Adrian Blundell-Wignall Deputy Director, Financial & Enterprise Affairs

1. OECD Breakfast series“Fixing Finance”Tuesday, October 13, 20098:30 a.m. - 10:00 a.m.New America Foundation1899 L St NW, Suite 400Washington, DC 20036 Adrian Blundell-Wignall Deputy Director, Financial & Enterprise Affairs

2. Causes of the Crisis Macro • Global Imbalances • Reserve Currency • Asian & Other Exchange Rate Arrangements • Liquidity: The Dam Overflowing

3. Fig. 1: US Monthly Trade Balance, Bilateral Comparisons 3 Source: Datastream, OECD

4. Fig. 2: Chinese Exchange Rate Pressure 4 Source: Datastream, OECD

5. Fig. 3: US--China External Adjustment 5 Source: OECD

6. Causes of the Crisis Structural • Equity Culture in Banking • CDS/Derivatives/Securitisation • Capital Arb./Tax Structuring • SEC rule change/Leverage

7. Fig. 4: Structural/Regulatory Causes of the Crisis

8. Fig. 5: The Explosion of CDS Contracts Source: BIS

9. Fig 6: Capital Regulations • Banks are desperately short of capital—Basel II asks them to hold less. • Basel Pillar 1 does not penalise concentration risk!!!! And relies on supervisors to do something in pillar 2!! • Basel lets the regulated entities determine their own capital weights!!! & is pro-cyclical. • Basel II does not allow for idiosyncratic or local risk (based on a single global risk factor). • Weightings create regulatory arbitrage possibilities to raise leverage by off-balance sheet activity or CDS insurance to “de-risk” the balance sheets. • A SIMPLE LEVERAGE RATIO IS SUPERIOR—BUT NOT ENOUGH (EXCESS RISK TAKING!).

10. Fig 7: Citigroup & Capital Arbitrage • Securitized off-balance-sheet mortgages 0% capital charge under Basel I, & 50% if on B/Sheet. • Arbitrage: what % of on and off-B/Sheet mortgages allow the increased return now (from 2004) without causing a shortage of capital later on when Basel II became fully operational? • 0.4*(50% On-B/Sheet Cap/wt.)+6%*(0% Off-B/Sheet) =20% Basel II Equivalent Capital Requirement for Mortgages • CITIGROUP end of 2007 10K filings show $313.5bn on balance sheet, $510.5bn off (VIE’s and retained interests in QSPE’s): i.e. about 38% on b/sheet and 62% off b/sheet. • Citigroup had a further $733.7bn in QSPE’s, where the interests had been transferred away from Citigroup.

11. Fig 8: Northern Rock CEO & UK Treasury Committee Evidence • Mr Fallon: “Mr Applegarth, why was it decided a month after the first profit warning, as late as the end of July, to increase the dividend at the expense of the balance sheet?” • Mr Applegarth: “Because we had just completed our Basel II two and a half year process and under that, and in consultation with the FSA, it meant that we had surplus capital and therefore that could be repatriated to shareholders through increasing the dividend.”

12. Fig 9: The Hypo Bank Quote • By purchasing CDS protection on its assets, which remain on its balance sheet, Hypo transfers the credit risk to someone else, and this is recognised in its Basel risk-weighted assets. (As long contracts can be renewed—no global financial crisis). • “Since October 2007, DEPFA has been a member of the Hypo Real Estate Group, and this transaction achieves a number of objectives for DEPFA, and the Group as a whole: DEPFA has reduced the amount of regulatory capital required to support the assets (which under current BIS rules are 100% risk weighted, though under Basel II this will reduce substantially), and at the same time has improved the return on equity and credit risk”

13. Fig 10: The Tax Issue • The tax system encourages securitisation. • Tax haven opaqueness allows capital gains and income to be shifted in CDO creation • Inequality of tax treatment of income and capital gains/losses causes CDS boom in synthetic CDO’s. • Debt versus equity bias pushes up leverage—double dipping deductions.

14. Fig. 11: The Tax Arbitrage in CDS Source: , Samuel Eddins, OECD

15. Fig. 12: Leverage Ratios Prior to the Crisis Source: Company reports

16. Fig. 13: The Explosion of Private Label Securitised Mortgages Source: BIS

17. Causes of the Crisis Competition • Concentration issue. • New Businesses in structured products. • Glass-Steagall removal & corporate control. • Contagion risk.

18. Fig. 14: Concentration & Ratings Source: Datastrean, OECD

19. Fig. 15: Notional & Delta Adj. Index Tranche Obligations, Structured Credit Notes Source: Datastrean, OECD

20. Fig. 16: Notional & Delta Adj. Index Tranche Obligations, Structured Credit Notes: Main Issuers Source: Datastrean, OECD

21. Fig. 17: Notional & RW Issuance: Collateralised Synthetic Obligations Source: Datastrean, OECD

22. Fig. 18: Collateralised Synthetic Obligations: Main Issuers Source: Datastrean, OECD

23. Fig. 19: USA Takeovers As Glass-Steagall Abolition Approaches Source: Thomson, OECD

24. Fig. 20: Europe Takeovers Source: Thomson OECD

25. Fig. 21: Australia Takeovers Source: Thomson OECD

26. Exit Strategy Issues Forbearance & Time • Losses & Writedowns. • Recapitalisation. • Coordination May Not Mean Simultaneity.

27. Fig 22: The 5 Policy Steps • Emergency measures in monetary policy, central bank loans and public guarantees. • The need to deal with impaired assets both on and off bank balance sheets. • The need to recapitalise banks to get credit and other forms of financial intermediation moving again to avert a credit crunch. • The eventual necessity to exit from emergency measures, and government loans and guarantees. • Decisions about the longer-run shape of the future global financial system.

28. Fig. 23: Losses, Capital Rebuilding 2009 Mid Year Source: Bloomberg

29. Fig. 24: USA (19 SCAP Banks) Losses, Capital Raised Source: OECD, Company reports

30. Fig. 25: Europe (Loss Banks) Losses, Capital Raisings, & Scenarios Source: OECD, Company reports and Bloomberg

31. Fig. 26: Fannie and Fredddievs Private Label Mortgage Securitisation Source: BIS

32. Fig. 27: US Bank Intermediation (Bank Loans + ABS), GDP & Real Consumption Source: Datastream, OECD

33. Fig. 28: US Bank Intermediation versus GDP % Change & US House Prices % Change Source: Datastream, OECD

34. Exit Strategy Issues Policy Withdrawal • Fiscal & monetary. • Guarantees and loans. • Coordination May Not Mean Simultaneity.

35. Fig. 29: Two Routes to Deleveraging Source: OECD

36. Fig. 30: Fiscal Deficit Projections Source: OECD

37. Fig. 31: Support Packages For Financial Sector Source: OECD, IMF

38. Exit Strategy Issues New Fault-lines Already Emerging • Asia versus the crisis countries. • The broken dam refilling anew with liquidity before it is fixed. • Asset prices bouncing strongly.

39. Fig. 32: China: Money vs Domestic Credit, Opposite of OECD Countries Source: Datastream, OECD

40. Fig. 33: China: IP, FAI, Real M2 Exports Source: Datastream, OECD

41. Fig. 34: Global Forex Reserves & China Stock Market Source: Datastream, OECD

42. Fig. 35: Stock Markets: Better EM Fundamentals? Source: Datastream, OECD

43. Fig. 36: Dividend Yield vs Cash Source: Datastream, OECD

44. Exit Strategy Issues Defining What the Future Global Financial System Should Look Like.

45. Fig 37: What IS & IS Not Being Addressed • Is addressed: ●capital rules—the FSB & G20 are on the right track. ●compensation—but it is a symptom only . ●accounting, clearing, back office. • Is NOT addressed: ●“Too big to fail” & the implicit ‘puts’ & the ‘equity culture’. ●Contagion risk & corporate structure—what banks should do. ●Corporate governance reform to align shareholder & management interest more generally than compensation. ●The structure of competition in banking conducive to a credit culture. ●The structure & governance of regulatory agencies to avoid overlap & conflicts. ●Tax reform to remove incentives to structuring.

46. Fig 38: Equity Culture, & Competition vs Prudence • Equity culture—the creditor-versus-equity-owner put in banking—asymmetric upside; & the CEO shareholder asymmetry of interests. • “Too big to fail” is a huge problem—the government implicit put that ensures that risk is mispriced. • “Too big to fail” problems come out of M&A & growth via structured products helped by commercial banks owing investment banking/securities businesses with massive leverage on of off the balance sheet. • Australian banks are in the top 20. Why? A clue here. They had Basel, the same Credit Rating Agencies, & access to securitisation & derivatives. Their success must have been due to something else—Less equity culture.

47. Fig 39: Why Is Australia Better Placed?? • Twin Peaks regulatory structure: APRA, ASIC. The RBA focus on monetary policy & stability of the payments system. • Hence macro policy without conflict of interest: Budget surplus, and high interest rates. Plenty of room to ease. • 4 Pillars: Stable, medium-sized oligopolies that did not compete excessively in securities. 80% of the market does not fear competition in the market for corporate control, which is conducive to a “credit culture”. • Australian banks take deposits and lend as the main focus of their business—they look for profitable lending opportunities, rather than structuring notes and CSO/CDOs. • Macquarie: our one big IB introduced a Non-Operating Holding Company Structure (NOHC) in 2007. Reduces contagion risk amongst affiliates.

48. Fig. 40: Comparative Bank Structures Source: Datastream, OECD

49. Fig. 41: $70.6bn Payments to AIG Counterparties ($45.7bn to EU!): Sept. 16 to 31 December 2008 Source: Fed, US Treasury

50. Fig. 42: Non-operating Holding Company NOHC Source: OECD