SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 1 On the turbulences in the money and financial markets Governor Erkki Liikanen Moscow University 10.10.2007
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 1
On the turbulences in the money and financial marketsGovernor Erkki Liikanen
Moscow University 10.10.2007
2SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Northern Rock Plc share price
0
200
400
600
800
1000
1200
1400
Jan-07
Feb-07
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
NORTHERN ROCK PLC
3SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
EUR overnight rate
5 Minute QEUROND= [Line]11.7.2007 - 20.8.2007 (GMT)[Professional]
17 23 29 03 09 15July 07 Aug 07
Price
3.8
3.9
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4
QEUROND=, Close(Ask), Line20.8.2007 6:30:00 4,07
4SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
EUR, USD and GBP overnight rates
4.0
4.5
5.0
5.5
6.0
6.5
7.0
July-07 August-07 September-07 October-07
3
3.5
4
4.5
5
5.5
6
USD overnight rate GBP overnight rate EUR overnight rate
5SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Price of money with and without collateral on euro area interbank markets
3,6
3,8
4,0
4,2
4,4
4,6
4,8
5,0
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07
Euribor 3 kk Eurepo 3 kk
6SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
10-year risk premium over government bond return requirement
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1999 2000 2001 2002 2003 2004 2005 2006 2007
United States Euro area% points
Source: Bloomberg
7SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Price of protection from credit risk
0,0
1,0
2,0
3,0
4,0
5,0
Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07
Non-investment -grade (Itraxx)%-points
Source: International Index Company
8SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Yields on 2- and 10-year US benchmark government bonds
3.75
4
4.25
4.5
4.75
5
5.25
5.5
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
USD 2YEAR USD 10YEAR
Percent
”Safe haven”
Employment data
9SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Yields on 2- and 10-year euro benchmark bonds
3.5
3.75
4
4.25
4.5
4.75
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
EUR 2YEAR EUR 10YEAR
Percent
10SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Performance of US banking sector shares
0.76
0.80
0.84
0.88
0.92
0.96
1.00
1.04
1.08
1.12
2.1. 2.2. 2.3. 2.4. 2.5. 2.6. 2.7. 2.8. 2.9. 2.10.
S&P 500 S&P Banks S&P Inv. Banks
11SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Performance of European banking sector shares
0.85
0.88
0.91
0.94
0.97
1.00
1.03
1.06
1.09
1.12
1.15
2.1. 2.2. 2.3. 2.4. 2.5. 2.6. 2.7. 2.8. 2.9. 2.10.
S&P EURO 350 S&P EURO 350 Finan. Banks (Germany)
12SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
ECB’s fine-tuning operations in relation to all open market operations
-100 000
0
100 000
200 000
300 000
400 000
500 000
600 000
May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07
Fine-tuning operationMain refinancing operationLonger-term refinancing operation
EUR m
Source: Bank of Finland
13SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
ECB’s monetary policy operations
Date Operation (duration) ParticipantsBids Accepted Margin Average
9.8. Fine-tuning (1d) 95 95 4,00 % 4,00 % 4910.8. Fine-tuning (1d) 110 61 4,05 % 4,08 % 6213.8. Fine-tuning (1d) 85 48 4,06 % 4,07 % 5914.8. Fine-tuning (1d) 46 8 4,07 % 4,07 % 4114.8. Main refinancing (1w) 427 310 4,08 % 4,10 % 34421.8. Main refinancing (1w) 440 275 4,08 % 4,09 % 35523.8. Extra longer-term (3m) 126 40 4,49 % 4,61 % 14623.8. Longer-term (3m) 120 50 4,56 % 4,62 % 16828.8. Main refinancing (1w) 353 210 4,08 % 4,09 % 320 4.9. Main refinancing (1w) 426 256 4,15 % 4,19 % 356 6.9. Fine-tuning (1d) 91 42 4,06 % 4,13 % 4611.9. Fine-tuning (1d) tightening 66 60 4,00 % 4,00 % 3711.9. Main refinancing (1w) 406 269 4,14 % 4,17 % 38112.9. Extra longer-term (3m) 139 75 4,35 % 4,52 % 14018.9. Main refinancing (1w) 356 155 4,15 % 4,16 % 37125.9. Main refinancing (1w) 369 190 4,27 % 4,29 % 37826.9. Longer-term (3m) 85 50 4,50 % 4,63 % 1592.10. Main refinancing (1w) 299 163 4,14 % 4,16 % 316
Volume (€ bn) Rates
14SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Market development
High demand for dollar liquidity in Europe resulted in:– rise of shortest money-market rates – thereby to measures by central banks, such as the Eurosystem.
Uncertainty and lack of confidence among banks resulted in:– friction in the financial markets– price differential between money with collateral and without
collateral– drying up of market finance and– capital flows into lower-risk investments.
15SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
What lies behind the turbulence?
The turbulece was triggered by an alarming increase of defaults in housing loans granted to households with low creditworthiness in the US– These so-called subprime mortgage loans account for about
15% of the US housing loan stock– Extensive spreading of the problems in the financial system is
explained by two factors:
1.Active innovation of new financial instruments
2.Prolonged exceptionally favourable credit conditions
16SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Innovation of financial instruments in the 21st century focused on redistribution of credit risks
Development of securitisation techniques and credit derivatives have enabled more effective diversification of credit risks outside the financial sector, which is positive
Risks have also been observed in the developments:– Complexity of pricing models and low availability of historical data used
as valuation background
– Allocation of credit risks to parties with less understanding of them
– Backtracking of credit risks ultimately to banks due to market linkages
– Neglect in the monitoring of banks’ borrowing customers after risks have been transferred to other parties
17SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Example of securitisation: Collateralised Debt Obligations (CDO)
A bank bundles a large number of different assets and sells them to a special purpose vehicle (SPV)
The SPV finances the purchase of the aseets by issuing bonds collateralised with the assets
The bonds are given different privileges to the cash flows generated by the collateral assets; bonds of different tranches have different credit ratings
Tranche 1
Tranche 2
Tranche n
Law of large numbers: Although there are assets with low credit ratings in the collateral pool, a debt security granting a senior privilege to the cash flows generated by a large portfolio may receive a high credit rating..
AAA
AA
C
Certain structures include arrangements ensuring the solvency of the SPV, such as guarantees, credit limits etc.
18SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Spread of the turbulence into a global liquidity crisis
In early 2007, information released of a steep increase in defaults on the US subprime mortgage market
Credit ratings of subprime-linked assets were lowered from June-July onwards
Suspicion of potential large losses Diversification of credit risks has decreased
transparancy of the markets it is unknown how large the risks are and to whom ultimately belong
Lack of confidence and liquidity squeeze
19SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Why the uncertainty over banks’ risks? (1)
Valuation of all subprime-linked assets is very difficult due to strong market fluctuation– Pricing models have failed and trading on the markets has dried
up
Backtracking of risks transferred away from banks’ balance sheets due to credit limits granted to SPVs– Certain types of SPVs financed with very short-term money
(asset-backed commercial paper, ABCP) investor retrenchment reflected rapidly as problems
– Banks have been forced to patch up the finance dried up from the markets
20SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Why the uncertainty over banks’ risks? (2)
Linkages of banks and hedge funds– Hedge funds have purchased significant exposures in credit
risks previously concentrated on the banking sector – On the other hand, banks function as the main financiers of
hedge funds ultimately the risks are still borne by banks?
Financing of venture capitalists– Banks finance venture capitalists with a large sum and resell
financing interests to other investors only with a lag– When market conditions change significantly, resale of the
financing interests becomes much more difficult
21SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Impact on EU banking sector
Direct losses from the US subprime mortgage markets are limited
Lack of confidence and liquidity squeeze are a significant problem – a great deal depends on the duration of the exceptional circumstances
Subprime risks of Finnish banks are very limited
22SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Too soon to assess quantitative impacts of the turbulence on real economy
However, there is no doubt as to the +/- sign of the impacts
The impacts depend on the duration, extent and depth of the shock– … and economic policy reactions.
Impacts surface through many channels– Financing conditions generally tighter → investmets– Asset prices globally lower → consumption– Exchange rate changes → foreign trade– Weakened confidence has wide-reaching consequences
In the long term, normalisation of the pricing of risks is a a good thing also from the viewpoint of sustainable economic growth
23SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Conclusion
Long-expected correction in the pricing of risks, partly welcome
Reveals excessive risks and deficiencies in risk management, but losses are likely to remain limited shock tolerance of the new type of financial system is put to the test
Banks’ risk-bearing capacity is solid in a historical perspective (prolonged high profitability)
The key issue is restoration of confidence in the markets increase of transparency
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 24
What are the core tasks of the Bank of Finland today in the Eurosystem and in Finland?
25SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
1999
EURO taken into use
1865
MARKKA joins silver standard
Heading for stable monetary conditions
26SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
The Bank of Finland’s four core functions
Monetary Policy
Financial Supervision
Banking Operations
Cash Supply
27SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Key tasks The Governor is a member of the ECB’s Governing
Council and therefore is part of the monetary policy decision making process – simultaneously implementing euro area and Finland’s interest rates
Decentralisation of monetary policy implementation through national central banks
Bank of Finland is an active participant in domestic economic policy discussions
Objective Price stability in the euro area
Monetary Policy
28SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
For example:Juha Kilponen and Antti Ripatti’s research was selected as the best international research undertaken by a central bank, 2005 (CEPR & ESI)
According to their paper, over timeincreased competition in the labour and product markets bring about improvements in productivity and welfare
Monetary Policy
29SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Research into Russia and ChinaThe Bank of Finland researches the Russian and Chinese economies.
The Bank of Finland Institute for Economies in Transition (BOFIT)is an internationally renowned high level research institute, specialising in economies in transition, monitoring and analysing the target countries’ development and undertaking long-term research on their economies
Monetary Policy
30SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Financial Stability
Key tasks To promote the stability and efficiency of Finland’s financial markets
The Bank of Finland has oversight of the entire financial system and publishes statistics on the monetary economy
The Financial Supervision Authority (FIN-FSA) operates in cooperation with the Bank of Finland, who together monitor the individual entities in the market, such as banks
The Bank’s responsibilities are emphasised in times of crisis in the financial markets – BoF is also the source of emergency funding
Objective High level stability analysis and
crisis management preparedness
31SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Banking Operations
Key tasks Implementation of ECB monetary policy in Finland Securing the Banking system’s liquidity management Transmission of large-value payments between banks Investment of Bank’s financial assets (incl. foreign reserves)
Objectives Competitive central banking services
for its customers Prudent and productive investment
of financial assets
32SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Cash Supply
Key tasks Issuing banknotes and coins in Finland Ensuring the fitness and authenticity of the cash in circulation Bank of Finland works in cooperation with banks and specialist
cash distribution and sorting companies
Objective To develop the cost-effectiveness of the
entire currency supply system for the benefit of consumers and the Finnish economy
33SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
The Bank of Finland’s four core functions
Monetary Policy
Financial Supervision
Banking Operations
Cash Supply
34SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Change in the number of personnel in Dec/2001 – Dec/2008 is 232 persons (-32%)
Personnel development at the Bank of Finland
722
673,5
626,5
559,5543,5
524
490
847
798,5
764,5
698,5681,5
664,5
632
450
500
550
600
650
700
750
800
850
900
2001 2002 2003 2004 2005 2006 2008
Bank of Finland & FIN-FSA
Bank of Finland
35SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Distribution of profits
0255075
100125150175200225250275300325
1990 1992 1994 1996 1998 2000 2002 2004 2006
EUR m
Voitonjako valtiolle
Vararahastoon
For example: Banking crisis prevented distribution of profits to the State for many years
Bank of Finland’s balance sheet and profit and loss account