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Financial Integration and Global Financial Turmoil Hamid Faruqee Assistant to the Economic Counsellor Research Departme

Financial Integration and Global Financial Turmoil Hamid Faruqee Assistant to the Economic Counsellor Research Department, IMF June 25, 2008. Integrating Europe’s Financial Markets. Overview Financial Integration Financial Stability

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Financial Integration and Global Financial Turmoil Hamid Faruqee Assistant to the Economic Counsellor Research Departme

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  1. Financial Integration and Global Financial Turmoil Hamid Faruqee Assistant to the Economic Counsellor Research Department, IMF June 25, 2008

  2. Integrating Europe’s Financial Markets Overview • Financial Integration • Financial Stability • Europe’s Road to a “Single Market” in Financial Services

  3. FSAP (2005) Capital Flows (1988) Treaty of Rome (1957) Internal Market (1993) EMU (1999) Banking Directive (1989) Single European Act (1986) Europe’s Road to a “Single Market” in Financial Services

  4. Financial Integration: Concepts, Benefits & Risks Completeness & Risk Sharing Scale Economies & Innovation Competition & Arbitrage “Single Market” Autarky Interdependent Markets

  5. Evolving Risks from Integrating Financial Markets “As Europe’s system of financial markets continues to evolve, so to will the risks... integration will introduce risks that are not yet known and that are more likely to spread...” (p. 40)

  6. Global Financial Turmoil • Epicenter— U.S. Subprime Mortgage Crisis • Tremors — Credit Squeeze & Rising Spreads, Liquidity Strains in Term-Funding (ABCP / Interbank) • Wider Aftershocksand Fault Lines —Frozen Markets in ABS/CDO, Valuation problems, Bank Capital, Monoline Insurers, Liquidity “run” • Policy Issues — “Front-end” (mortgages) and “Back-end” policy reactions (liquidity)

  7. U.S. Subprime Delinquencies (in percent of total subprime loan amount; 2007Q1)

  8. U.S. Subprime Delinquencies (in percent of total subprime loan amount; 2007Q2)

  9. U.S. Mortgage Resets and Delinquencies Monthly Mortgage Rate Resets (in billions of U.S. dollars) Housing Market Delinquencies (percent of total residential loans outstanding) Months to first reset

  10. Mortgage Delinquency by Vintage year (60+ days delinquencies; in percent of balance) Subprime Prime 2005 2006 2000 2000 2001 2002 2005 2004 2006 2007 2001 2003 2007 2004 2002 2003 Months after origination

  11. U.S. House Prices and Mortgage Delinquencies Sources: Moody's Economy.com, Equifax, Case-Shiller and OFHEO. 1/ Delinquency rate defined in percent of outstanding mortgages (in dollar amounts).

  12. Virtual Shutdown of Subprime Lending Mortgage-Related Company Failures and Acquisitions

  13. U.S. Interest Rate Spreads and Credit Squeeze Mortgage Spreads (in basis points; rel. to 1-m LIBOR) Corporate Spreads (basis points) 6/6 6/9

  14. Corporate Default Rates and Bond Spreads 1/ (default rates in percent; bond spreads in basis points) 1/ Speculative grade defaults based on Moody’s data through end-March.

  15. Bank Surveys and Tighter Lending Conditions (Change in credit standards over past 3 months; in percent 1/) Fed’s Lending Survey ECB’s Lending Survey 1/ Change in the balance of respondents between the “tightened considerably and tightened somewhat" and the "eased somewhat and eased considerably.“

  16. Liquidity and Credit Strains 3-Month LIBOR Spreads to OIS (Overnight index swap; in basis points) Bank CDS Spreads (5-years; in basis points; Median) U.S. Europe 6/6 6/6

  17. Global CDS Spreads (5-years; in basis points) United States World 1/ 2/ Major Economies 1/ Asia ex. Japan Below Investment Grade Investment Banks U.S. Investment Grade Europe Commercial Banks Japan 6/9 6/9 6/9 Source: IMF staff estimates. 1/ Consolidated series based on investment grade entities from various sectors. Asia ex. Japan includes some non-investment grade entities. 2/ Median based on U.S., Europe, Japan, Asia ex. Japan. Shaded area represent (+/-) one standard deviation.

  18. Global Bank Writedowns and Capital Infusion (in billions of U.S. dollars) 392.4 291.7 1/ Includes writedowns due to asset valuation, yet to be passed through income statement.

  19. House “Price Gaps” and Monetary Policy Rates House “Price Gaps” (in percent of real house prices) Monetary Policy Rates (in percent) Australia U.K. U.S. ECB Japan Source: IMF staff calculations.

  20. Key Lessons and Policy Issues • Incentives and Standards — Oversight & Agency Problems in “Originate-to-Distribute” / Securitization • Credit Risk Transfer — ”Boomerang” from SIVs back to Banks; off-balance sheet transparency • Liquidity Fragility — at times of market stress, Complacency Problem & Counterparty Implications • Complex Products — Valuation Problems, Reliance on Rating Agencies, Breakdown of Due Diligence

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