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

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

3. 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)

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

5. “ 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

6. 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)

7. 6 U.S. Subprime Delinquencies (in percent of total subprime loan amount; 2007Q1)

8. 7 U.S. Subprime Delinquencies (in percent of total subprime loan amount; 2007Q2)

9. 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

10. 9 Months after origination SubprimePrime 2003 2006 2000 2002 2005 2001 2004 20072003 2004 2002 2005 2000 2001 2006 2007 Mortgage Delinquency by Vintage year (60+ days delinquencies; in percent of balance)

11. 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).

12. 11 Virtual Shutdown of Subprime Lending Mortgage-Related Company Failures and Acquisitions

13. 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

14. 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.

15. 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

16. 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

17. 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

18. 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. 392.4 291.7

19. 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

20. 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