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

1. International Exposure to U.S.-Centered Credit Market Turmoil Stijn Claessens Assistant Director, Research Department, IMF Federal Reserve Bank of Atlanta Conference Financial Innovation and Crises Jekyll Island, Georgia, May 11-13, 2009

2. International Exposure to U.S.-Centered Credit Market Turmoil • “Causes” of the current crisis • Many commonalities with previous crises • Some new dimensions • International dimensions • Interventions • Policy actions • Medium term reform options • General national & international financial architecture • Cross-border banking: specific options 2

3. “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

4. “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

5. International financial integration increased sharply in last few years

6. International lending and interbank exposures grew Growth 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.

7. Dispersion of players increased (top 50 banks across countries)

8. 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

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

10. Timeline of events • August 1-17, 2007—German bank IKB. BNP Paribas; ECB, other central banks inject overnight liquidity; Sachsen LB. • September 14-19 — Northern Rock • December 12, 2007— Fed, ECB, SNB, Bank of Canada; Fed (TAF). • March 11-16, 2008— Bear Stearns • September 7— Fannie Mae and Freddie Mac • September 15-16—Lehman Brothers and AIG. • September 20—$700 billion Troubled Asset Relief Program • September 29—Fed currency swap lines; Fortis; Iceland • October 7-8—Coordinated interest rate cuts; CPFF Iceland; U.K. provide capital to banks and issues debt guarantees. • October 13-14—Euro governments provide capital; U.S. Capital Purchase Program (up to $250 billion) under TARP. • November 23-25—Citigroup’s. Fed $200 billion new facility. • December 4— Large joint interest rate cuts in Europe

11. International spillovers:phases and mechanisms • 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 • Liquidity • Liquidity shortages, freezing of credit markets, stock markets declines • Affected many markets (UK Sterling, Euro, SwFr) • $-shortage  swaps between major central banks

12. International spillovers:phases and mechanisms • 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 • Real and financial sector links • Perverse feedback loops in Q4 2008 and Q1 2009

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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)

21. 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

22. Options for cross-border banking • Second (or third best) solutions • International bank charter—a new regime • Increased convergence in rules and practices without increased coordination • Increased coordination with less or no harmonization or convergence in rules

23. 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

24. 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”

25. 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

26. 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