance to Current conjuncture bears some resemblance to previous episodes of bankingprevious episodes of banking--related financial related financial stress episodes that were followed by recessionsstress episodes that were followed by recessions

70

75

80

85

90

95

100

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for United StatesExample: FSI for United States

Note: Shaded areas indicate periods of financial stress.

50

55

60

65

70

75

80

85

90

95

100

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for United KingdomExample: FSI for United Kingdom

Note: Shaded areas indicate periods of financial stress.

50

55

60

65

70

75

80

85

90

95

100

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for JapanExample: FSI for Japan

Note: Shaded areas indicate periods of financial stress.

40

45

50

55

60

65

70

75

80

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for GermanyExample: FSI for Germany

Note: Shaded areas indicate periods of financial stress.

50

55

60

65

70

75

80

85

90

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for FranceExample: FSI for France

Note: Shaded areas indicate periods of financial stress.

50

55

60

65

70

75

80

85

90

95

100

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Example: FSI for CanadaExample: FSI for Canada

Note: Shaded areas indicate periods of financial stress.

Main global financial stress episodesMain global financial stress episodesare captured by FSIare captured by FSI

Share of Countries Experiencing Financial Stress

0

10

20

30

40

50

60

70

80

90

100

1980q1 1984q1 1988q1 1992q1 1996q1 2000q1 2004q1 2008q1

Stock market crash

Nikkei/junk bond collapse

Scandinavian banking crises

ERM crisis

LTCM collapse

Economic downturns tend to be more severe when preceded by financial stress...

Cumulative Output Loss during Slowdowns and Recessions

(median; percent of GDP)

-5

-4

-3

-2

-1

0

Preceded by financial

stress

Preceded by financial

stress

Not preceded by financial

stress

Not preceded by financial

stress

Slowdowns Recessions

Banking system stress is associated withBanking system stress is associated withlarger output consequenceslarger output consequences

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12

Real GDPReal GDP(percent change from one year earlier)(percent change from one year earlier)

Quarters before and after the start of financial stress

All financial stress episodesBanking-related financial stressNon-banking-related financial stress

-2.0

-1.5

-1.0

-0.5

0.0

0.5

Recessions Slowdowns Other

Downturns more likely with financial Downturns more likely with financial imbalances and large corporate borrowingimbalances and large corporate borrowing

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Recessions Slowdowns Other

Credit (percent of GDP; cumulative percent deviation from trend over six quarters before

start of financial stress)

p-value = 0.00

-20-15-10-505

1015202530

Recessions Slowdowns Other

Real House Prices (cumulative percent deviation from trend over six quarters before

start of financial stress)

p-value = 0.00

p-value = 0.00

-0.8-0.7-0.6-0.5-0.4-0.3-0.2-0.10.0

Recessions Slowdowns Other

Nonfinancial Corporate Net Lending/Borrowing (percent of GDP; deviation from trend one year

before start of financial stress)

p-value = 0.05

Household Net Lending/Borrowing (percent of gross disposable income; deviation from trend

one year before start of financial stress)

p-value = 0.04

p-value = 0.02

p-value = 0.05

Evidence of “credit crunch” in banking-related recessions

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

Recessions Slowdowns Other

Change in Cost of Capital(percentage points)

p-value = 0.00

0.00

0.05

0.10

0.15

0.20

0.25

Recessions Slowdowns Other

Change in Bank Assets(percent)

p-value = 0.05

p-value = 0.05

Investment banksInvestment banks’’ leverageleverageis is procyclicalprocyclical

Top 50 Investment Banks

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

-4 -3 -2 -1 0 1 2 3Leverage Growth

Asset G

rowth

Investment Banks Linear Regression Linear Regression (excl. outliers) Median Regression

β = 0.43

...while for commercial banks...while for commercial banksevidence is mixedevidence is mixed

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

-1.5 -1.0 -0.5 0.0 0.5 1.0Leverage Growth

Ass

et G

row

th

United Kingdom, Commercial BanksLinear RegressionLinear Regression (excl. outliers)Median Regression

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0Leverage Growth

Asset G

rowth

Germany, Commercial BanksLinear RegressionLinear Regression (excl. outliers)Median Regression

β = 0.38 β = 0. 13

More evidence of More evidence of procyclicalprocyclical leverage leverage in armin arm’’ss--length financial systems...length financial systems...

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.2 0.3 0.4 0.5 0.6 0.7 0.8Arm's-Length Index

Degree of procyclical leverage

USA

GBR

NLD

CANDNKBEL

AUT

FRADEU

ESPFIN

SWE

ITA

JPN

NORAUS

...which may explain larger real spillovers ...which may explain larger real spillovers from financial crises in these economiesfrom financial crises in these economies

Countries with above-median arm’s-length financial systems

Countries with below-median arm’s-length financial systems

Financial Stress Followed by Recessions: Output(median; real GDP percent change from one year earlier)

-1

0

1

2

3

4

5

-3 -2 -1 0 1 2 3

years; start of financial stress episode at t = 0

Difference between mediansstatistically significant at time t = 1

-3

-2

-1

0

1

2

3

-3 -2 -1 FS 1 2 3

The Current Episode in Historical Context: The Current Episode in Historical Context: United StatesUnited States

House Prices (percent deviation from trend; quarters on the x-axis)

Credit (percent of GDP; percent deviation from trend; quarters on the x-axis)

Household Net Lending/Borrowing Ratio (deviation from trend; years on the x-axis)

Nonfinancial Corporate Net Lending/Borrowing Ratio (deviation from

trend; years on the x-axis)

Median across financial stress episodes for six case studiesMedian across financial stress episodes followed by recessionsUnited States (current episode)

-10

-5

0

5

10

-12 -8 -4 FS 4 8 12

-4

-2

0

2

4

6

8

-12 -8 -4 FS 4 8 12

-4-3-2-101234

-3 -2 -1 FS 1 2 3

House Prices (percent deviation from trend; quarters on the x-axis)

The Current Episode in Historical The Current Episode in Historical Context: Euro areaContext: Euro area

Credit (percent of GDP; percent deviation from trend; quarters on the x-axis)

Household Net Lending/Borrowing Ratio (deviation from trend; years on the x-axis)

Nonfinancial Corporate Net Lending/Borrowing Ratio (deviation from

trend; years on the x-axis)

Median across financial stress episodes for six case studiesMedian across financial stress episodes followed by recessionsEuro area (current episode)

-10

-5

0

5

10

-12 -8 -4 FS 4 8 12

-4

-2

0

2

4

6

8

-12 -8 -4 FS 4 8 12-3

-2

-1

0

1

2

3

-3 -2 -1 FS 1 2 3

-4-3-2-101234

-3 -2 -1 FS 1 2 3

Policy MessagePolicy Message

•• One important takeOne important take--away from this analysis is the away from this analysis is the importance of core financial intermediaries in the importance of core financial intermediaries in the transmission of financial shocks to the real economy. transmission of financial shocks to the real economy.

•• This underlines the importance of restoring the capital This underlines the importance of restoring the capital bases of these institutions to help alleviate economic bases of these institutions to help alleviate economic downturns.downturns.