International Exposure to U.S.-Centered Credit Market Turmoil

Stijn Claessens Assistant Director, Research Department, IMF

Federal Reserve Bank of Atlanta ConferenceFinancial Innovation and CrisesJekyll Island, Georgia, May 11-13, 2009

International Exposure to U.S.-Centered Credit Market Turmoil

1. “Causes” of the current crisis Many commonalities with previous crises

Some new dimensions

2. International dimensions Interventions

Policy actions

3. Medium term reform options General national & international financial architecture

Cross-border banking: specific options

2

“Causes” of the Current Crisis: Many Commonalities with Previous Crises

Asset price bubbles: housing, equity, .com Ex-post clear, ex-ante always less

Credit booms With deteriorating lending standards

Now too, but this time more households

Systemic risk buildup Subprime and loans in FX, became correlated

Regulation and supervision failures Do not keep up, this time especially derivatives

“Causes” of the Current Crisis: Some New Dimensions

Increased opaqueness Securitization: poorer risk assign, monitoring

Harder to value once crisis started

Increased role of leverage In many sectors and markets

Central role of households Complicating restructuring

Financial integration & interconnectedness Larger capital flows /cross-border positions

Greater connection between markets

International financial integration increased sharply in last few years

0

100

200

300

400

500

600

700

76 79 82 85 88 91 94 97 00 03 06

High

Middle

Low

All

Gross External Assets and Liabilities (Percent of GDP; by income group; 1976-2006)

Source: Lane and Milesi-Ferretti (2006).

-30

-20

-10

0

10

20

30

40

90 92 94 96 98 00 02 04 06

J apanUnited StatesNordic countries 2/Other nationalities 3/

0

1

2

3

4

05 06 070

5

10

15

20

25Total (LHS)FranceGerm anyJ apanNetherlandsSwitzerlandUnited KingdomUnited States

International lending and interbank exposures grewGrowth in International

Claims, by Bank Nationality 1/

(in year over year percent change)

Foreign Exposures 4/ 5/(in trillions of U.S. dollars)

07Q4

1/ Foreign currency claims on home country residents are excluded.2/ Danish, Finnish, Norwegian and Swedish banks.3/ Total international claims excluding those booked by Japanese, Nordic and US banks.4/ On an ultimate risk basis and excluding inter-office transfers.5/ Foreign claims vis-à-vis entities (banks and non-banks) in advanced economies, booked by banks headquartered in the countries shown.

Dispersion of players increased (top 50 banks across countries)

0%

20%

40%

60%

80%

100%UK

F RAN CE

US A

J AP AN

N ET HERLAN D S

G ERM AN Y

CHIN A

BELG IUM

S W IT ZERLAN D

O T HERS

U.S. is largest economy and financial center, leading easily to spillovers

US size/interconnectedness bound to global effects/spillovers

U.S. = 31 percent of global financial assets

U.S. dollar = 62 percent of reserve currency assets

U.S. financial assets perceived to offer safety and liquidity

attractive for private and public investors

United States is major financial intermediary with large

gross (two-ways) cross-border capital flows

Large size also means large real sector shocks, as US

recession affects global demand

Crisis spread through lack of liquidity, then solvency, confidence, now subsiding

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

5/1/07 8/1/07 11/1/07 2/1/08 5/1/08 8/1/08 11/1/08

U.S.Euro areaJapanU.K.

Interbank Market Spreads(in percent; 3-month LIBOR minus 3-month

1

2 34

67

8

9

10

115

12

Timeline of events1. August 1-17, 2007—German bank IKB. BNP Paribas; ECB, other central banks

inject overnight liquidity; Sachsen LB.

2. September 14-19 — Northern Rock

3. December 12, 2007— Fed, ECB, SNB, Bank of Canada; Fed (TAF).

4. March 11-16, 2008— Bear Stearns

5. September 7— Fannie Mae and Freddie Mac

6. September 15-16—Lehman Brothers and AIG.

7. September 20—$700 billion Troubled Asset Relief Program

8. September 29—Fed currency swap lines; Fortis; Iceland

9. October 7-8—Coordinated interest rate cuts; CPFF Iceland; U.K. provide capital to banks and issues debt guarantees.

10. October 13-14—Euro governments provide capital; U.S. Capital Purchase Program (up to $250 billion) under TARP.

11. November 23-25—Citigroup’s. Fed $200 billion new facility.

12. December 4— Large joint interest rate cuts in Europe

International spillovers:phases and mechanisms

1. Direct links Exposure to the US subprime, CDOs, etc Hitting European banks, IKB, BNP Triggered turmoil in similar housing boom markets,

bank run on UK Northern Rock

2. Liquidity Liquidity shortages, freezing of credit markets, stock

markets declines Affected many markets (UK Sterling, Euro, SwFr) $-shortage swaps between major central banks

International spillovers:phases and mechanisms

3. Solvency concerns Recapitalization (SWFs) fallen short Deficiencies in resolution frameworks Lehman, AIG spillovers October 2008, solvency concerns affecting

systemically important global financial institutions Much government interventions

4. Real and financial sector links Perverse feedback loops in Q4 2008 and Q1 2009

Interventions create spillovers

Liquidity provision Not always well coordinated, e.g., shortage of dollars Some countries left out, e.g., emerging markets

Guarantees of wholesale, retail deposits, others Difference in coverage, terms, led to capital flows, large

differences in spreads, sovereign risks (e.g., Ireland) Regionally more coordinated (EU), globally not

Purchases or exchanges of assets Much direct purchases and indirect support Rules vary across countries

Interventions create spillovers

Capital injections and other support to banks Favoring national financial institutions (due to fiscal) Ring-fencing of assets (UK-Iceland; Germany-Lehman) Few cross-border (Dexia, Fortis), but largely national (also

legal, e.g., US domestic depositor preference) Purchases of non-performing assets

Little NPAs so far, but rules do differ, create distortions Exit: to come, many coordination issues

Unwinding of guarantees, sale of state-ownership/assets Distortions: unfair competition, weaken market discipline

As crisis ongoing, government interventions continue

Financial sector and monetary/fiscal actions Measures did not prevent adverse feedback, recessions Conventional monetary has limits; fiscal stimulus, but slower

More financial sector actions still likely (needed) Covering financial sector more comprehensively Including housing and corporate sectors Means interventions will continue to distort

Emerging markets have specific problems Have worse coping mechanisms, more at risk External official financing can soften somewhat

What to do in the medium-term regarding cross-border activities? Cross-border generally problematic

Hard to coordinate, design and implement global or even regional solutions

Many global public good aspects Still, some “predictable” events could be averted

What to do? Improve foremost national regulation and supervision

Medium-term: adopt specific options for cross-border

Enhance international financial architecture

Directions for the medium-term: national regulation and supervision

Regulatory perimeter Broadened to ensure that all financial activities that

pose systemic risks are adequately captured and covered by information collections

Micro-prudential regulation Individual risks and systemic potential

Macro-prudential regulation To dampen procyclicality

Directions for the medium-term: national regulation and supervision

Information and market discipline

Enhance market discipline, improve corporate

governance, reduce conflict of interests

Organization of regulation and supervision

Greater coordination within and across countries in

design of regulation and systemic risk monitoring

Sharing of benefits and costs of financial integration ultimately relate to public goods

Negative externalities Poor regulation/supervision, limited ability of home

countries to stand behind their institutions Positive externalities (“spill-ins”)

Stability benefits accruing to others, by importing services from well-regulated, well-funded markets

Coordination issues in general large but worse in crises Regulatory competition: common denominator Ex-post burden-sharing: very hard to do ex-ante Institutional uncertainties, e.g., resolution, create turmoil

Current approach for cross-border banking

Current approach (BCBS): home-host principle Has its limits, especially since foreign banks

penetration increased sharply Intragroup already many possible conflict of

interests and governance issues Many subsidiaries are large in host, but not always

important for home, conflict of interests Improvements are possible

But EU/EMU experience show limits (e.g., most foreign banks remain subs)

Options for cross-border banking

First best: World Financial Authority? International financial regulator: very demanding,

not attainable (or desirable?) Hard to govern given fuzzy mandate

E.g., how to set the voting structure: assets or liabilities, financial or economic impact?

Needs to be complemented in many ways Lender of last resort, liquidity, deposit insurance,

recapitalization fund

Options for cross-border banking

Second (or third best) solutions

1. International bank charter—a new regime

2. Increased convergence in rules and practices

without increased coordination

3. Increased coordination with less or no

harmonization or convergence in rules

1. A new regime: International Bank Charter (IBC)

International banks can choose (or are forced) to charter with (new) international agency

New agency has all usual tools, much is rules bound Complemented by LoLR, liquidity, deposit

insurance, recapitalization fund facilities (hard to do) In exchange, banks can operate in “member”

countries with no extra oversight lower compliance costs, more certainty

Countries could opt-in, but with sanctions for exit

2. Decentralized, but converged approach

Rules and practices (in all dimensions) converge Regulation, supervision, accounting, resolution

By acting similar, coordination issues are reduced E.g., same PCA, prepackaged bankruptcy, etc. make for

fewer differences of opinion in financial crises

Needs backup up of enhanced monitoring of practices

Still requires enforcement of ex-post burden sharing Very hard in practice

“Cross-border in life, but national in death”

3. Enhanced coordination approach Rules and practices need not converge fully But actions to be coordinated

At individual financial institution’s level (colleges) At regional/global levels (ECB, De Larosiere, FSB, IMF,?) Ex-post actions and somewhat ex-ante (rulings)

Still much to be sorted out E.g., colleges do not consider systemic risks Information needs to be shared more

And could risk complacency Coordination is a nice word

Complementary, international financial architecture changes needed, regardless

Information on exposures/risks

Surveillance of countries, systems

Mandatory compliance, less voluntary assessments

Regulatory governance, national/international

Understanding of macro-financial links

Early vulnerabilities’ warning systems

International liquidity provision