The 2008-09 Financial Crisis: Likely impact on ECA countries & Policy Responses

1. The 2008-09 Financial Crisis:Likely impact on ECA countries &Policy Responses WORLD BANK Fernando Montes-Negret, Director Finance and Private Sector Development Department Europe & Central Asia Region, The World Bank May, 2009

2. Agenda • Sequence of Major Events • Phases of a Financial Crisis • Potential Risks in ECA • Market Perceptions of Risks • Role of Policy Makers and Supervisors

3. Sequence of Major Events • Detonator: US sub-prime mortgage crisis (mid-2007); Limited international contagion (Germany); • Amplifier (1): Highly leveraged financial institutions; Rapid de-leveraging & downward spirals Risk aversion; Lack of trust & counterparty risk; Liquidity and “fluidity” crises; • Mitigator (1): Central Banks flooding market with liquidity; • Amplifier (2): Lehman Brother’s failure (Fall-08); US piecemeal approach; Loss of confidence & collapse of stock markets (world wide); • Mitigator (2): TARP, Blanket Dept. Insurance, …

4. Mid-size detonator, huge bomb! “The Crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity, where excessive leveraging and bubbles were not limited to housing in the US but also housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: a housing bubble, a mortgage bubble, an equity bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector de-leveraging since the Great Depression”. Nouriel Roubini RGE Monitor, Oct.9/08

5. Dangerous Spirals: Over-Sold Markets

6. Vicious Cycles “A liquidity vicious cycle- in which asset prices fall, people sell and therefore prices fall more; A Keynesian vicious cycle- where people’s incomes go down, so they spend less, so other people’s income falls and they spend less; and a Credit accelerator, where economic losses cause financial problems that cause more real economic problems”. Larry Summers “Fed believes US will avoid deep recession”, FT, March 13, 2008

7. Crisis of the prevailing Intermediation Model- The End of an Era • Bank-Intermediated Model (originate & retain): Banks as dominant financial intermediaries w/assets valued at historical cost; Versus … • Securitized or Market-based Finance (originate and transfer): Most financial intermediation takes place in the market by trading securities (primary & re-packaged). Ex. MBS, CDOs, and ABS). • Shadow Financial System (“boomerangs”): Limited/partial transfers of risk, in view of: SIVs, Conduits, Off-Balance Sheet operations without capital. => Huge increase in total bank assets, but flat Risk-Weighted Assets!.

8. Major Structural Changes in the US and International Financial System => Self-contained institutions transformed into an inter-linked NETWORK, making very difficult to disentangle and let one particular institution fail (ex. Bear Sterns). Often it became impossible to know who had the risk!!. => Loss of Confidence paralyzed money and inter-bank markets. 1

9. Significant second round impacts are being felt globally … • Huge (paper) wealth losses:$2.5 trillion erased from global equities market • Global credit crunch, affecting banks and corporates alike • Inter-bank rates soared: • Euribor at record 538bp • 3m Libor at record 539bp • 3m USD LIBOR-OIS at record 348bp • Corporate short term borrowing rates soared: • Yields on overnight US commercial paper jumped by 94bp to 3.68% • CP debt outstanding fell by 15% ($264 bn) to a 3-year low level of $1.5 trillion Note: data as at Oct. 9, 2008

10. … including in emerging markets • Stock markets have declined significantly: • Markets closed in Russia, Indonesia, Romania and Ukraine • Sharp declines in Brazil, Poland, etc. • Banks are facing increasing difficulties and runs: • Depositors’ runs (e.g. Brazil, Taiwan, Korea, Serbia) Source: Bloomberg • Increase in NPLs (e.g. Estonia, Latvia) • Bank failures (e.g. Ukraine) • Liquidity is out-flowing emerging markets: • Large outflows (around $30 bn so far in 2008) from emerging market funds; $16 bn out of Russia in 3rd Q • Large repatriation of funds to HQ by foreign banks (e.g. Citibank from Mexico to US) • Drastic reduction in interbank lines from international banks to domestic banks

11. Contagion and Real Sector Impacts Un-chartered Territory but .. • Typically the liquidity and market shocks are followed by slower growth, company insolvencies, and solvency problems in banks, as liquidity tightenss and loan portfolios deteriorate and NPLs rise. • Greatest concern about: • Weak banking systems (poorly capitalized & provisioned banks with weak regulation, supervision & enforcement and disclosure); • Vulnerable Banks with high (Loan-to-Deposit Ratios, high rollover & refinancing risks); • Countries with large or increasing Macroeconomic imbalances, particularly large CADs; • Policies with poor policy responses & policy mixes.

12. Typology of ECA countries CIS Countries EU Members EURO or not Turkey Other

13. Phases of the Crisis Liquidity crisis Economic crisis Solvency crisis 1

14. ECA countries are exposed to three main channels of contagion • ECA countries are exposed to four potential channels of contagion: • Parent banks’ troubles • Liquidity crunch: • Impact of global credit crunch on domestic banking system • Credit contraction at the level of subsidiaries of European banks • Borrowers’ defaults: • Large exposures to interest rates • Large exposures to exchange rates • Large exposure to real estate prices (losses and weaker collaterals) • Negative market sentiment towards emerging economies • The liquidity crunch (external refinancings & possible run of deposits) and rising NPLs are already bringing Ukraine into a serious crisis.

15. (L/D) Ratios Source: IFS

16. Parent bank troubles could have a significant impact on a number of countries

17. EU and Balkan countries are particularly exposed to Swedish and Austrian banks • Swedish banks account for 51 to 85% of the banking sector of Baltic countries • Austrian banks are present in 8 ECA countries, accounting for up to 48% of their banking sector • Countries where foreign banks play a dominant role are particularly exposed:e.g. Raiffeissen in Albania (45%), Unicredit in Croatia (23%) Source: Bakscope, staff calculations

18. While all top European banks seem strongly committed to the region…

19. … faced with difficulties, their decisions re. subsidiaries will depend on global markets and domestic risks Raiffeisen may face liquidity constraints • High profitability of ECA subsidiaries may lead parent banks to protect their franchise value • But, ultimately, the global credit crunch may force them to contract their funding to them • Their decisions will also depend on their perception of risks in ECA countries, including household leverage, real estate risk, etc • Also, the internal structures of subsidiaries may play a role (e.g. Raiffeissen can easily sell off its ECA franchise structured in an independent holding company) Source: Unicredit

20. The liquidity crunch is affecting Ukraine, Kazakhstan, and the Baltics Romania, Bulgaria, and Hungary are also at high risk • Banks in ECA financed growth through cross-border financing • ECA is by far the region most dependent on debt financing and the most exposed to the current liquidity crunch • A sudden stop in cross-border capital can cause a sudden stop in credit markets and have a material impact on domestic activity Source: Unicredit

21. Borrowers in many ECA countries are over-exposed to financial risks… • Most mortgage loans, and loans in general, have been extended in Euro, Swiss Francs, Yen, at variable interest rates, on the basis of rapidly rising real estate prices • Thus, borrowers, and banks, are exposed to • Variations in exchange rates and interest rates • Real estate prices (sales of collateral in thin markets can create a financial accelerator effect) Source: Unicredit

22. …and NPLs have already started to increase in some countries

23. Market Perceives High Risk especially in Ukraine, Kazakhstan, the Baltics, Romania and Bulgaria… Note: A credit default swap (CDS) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default. Source: Bloomberg

24. … as well as for some Western banks with a significant presence in ECA Source: Bloomberg

25. Yes, ECA is at risk of sharp economic decline and poverty increase The global credit crunch is likely to lead to a significant slow down in growth • Re-pricing of risks by financial institutions is likely to reduce financing for firms and households • Massive inflows of liquidity by central banks to safeguard the financial system is likely to generate inflation • Hence, countries are likely to enter into a period of stagflation • Tensions on exchange rates and interest rates could lead to significant losses for households with debts in foreign currency at floating rates • Declines in securities markets will impact the investment portfolios of insurance companies, investment funds, and pension funds in addition to banks • Declines in pension funds’ returns will affect retirement incomes Source: IMF, World Economic Report 2008

26. Ukraine, Kazkhstan, and the Baltics are at particular risk; a crisis there could contaminate other ECA countries • These countries are particularly exposed to the credit crunch due to: • Their high current account deficits, • High external debt, • High dependency on external capital inflows • In case of a deeper crisis in these countries, other ECA countries could be affected as market sentiment for the region deteriorates Source: Fitch, September 2008

27. Thus, the challenges ahead are substantial • Main objective: restore the global financial system to full functionality, at the least possible cost to taxpayers: i.e. • Restore adequate liquidity • Strengthen impaired balance sheets • Rebuild capital where needed • Restore trust in the global financial system • Allow credit to resume • Challenges: • Consolidation of financial systems in many countries • Adequate use of public balance sheets to contain systemic financial risks • Avoiding excessive moral hazard • Regaining investors and depositors confidence • Significant additional risks could materialize (e.g. counterparty risk in $55 trillion CDS market)

28. What Needs to be Done ? Action Plans (1) Policy Makers: • Improve quality of financial information; • Understand group/ conglomerate structures • “Get out of the Dark” –understand your banks and risks; • Crises must be managed; • Align incentives of all players; • Reduce the Unknowns- Provide policy certainty • Putting in place a credible (big) package at once, but preferably only once! • Political consensus or consultation for major decisions; • Inter-Agency coordination crucial (crisis mgmt. team); • Communication & Leadership key; • Prepare to manage bad assets (AMC)- Insolvency Solvency Regime

29. What Needs to be Done ? Action Plans (2) Policy Makers: • Check your “tool box” to be sure you have: • Adequate legal, regulatory and organizational arrangements to deal effectively and quickly with the crisis. • Are all “the players on the same page”? • Adequate Diagnostics? Adequate Bank Resolution System • Adequate liquidity (LOLR). : market liquidity vs. ELA (emergency liquidity assistance). Quality and scopeof eligible collateral. • Adequate Deposit Insurance System (funded and able to return insured deposits fast)? • Adequate loss-absorption mechanisms (fiscal/external)? • Adequate crisis communication strategy?

30. What Needs to be Done ? How can we help? World Bank: • Encourage Contingency Planning and Crisis Preparedness; • Mobilize expertise- Inside & Outside Bank; • Crisis response teams must have diverse skills: legal advice (instruments for bank resolution), asset valuation, financial analysis, central and commercial banking, macroeconomists,.. • Cross-Border Issues are likely to be important in ECA, particularly if a major European bank were to fail; • Consolidation and failures will happen; • Pre-design Loan types.

31. Supervisory Weaknessess and Recommendations 1

32. Supervisory Weaknessess and Recommendations (2) 1

33. The Bank can play a key role in four main areas Immediate • Advice on diagnostics & crisis management, in collaboration with other IFIs, including: • Methods of bank monitoring and viability assessment (triage & recapitalization strategies) • Methods for restructuring failed banks, cleaning up balance sheets, orderly resolution & Exit, etc. Provision of budget support for bank recaps/carve outs, in coordination with IMF Emergency Facility, through FS DPLs and transaction-based lending (ex. Mexican crisis). Support to the Real Sector via Lines of Credit (examples Turkey & Ukraine) • TA to further strengthen banking and securities market prudential regulation and supervision. => Speed is important Short-term