suomen pankki | finlands bank | bank of finland 1 on the turbulences in the money and financial...

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


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


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


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


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


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


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


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


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


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)


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


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


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.


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


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


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.


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


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


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


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


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


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?


1999

EURO taken into use

1865

MARKKA joins silver standard

Heading for stable monetary conditions


The Bank of Finland’s four core functions

Monetary Policy

Financial Supervision

Banking Operations

Cash Supply


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


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


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


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


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


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


The Bank of Finland’s four core functions

Monetary Policy

Financial Supervision

Banking Operations

Cash Supply


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


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

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