ECONOMIC CONDIHONS IN 2012 AND POLICY RECOMMENDATIONS
AJM 66.7: Describe the economic condition of the European financial sector in
spread of futurecrises.
possible policy implementation thatcan help mitigatethe
some
By2012,theglobalfinancialsystem has becomestrongly integrated.This
interconnectedness requiresa prudent approachtogovernment finances and financial stability,andpolicymakers needtofactorinspillovereffectsin theirdecisions, asdecisions in one jurisdictioncan affecteconomicandfinancialdevelopmentsinother regions through chain reactions.
Oneofdie keytasksin 2012and beyond istorebuild public confidenceinsovereigns,in
order to restore die risk-free sovereignstamsofgovernments.This Isparticularlyimportant, as thetraditionalapproach toriskweightingistoassign a zeroweighttosovereigns, which isdifficult tosustain ifsovereign risk does notimprove. InsLead, itIs more prudent10 assign a potentialriskweightotherthan zero (thisisclearlyseen under therequirementsof BaselIIandBaselIII}, which requires banks touseagranularapproachindistinguishing amongsovereign risk, applyinga higherriskweighdngforhigher risksovereigns.Basel TIT regulationsalsosetafloorof 3% for the leverageratio on the capitalbackingof sovereign holdings.Insummary,governments needtostrive torebuild investorconfidence througha
multistepprocess.
The short-term role ofgovernmentsis toimplement actionstoreduce their high indebtednessby fiscalconsolidations, timely reforms,andfinancing backstopsin order
tomaintain investor confidence. In thelongterm, governmentsneed toprovidea countercyclical policyapproach through theimplementationofautomaticstabilizersor
discretionaryactions*Asa result,governmentsneedtoremaincreditworthyduring timesof
stress bybuildingup adequate financial buffersduringeconomicbooms*
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KEY CONCEPTS
AIM 66.1
Thereare threekeyinitialconditions thatcontributed totheglobal economic crisis:(1) therewasinsufficientcapital, bigh leverageandlarge maturity andcurrency mismatches of the bankingsectorofmajor developedeconomies,(2) majorsovereignsaccumulated insufficientreservesduringboom times tofullyfundalllong-term obligations duringthe financialcrisis,and(3) the veryhigh level of integrationin theglohalfinancialsystem
amongsovereignsand financialinstitutionsexacerbatedthe crisis.
AIM 66.2
Three primaryways inwhich riskfrom the financial sectorcan he traitsmitiedtosovereigns include: (1)improper government policiesasa resultof one-off boosts tofiscal balances from financialinstitutions,(2) lendingCOILStraintsof financialinstitutionsthat resultin largerpublicsector deficit and deterioratingsovereigncreditworthiness,and (3) necessary governmentsupporttostrugglingfinancial institutionsinorder topreserve financial stability.
AIM66.3
Five ways in which sovereign riskcan he transmitted todie financial sectorinclude:(1) portfolioexposuresof financialinstitutionstoboth domesticandforeignsovereignrisk diroughdieirholdingsof sovereignbonds,(2)fundingconditions, as theavailabilityof eligiblecollateraldeclineswithsovereignriskincreases,reducing banks’fundingcapacity, (3) sovereign capacitytoassist, asweakersovereignshaveareduced capacity to provide assistance tobanks under pressure,increasing banks’ credit risk,(4)crowdingout,where
governmentdebt maycrowdout privatesectordebtby increasingthecostandreducingthe availabilityof bankfunding, and {5) alossof marketconfidenceinsovereigndebtmaylead
tofiscal consolidation.
AIM66.4
During the2002—2007 periodleading uptothe economiccrisis,sovereigndebt-to-GDP
ratios were within sustainablelevels,bondyieldswerelow,sovereign ratings remainedhigh, and bank profitabilityincreased each year.Banksbecameheavilydependenton accessto
cheapshort-termfundingand,asa result,didnotbuildup adequateliquidityreserves.
Factors that contributedtothe crisisincluded:(1) afailure bymarkets torecognize the significantrisein private credit-to-GDPratiosand realestateprices above theirlong-term trends,(2) acontinued expansion ofbusinesscycleswhich ledtohigher publicsector
account balances,and (3)increasing assetandrealestate prices that causedgovernmentsto continue tospend freely.
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AIM66.5
During thefinancialcrisis,sovereigncreditworthinesswascalledintoquestion, resulting innegative correlationsof rising sovereignCDSspreadswithdecliningbankCDSspreads.
Beginningin late2t)09as thecrisisdeepened, this correlation ofCDSspreads turned positive.
AIM 66.6
During the financialcrisis,banks’foreignclaimsonsovereigns declinedalongwitha
declinein publicsectordebt. Thereweredireereasonsfor the decline.First,someof the sovereigndebt that matured onthe banks’ balance sheetswas notrenewed.Second, banks already markeddownthevalueofsovereign debt to market value.Third, hankseithersold a portion offoreign governmentdebt totheECBor tothedomesticbanksof thesovereign governments.
During2011,banks’ exposures toforeign publicsector debt remained elevated whileforeign portfoliosof euro-area banks remained concentratedin riskierEurozonesovereign debt.
AIM66.7
By2012,dieglobalfinancialsystem has becomestronglyintegratedwheredecisionsinone
jurisdictioncansignificandyaffecteconomicand financialdevelopmentsinocher regions.
Rebuilding publicconfidenceinsovereignsis paramount.
Thereareseveral policyrecommendations tomitigatethespreadof futurecrises.
Regulationsshouldsetafloorfor dieleverage ratio.Banks shouldapplya granularapproach in distinguishingamong sovereignrisk,applyingahigherriskweightingforhigher risk sovereigns.In the short term,governments needtoimplementactions toreduce their highindebtednessbyfiscalconsolidations,timely reforms,andfinancingbackstops in ordertomaintain investorconfidence.Inthelongterm,governmentsshould providea
countercyclical policyapproachinorder toremaincreditwordiy.
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CONCEPT CHECKERS
A recentlypublishedarticleinafinancialjournalrevealed thatduring2007-21)08
oneof the majorEurozonefinancialinstitutionsmaintainedinadequate capital coupledwithhigh leverage,andhad considerableexposuretoeuro-area publicsector
debt. Basedon these revelations, how manyof the diree initialkeyconditionsof the spreadof the financial crisiswere satisfied?
A. None.
B. One, C. Two.
D. Three.
1.
FennTonmick isariskanalystatoneof the major equity research firmsspecializing inEurozonebanks. Inarecentreview of die European financialcrisis,Tomnick indicateddiatin timesofdistressofsystematicallyimportant financialinstitutions, sovereigngovernmentsareoftencompelled toprovidefinancialsupport to the strugglinginstitution.Whichof thefollowingstatementsbest describes Tomniclds example?
A. Theexampledescribesoneof thechannels dirough whichsovereignrisk Is transmittedtodie financialsector.
B. Theexampledescribesoneof the channels dinough which financialsectorrisk is transmittedtosovereigns,
C, Theexampledescribesakeyway inwhich financial institutionsarevulnerable
toexposure toprivatesectordebt.
D. Theexample providesan illustrationof dieinterconnectednessof dieglobal financialsystem.
Whichofdiefollowing examplesleastlikelydescribesoneofthemainchannels throughwhich sovereign riskcanbe transmittedtodie financialsector?
A. Alossof market confidenceinsovereigndebt triggersfiscalconsolidation.
B. An increaseinsovereign risk reduces availablecollateral,leadingtoreduced fundingcapacitybybanks.
C. Sovereign distressraisesthecostof bankfunding, crowdingout privatesector debt,
D. A troubled,systemicallyimportanteuio-aiea bankis bailedoutbyitssovereign.
“Duringthe2002—2007period,euro-areabankswere someofthelargestlendersto
riskierEurozone sovereigns, while non-Eurozone banksprimarilylenttosafereuro-area
sovereigns.v Thisstatement1st A. Correct,
B. Incorrect,becausenon-Eurozone bankswere thelargestlenders toriskier Eurozone sovereigns.
C. Incorrect,becausesafereuro-areasovereignsdid notseek externalfunding.
D. Incorrect,because riskierEurozone sovereignswere unabletoobtainfunding from eidiereuro-areaorinternationalbanks,
2.
3.
4.
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Whichof thefollowing policy recommendationsbestdescribesaway tomitigate the spreadof futurecrises?
A. Regulationsshouldsetafloor for theleverageratioon the capitalbachingof sovereign holdings*
B. Banksshouldapplyanon-gran ular approachinsovereign riskweights.
C. In thelongterm,governmentsneed toprovideacyclical policyapproach in ordertoremaincreditworthy.
D. Inthe short term,governmentsneed tobe less concerned withreducing their high indebtednessby fiscalconsolidations.
Foradditional Book 4, Topic66practice questionssee:
5.
Self-Test Questions:#7(page254)
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CONCEPT CHECKER ANSWERS
1. E Onlyoneof the threekeyinitialconditionsof thespreadof thecrisiswassatisfied (inadequate capital).The three conditionswere(1)inadequatecapitalof thehanking
systemcoupledwith high leverage,(2)inadequatefiscal reserves,and (3)large degreeof interconnectednessoftheglobalfinancialmarkets,
2. B Theexampledescribesoneof the channelsthroughwhich financialsectorriskIstransmitted
tosovereigns. These channels include(1)impropergovernmentpolicies (c.g.,unsustainable spendingincreases) asaresultof one-off booststofiscal balancesfrom financialinstitutions, (2)lendingconstraintsof financial institutionsthatresultinlarger publicsectordeficit and deteriorating sovereign creditworthiness,and(3) necessarygovernmentsupporttostruggling financialinstitutions inordertopreservefinancialstability
3. D Sovereign bailout ofatroubled bankisan exampleofoneof the channelsthroughwhich financialsectorriskcanheTransmittedtosovereigns.
4. A During2002—2007,euro-areabanksbecamesomeof thelargestlenderstoriskierforeign
governmentsincludingItaly, Spain,andGreece,whileforeignbanks outside theEurozone continuedtoprimarilylendtolessriskyeuro-areagovernments,includingGermanyand Prance.
5. A Regulationsshouldsetafloorfortheleverageratioon thecapital backingofsovereign holdings.
Banks should applyagranularapproach indistinguishingamongsovereign risk,applying
ahigherriskweightingforhigherrisksovereigns. In the longterm,governmentsneed
toprovideacountercyclical policyapproach inordertoremaincreditworthy.In the short
term,governmentsneedtoimplementactionstoreduce theirhigh indebtedness hyfiscal consolidations,timelyreforms, andfinancingbackstopsin ordertomaintain investor confidence,
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AIMstatementssetforthbyGARI"2*.TliistopicIsalsocoveredin: