Ph.D. Renata Karkowska

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The impact of global crisis on banking system.

• Ph.D. Renata Karkowska
• Banking and Financial Markets Department
• FACULTY of MANAGEMENT
• WARSAW UNIVERSITY

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Course schedule

• sub-prime crisis
• European Financial Market
• crisis banking in emerging markets
• future face of Europes 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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What was the reason of the subprime crisis?

• 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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What was the reason of the subprime crisis?
Sub-prime lending Growth 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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Causes of the crisis

• 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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Causes of the crisis
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Causes of the crisis
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Causes of the crisis
Role of housing investors and speculators Specula
tion 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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Causes of the crisis
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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Causes of the crisis

• 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.

Risk transfer fee
CDS (protection) buyer
CDS (protection) seller
compensation
reference asset

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Causes of the crisis
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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Causes of the crisis
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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Causes of the crisis
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

• sub-prime crisis
• European Financial Market
• crisis banking in emerging markets
• future face of Europes Financial System

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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 MA transactions. This
trend was particularly strong in 2005, when
several large-value transactions were conducted,
amounting to over 50 of the total MA 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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Characterization of single European financial
market

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Characterization of single European financial
market

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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

• sub-prime crisis
• European Financial Market
• crisis banking in emerging markets
• future face of Europes Financial System

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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).

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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.

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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.

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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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Whats 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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Effects of the capital outflows from EM

• 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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Effects of the capital outflows from EM

• 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.

Foreign currency
European Central Bank
CEE central banks
Local currency

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

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Effects of the capital outflows from EM
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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Exotic derivatives in EM
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 childrens stories.
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Exotic derivatives in EM
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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Exotic derivatives in EM
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 Polands Business 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 Indonesias exporters and
571 of Koreas 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 Lankas publicly owned
Ceylon Petroleum Company lost 600 million, and
Chinas Citic Pacific suffered 2.4 billion in
losses.
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Exotic derivatives in EM
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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Exotic derivatives in EM

• 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 a
• period of one or sometimes two years. A KIKO
  structure
• used long call options (giving the buyer the
  right to buy the
• currency at a certain price over a certain period
  of time) and
• short put options (granting the right to sell).
  That created the
• economic equivalent of a futures or forward
  contractthe
• investor gains from an upward movement in the
  underlying
• price and losses from a downward movement.
• BUT the losses was twice times bigger !!

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Exotic derivatives in EM

• What were they?
• Potential gains on the transaction were limited.
• In some cases it was a so-called knock-out
  provision
• that canceled the monthly payment if the foreign
  currency
• appreciated beyond a specified exchange rate
• Potential losses were not limited.
• The initial cost or premium to enter into these
  transactions
• was zero.

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Exotic derivatives in EM

• The rule was 1 put 2 call, barrier knock
  downout
• If the EUR/PLN rate will be below A, bank pays X,
• But if the EUR/PLN rate will be above A client
  pays 2X
•  

payoff
Risk-Return Function option structure
___ put option bought by client ___ call option
sold by client ___ structure function
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Hedged or speculated?
It is hard to know whether the nonfinancial firms
intended to hedge against further strengthening
of their currency or speculate. It is also hard
to know how they understood the risk-return
profile of these transactions.
Recomended literature Randall Dodd, Playing with
Fire, FinanceDevelopment, June 2009
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Effects of the capital outflows from EM
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

• sub-prime crisis
• European Financial Market
• crisis banking in emerging markets
• future face of Europes Financial System

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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.

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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The lessons of the crisis for financial
supervisory policy

• 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 markets
• the 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.

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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The lessons of the crisis for financial
supervisory policy

• 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.

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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The lessons of the crisis for financial
supervisory policy

• 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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The lessons of the crisis for financial
supervisory policy

• 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
  system
• Somebody recommends set up a new body called
  the European Systemic Risk Council (ESRC)

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The lessons of the crisis for financial
supervisory policy

• 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 crisis
• European Financial Market
• crisis banking in emerging markets
• future face of Europes Financial System
• capital market in Poland

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Polish Capital Market

• 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.

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Evolution of Polish capital market 1989 -2007
Polish Capital Market
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 (SP), also speculative capital
Strength of domestic currency Strong inflation process Strong currency
Source authors own research
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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, sourceWSE)
68
FOREIGN COMPANIES LISTED ON STOCK EXCHANGES IN
THE REGION (end of July 2008, sourceWSE)
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WSE CAPITALISATION AND LISTED COMPANIES
2002
2000
2001
2005
2006
2007
2003
2004
Aug 2008
Source WSE
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Polish capital market in Central Europe
The success of WSE results from a variety of
factors the countrys economic potential,
favourable legislative framework, strength
and resources of financial investors, IT
infrastructure
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WSE INTERNATIONAL MARKET
REINHOLD
SILVANO OLYMPIC
CEDC
BMP AG
AMREST CINEMA CITY PLAZA CENTER
ASTARTAKERNEL
ATLAS ESTATES
ASSECO
CEZ PEGAS NWR
ORCO GROUP
MOL
SKYEUROPE WARIMPEX IMMOEAST
BELVEDERE
UNICREDIT ITALIANO
ACE
ASBIS
RONSON
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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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MARKET CAPITALISATION AND NUMBER OF LISTED
COMPANIES
PLN mln.
75
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
rkarkowska_at_mail.wz.uw.edu.pl