1 ECONOMICS 3150N Winter 2013 Professor Lazar Office: N205J, Schulich 736-5068.

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Presentation transcript:

1 ECONOMICS 3150N Winter 2013 Professor Lazar Office: N205J, Schulich

2 Lecture 5: February 14 Ch. 20, 21

3 Offshore Banking and Eurocurrencies Offshore banking –Business conducted by the foreign branches, subsidiaries of a bank outside the home country of the bank Eurocurrencies –Bank deposits denominated in a currency other than the domestic currency of the country in which the bank or its foreign operations reside Offshore currencies Typical Eurocurrency deposit is non-negotiable time deposit with fixed term to maturity ranging from overnight to 5+ years US$ deposits in a bank in Canada (Canadian, US, other) – part of Eurodollars – Eurodollars: US $ deposits in banks outside US C$ deposits in a bank outside of Canada (Canadian, other) –Eurobanks: banks that trade in market for Eurocurrencies – take deposits, make loans Most Eurocurrency trading occurs in non-European centers

4 Eurocurrencies Euro-deposit rates – 3 months 08/26/0908/24/0807/14/08 U.S.0.30%5.48%2.81% Canada Euro Yen Pound

Euro Deposit Rates Today US: 0.27% Canada:1.03% Euro:0.77% Yen:0.17% Pound:0.65% 5

6 Rapid Growth of International Banking Reduction in trade costs  growth in international trade –Hedging currency risks Liberalization of capital markets –Growth of MNEs – banks have followed corporate customers abroad Circumvent restrictive domestic government regulations on financial activity – reserve requirements, interest rate ceilings, deposit insurance Political factors – desire by some depositors to hold currencies outside jurisdiction of countries that issue them – freezing accounts Money laundering – drugs, arms sales, bribes, other criminal activities

7 Creation of Eurocurrencies Bombardier sells US$46 M CRJ-900 to Jet Airways – Jet pays initial deposit of US$10 M by check drawn on U.S. bank branch in Mumbai (Citibank) Options for Bombardier –Convert to C$ at current spot rate (E) –Keep US $ (required for purchases of engines, avionics, consulting services, etc.) Buy US TBs Buy CD from US bank Buy Euro-US dollar deposit from Royal Bank branch in Montreal –Only this option leads to creation of Eurodollar deposit – no change in US money supply

8 Creation of Euro-US Dollars Bombardier –Asset: US$ Deposit with RB (Montreal) –Liability: US$ customer advances Jet Airways –Asset: US$ customer advance –Liability: US$ loan from Citi Citi (Mumbai) –Asset: US$ Loan to Jet Airways –Liability: US$ Loan from Citi (NY) Citi (NY) –Asset: +US$ Loan to Citi (Mumbai) –Asset: -US$ Deposits with Fed Royal Bank (Montreal) –Asset: US$ Deposit with DB (Frankfurt) –Liability: US$ Deposit of Bombardier Deutsche Bank (Frankfurt) –Asset: US$ Deposit with JPMorgan Chase (NY) –Liability: US$ Deposit of RB JPMorgan Chase (NY) –Asset: US$ deposits with Fed –Liability: US$ Deposit of DB

9 Vulnerabilities Absence of regulatory oversight Inter-bank lending (as in preceding example) – hierarchy of banks –“Offshore” bank in turn lends to another bank – interest rate on Eurodollar deposits increases as the money moves up the hierarchy of banks –At top of the hierarchy, much greater default risk than at bottom –If bank or ultimate borrower at top defaults, default could create domino effect – Royal’s exposure may be much different because of interbank lending Consider structure of CDOs, credit default swaps

10 Counter-Party Risks Derivatives –Exchange traded – rules, collateral –Private transactions – no rules (other than contracts), no collateral (other than specified in contracts) –CDS –Other risks related to assumptions entered into black boxes

11 Domestic Safeguards Deposit insurance Reserve requirements Capital requirements and asset restrictions Bank examination Lender of last resort facilities – central bank Government-organized bailout Difficulties in regulating international banking

12 Interdependence of Financial Markets Bubbles and collapses Herd effects – equilibrium and overshooting/undershooting Diversification – geographic, industry, asset class: purpose of diversification Contagion effects – spreading of economic shocks: open vs. closed financial markets –Is geographic diversification possible?

13 Interdependence of Financial Markets Bubbles and collapses Herd effects – equilibrium and overshooting/undershooting Diversification – geographic, industry, asset class: purpose of diversification Contagion effects – spreading of economic shocks: open vs. closed financial markets –Is geographic diversification possible?

14 Interdependence of Financial Markets “We have more complexity today because of the sheer size of the capital markets and the presence of new and unpredictable players” (Robert Bruner, Dean of the business school at the U. of Virginia in Charlottesville) –Complex financial instruments: new generations of derivatives –Increasing use of leverage –New institutions: hedge funds –Globalization –Ineffective regulations –Rapid movement of capital

15 Financial Crisis 1 Rocket scientists, derivatives and a free lunch Banks: more money in fees than direct lending Investors: searching for higher returns without more risk –Money for nothing and the ….. for free Leverage Shadow banking system Greed, trust, uncertainty Absence of regulatory oversight Central banks did not appreciate degree of interdependence between Lehman and all major financial institutions

16 Financial Crisis 1 Fed: –Widespread declines in underwriting standards –Breakdowns in lending oversight by investors and rating agencies –Increased reliance on complex and opaque credit instruments that proved fragile under stress –Unusually low compensation for risk-taking

17 Market Failures Declining housing prices Failure of two Lehman hedge funds Failure of IndyMac Federal Bank Fannie Mae and Freddie Mac placed into conservatorship Bear Stearns Lehman, Merrill Lynch –Credit markets worldwide freeze up –Money market mutual fund breaks the “buck” AIG Washington Mutual Wachovia (4 th largest bank) Citigroup Bank of America Just in the U.S. –Iceland, U.K., Netherlands/Belgium, Russia, China, Dubai

18 St. Bernanke: Time Magazine Person of the Year Innovations – quantitative easing –Provision of short-term liquidity to banks and other depository institutions and other financial institutions –Provision of liquidity directly to borrowers and investors in key credit markets –Expanded traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities –Interest on reserve balances with Fed

19 St. Bernanke Innovations –Term Auction Facility –Primary Dealer Credit Facility –Asset-Backed Commercial Paper Facility –Money Market Mutual Fund Liquidity Facility –Term Asset-Backed Securities Loan Facility –Commercial Paper Funding Facility (CPFF) –Outstanding principal amount of loans to American International Group, Maiden Lane LLC, Maiden Lane II LLC, and Maiden Lane III LLC –Central bank liquidity swaps

20 Traditional Balance Sheet Assets Aug/07) U.S Treasury securities: $791 B Gold, SDRs, other: $83 B Total: $874 B Liabilities Aug/07) Currency in circulation: $814 B Bank deposits: $17 B Treasury balance: $5B

21 Changes in Fed Balance Sheet: August 1, 2007 to December 17, 2008 Assets Treasury securities: +$340B Mortgage-backed securities: +$18B Lending to banks: +$538B Credit extended to AIG: +$82 B Lending to primary dealers: +$47B Lending for purchase of Commercial Paper: +$346B Assets purchased from Bear Stearns: +$27B Swaps with central banks: +$572B Total: +$1.4 T Liabilities Currency in circulation: +$64B Bank deposits: +$785B Treasury cash deposits: +$475B

22 Current Balance Sheet 26/12/12 US Treasury securities: $1,657 B Mortgage-backed securities: $927 B Federal agency debt securities: $77 B Gold: $11 B Central bank liquidity swaps: $9 B Total: $2.9 T 09/07/11 Currency in circulation: $1,125 B Reverse repurchase agreements: $100 B Bank deposits: $1,533 B Total Capital: $54.7 B

23 Financial Crisis 1 US Treasury allocated US$700 B to buy troubled assets from banks US$250 B used instead to invest in capital of banks –Earned profit on investments –“Bailout of Wall Street” needed to prevent collapse of Main Street US$85 B used to bailout AIG and counter-parties to about US$400B in CDS sold by AIG Investments in GM and Chrysler

24 Financial Crisis 2 Debt wall for Greece (and Italy, and perhaps Spain, Belgium and France) Greece default likely – traders/speculators bet against Greek debt Costs for Greece of rolling over debt and financing ongoing deficits Austerity demanded – impacts on GDP and revenues

25 Financial Crisis 2 Mark-to-market rules – debt would have been reduced and interest costs of Greece would decline Problem: holders of Greek debt, primarily EU banks, did not have to reduce value of Greek and other debt if expectation that interest and principal payments will be made on schedule –If bonds sold, loss would have to be recorded –Capital of banks would decline – need to raise additional equity or merge with stronger banks –ECB: fear of weakening banks and contagion effects because of unknown linkages and size and participants in credit derivatives markets

26 Financial Crisis 2 Pull the plug and restructure Greek debt –Unknown consequences –Banks unable to lend; unwilling to lend to other banks

27 Basel 1975: Concordat –Allocates responsibility for supervising multinational banks between home and host countries 1988: Basel I –Bank capital of 8% of risk-adjusted assets 1997: Core Principles for Effective Banking –25 principles for minimum necessary requirements for effective bank supervision –Licensing, supervision methods, reporting requirements for banks, cross-border banking 2004: Basel II –Capital requirements and new risk adjustments

28 Central Bank Swaps Central banks lenders of last resort to domestic banks in domestic currencies European banks invested in US MBS –Highly rated, so less capital required to backstop under Basel II rules –Interest rate premium for AAA-rated securities (“Money for nothing”) –Borrowed short-term US $ to hedge/finance investments –When financial crisis 1 hit – European banks did not want to sell MBS and incur loss (write-down of capital); needed to roll-over short-term loans in US $ –Inter-bank lending froze

29 Central Bank Swaps US Fed became global lender of last resort –Swap lines to other central banks so that e.g. ECB could borrow from Fed (swap Euros into US $) and lend to domestic European banks –Wound down swap lines in February 2010 –Reactivated later in 2010 as Greek debt crisis erupted

30 Optimum Currency Area High degree of economic integration Labor and capital mobility Similar economic structures Limited policy autonomy – large spillover effects Limited role for exchange rate movements to insulate against external shocks

31 Economic Integration Varying degrees of integration Preferential free trade arrangements – lower trade barriers among participating countries Free trade area –All trade barriers removed among participants –Each country retains own barriers against non-members –Sources of products need to be identified Definition of domestic product (domestic content requirements)

32 Economic Integration Customs Union –Common trade barriers against non-members –Trade creation vs. trade diversion Trade creation if tariffs blocked trade prior to customs union Trade diversion if customs union leads to substitution of imports from partner country from non-partner country (lower cost imports from outside union replaced by higher cost imports from union member) –Gains more likely if trade creation more prevalent than trade diversion  high pre-union tariff barriers; low tariffs with ROW; many countries part of customs union; closer geographically are members of union (transportation costs, tastes: lower obstacles to trade among members) Common market –Free movement of capital and labor –Harmonization of labor and other laws

33 Economic Integration Economic Union –Monetary union – single currency –Restrictions on fiscal policy –Harmonization of monetary policy, fiscal policy, tax rates –EU has had difficulty in dealing with economic and financial crisis – no single response as in the U.S. Political union