DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 WP2: Financial markets The transformation of international financial markets Analysis and scenarios

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Post WWII bank-centred financial crises Germany, US1974 UK1974 Spain and Germany1977 Canada1983 United States1984 Norway1987 Australia1989 Finland and Sweden1991 UK1991 Japan1992 France1994 United States1998 United States, UK, Germany2007 Eurozone2011?

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Transformation of financial markets Globalisation of international financial market: new institutions new products Creation of an international sovereign bond market Growth in total volume of assets traded relative to GDP (and consequential changes in the size and composition of bank balance sheets). Loss of sovereign status and then of quasi-sovereign status for members of the Eurozone

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Post-liberalisation growth of markets The ratio of forex trading to international trade in goods and services plus long term investment rose from 2:1 to 80:1 today Overseas sales of US bonds rose from 3% of US GDP in 1970 to 200% in the early 2000s. Overseas sales of UK bonds rose from nil in 1970 to 1000% of UK GDP in the early 2000s. The stock of assets traded in global markets exceeds 3 times OECD GDP Banks’ balance sheets are now around 20 times greater, relative to the given underlying gdp, than was the case in 1978.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Growth in total volume of assets traded relative to GDP

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Short Intermediation Chain householdsmortgage bankhouseholds deposits mortgage

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Long Intermediation Chain households ABS mortgage securities firm commercial bank money market fund ABS issuer mortgage pool MBS Repo Short-term paper MMF shares

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Gross debt matters Netting impossible when assets and liabilities do not match. Lehman Bros OTC CDS book had gross notional value of $72bn, net $5.2bn AIG CDS book had notional value of $270bn, actual losses $3bn – but collateral required against gross figure.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Repos and Financial CP as Proportion of M2 (Source: US Federal Reserve)

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Overnight Repos and M2 (weekly data) (Normalized to 1 on July 6th Source: Federal Reserve)

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Short-term funding in the EU Of the 90 banks covered by the recent European Banking Authority stress tests, for example, need to refinance €5,400bn of debt in the next two years, equivalent to 45 per cent of European Union gross domestic product.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Loss of sovereign status and then quasi- sovereign status for members of the Eurozone

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Public debt to GDP %

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Quasi-sovereign status Taking Canada, Japan, the US, and the UK together, the overseas proportion of public borrowing is around 12%. Taking Belgium, France, Germany, Greece, Ireland, Italy, Portugal and Spain together, around 50% of public debt is funded by foreign lenders.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Eurosystem and the repo market Two serious errors: first, the assignment of all eligible euro- denominated sovereign debt instruments issued by the Eurozone central governments to the same (highest) liquidity category. second, the excessive increase in the valuation haircut when the remaining maturity of the collateral increases.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Moral hazard 2005?

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Turnover (lending plus borrowing) in the euro interbank money market

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Share of euro-denominated euro area central government bonds

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Outstanding amounts (lending plus borrowing) in European repo markets

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Capital flight: claims of euro area members from netting of Euro System cross-border payments. €bn at end 2010

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Public or private debt Banks did what they were encouraged to do – bought sovereign euro debt. Do markets care more about debt, or about recession? Where is the risk ultimately held? How many extra links in the chain?

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Scenarios

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Scenario One: Muddling through European finances dominated by austerity (whether or not eurozone survives intact). Regulatory measures to increase bank capital and liquidity result in a fall in bank lending, and some growth of shadow banking. Continued austerity in the US, squeezed by government financing concerns that are a function of continued growth in balance of payments deficit. Eastern countries do not fully implement Basel III.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Scenario Two: bi-polar world US-China economic rapprochement results in higher growth in US and sustained expansion in China and SE Asia. Within national jurisdictions (including the EU) there are new measures introduced to limit the destabilising impact of wholesale financial markets. These include pro-cyclical provisioning, leverage collars, liquidity rules, and a variety of devices to separate commercial banking from investment banking. These regulatory actions are not accompanied by any new approach to macro-economic imbalances. The pressures of international bond markets continue to exert deflationary pressures on deficit countries. Continued EU austerity.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Scenario Three: regional balances Regional groupings emerge that seek to stabilise macro-financial relationships within the region. These groupings comprise not just the EU and NAFTA, but also new groupings in Asia and Australasia. The international environment is characterised by negotiation between regional groupings. Concerted macro-economic policy is accompanied by common measures to limit instability generated by financial markets, notably by quantitative controls on the expansion of wholesale funding (leverage collars and the like) and by regulation of liquidity. Over the next 20 years the dollar remains the predominant international currency, but the relative decline of the United States and the regionalisation of the world economy, steadily weakens the dollar’s position, resulting in destabilising swings in financial markets. There is a clear divergence of interest between East and West. Within the eurozone a single eurobond is established with a concerted eurozone wide treasury function.

DG Research and Innovation, CDMA building, 21 rue Champ de Mars, Brussels AUGUR AUGUR stakeholder’s workshop, November 2011 Scenario Four: international management A World Financial Authority is established to regulate financial markets. The WFA has treaty powers inherited from the IMF, and an approach to regulation based on the structures of the Financial Stability Board, i.e. bringing together regulators, central banks and treasury departments. The WFA has wide ranging policy making powers and there are agreed enforcement procedures mediated through national jurisdictions. There is a concerted attempt to limit the cyclical instability generated by wholesale financial markets, via a levy on non- core funding and tight leverage controls. International imbalances are tackled by expansionary policies in surplus countries. There are symmetric penalties in surplus and deficit countries.