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OECD Breakfast series Fixing Finance Tuesday, October 13, 2009 8:30 a.m. - 10:00 a.m. New America Foundation 1899 L St NW, Suite 400 Washington, DC 20036.

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Presentation on theme: "OECD Breakfast series Fixing Finance Tuesday, October 13, 2009 8:30 a.m. - 10:00 a.m. New America Foundation 1899 L St NW, Suite 400 Washington, DC 20036."— Presentation transcript:

1 OECD Breakfast series Fixing Finance Tuesday, October 13, 2009 8:30 a.m. - 10:00 a.m. New America Foundation 1899 L St NW, Suite 400 Washington, 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 Oct-2009 2

3 Fig. 1: US Monthly Trade Balance, Bilateral Comparisons Source: Datastream, OECD Oct-2009 3

4 Fig. 2: Chinese Exchange Rate Pressure Source: Datastream, OECD Oct-2009 4

5 Fig. 3: US--China External Adjustment Source: OECD Oct-2009 5

6 Causes of the Crisis Structural Equity Culture in Banking CDS/Derivatives/Securitisation Capital Arb./Tax Structuring SEC rule change/Leverage Oct-2009 6

7 Fig. 4: Structural/Regulatory Causes of the Crisis Oct-2009 7

8 Fig. 5: The Explosion of CDS Contracts Oct-2009 Source: BIS 8

9 Fig 6: Capital Regulations Banks are desperately short of capitalBasel 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 SUPERIORBUT NOT ENOUGH (EXCESS RISK TAKING!). Oct-2009 9

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 (VIEs and retained interests in QSPEs): i.e. about 38% on b/sheet and 62% off b/sheet. Citigroup had a further $733.7bn in QSPEs, where the interests had been transferred away from Citigroup. Oct-2009 10

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. Oct-2009 11

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 renewedno 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 Oct-2009 12

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 CDOs. Debt versus equity bias pushes up leveragedouble dipping deductions. Oct-2009 13

14 Fig. 11: The Tax Arbitrage in CDS Source:, Samuel Eddins, OECD Oct-2009 14

15 Fig. 12: Leverage Ratios Prior to the Crisis Oct-2009 Source: Company reports 15

16 Fig. 13: The Explosion of Private Label Securitised Mortgages Oct-2009 Source: BIS 16

17 Causes of the Crisis Competition Concentration issue. New Businesses in structured products. Glass-Steagall removal & corporate control. Contagion risk. Oct-2009 17

18 Fig. 14: Concentration & Ratings Source: Datastrean, OECD Oct-2009 18

19 Fig. 15: Notional & Delta Adj. Index Tranche Obligations, Structured Credit Notes Source: Datastrean, OECD Oct-2009 19

20 Fig. 16: Notional & Delta Adj. Index Tranche Obligations, Structured Credit Notes: Main Issuers Source: Datastrean, OECD Oct-2009 20

21 Fig. 17: Notional & RW Issuance: Collateralised Synthetic Obligations Source: Datastrean, OECD Oct-2009 21

22 Fig. 18: Collateralised Synthetic Obligations: Main Issuers Source: Datastrean, OECD Oct-2009 22

23 Fig. 19: USA Takeovers As Glass-Steagall Abolition Approaches Source: Thomson, OECD Oct-2009 23

24 Fig. 20: Europe Takeovers Source: Thomson OECD Oct-2009 24

25 Fig. 21: Australia Takeovers Source: Thomson OECD Oct-2009 25

26 Exit Strategy Issues Forbearance & Time Losses & Writedowns. Recapitalisation. Coordination May Not Mean Simultaneity. Oct-2009 26

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. Oct-2009 27

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

29 Fig. 24: USA (19 SCAP Banks) Losses, Capital Raised Oct-2009 Source: OECD, Company reports 29

30 Fig. 25: Europe (Loss Banks) Losses, Capital Raisings, & Scenarios Oct-2009 Source: OECD, Company reports and Bloomberg 30

31 Fig. 26: Fannie and Fredddie vs Private Label Mortgage Securitisation Oct-2009 Source: BIS 31

32 Fig. 27: US Bank Intermediation (Bank Loans + ABS), GDP & Real Consumption Source: Datastream, OECD Oct-2009 32

33 Fig. 28: US Bank Intermediation versus GDP % Change & US House Prices % Change Source: Datastream, OECD Oct-2009 33

34 Exit Strategy Issues Policy Withdrawal Fiscal & monetary. Guarantees and loans. Coordination May Not Mean Simultaneity. Oct-2009 34

35 Fig. 29: Two Routes to Deleveraging Source: OECD Oct-2009 35

36 Fig. 30: Fiscal Deficit Projections Source: OECD Oct-2009 36

37 Fig. 31: Support Packages For Financial Sector Source: OECD, IMF Oct-2009 37

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. Oct-2009 38

39 Fig. 32: China: Money vs Domestic Credit, Opposite of OECD Countries Source: Datastream, OECD Oct-2009 39

40 Fig. 33: China: IP, FAI, Real M2 Exports Source: Datastream, OECD Oct-2009 40

41 Fig. 34: Global Forex Reserves & China Stock Market Source: Datastream, OECD Oct-2009 41

42 Fig. 35: Stock Markets: Better EM Fundamentals? Source: Datastream, OECD Oct-2009 42

43 Fig. 36: Dividend Yield vs Cash Source: Datastream, OECD Oct-2009 43

44 Exit Strategy Issues Defining What the Future Global Financial System Should Look Like. Oct-2009 44

45 Fig 37: What IS & IS Not Being Addressed Is addressed: capital rulesthe FSB & G20 are on the right track. compensationbut 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 structurewhat 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. T he structure & governance of regulatory agencies to avoid overlap & conflicts. Tax reform to remove incentives to structuring. Oct-2009 45

46 Fig 38: Equity Culture, & Competition vs Prudence Equity culturethe creditor-versus-equity-owner put in bankingasymmetric upside; & the CEO shareholder asymmetry of interests. Too big to fail is a huge problemthe 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 elseLess equity culture. Oct-2009 46

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 businessthey 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. Oct-2009 47

48 Fig. 40: Comparative Bank Structures Source: Datastream, OECD Oct-2009 48

49 Fig. 41: $70.6bn Payments to AIG Counterparties ($45.7bn to EU!): Sept. 16 to 31 December 2008 Oct-2009 Source: Fed, US Treasury 49

50 Fig. 42: Non-operating Holding Company NOHC Source: OECD Oct-2009 50

51 Fig 43: Competition Policies Open market buying of toxic assets is least distortive. Stable oligopolies that dont compete excessively in the securities and derivatives businesses. Foreign acquisition of domestic weak banks fosters better competition without disturbing the local structure. Selling asset of failed firm in pieces enhances competition. Temporary nationalisation is better than a megamerger. Promote entry with competitive mergers of smaller healthy banks e.g. regionalsin overbanked jurisdictions. They are ready to lend and competition will force recapitalised banks to lend. Foster removal of regulatory barriers to entry in the loan market: fine grained credit rating information on consumers and small businesses. NOHC structures to foster transparency, competition, and regulatory ease. Oct-2009 51

52 Fig 44: Corporate Governance Independent directors: strengthen fit and proper person test to cover competence, technical expertise. Risk management skills; formal separation of CEO and Chair; term limit on board membership. Risk officer role with access to the board (with special employment terms--CEO doesnt fire or set salary). Fiduciary responsibility of directors: clarified tying duties to single affiliate in the case of complex firms. Remuneration: board reform helps, and tax incentives provide teeth. Oct-2009 52

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