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

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

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

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

“ 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) Evolving Risks from Integrating Financial Markets

Global Financial Turmoil  Epicenter — U.S. Subprime Mortgage Crisis  Tremors — Credit Squeeze & Rising Spreads, Liquidity Strains in Term-Funding (ABCP / Interbank)  Wider Aftershocks and 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)

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

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

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

9 Months after origination SubprimePrime Mortgage Delinquency by Vintage year (60+ days delinquencies; in percent of balance)

10 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).

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

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

13 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.

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

15 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) Europe U.S. 6/6

16 Global CDS Spreads (5-years; in basis points) Investment Grade United States Major Economies 1/ World 1/ 2/ 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. Investment Banks Commercial Banks U.S. Europe Japan Below Investment Grade Asia ex. Japan 6/9

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

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

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