Global Financial Crisis, Key Risks,

and Implications

FPD Financial Systems Practice

January 2012

HOW IS THE CRISIS UNFOLDING—DIFFERENT

STAGES

2

The Origins of the Crisis in 2007-08

Weak oversight/infrastructure

Inadequate regulation (K, L)

Insufficiently wide perimeter

Poor supervision/disclosure

Poor risk management

Lack of resolution tools

Weak market infrastructure

Financial System

Highly complex and opaque

TBTF institutions

Overleveraged

Reliant on short-term funding

Funding activities of dubious quality

Heavily interconnected

Shadow banking activities

3

Global

financial crisis

Macro

Very low interest rates

Abundant liquidity

Radical reforms needed to

strengthen stability and

resilience of the global

financial system

Micro

Managerial incentives

Implicit guarantees

Changing Nature of the Crisis and Policy Response

4

Subprime crisis

Liquidity crisis globally

Solvency problems for weak financial institutions

(US, EUR)

Large scale official support

to weak institutions and policies to revive economic growth

Debt crisis (as fiscal deficits and debt/GDP

ratios ballooned

Confidence crisis in

countries with fiscal problems and weak banks

Negative feedback loop (between sovereign, bank,

real sector risks) combined w/ policy and

political uncertainty

Contagion in and outside Europe

Spillover to emerging markets

• Bank recapitalization plan • Greek debt write-down • EFSF/ESM firewall • Large scale ECB support • (ECB facilities; SMPP) • 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

0

50

100

150

200

250

Europe Africa Middle East Asia Latin America

Regional EMBI Spreads (Change from a year ago, basis points)

-30

-25

-20

-15

-10

-5

0

Europe & Middle East

Eastern Europe

Euro Stoxx 50

Latin America

Asia ex Japan

Regional Stock Market indices (change from a year ago, % change)

Source: Bloomberg and staff computations

KEY RISKS AND VULNERABILITIES AND POSSIBLE TRANSMISSION CHANNELS

TO DOMESTIC DEBT MARKETS

7

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 riskscontinued 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

0

50

100

150

200

250

300

350

400

France Italy Germany Spain Greece Portugal Ireland

Funding needs* (EUR billion)

* Including bills, bonds, deficit and others.

Source: UBS Investment Research, European Weekly Economic Focus, January 2012

(Total of €1.3 trillion)

(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

(50,000)

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

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

Change in Holdings between July and Dec 2011 (EUR million)

Own Core Periphery Eastern Europe UK

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

EXTRA SLIDES

16

European Banking Systems More Leveraged than Other Regions

17

0

20

40

60

80

100

120

140

Adv EUR Europe Central Asia

Advanced Other Latin America Caribbean

High Non OECD South Asia East Asia Pacific Sub Saharan Africa

Middle East NAfrica

(Loan to Deposit Ratios, in percent)

Source: Finstats, 2010, the World Bank.

Both in EU and Non-EU Countries (Loan to Deposit Ratios)

18

0

50

100

150

200

250

(in percent)

Source: Finstats, 2010, the World Bank.

Dependence on Wholesale Funding 19

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

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ISP

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red

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CP

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Su

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Dn

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or

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B

Alp

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S

tan

Ch

ar

Ra

iffe

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E

rste

P

ira

eus

NB

Gr

MS

G

S

BA

C

Cit

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PM

B

an

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W

FC

S

un

Tru

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PN

C

Bra

nch

R

egio

ns

CB

A

Miz

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NA

B

Wo

ori

S

um

ito

mo

S

hin

ha

n

Ba

nk

of

Ch

ina

C

CB

C

ICB

C

EUR US Asia

( 2009 data, in percent)

EUR average = 39%

US average = 31%

Asia average = 20%

Source: Bankscope staff computations.

Global policy response to the crisis: Manage the crisis and reform the financial system

Microprudential regulations–

Globally coordinated

Intensive proactive

supervision

Robust national & cross-border

resolution frameworks

Macro-prudential dimension for systemic risk

Expanded regulatory perimeter

20

FSB BCBS BIS

IMF/WB

Massive liquidity

support by CBs

Capital injections by

national governments

Euro Area Bond Spreads over Bund Reached Unprecedented Levels

21

0

500

1000

1500

2000

2500

3000

3500

0

100

200

300

400

500

600

Basis points

France Italy Spain Greece (Right) Portugal (Right)

Source: Bloomberg

Global EMBI Spreads Rising since Summer 2011

22

100

150

200

250

300

350

400

450

500

550

600 Basis points

Africa Asia Europe

Latin America Middle East Gobal Composite

Source: Bloomberg

So are Regional CDS Spreads esp. for Europe

23

0

50

100

150

200

250

300

350

400

450

Basis points

CEEMEA Western Europe Asia Pacific

Source: Bloomberg

Regional Equities Falling Across the Board

24

25

45

65

85

105

125

145

165

185

205

FTSE All World $ Asia ex Japan Europe & Middle East

Latin America Eastern Europe

Index date = 1/1/2010

Source: Bloomberg

Correlation between Bank & Sovereign Risk has been Increasing since September 2011

25

TARP/Cap. Purch. Program 1st Greek Support

Greek PSI US Downgrade

ITL/ESP Bond Purch

-.5

0

.5

1

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Europe-Core Europe-Peripheral

Correlations are Europe-Core: Sovereign vs Bank CDS and Europe-Peripheral: Sovereign vs Bank CDS

(356 day rolling window)

Source: Staff computations

European Bank Exposure to Peripheral Sovereigns

26

217%

153%

138% 137% 132% 130%

57% 51%

32% 24%

13% 11% 7% 4% 2% 1% 0% 0% 0% 0% 0%

50%

100%

150%

200%

250%

BE IT CY PT LU ES DE IE FR NL SI AT UK FI DK SE HU MT NO PL

(as percent of Core Tier 1 Capital)

Source: EBA and staff computations

European Banks Capital Shortfalls

27

15.3

8.0

6.3 6.3

5.3

3.7 3.3 3.2

2.7 2.6 2.5 2.1 2.1 2.1 2.0 1.8 1.6 1.6 1.5 1.5

0

2

4

6

8

10

12

14

16

18

Top 20 bank with biggest capital shortfalls - Dec 2011 (EUR billion)

Source: EBA and staff computations