How to avoid the next financial crisis

The next European Financial Crisis The Italian liquidity issue

Presented by: Gabriele Calabrò Module:

Global Financial Crisis

TABLE OF CONTENTS: • GENERAL INFORMATION • THE ITALIAN LIQUIDITY ISSUE • POTENTIAL CONSEQUENCES • GLOBALIZATION • PREVENTABLE MEASURES

GENERAL INFORMATION

Types of financial crisis: •

Currency crisis (90-92 ERM Crisis, 97-98 Russian Crisis)

•

Banks crisis (Credit Risk, Illiquidity Risk and Interest rate Risk)

•

Twins crisis

•

Debt crisis (Balance of Payments (BoP), Sovereign debt crisis or household debt crisis)

The BoP crisis occur when a country cannot attract or generate the capital needed to finance a current account deficit.(Geoff Riley, 2016)

How a debt crisis may happen: Debt to Productivity 10 8 6 4 2 0 Category 1

Category 2

productivity

Category 3

Category 4

long term debt

TWO CASES: INSOLVENCY

which means debt value bigger than assets value

LESS PROBABILE

ILLIQUIDITY

debt value smaller than assets value but illiquid (e.g. it takes a long time to sell a house)

REAL DANGER

WHERE THE ILLIQUIDITY RISK COME FROM: •

FUNDING LIQUIDITY: The Basel Committee of Banking supervision defines funding liquidity as the “ability of banks to meet their liabilities, unwind or settle their positions as they come due” (BIS, 2008)

•

MARKET LIQUIDITY: the capability to sell a collateral in a short period of time, without influence on its price. (Fernandez, 1999)

•

CENTRAL BANK LIQUIDITY: the capacity of the central bank to provide the required level of liquidity into the Financial system (European Central bank, 2009) Least but not last CREDIT(DEBT)

WHY ITALY?

THE ITALIAN LIQUIDITY PROBLEM:

• Level of non performing loans: 360 billion of euro in Italy alone which is 18% OF ALL LOANS IN THE COUNTRY ( J. Micallef, 2017) • Level of segmentation of the industry  high operating costs • Over 500 banks  more complex regulation

• Strongly interconnected Banking Sector  spread of inefficiency systemic banking crisis

Italian Funding liquidity problem: 2016

2017

IMPAIRMENT RATE

STOCKS OF PROVISION

COVERAGE RATIO DEFAULT STOCK

IMPAIRMENT RATE

STOCKS OF PROVISION

COVERAGE RATIO DEFAULT STOCK

ITALY

0,6%

26,054

44,6%

0,4

27,192

43,6%

FRANCE

0,1%

44

46,5%

0,1%

48

40,8%

GERMANY

0,2%

38

35,9%

0,1%

42

34,8%

SPAIN

0,4%

61

30,6

0,3%

70

30,8%

IMPAIRMENT RATE: It is defined as a reduction in the value of a company’s assets (EBA, 2016 stress test results)

HOW LIQUIDITY RISK MIGHT OCCUR IN ITALY: •

Italian GDP is the lowest among the main European Countries

•

Italian government debt to GDP is the highest with 133%

•

Italian impairment rate is the highest with 0,6%

•

Highest unemployment rate with 11,5% Low GDP + High Debt(credit not repayed)= Illiquidity

POTENTIAL CONSEQUENCES: MACROECONOMICS

MICROECONOMICS

• Negative Balance of Trade

• Low price of the assets of defaulting

• Euro depreciation • Low borrowing capacity • European community worst off • Firms are constrained • Freeze of the credit market • Falling market confidence • Bad Equilibria • Collapse of Italian bank system • Higher unemployment rate

Globalization: Financial globalization is defined as the integration of a nation’s local and international financial systems markets and institutions.(Sergio L. Schmukler, 2004).

BENEFITS • More financially integrated world • More stable, and better-regulated financial markets.

• More rapid growth (Levine, 2001)

RISKS • Short run, when countries open.

• Financial crises 97-98 Asian and Russian 99 Brazil 2000 Ecuador 2001 Turkey, Argentina 2002 Uruguay • Capital inflow • Deterioration of market fundamentals • Speculative attacks • International market imperfections, crises and contagion.

• Segmentation ( Those who rely on domestic m. and those able to be global)

For successful globalization: • Economic fundamentals must be strong.

• Local markets need to be properly regulated and supervised.

NEW CHALLENGES FOR POLICY MAKER: • To minimize the risks it implies.

• Less available policy tools for governments.

General prevention methods: INFLATIONARY SOLUTIONS

DEFLATIONARY SOLUTIONS

• Quantitative easing

• Debt cut

• Created a Fund in order to back up insolvent banks

• Redistribution policies • Interest Rate

• Capitalize a reserve to provide failing banks with emergency loans

• Reduction in government spending

Prevention method 1:

To divide Euro in two currencies: •

SOFT EURO ( Southern Countries: Spain, Italy etc)  Devaluation benefits

•

HARD EURO ( Northern Countries)

Prevention method 2, Nash Equilibrium in Macroeconomic: (V. Quadrini, 2011): Since we can not avoid to have credit in the Economy how can we reach the optimal solution?

LOW RISK

HIGH RET HIGH RISK

LOW RISK

LOW RET

HIGH RET

HIGH RISK

LOW RET

HYPOTHESIS: • Two Nations model • Firm managers can use credit to finance, to hire and to pay dividends to shareholders.

• Two countries are financially integrated THESIS:  shadow cost of credit is equalized across countries.

THEORICAL DEMONSTRATION: In case of managers do not respect a credit constraint equilibrium employment is influenced by the shadow cost of credit which is influenced by the tightness of credit limits.

BOTH RESPECT CONSTRAINT

A RESPECT B DOES NOT RESPECT

A DOSE NOT RESPECT B RESPECT

NEITHER A and B RESPECT CONSTRAINT

CONCLUSION: Thus, an ‘exogenous’ shrink of credit limitations influence economic employment and activity in all Nations, regardless of where the original shrink came from. (F. Perri, 2011)Exogenous (co-movement in real activity but not necessarily in financial intermediation)

Tighter/looser credit constraints can emerge endogenously as multiple selffulling equilibria (F. Perri, 2011): GOOD EQUILIBRIA BAD EQUILIBRIA Low price of the assets of defaulting FIRMS

High price of firms’ assets with high debt

Good level of sustainability

A lot of firms can purchase the assets

High borrowing capacity

Firms are unconstrained

Bad Equilibria

No firms can purchase the assets of liquidate firms

Low borrowing capacity

Firms are constrained

THINK LONG, NOT SHORT TERM (Matt Kinh, 2013)

THANK YOU FOR YOUR ATTENTION