Petar Goshev: Brief overview of the financial crisis and its impact
Opening speech by Mr Petar Goshev, Governor of the National Bank of the Republic of
Macedonia, at the international economic forum "Faster towards the European Union",
organized by the Economic Chamber of the Republic of Macedonia, Ohrid, 2 November
2008.
* * *
Honorable President Azevski,
Dear presidents, business leaders, honorable excellencies, ladies and gentlemen.
Let me thank Mr. Azevski for the given honor to speak in front of you this evening, in this
exceptionally turbulent, exciting and at the same time challenging period in the economic and
financial history of the world. From the invitation I can read that I have the honor to address
representatives of ten countries in the region, primarily people who face all sorts of
challenges in solving the puzzles from the real economic life, every day. From the statistics I
looked through, I may conclude that I have the pleasure to speak in front of representatives
of nearly 64 million citizens (63.89 in 2007), whose GDP was around 507 billion Euros
altogether in 2007, as opposed to the GDP of 40,000 billion achieved by the world (i.e.
1.27% of those 40,000 billion), in front of the representatives of the 64 million citizens who
during the same year exchanged goods and services with the rest of the world in the amount
of 295 billion Euros, as opposed to the 20.4 thousand billion of realized foreign trade of the
whole world, i.e. a share of 1.43%. Since the European Union has realized GDP of 12.34
thousand billion of the world's 40,000 (which means around 30%), our share, i.e. the share of
the 10 countries, participants in tomorrow's conference, in the GDP of the 27 EU Member
States, equals 4.5%.
Ladies and Gentlemen,
I do not present these figures for pure statistical reasons. It was agreed with president
Azevski to give you a brief overview of today's hottest issue, "the financial crisis in the world".
Management of this crisis, as well the response of each of us individually and jointly of the
region, is directly related to the answer to the question in the focus of tomorrow's conference:
How to go faster towards the EU? The figures that you are very well aware of, and I only
reminded of them, indicate that: we were not in a position to cause the latest world financial
crisis, that we are not in a position to solve it, but that we are definitely bearing the
consequences from it for a simple reason: borders are open. Balance of payments current
accounts are 100% liberalized. Varying from country to country, the export and import of
goods and services participate with over 50%, up to nearly 100% in the domestic GDP.
Capital accounts are also 100% liberalized in some of the participants in the conference, the
others are close to that. Both individually and all together we are absorbers of the shocks
coming from the rest of the world, and that rest of the world is 98.75% of the world population
(we are only 1.25%); 98.57% of the foreign trade, 98.73% of GDP in 2007. Therefore it is
important for us to penetrate as close as possible to the nature of the current financial crisis,
to the necessary and true answers to the question how it should be managed, which are
primarily sought and ought to be found by the developed countries, what lessons are to be
drawn from this crisis, what will be the damage for the region, what is the best way to
cushion part of the inevitable impact as successfully as possible.
What has actually happened?
Starting from August 2007, the world was lapped by an intensive financial disorder, turmoil.
Once again the trigger was pulled with a severe downward turn in the USA. First, "Fannie
Mac" and "Freddie Mac" were taken into conservatorship. The following weekend "Lehman
Brothers" turned out to be incapable of finding a buyer and they went bankrupt. This shocked
the market, which expected that it will be saved by the government, as it was the case with
"Bear Stearns" in the beginning of the year. Then, "AIG" had to be rescued after the rumors
about the size of its losses incurred by agreements for commercial debt securities. Hence,
the pressures increased enormously for the other dealers in securities. Then, Secretary
Paulson revealed the initial plan of 700 billion $ for purchasing assets in order to support the
banking sector. However, this did not eliminate the doubts.
The pressures grew in Europe, too. In September, Dexia, Fortis and Hypo Real Estate had to
receive an urgent capital injection, mainly from the governments. In England, the authorities
facilitated the quick consolidation in the mortgage sector by having Abbey Santander buying
Alliance and Leicester, they supported some mergers in the construction sector and
suggested a merger of LTSB and HBOS. Finally, at the end of September, the transparent
authorities in England intervened in order to solve the rising difficulties in Bradford and
Bingley, by transferring the deposits and the branch network to Abbey Santander and by
undertaking the remaining assets and liabilities in public ownership, and subsequently
closing them in an organized manner.
All analysts perceived the events on the financial markets as something unseen ever since
the great financial crisis in the period 1929-1933 of the previous century. As early as in the
second half of September the companies and non-banking financial institutions accelerated
their withdrawal even from the short-term financing of the banks, and the banks were
increasingly losing the confidence for extending loans to each other. The costs of financing
grew tremendously. Many institutions could make only overnight borrowing. The credits to
the real sector almost stopped. On the financial markets, the trust to the others plummeted to
a point below which the investors sought their way out mainly in the government instruments,
for example US Treasury Bills, which at a certain point had a negative yield. Distrust went
much further than the sub-group of vulnerable banks. The reports reveal that USA and
Europe have registered market losses from the asset loans of nearly 3 trillion US Dollars.
Regardless of the fact that all these losses will not encumber the banks and can
overemphasize the losses of those able to keep the debt until the maturity, the investors and
their partners became very concerned about the amount of the actual losses in the banking
and trade portfolio in broader scope of the institutions and their capability to continue
financing their business. The focus of the concern moved from prospective profitability to
prospective survival. That is why the CDS premium increased to unprecedented ranges, the
prices of the banks' shares plunged, while the money market overdried. The interbank
lending margin deepened dramatically, the lending, as I mentioned previously, reduced to
only overnight loans. Around October 6 and7 even the overnight loans stopped.
How did the central banks of the countries in the crisis' epicenter respond?
In the beginning, the central banks were committed to provide liquidity as much as
necessary. The volume of the liquidity support from the central banks of USA, England,
Europe was without precedent in the history so far. It included a wide spectrum of measures,
including the long-term repo based on broad spectrum of collaterals and introduction of
special liquidity patterns enabling the banks to swap illiquid assets for Treasury Bills for a
period of up to three years. Incredible, unseen till now. However, some knew, others maybe
did not, that is far from sufficient. That the liquidity injecting has vital role only to delay,
prolong the immediate, forthcoming collapse. That such steps can help to overcome the
crisis only until the elimination of the actual reasons that were spreading the distrust. Also, to
help understanding the severity of the fundamental problem and to postpone the inevitable
day for calling to account. "Exactly as the high temperature, the fever (as Mervin King wrote)
is by itself a symptom for the basic condition, thus the freezing of the interbank and money
markets was a symptom for deeper structural problems in the banking sector". That is why
another group of measures had to follow. The new, additional measures were designed to
eliminate the fear arising from the thought and the facts that the banks are insolvent. To
ensure that the banks have enough capital to survive the harsh economic plummeting and
hence, to enable them to continue lending on normal criteria for the good credits. With a fully
solvent banking system, guarantees may be given without exposure of the tax payers to
unacceptable risk (just to mention that the British tax payers currently have larger claims in
the form of bank assets, as collateral maintained by the Bank of England, than the total value
of the banks' capital in England). That is the reason why the morning of October 8, the Prime
Minister of England and the Minister announced the plan for recapitalization of the banking
system, which was then, one way or another, followed by others in the world, primarily USA
and Europe.
More precisely, why did this radical plan have to follow?
When the financial turmoil commenced (in August 2007), the markets of numerous financial
instruments, including the MBS (mortgage-backed securities), ceased functioning. They dried
out. Most of the analysts thought that it is on a temporary basis. But, the time passed and the
markets failed to reopen. It became clear that the problem is much bigger. The concern that
insolvency is in question was rising and it was verified. Actually, it became evident that the
main problem is solvency and sustainability of the financing model. That is why the liquidity
injecting was only intended to buy some time. The securitized mortgages, polling of
mortgages sold through securities, including the infamous US-sub-prime mortgages, were
traded on the market during the upward trend in the prices of apartments and houses, and
when the interest rates were low, it disguised the risks of the core loans. With securitization
of mortgages in such a volume, the banks have transformed the liquidity in their loan
portfolios. They financed that by wholesale borrowing. But when the defaults multiplied, and
the prices of the apartments dropped, firstly in the USA, and then wider, the investors had to
reassess the risks inherent to these securities. Observed as more risky, they lost their value.
The demand for these securities plunged. For the same reasons, the value of the mortgage
portfolio went down. The value of their assets reduced, whereas the value of the liabilities
which remained unchanged. The negative effect increased with the very high level of
borrowing compared to the capital (or the so-called leverage), with which many banks
worked, and with the fact that the banks have purchased a large quantity of securitized and
more complex financial instruments from one another. Not only the real evaluation was
difficult, but the distribution of the losses through the financial system was vague. The price
of the banks' shares dropped. The capital became restricted. The market has sent a clear
signal: the banks' capital was insufficient. The message? Recapitalize them immediately.
What does the latest news from the market say?
Since the recapitalization packages and other measures have been announced, signs of
improvement occurred. The credit default swap premium indicator, showing the markets'
concern for the banks' solvency, which according to many experts is the most significant
individual diagnostic statistics, started to decline. Especially the CDS premium (commercial
debt securities premia) dropped significantly.
The progress with the guarantees, although gradual, is also encouraging, with more banks
issuing bonds even without utilization of guarantee (government) being registered. The
LIBOR spread also shrunk, and it is expected to "continue to narrow gradually compared to
the period before the measures were undertaken" (this primarily pertains to England).
Many banks continue to face with deleveraging and rebalancing in order to lower the
dependence on financing through the central banks.
The stronger capital and financial position of the banks will be possible in a period of several
years. In wider terms, the financial system remains to be under acute clench, tension. The
real economic sector bears the consequences.
The unemployment increases. The business financing is getting harder and more expensive.
The economies' growth decreases. Also the so-called emerging economies started to feel
decline in the growth. It seems that we are entering into recession. The central banks of the
developed economies transfer the focus of their measures from the inflation control to
recession prevention.
What conclusions can be derived from this crisis?
1. Nout Wellink, President of the Basel Committee on Banking Supervision and
Governor of the Central Bank of the Netherlands, quotes Charles Kindleberger,
saying in his famous book "Manias, Panics and Crashes", that the "financial crises
are typically a result of extended accumulation of imbalances preceded by certain
exogenous shock, or structural changes in the financial system. The examples are
in the changes in the political environment, new regulations and financial
innovations. These changes create new possibilities, but also, uncertainties and lack
of awareness of potential risks from the so-called unknown-unknowns". In such
environment, says Wellink, "the traditional checks and balances can become
inappropriate and can easily result in excessive risk".
Really, we have faced:
•
Fiscal and balance of payments deficits, which failed to be treated because
there was no enough good will for that in the globalized world, and
accordingly to discuss about the foreign exchange rates.
•
Huge imbalances in the financial sector, the dimensions of which grew to
explosion. While the savings rates were decreasing with a limited rise in the
households' deposits being registered, the banks were filling in the gap
between the retail deposits and the credit growth by using sources from the
wholesale markets. For example, in England, the gap between the lending
to clients and the deposits climbed from zero, in the beginning of the
century, to over British Pounds 700 billion in the first half of 2008, says Sir
John Gieve, Deputy Governor of the Bank of England.
•
The expansion of the banks' aggregate balances, which became too
padded out, exceeded the increase in the real economy.
•
The structure of the liabilities excessively relied on the maintained
availability of the so-called wholesale funding, the maturity of which was on
a short-term basis.
•
The discrepancy between the capital and liquidity on one hand and the
risks on the part of liabilities, was constantly increasing.
•
The financial innovations brought a lot of unknown-unknowns, together with
the fast trend of globalization. It means that structural changes through
financial innovations occurred. The best illustration for this is the so-called
"originate-to-distribute" model, i.e. extending credits and claims distribution
to chained financial intermediates and end-users, which replaced the
socalled "originate-to-hold" banking model, i.e. issuance of credits and
holding to their maturity. It really opened new possibilities for the financial
system to broaden and manage risks and maturity mismatches. Some of
the banks developed this model into a complete integrated business
strategy and primary source of financing of their activities. They securitized
the loans, transferred the risk to others in a short period of time, in order to
borrow capital over and over again, in order to sell the claim again, and to
benefit promptly, but it definitely lowered the lending standards.
2. What should be the medium-term agenda of response to the fundamental problems
in the financial sector as a lesson from what we have witnessed so far?
•
Neither macroeconomic nor sector imbalances, of which I have spoke
before, must be tolerated for too long.
•
The banks' risk management processes and procedures must be
dramatically improved. This includes revision of the existing limits on the
banks' exposure to certain risks, improvement of the stress-testing
procedures and elimination of the weaknesses related to risk management
which arise from the investments in structural financial products. We, as
National Bank of the Republic of Macedonia, have adopted new regulations
related to these issues and we continue to work on that with our banks.
• Strengthening of the principles for liquidity risk management, especially in
crisis. Internationally, steps have already been undertaken. In April 2008,
FFS prepared a Report and defined 67 activities for strengthening the
markets and the resilience of the institutions. The Report pays special
attention to liquidity, and on September 28, the Basel Committee on
Banking Supervision announced the new Principles for Sound Liquidity
Risk Management and Supervision. The responsibility is located with the
banks and supervisors. We, as National Bank, have already passed new
regulations for defining the main elements which the liquidity risk
management system of each bank must incorporate. The aim is to ensure
level of liquidity which the banks will be able to use as source for covering.
•
The transparency of the operations of the financial institutions must
increase through the type and the scope of the data these institutions will
disclose. This will lead to increasing the confidence in the financial system.
The Basel Committee on Banking Supervision and the Board for
International Accounting Standards have already undertaken certain
activities.
•
The regulation on determining and measuring banks' solvency deserves
special attention. The appropriate level of capital is the main anchor for a
stable banking system. When this issue is discussed internationally,
primarily a reference is made to the New Capital Accord, the so-called
BASEL II. It is being criticized even before its full implementation and
therefore it is inappropriate to refer to it as one of the reasons for the
current crisis. However, it is important to mention that draft amendments
have already been prepared as a response to the new developments.
Those are, inter alia, the following:
- Improvement of the manner of covering the risks arising from the
use of structural financial products.
- Changes in determining the capital necessary for covering the
risks from banks' trading portfolio, especially of those instruments
characterized with lower liquidity on the market.
- Measures for reducing the effects from the economic cycles on the
level of the capital requirement. The purpose is: to allocate more
reserves in periods of expansion in order to provide sufficient
capital for covering the losses in times of crisis. This is Spanish
experience, known as "dynamic provisioning".
- Expanding of the type of data which the banks will be obliged to
disclose. I would only like to mention that the National Bank has
commenced the activities for implementing BASEL II in the
Macedonian banking system.
Does and will this crisis have an impact on our economies?
It already has and it will have an additional impact depending on its duration. The first blow is
for the real sector. In all of our countries, depending on the structure of the economy, the
export sector will be most severely hit.
Consensus Forecasts of October 2008, envisages that the growth of the US economy will
equal 1.4% and in 2009 it will be 0%, with a projected fall of the personal consumption and
faster decline in the investment consumption.
The growth of the EU economy for 2008 has been adjusted downward (1.4%) and for 2009 it
is 0.6%. For an illustration, 60% of the Macedonian export is in the EU countries. The trading
conditions have already deteriorated and we project further deepening of the trade and the
current account deficits, whereas the increased minus between the exports and the imports
will act toward reducing our growth rate. We expect a negative impact also in the capital and
financial accounts, but at this moment it is difficult to quantify it. Banking will not be hit
directly. There is no exposure in risk-bearing financial instruments. Deposits are dispersed
according to the regulations. It will be very important for the banking in the region to work as
hard as possible on preserving the confidence in the institutions, in the banks. To prevent as
much as possible the speculations which may cause panic with the depositors. The region
should respond to the world financial crisis and recession movements with increased mutual
cooperation. Both economic and political. The reduced export demand in the developed
economies could be partially offset with the increased trade and mutual increase in the
private crediting in trading or financial terms. Tomorrow's conference has a chance to give its
contribution to that.
Is the world financial crisis going to create larger innovations in the international
financial system and order and are there any developments, redistributions in the
international financial architecture and power in sight?
I personally think that it is quite possible. Almost inevitable.
From the one hand, it is becoming very clear that globalized markets and the total globalized
economy require global and efficient international institutions where efficient and timely
coordinated responses to the economic and financial risks and crises will be agreed.
Just for example, Switzerland was obliged to support UBS and Credit Suisse. However, the
problem is that they exceed its capacity, as in that case, and in many new such cases, with
the financial giants in many other countries.
Bush and Sarcozy have met, and the issue was nothing less than an entirely new world
financial system, immediately encompassing China, India and Brazil. These countries are
included in order to help the West to overcome the recapitalization problems.
The British Prime Minister Gordon Brown strongly supports new "Bretton Woods" Agreement
for the international monetary system. The freedom that the New York institutions for
residential sector financing enjoy currently, will vanish.
It seems that the Arabian countries and Russia are not ready to discuss in this direction,
or it
just seems like that. But Putin, during his visit to China, suggested the Chinese leaders to
initiate trade in their national currencies, showing explicit non-confidence in the US Dollar.
The Persian Gulf countries are planning a monetary union. Will they take this step?
According to all this, dear Ladies and Gentlemen, we are living in an exciting historical
period. Yes, it is crisis. But, probably, it is not by chance that the wise Chinese have two
signs for the crisis. The one denotes the danger, and the other one, possibilities. This crisis is
a real possibility to learn a lot, in this case from the mistakes of the developed ones, in order
to build a financial system and an economy which will be less vulnerable to any future
shocks.
Thank you!