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Princeton, Oct 24th, 2011
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Overcoming the crisis
backwards induction approach:
1. Diagnosis how did we get there?
Run-up phase Crisis phase
2. Give long-run perspective Banking landscape (ESBies, European FDIC, resolution,)
Monetary framework
Fiscal coordination
3. Transition to long-run 2
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0
5
10
15
20
25
0
5
10
15
20
25
Jan 94 Jan 97 Jan 00 Jan 03 Jan 06 Jan 09
Germany
Italy
Par Yield
France
Greece
Spain
Source: Eurostat
Eurozone: 10 Y Sovereign debt yield
3
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80
100
120
140
160
80
100
120
140
160
Jan 96 Jan 00 Jan 04 Jan 08
12-Mo. Moving Average HCPI for Eurozone(1999=100)
Germany
Italy
Par Yield
France
Greece
Spain
Source: IMF
Eurozone: Persistent Inflation Divergence
4
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Real interest rate gap
Average rates 99-07 Germany Spain Greece
Nominal interest rate 3.8% 3.9% 4.4%
Inflation rate 1.8% 3.3% 3.5%
-------------------------- ---------------------- ---------------------- ----------------------
Real interest rate 2.0% 0.6% 0.9%
5
Rate for German savers > Rate for Spanish/Greek borrowers
(Government)
Risk charge for sovereign debt = 0
Consequence: larger savings in Germany + capital outflows
boost to Spanish economy & inflation
Source: Bloomberg 5 year government note indices
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Eurozone Accumulated Net Capital Inflows
6
-1200
-1000
-800-600
-400
-200
0
200
400
600800
Q1 1994Q1 1997Q1 2000Q1 2003Q1 2006Q1 2009
Germany
Italy
Billion
France
Greece
Spain
Source: Eurostat
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German Foreign Claims
8
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
Jun.1991
Dec.1992
Jun.1994
Dec.1995
Jun.1997
Dec.1998
Mar.2000
Dec.2000
Sep.2001
Jun
.2002
Ma
r.2003
Dec.2003
Sep
.2004
Jun.2005
Mar.2006
Dec.2006
Sep.2007
Jun
.2008
Mar.2009
Dec.2009
Sep.2010
BelgiumGreece
Ireland
Italy
Portugal
Spain
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-20
0
20
40
60
80
100
1995 1997 1999 2001 2003 2005 2007 2009 2011
Germany
Italy
Percent
France
GreeceSpain
Source: OECD
Belgium
Ireland
PortugalEurozone
Eurozone: Accumulated GDP Growth
9
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Crisis diagnosis 1: Flight to safety
Today: asymmetric shifts across borders
Value of German bund/French debt increases German CDS spread rises, but yield on German Bund drops (flight to safety)
Value of Italian/Spanish/Greek sovereign debt declines
10
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Crisis diagnosis 1: Flight to safety
Today: asymmetric shifts across borders
Value of German bund/French debt increases German CDS spread rises, but yield on German Bund drops (flight to safety)
Value of Italian/Spanish/Greek sovereign debt declines
11
1
2
3
4
20
40
60
80
100
120
Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11
German Sovereign 5Y CDS and 10Y Yield
CDSSpread
10Y Yield
Par Yield
Source: Bloomberg
Basis Points
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Crisis diagnosis 2: Diabolic Loop
Contagion due to diabolic loop twin crisis
Banks need risk-free asset for transactions (best collateral)
12
Trigger
Bank insolvency
(Ireland, Spain)
Public debt/slow growth(Greece, Portugal, Italy)
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Distortions - Inconsistency
Sovereign debt is treated as safe asset
Basel: Zero risk-weight (for own sovereign)
ECB: Low haircut
e.g. 10 year Greek bond has 10% haircut
Concentration of sovereign risk in banks
Inconsistency
No-bailout clause
Zero risk weight
13
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ESBies proposal
1. Create safe asset
With flight to quality correlation structure
Remove pressure for capital flows across borders
channel them across different tranches2. Appropriate risk weights + haircuts for sovereign debt
Break diabolic loop
Part of bigger proposal
European FDIC, bank resolution, etc.
14
9 economists: www.euro-nomics.com
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ESBies structure
up to 60% of GDP (5 year average) from all Euro-members
ESBies flight to quality/safety assetcoordination!
Basel: zero weight
ECB: preferred asset to conduct open market operations
No control rights for junior tranche!
15
sovereign
bonds ESBies
Junior tranche
A L
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Flight to safety: in times of crisis
Today: asymmetric shifts across borders
Value of German bund/French debt increases German CDS spread rises, but yield on bund drops (flight to quality)
Value of Italian/Spanish/Greek sovereign debt declines
With ESBies: Negative co-movement across tranches Value of ESBies tranche expands due to flight to quality
Value of Junior tranche shrinks due to increased risk Asset side is more stable 16
sovereign
bonds ESBies
Junior tranche
A L
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How to create value?
Flight to safety fluctuations are reduced
No negative distributional effects away from Greece, Italy, towards Germany in times of crisis
Can be used in current transition phase! ESBies liquidity premium in normal times (ex-ante)
Estimates: 0.7% in normal times
Shared across all euro-members
Advantages in crisis times are much larger
Especially for peripheral countries!
17
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Transition phase
Give long-run perspective
Phase in
ESBies (market has to learn about junior tranche)
Increase in capital requirements
Swapexisting holding of sovereign debt for ESBies(at market prices after price adjustment due to ESBies proposal)
Recapitalizationof banks Now smaller --- but there is no way around it
mandated private (to avoid stigma) + public backup
Similar to U.S. in spring 2009 after SCAP
Has to be done in coordinate fashion otherwise free-riding18
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Conclusion: Guiding Principles
Reduce flight to safety capital flow fluctuations coordinate on new asset
Isolate banks from sovereign risk - avoid diabolic loop Higher risk charges for sovereign debt are essential!
Dont distort incentives for sovereigns Interest rate signal as corrective (market) force should remain intact
Stable credibleand transparent rule for portfolio weights Fixed rule based on easily measurable units (e.g. (lagged) GDP or ECB key)
Change require anonymity of parliamentary approval and go along withchange in voting power (change in ECB key)
Avoid procyclicality Set tranching points conservatively (in good times) in order to have buffer for bad times
note that correlation will shoot up in times of crisis!
Extra Sweetener for transition phase Take advantage of liquidity premium
Not a guiding principle
Maximize size of ESBIES tranche 19
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