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On the turbulences in the money and financial
markets
Governor Erkki Liikanen
Moscow University 10.10.2007
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
1
Northern Rock Plc share price
NORTHERN ROCK PLC
1400
1200
1000
800
600
400
200
0
Jan07
Feb07
Mar07
Apr07
May07
Jun07
Jul07
Aug07
Sep07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Oct07
Nov07
Dec07
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EUR overnight rate
5 Minute QEUROND= [Line]
[Professional]
11.7.2007 - 20.8.2007 (GMT)
Price
QEUROND=, Close(Ask), Line
20.8.2007 6:30:00 4,07
4.7
4.6
4.5
4.4
4.3
4.2
4.1
4
3.9
3.8
17
23
July 07
29
03
09
Aug 07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
15
3
EUR, USD and GBP overnight rates
USD overnight rate
GBP overnight rate
EUR overnight rate
7.0
6
6.5
5.5
6.0
5
5.5
4.5
5.0
4
4.5
3.5
4.0
July-07
August-07
September-07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
3
October-07
4
Price of money with and without collateral on
euro area interbank markets
Euribor 3 kk
Eurepo 3 kk
5,0
4,8
4,6
4,4
4,2
4,0
3,8
3,6
Jan-07
Feb-07 Mar-07
Apr-07 May-07 Jun-07
Jul-07
Aug-07 Sep-07 Oct-07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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10-year risk premium over government bond
return requirement
% points
United States
Euro area
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
1999
2000
2001
2002
2003
2004
2005
2006
2007
Source: Bloomberg
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Price of protection from credit risk
Non-investment -grade (Itraxx)
%-points
5,0
4,0
3,0
2,0
1,0
0,0
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Source: International Index Company
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Yields on 2- and 10-year US benchmark
government bonds
USD 2YEAR
USD 10YEAR
Percent
5.5
5.25
5
4.75
4.5
”Safe haven”
4.25
4
Employment data
3.75
Jan-07
Feb-07 Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Oct-07
Nov-07 Dec-07
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Yields on 2- and 10-year euro
benchmark bonds
EUR 2YEAR
EUR 10YEAR
Percent
4.75
4.5
4.25
4
3.75
3.5
Jan-07
Feb-07 Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Oct-07
Nov-07 Dec-07
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Performance of US banking sector shares
S&P 500
S&P Banks
S&P Inv. Banks
1.12
1.08
1.04
1.00
0.96
0.92
0.88
0.84
0.80
0.76
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
2.7.
2.8.
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
2.9.
2.10.
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Performance of European banking sector
shares
S&P EURO 350
S&P EURO 350 Finan.
Banks (Germany)
1.15
1.12
1.09
1.06
1.03
1.00
0.97
0.94
0.91
0.88
0.85
2.1.
2.2.
2.3.
2.4.
2.5.
2.6.
2.7.
2.8.
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
2.9.
2.10.
11
ECB’s fine-tuning operations in relation to all
open market operations
Fine-tuning operation
Main refinancing operation
Longer-term refinancing operation
EUR m
600 000
500 000
400 000
300 000
200 000
100 000
0
-100 000
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Source: Bank of Finland
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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ECB’s monetary policy operations
Date
9.8.
10.8.
13.8.
14.8.
14.8.
21.8.
23.8.
23.8.
28.8.
4.9.
6.9.
11.9.
11.9.
12.9.
18.9.
25.9.
26.9.
2.10.
Operation (duration)
Fine-tuning (1d)
Fine-tuning (1d)
Fine-tuning (1d)
Fine-tuning (1d)
Main refinancing (1w)
Main refinancing (1w)
Extra longer-term (3m)
Longer-term (3m)
Main refinancing (1w)
Main refinancing (1w)
Fine-tuning (1d)
Fine-tuning (1d) tightening
Main refinancing (1w)
Extra longer-term (3m)
Main refinancing (1w)
Main refinancing (1w)
Longer-term (3m)
Main refinancing (1w)
Volume (€ bn)
Rates
Bids
Accepted
Margin
Average
95
95
4,00 % 4,00 %
110
61
4,05 % 4,08 %
85
48
4,06 % 4,07 %
46
8
4,07 % 4,07 %
427
310
4,08 % 4,10 %
440
275
4,08 % 4,09 %
126
40
4,49 % 4,61 %
120
50
4,56 % 4,62 %
353
210
4,08 % 4,09 %
426
256
4,15 % 4,19 %
91
42
4,06 % 4,13 %
66
60
4,00 % 4,00 %
406
269
4,14 % 4,17 %
139
75
4,35 % 4,52 %
356
155
4,15 % 4,16 %
369
190
4,27 % 4,29 %
85
50
4,50 % 4,63 %
299
163
4,14 % 4,16 %
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Participants
49
62
59
41
344
355
146
168
320
356
46
37
381
140
371
378
159
316
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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.
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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)
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..
Certain structures include arrangements ensuring the
solvency of the SPV, such as guarantees, credit limits etc.
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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
Tranche 1
AAA
Tranche 2
AA
Tranche n
C
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
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What are the core tasks of the Bank of Finland today
in the Eurosystem and in Finland?
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Heading for stable monetary conditions
1865
1999
MARKKA joins silver standard
EURO taken into use
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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The Bank of Finland’s four core functions
Monetary Policy
Financial Supervision
Banking Operations
Cash Supply
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Monetary Policy
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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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 time
increased competition in the labour
and product markets bring
about improvements in productivity
and welfare
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Monetary Policy
Research into Russia and China
The 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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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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
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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The Bank of Finland’s four core functions
Monetary Policy
Financial Supervision
Banking Operations
Cash Supply
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
33
Personnel development at the Bank of Finland
900
847
850
798,5
800
750
764,5
722
698,5
673,5
700
681,5
664,5
632
626,5
650
Bank of Finland & FIN-FSA
600
559,5
543,5
550
524
490
500
Bank of Finland
450
2001
2002
2003
2004
2005
2006
2008
Change in the number of personnel in Dec/2001 – Dec/2008 is 232 persons (-32%)
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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Bank of Finland’s balance sheet
and profit and loss account
Distribution of profits
EUR m
325
300
275
250
225
200
175
150
125
100
75
50
25
0
Voitonjako valtiolle
Vararahastoon
1990
1992
1994
1996
1998
2000
2002
2004
2006
For example: Banking crisis prevented distribution
of profits to the State for many years
SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND
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