Universita' di Urbino "Carlo Bo", November 2009 Ph.D. Renata Karkowska Banking and Financial Markets Department FACULTY of MANAGEMENT WARSAW UNIVERSITY

Universita' di Urbino "Carlo Bo", November 2009

Ph.D. Renata Karkowska

Banking and Financial Markets Department FACULTY of MANAGEMENT

WARSAW UNIVERSITY

The impact of global crisis on banking system.

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Course schedule

sub-prime crisisEuropean Financial Marketcrisis banking in emerging marketsfuture face of Europe’s Financial System

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What was the reason of the subprime crisis?

The early part of this decade saw a long period of unusually easy macroeconomic conditions, with low or negative real interest rates in the major economies. It encouraged a build-up in leverage and risk-taking, among both regulated and unregulated entities.

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FED interest rates in USA

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CPI in USA

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Easy credit, combined with the assumption that housing prices would continue to appreciate, encouraged many subprime borrowers to obtain loans. Some homeowners were unable to re-finance their loans and began to default.

The reasons for this crisis are very complex (both in the housing and credit markets). Some of these include: • the inability of homeowners to make their mortgage payments; • poor credit judgment by the borrower and/or the lender; • risky mortgage products (CDO); • high personal and corporate debt levels; • central bank policies; and regulation (or lack of there).

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Sub-prime lendingGrowth of the housing bubble

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Causes of the crisis

Source Data: US Department of the Treasury, Financial Crimes Enforcement Network

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Role of securitization

Securitization is a structured finance process in which credit assets are extract from the balance sheet and classified into pools, and offered as collateral for investors.

Due to securitization: • investors appetite for mortgage-backed securities (MBS), • the tendency of rating agencies to assign investment-grade ratings to MBS, • loans with a high risk of default could be originated, packaged and transferred to others.

Asset securitization began in the 1970s.

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Role of housing investors and speculators

Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences.

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Role of financial institutions

The lenders offered an increasing higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 , 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "risk premium") declined from 2.8 percentage points in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans.

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Financial innovation and complexity.

Development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower):

- Credit Default Swaps,- Mortgage-Backed Securities (MBS),- Securitization.

reference asset

CDS (protection)

buyer

Risk transfer & fee

compensation

CDS (protection)

seller

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Role of credit rating agencies

Credit rating agencies gave investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans.

Rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.

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Role of central banks

Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the "lenders of last resort" to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble.

Central banks have generally chosen to react after such bubbles to minimize impact on the economy, rather than trying to avoid the bubble itself.

There is significant debate among economists regarding whether this is the optimal strategy.

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During the years preceding the crisis, U.S. financial institutions became increasingly indebted or overleveraged. This increased tend to the collapse of the housing bubble.

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Effects of Crisis

Effect on world economy When the crisis first came to light, many analysts called it a domestic problem — one that would only affect US housing markets.

However, the crisis quickly spread throughout the world.

People started to withdraw their savings due to fallout from the subprime crisis.

The collapse of Lehman Brothers was a symbol of the Crash of 2008

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Effects of the crisis

Effects on stock markets

The crisis has caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and put it into commodities.

Financial speculation in commodity futures following the collapse of the financial derivatives markets and it has contributed to the world food price crisis and oil price increases. Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds.

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Effects of the crisis

Effects on financial institions

During 2007 and 2008, over 100 mortgage lenders went bankrupt. In March 2008 ivestment bank Bear Stearns collapsed. Several major institutions failed or were subject to government takeover. These included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and AIG.

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Effects of the Subprime Crisis

Many banks, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation.

Profits at the 8 533 USA banks declined from $35.2 billion to $646 million (90 percent) during the fourth quarter of 2007 versus the prior year.

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Course schedule


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Effects on the global economy

The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes and commodities.

OMX Iceland 15 closing prices during the five trading weeks from September 29, 2008 to October 31, 2008.

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Characterization of single European financial market

1/ EU financial markets are increasingly integrated, especially in the wholesale markets. 2/ The banking and insurance markets are dominated by pan-European groups, in which risk management functions are centralised in the group's headquarters. 3/ There has been an increase in cross-border M&A transactions. This trend was particularly strong in 2005, when several large-value transactions were conducted, amounting to over 50% of the total M&A value in the euro banking system.

4/ EU banks have become more international than ever, expanding into foreign markets both in Europe and beyond. 5/ Currently around 70% of EU banking assets is in the hands of 43 banking groups with substantial crossborder activities. Especially in the Central and Eastern European countries, the banking sectors are dominated by foreign financial groups.

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Impacts of crisis on financial institutions

One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. It led to investor panic and a bank run in September 2007.

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock, as they could no longer obtain financing through the credit markets.

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Impacts on financial institutions

During September 2008, the crisis hits most critical stage. There was the equivalent of a bank run on the money market mutual funds, which frequently invest in commercial paper issued by corporations to fund their operations.

The TED spread, an indicator of credit risk in the general economy, spiked even higher in September 2008, reaching a record 4.65% on October 10, 2008.

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European policy responses

1/ As the financial crisis began to seriously affect the economy, from September 2008, many countries announced specific measures: Germany, Spain, Italy, Netherlands, United Kingdom, Sweden. 2/ The European Commission proposed a EUR 200 billion stimulus plan to be implemented at the European level by the countries. 3/ The European Central Bank injected $99.8 billion in a one-day money-market auction. 4/ The Bank of England pumped in $36 billion. On September 2008 the Belgian, Luxembourg and Dutch authorities partially nationalized Fortis bank. The German government bailed out Hypo Real Estate. On October 2008 the British Government announced a bank rescue package of around £500. The plan consisted of three parts: • increase banks liquidity scheme, • increase the banks' market capitalization, • temporarily underwrite any lending between banks.

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European countries in economic recession or depression

Many countries experienced recession in 2008.

In the first quarter of 2008 Denmark went into recession. Iceland fell into an economic depression in 2008 following the collapse of its banking system.

In the second quarter of 2008, the following countries went into recession : Estonia, Latvia, Ireland.

In the third quarter of 2008, the following countries went into recession: Sweden, Turkey and Germany. As a whole the fifteen nations in the European Union that use the euro and the United Kingdom went into recession.

In addition, the European Union, the G7, and the OECD all experienced negative growth in the third quarter.

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Countries maintaining growth or technically avoiding recession

Poland is the only member of the European Union, which avoided a decline in GDP, meaning that in 2009 Poland has created the most GDP growth in the EU. As of September 2009 the Polish economy had not entered recession.China and India have experienced slowing growth, they have not entered recession.South Korea avoided technical recession in the the first quarter of 2009. The International Energy Agency stated that South Korea could be the only large OECD country to avoid recession for the whole of 2009. However, as of the October, the Australian economy has managed to avoid recession thanks to a strong mining sector. It was the only developed economy to expand in the first half of 2009. On October, Australia became the first G20 country to raise its main interest rate, with the Reserve Bank of Australia deciding to move rates up to 3.25% from 3.00%.

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Course schedule


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Strong belief of emerging markets

At the beging of the Subprime crisis, everybody supposed that Emerging Economies are stronger than they have been during previous crises (the Asian crisis of the late 90s).

There was strong belief that the BRIC economies (Brazil, Russia, Indian and Chinese) are so big, modern and well-balanced to support demand for goods & services in global economy, in spite of crisis in USA and Europe. This phenomenon was named decoupling.

In EM economies there were not mortgage instruments connecting with securitisation, CDS – Credit Default Swap). 34

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Why the EM economies have looked stronger?

Many countries in the CEE region would be protected from the global financial crisis, because:

- their banks' finance came not from markets but from the multinational banks that have bought most local lenders.

- EM banks have not buy MBS in a huge quantities,

- little exposure to the subprime lending instruments,

- preparing to join the European Union in 2004, they also strengthened their regulatory and supervisory processes.

- there is not investment banking in CEE, like in USA.35

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Banking crisis in patern-banks

In CEE countries between 60 and 80 percent of the banking sector assets are controlled by foreign banks.

The presence of foreign banks in the EM banking system has managed to: - the lack of confidence between local banks, because of insolvency of their patern-banks, - and the liquidity crisis in the interbank markets.

In Poland there was a problem with lack of confidence of Pekao Bank, which is Polish subsidiary of UniCredito Italiano, when it facing with liquidity problems at home. 36

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Effects of the capital outflows from EM

Interbank markets interest rates increased dramatically. Local banks stopped lending money one another.

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What’s happened in 2007?

After the information about crisis in America there was the strong belief about the strongness of EM economies. It caused a very big capital inflow to emerging markets up to $1 trillion. First of all, it was short term loans for EM banks.

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External loans and deposits of BIS-reporting banks in Eastern Europe

These loans were used to increased credit action in foreign currency in EM countries. About the middle of 2007, external loans have been growing deposits from the region.

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What happened after the bankruptcy of Lehman Brothers (09/2008)

• In EM 52% of currency credits was lending in USD.

• In this case EM banking system much more depends on foreign loans (American& European banks).

• After the bankruptcy of Lehman Brothers (09/2008) the biggest world banks started to afraid about their own liquidity and insolvency.

• This spectaculative bankruptcy caused the change of direction of international capital flows.

• Parent banks (mainly in Western Europe) have become progressively less able and/or less willing to finance their subsidiaries in Central & Eastern Europe.

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• The loss of large share of external loans in currency developed the confidence crisis in EM banking systems.

• Local banks have been stopping lending one another.

• The reason of the confidence crisis in EM banking systems was not MBS losses, but difficulty in currency finansing.

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• The situation was so dramatic that CEE countries have led the ECB to take the extramely unusual step of making swap transactions available to the central banks.

European

Central Bank

CEE central banks

Foreign currency

Local currency

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The capital outflows from Central Europe gave occasion to strong depreciation of EM currencies and a lot of speculations in the FOREX (currency markets)

The bankruptcy of Lehman Brothers

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48%

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The zloty has dropped 33 % against the Euro. In the same period, the Czech koruna decreased 14 % and the Hungarian forint lost 24 %.

We can say about a speculative attacks made on Polish zloty, HUF, made by hedge funds.

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38%

Exotic derivatives in EM

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Emerging markets firms entered into exotic derivatives contracts that caused massive losses.

KIKO in Korea, TARN in Brazil and other

- this is the names of the exotic derivatives, sound like toys or children’s stories.


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The first reported losses were at private firms in the tradable goods sector. Most of the firms were exporters that appeared to be using the derivatives to hedge against ill effects if their domestic currency were to appreciate. But when the currencies depreciated instead and the losses were disclosed the firms had to sell local currency for euro to cover their losses.


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Transactions in these derivatives have resulted in massive losses that fueled currency market panics and helped transmit the financial crisis to emerging markets.

The very real consequences led the head of Poland’sBusiness to call them a “product from hell.”

The direct losses have been deep and wide. An estimated 50,000 firms in the emerging market world have been affected. This includes 10 percent of Indonesia’s exporters and 571 of Korea’s small and medium-size exporters. Losses in Brazil are estimated at $28 billion, in Indonesia at $3 billion, and in Mexico and Poland at $5 billion each. Sri Lanka’s publicly owned Ceylon Petroleum Company lost$600 million, and China’s Citic Pacific suffered $2.4 billionin losses.


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There are two fundamental questions at the core of the problem:

1/ Did the firms intend to hedge — which, insulate themselves from currency movements — or speculate?

2/ And did banks, acting as derivatives dealers, merely meet the needs of their clients or did they engage in deceptive trading practices?


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What were they? • The derivative provided a long position, in which the investor gains from an apreciotion in the value of the underlying currency.

• The derivative generated monthly payments for aperiod of one or sometimes two years. A KIKO structureused long call options (giving the buyer the right to buy thecurrency at a certain price over a certain period of time) andshort put options (granting the right to sell). That created theeconomic equivalent of a futures or forward contract—theinvestor gains from an upward movement in the underlyingprice and losses from a downward movement. BUT the losses was twice times bigger !!


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What were they?

• Potential gains on the transaction were limited.In some cases it was a so-called knock-out provisionthat canceled the monthly payment if the foreign currencyappreciated beyond a specified exchange rate

• Potential losses were not limited.

• The initial cost or premium to enter into these transactionswas zero.


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Risk-Return Function option structure

The rule was: 1 put + 2 call, barrier knock down&outIf the EUR/PLN rate will be below A, bank pays X,But if the EUR/PLN rate will be above A client pays 2X

___ put option bought by client

___ call option sold by client

___ structure function

payoff

Hedged or speculated?

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It is hard to know whether the nonfinancial firms intendedto hedge against further strengthening of their currency orspeculate.

It is also hard to know how they understood the risk-return profile of these transactions.

Recomended literature:Randall Dodd, Playing with Fire, Finance&Development, June 2009

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Poland is a member of EM region basket. When international investors see bad condition in one of the countries from this region, they also go out from Polish market. Then foreign investors sell Polish Treasury bonds, stocks and Polish zloty making its depreciation.

So now there is a big problem with stability of our currency, because of capital flows.

The solution of the problem could be the enter of Poland to Eurozone.

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Course schedule


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The lessons of the crisis for financial supervisory policy

A first lesson of the financial crisis is that it has been a consequence of:the overall macro-financial environment as well as the behaviour of individual institutions and the functioning of specific market segments.

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At a macroeconomic level: large global imbalances, rapid credit expansion over a protacted period of time, in a environment of low inflation and high growth, a huge increase in leverage, a significant underpricing of risk and a consequent divergence of asset prices from fundamental values. At a micro-economic level: financial innovations, the securitisation process helped to better diversify and distribute risk, the creation of complex products whose real value and risk was difficult to assess, and the establishment of off-balance sheet investment vehicles.

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A second lesson of the crisis is that the nature of the systemic risk in the financial sector is not related only to: the potential illiquidity, or insolvency of large banks or other big regulated financial institutions, but it also depends on the degree of “interdependence” between financial institutions and between marketsthe size of some of the non-bank financial institutions and the activities of the “non-bank, non regulated sector” have become significant and can pose systemic risks.

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This “interdependence” reflects a variety of direct and indirect links in the financial system and it involves institutions and markets that are regulated or not regulated.

This second category includes not only hedge funds but also off-balance sheet financial entities, such as structured investment vehicles, as well as the securitisation market, and the market for credit default swaps (CDS).

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A third lesson is that the increasing financial integration in Europe and globally has important implications for the cross-border distribution and propagation of systemic risk.

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The growing presence and significance of cross-border financial institutions within the EU (the largest 43 cross-border banking groups in the EU accounted for 76 % of total EU bank assets at the end of 2007) requires the strengthening of the pan-European character of supervision.

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A fourth and final lesson that I want to stress is that effective crisis prevention and management call for close cooperation and efficient information exchange between the supervisory authorities as well as between the central banks

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What are conclusions can we draw from these lessons, and more generally from the recent experience, for supervisory policy?

to strengthen both the macro-prudential and micro-prudential supervision of the financial systemSomebody recommends set up a new body – called the European Systemic Risk Council (ESRC)

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The main functions of the macro-prudential framework include:the identification and assessment of risks and vulnerabilities in the EU financial system (including all markets, institutions and infrastructures);the issuance of risk warnings; and the adoption of related recommendations on macro-prudential policies.

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Course schedule

sub-prime crisisEuropean Financial Marketcrisis banking in emerging marketsfuture face of Europe’s Financial System capital market in Poland

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Poland started to change its economy from “100% banking based system” into more flexible mixed “banking and markets based system” in 1989.

One of awaiting effects of program implementation was creation new segment in the Polish Economy – Capital Market.

At the begining of the reform Poland have: • weak currency,• high inflation,• strong budget deficit.

Polish Capital Market

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Evolution of Polish capital market 1989 -2007

Problems 1989 2007

Proper legal solution Lack, some regulations of Commercial Code from 1930-ties

Solutions regarding capital market in important part compatible to EU solutions

Capital market institutions Lack Complete institutional infrastructure .

Domestic capital Very limited Permanently growing strength of institutional investors (pension funds, investment funds), still relatively weak individual investors

Foreign capital Lack due to low creditability of the country – high unpaid foreign debt

Creditability of the country at the safe level of BBB+ (S&P), also speculative capital

Strength of domestic currency

Strong inflation process Strong currency

Source: author’s own research

Polish Capital Market

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The History of the Warsaw Stock Exchange

One of the oldest in Europe, the capital market in Poland with its 190 years of history has an impressive heritage. Paradoxically, the interruption in exchange operations in Warsaw as a result of World War II and then the transition to the communist economic system enabled Poland to create a modern stock exchange.

The first stock exchange in Poland opened in Warsaw in May, 1817 under the name of the 'Mercantile Exchange'.

1991 12 April - Poland and France signed a co-operation agreement to open a securities exchange in Warsaw (The Warsaw Stock Exchange Company).

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From a national bourse to regional leadership

During the seventeen years of its history, the WSE has developed from a small national exchange into one of the fastest growing bourses in the European Union and an unquestionable leader in Central and Eastern Europe.

Number of listed companies

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From a national bourse to regional leadership

When WSE began its operations in April 1991, it had five companies listed. At the end of November 2007 there were as many as 345, out of which 21 were foreign companies. Additionally, NewConnect had 19 companies listed. WSE is the leader among exchanges in Central and Eastern Europe:* first position in terms of the number of listed companies, * first position in terms of the number of new companies coming to the bourse, * first position in trading in derivatives, * second position in capitalisation of domestic companies, * second position in value of equity trading.

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NUMBER OF LISTED COMPANIES ON EXCHANGESIN THE CEE REGION – DOMESTIC COMPANIES

(end of August 2008, source:WSE)

2339

85103

198

341

395

0

50

100

150

200

250

300

350

400

450

PragueStock

Exchange

BudapestStock

Exchange

LjubljanaStock

Exchange

WienerBörse

BratislavaStock

Exchange

WarsawStock

Exchange

BulgarianStock

Exchange

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FOREIGN COMPANIES LISTED ON STOCK EXCHANGES IN THE REGION (end of July 2008, source:WSE)

0 13

0 0

10

25

18

0

10

20

30

BratislavaStock

Exchange

BucharestStock

Exchange

BudapestStock

Exchange

BulgarianStock

Exchange

LjubljanaStock

Exchange

PragueStock

Exchange

WarsawStock

Exchange

WienerBörse

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WSE – CAPITALISATION AND LISTED COMPANIES

Source: WSE

32 25 2741

53

80

113

619

29

51

101114

142158

0

20

40

60

80

100

120

140

160

180

0

50

100

150

200

250

300

350

400

Capitalisation - domestic companies (Euro bn) - left scaleCapitalisation - foreign companies (Euro bn) - left scaleNumber of listed companies - right scale

2000 2001 2002 2003 2004 2005 2006 2007 Aug 2008

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Polish capital market in Central Europe

The success of WSE results from a variety of factors:

* the country’s economic potential,

* favourable legislative framework,

* strength and resources of financial investors,

* IT infrastructure

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SKYEUROPEWARIMPEXIMMOEAST

SILVANO OLYMPIC

BMP AG

MOL

AMRESTCINEMA CITYPLAZA CENTER

CEZPEGASNWR

ASSECO

ACE

ASTARTAKERNEL

CEDC

ASBIS

ORCO GROUP

REINHOLD

RONSON

UNICREDIT ITALIANO

ATLAS ESTATES

BELVEDERE

WSE – INTERNATIONAL MARKET

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IPOS ON STOCK EXCHANGES IN EUROPE Q2 2008, ALL MARKETS

No. Exchange No. of IPOs Value of IPOs (EUR m.)

1 London 46 6 298

2 Warsaw 37 1 890

3 NYSE-Euronext 15 1 615

4 OMX 10 178

5 Deutsche Boerse 8 330

6 Oslo 6 28

7 Luxembourg 6 49

8 Switzerland 3 412

9 Borsa Italiana 2 14

10 Madrid (BME) - -

11 Wiener Boerse - -

12 Ireland (ISE) - -

13 Athens - -

Source: PricewaterhouseCoopers

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Special facility for small issuers. Markets AIM type

British AIM, Polish NewConect are not regulatory markets.

This markets join trading public and private issue.

NewConect has provided a platform for financing and secondary trading for small and medium size companies showing high growth potential.

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-100

100

300

500

700

900

1100

1300

1500

August

2007

Septem

ber 2

007

October

2008

Novembe

r 200

7

Decembe

r 200

7

Janua

ry 20

08

Februa

ry 20

08

March 2

008

April 20

08

May 20

08

June 2

008

July 2

008

0

10

20

30

40

50

60

70

Market capitalization Number of listed companiesPLN mln.

MARKET CAPITALISATION AND NUMBER OF LISTED COMPANIES

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WIG - MARKET HISTORY 3Y

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www.WSE.com.pl

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www.NewConnect.eu

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www.WSEInfoSpace.eu

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Thank you for attention

[email protected]

Documents

Universita' di Urbino "Carlo Bo", November 2009 Ph.D. Renata Karkowska Banking and Financial Markets Department FACULTY of MANAGEMENT WARSAW UNIVERSITY