Lecture 1:

Why should a manager or entrepreneur study international economic &financial developments?

The main reason is that the uncertainty of your business is determined by the world economy as a
whole.
There are 2 sources of corporate uncertainty:
1. Aggregate
Income tax changes, National elections, Exchange rate fluctuations, Shift in interest rates,
Coronavirus
For all firms aggregate uncertainty is an important determinant of firm performance and survival.
2. Idiosyncratic (related to the firm itself)
Product safety issues, Factory fire, Litigation, Competitor cuts price
For large firms aggregate uncertainty is the dominant form of uncertainty.

Basic macro-economic concepts

Standard supply and demand curve

When there is a supply shock: the line

moves left.
For covid; many factories closed, which
resulted in less supply than there initially
was.
If there is a demand shock: the line moves
left.
When it is not going well with the economy, customers tend to save their money, which causes a
decrease in demand.

Measuring economic activity:

GDP Per Country

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All economic activity (expenditure approach)
Y=C+I+G+X-M
C: Consumption
I: Investment
G: Government
X: Exports
M: Imports
Y: Expenditure

Economic growth: Percentage change in real GDP

Useful to analyse the business cycle.

Prosperity: GDP per capita (per head of the population)

Useful for international welfare comparisons.

Euro Area Real GDP Growth

When something happens to the consumption (when it drops) you will often have a recession.

Economic growth:
Depends on the long run; which depends on: (Decades)
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- Employed population + Skill level
- Invested capital
- Technological progress
Together, these determine productivity capacity
When it depends on the short run; on the state of the business cycle (0-5)
- Too much demand given capacity —> economy ‘overheats’ —> price rises (inflation) (houses)
- Too little demand given capacity —> recession or depression —> prices decline (deflation)
- Recent recession is more complicated (balance sheet recession).

Why is inflation and deflation bad:

High inflation is bad: when you have a inflation rate that is too high it often says that the economy
is growing too fast.
- People loose faith in the value of their money; because it eats away the value of the savings
people have in their bank account.
Deflation is bad:
- People will stop spending; postpone their consumption
- Largest problem is the debt; because when there is deflation the value of the property (when you
buy a house for example) will decrease, but you still have the same mortgage, this means that it
is harder to pay off that debt. This same holds for companies who have a lot of debt.

In international money and finance , we are interested in the connections between financial markets
(money markets, capital markets and currency markets), financial institutions (banks) and the
economy (GDP growth, inflation, unemployment).

1. Money markets
These are always banks
- These trade in short term financial assets (maturity < 1 year, mostly between banks and central
banks).
- Central bank is a dominant player and controls the interest rates in these markets.

Is: Short-term interest rate (at ECB: refinancing rate)

Financial markets often eagerly await interest rate decisions by central banks.

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 When Is is close to zero,
central banks have resorted
to “unconventional” policy
instruments.

Zero lower bound: the interest rate of the central bank can not go down way lower than zero.

The longer the time to maturity the higher the return.

If a maturity is very short, than the interest rate is very low.
The line that shows the relation between the maturity and the interest rate is the yield curve.
If the price of a bond goes up then the yield goes down.
Yield curve shows the yield for bonds and loans at different maturities.
Right now, the yield on bonds and loans is close to 0, because of the interest rate policies. The yield
on longer term bonds and loans is somewhat higher. When the short-term interest rate hit the 0
bound, the government brought down longer term interest rates as well. This is a monetary policy
aimed at reducing the interest rate. This was done by purchasing long term debts, with purchasing
long term debts, the yield goes down.

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What if the policy is slowed down or even abolished? (The situation that the ECB would stop with
assets, so no more purchases of money). This means that the private market will need to buy the
bonds.
1. Then the long term yield goes up again.
2. But it might also be the case that the bank will increase the interest rates. When the short-term
interest rates increase the yield of the bond goes down.
!!If the bond price goes up the yield goes down, if the bond price goes down the yield goes up.

!Long-term bonds are very vulnerable to inflation.

So when the US market thinks that there will be inflation, there will be a steepening of the
yield curve; which indicates a signal of future inflation.
So, a credible financial bank may increase the interest rate for short term bonds, hence keeping the
interest rate long-term government bond low (flattening the line).

2. Capital markets
Stocks and bonds
The return on a long-term investment consists of a few components:
- Real Risk-free return
- Expected inflation
- Risk premium
Share market

If the stock market expects a temporary dip in the real economy such as with covid, then it makes
sense that the share prices are recovering much faster than the real economy.
Bond market

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Il: long term interest rate or long term yield
Il = Real risk free rate + expected inflation + risk premium
Credible monetary policy by central bank will keep expected inflation low
This will be done by the credible fiscal policy that will keep the risk premier low

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Quantitative easing (QE) by central banks has lowered Il.
We can see that a higher rate was demanded by investors for Greece than there were for Germany.
Before the introduction in the euro.
Investors wanted to have a higher bond yield on Greece, because the currency that Greece had
(dragma) was a way less stable currency that devalued over time compared to Germany. This can be
indicated as currency risk (compensation for the currency).
That is why, between 2000 and 2008 that the currency risk was eliminated.
However, after a period of time, even though all these countries had the same currency the bond
yield still fluctuated because of the default risk (the risk that the government could not pay back
their debt) and the exit risk (because Greece wanted to leave the euro).

You see periods of margining spread; of which the most important moment was march 2020.
This all happened in Italy; which already had a large debt.
So what happened; the bond yields increased.
After the statement of Christina Lagarde (CEO of central bank), stated that the ECB is not there to
close spreads. As a result the bond yields spiked even more. As a result, Lagarde had to take back
her statement and a new rule was introduced that the ECB could buy back bonds.

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The eventual risk with that is that countries such as Italy fall in a debt trap:
Debt = public debt
rt = interest cost on public debt
Deficit = primary deficit (excluding interest costs)
Debt t = (1+rt)Debt t-1+Deficit t

You can see the debt trap as a bath tub, in which the debt is the water:
The debt level will be raised;
- When there are high deficit levels
- High interest rates
- Negative growth
This will lead to; explosion of debt ratio and higher interest costs
The only thing to counter this is;
- Growth
For Italy we need to make sure that the bathtub does not over flow.

How monetary policy affects the economy: Transmission mechanism

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Explanation follows

Basic concepts: The exchange rates: Three definitions.

1. S: Bilateral nominal exchange rates
Bilateral: Involving two currencies
S: ‘spot’ rate <—> F: forward rate
This is for immediate delivery.
2. F: Forward rate
Rate agreed on NOW for delivery of foreign currency at a specified future date.
It is an exchange rate that you fix now for a transaction that will be completed in the future.

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It is an instrument to hedge currency risk. Because by setting the currency on a fixed rate, it takes
away the uncertainty.
3. Effective exchange rate
Weighted average of S vis a vis trading partners.
This shows if your currency is weakening or strengthening compared to another currency.
!Watch out, there are two different notations:
3. Per unit of foreign currency: e.g., €0.80 / $
- Domestic currency strengthens (appreciation): S ↓
- Domestic currency strengthens (depreciation) :S↑
4. Per unit of domestic currency: $1.25 / €
- Domestic currency strengthens: S ↑
- Domestic currency weakens (depreciation): S ↓
If in the first case 0.80 increases to 0.90 it means that the euro is weakening, because you need to
pay more eurocents for one dollar, hence indicating a weakening euro.

Real exchange rate: Q

Q: The real exchange rate = S adjusted for movements in domestic (P) and foreign (P*) price levels:
Q = (S P*)/P (when S follows notation 1)

Q: Measure for changes in competitiveness

- If Q decreases: real appreciation = worsening of competitive position
- If Q increases: Real depreciation = improvement of competitive position.
In practice Unit Labor Costs are often used as P.

Suppose that the dollar is weakening (maybe due to inflation), and nothing happens to inflation in
Germany, than the competitive position would not have changed. Because if there is inflation of
10% and the dollar weakened with 10%, then the competitive market is still the same. Therefore,
you need to use the real exchange rate.

When you want to compare the Big Mac price in the USA compared to the euro area.
Q = (S * Pbm$)/(Pbm€)
Bm: Big Mac
S: Spot rate; in this case the S should be the euro per dollar rate. Because you need everything in
euro as the nominator is euro, and therefore the denominator should also be turned into euro.
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If Q = 1, it indicates that the price is exactly the same.
Q < 1 : Then the valuta is more expensive than the other valuta —> competitive position is
worsening
Q > 1: Then the valuta is cheaper than the foreign valuta —> competitive position is increasing

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Competitiveness in Europe pre €

We can see that there is a large gap, especially in the 90’s. But it is highly misleading because it is
the graph is still given in the
local currency. But when you
convert the currency to a
similar currency, then the
graph would be completely
different.
Italy and Spain fixed this
problem by deflating (making
it more cheap) their currency.

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 ! We can learn from this that when labour
costs get out of hand, the problem can be
fixed by deflating the currency. However,
this emergency exit could no longer be
used once all these countries entered the euro.
Competitiveness in Europe post €
“What goes up must come down”

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Competitiveness and the Eurocrisis: the current account
Companies which had a deficit, they were importing more than they were exporting and they were
obtaining more debt; debt driven boom.

Balance of payments: Records all transactions between a country and the rest of the world.
2 types:
1. Current account for commercial transaction
2. Capital account for private capital flows; when a dutch investor invests in a company in Japan.

Compared to the normal balance heet:

- Balance of payments records flows (per year), not stocks at the end of the year.
- The balance of the payments also has to be in equilibrium (=adds up to zero)

Income identity:
Y = C + I + (X - M)
Y: GDP
C: Consumption
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I: Investment (domestic investment, real investment in plants etc.); if a country has a surplus, it
means that is has savings.
X: Exports
M: Imports

Savings:
S=Y-C

Result:
S-I=X-M
Capital account = current account
Poor country: S↓ - I↑ = X↓ - M↑
What the poor country can do is look for official aid at the IMF. Or the company could sell off
some assets (gold reserves), but that is the last option. For Syria for example with its many refugees,
it would be possible for the refugees who are now living in other countries send back money, which
can be spend again in Syria.
Rich country: S↑ - I↓ = X↑ - M↓

!When you export more than you import, you are increase your claim on another country.
Building blocks of exchange rate theory: purchasing power parity theory (PPP)
- Law of one price
- Tells you that the real exchange rate should be 1 everywhere. So you get the same price in the
USA as in Europe for the same product.
Two types:
1. Absolute
- Basket of goods
- According to absolute PPP: Sppp =P/P = 1
- This is the price ratio between the domestic and foreign price level.
- This means that you have a basket of goods, which together have an exchange rate of 1
- Arbitrage drives PPP; buying where the price is low, and selling where the price is high.
- Therefore, PPP might not hold
2. Relative
- (% change in S) = π - π* (π=inflation)

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- * is foreign country
- Q need not be 1, but is constant
- As absolute PPP does not hold, we sometimes tweak it to percentages, after which it does hold.

German hyperinflation: 1920-1923

This graph means that South Africa has a higher % of inflation, compared to the rest. The higher the
inflation the more the currency weakens.
The message of PPP: countries that experience a higher level of inflation over time had
weakening currencies. This also worked the other way around.

The following graph shows the hyperinflation of Venezuela:

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 Why do PPP holds quite well during a
hyperinflation: if the exchange rate would not
move with the hyperinflation, you would get
huge arbitrage opportunities

Covered interest parity: At heart of asset market is role of interest rates in influencing exchange
rates
You start off by examining Covered Interest Parity - relationship between interest rate
differentials and forward premium.

2 versions:
1. Covered interest parity (CIP)
Vertically it shows the conversion into
a foreign currency or your own
currency.

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Starting position is NOW is point 0.
You take your 1 euro, and from the bank you get the 1.02
Or you turn it into dollar which leads to 1.25 dollar and invest that in a US bank against a US
interest rate, and get out 1.2625 dollar. But eventually you want to have it all back to euros, and
with covered interest parity you take out any currency risk (you hedge the currency risk by using
the forward rate); this means that at time 0, you already know the rate at which you will convert the
euro back again. SO BASICALLY ALL THE INFORMATION IS KNOWN AT THE START.
When doing this you get exactly the same Rate of return as when you invest in euro. This is
logical, because otherwise arbitrage would happen every day.
!!CIP only works when there is free capital mobility between borders.

2. Uncovered interest parity

!the same same schedule is used but with one weird change; you no longer hedge the currency risk;
which means that you no linger use the forward rate to close the transaction.
This means that at the end of the period you will convert the dollar back to the euro at the then
available spot rate
- This introduces risk
- This eliminates arbitrage

Se in this case is the expected spot

rate.
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The advantage of taking the log formula is that the differences in interest rate is incorporated.
It tells you that the difference in the interest rate should be compensated for in the spot rate
and the spot rate right now.
If the interest rate of the euro is higher than the interest rate of the dollar:
+1 = 2 (€) - 1($).
Then the euro needs to depreciate, hence it decreases in value.

Lecture 3: Exchange rate management and currency risk

Example:
Initially:
I$ = 1%
I€ = 1%
But what if the euro increases it interest rate to 2%?
Investors will reconsider their portfolio, and the euro will become a more attractive investment
opportunity, therefore all investors will move all their money from dollar to euro —> hence
indicating a stronger €.
However

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(UIP) How does that change: %changeS = I€ - I$
The formula tells you that investors prefer to have the same expected returns on theories. Therefore
it also is the weakness of UIP as this is not always true. Other complications:(1) you can not
observe your interest rate, (2) Tells you that expected returns need to be the same, however in
practice different currencies have different levels of risks —> if you have a higher risk, you might
want a risk premium. As this formula assumes that there is no risk premium, this is not always true.
UIP = Uncovered interest parity
S = exchange rate
This means a weaker euro.
Both arguments are true, therefore we need to combine the arguments.
So what actually happens: when the news comes out, the stock immediately reflects the news, hence
indicating the increase of the value of the euro. However, after the news settles in, the second
situation happens where the euro weakens.

!If the euro strengthens, then the ECB rate will decrease; because then you pay less euro’s for more
dollars.
Because, if the line would increase (when you have S on the vertical axes and time on the
horizontal axes), then it means you would pay more euros for less dollars.
When you have a set share price, and the government determines to increase the risk free rate, as a
result the share price will decrease.
Then the central bank will step in (using the theory of CAPM as explained below), and the line
(indicating the share price) will increase again.
When you look at CAPM: it says that if the risk free rate increases, the expected return will also
increase, however, this is not true.

Example
UIP in the euro zone
%changeS = Igr - Ige
Gr = greece
Ge = germany
Then the formula does not hold, and will be zero —> indicating that UIP does not hold because
then the expected returns should be the same.
Therefore, Igr - Ige is actually a risk premium.

This lecture two perspectives will be discussed:

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3. Governments
4. Businesses

(Freely floating) Exchange rates: Reflects choices by government/central banks on:

- Currency convertibility (when you can easily convert your dollar to Chinese yen, or the other
way around without any restrictions)/capital control
- Choice of exchange rate system
- Means of influencing floating rates or defending fixed rates
Choices have implications for domestic policy.
It can be influenced by capital control
!There are restrictions because of capital flight; which means that the government is not in control
of the currency, so people move their money out of the country and move it to a place more stable.
If a government prevents this there is capital control.

Exchange rate systems:

Ranging from more flexible to very rigid.
5. Free float
- No central bank intervention
6. Managed float
- Some central bank intervention
7. Wide target zones
8. Crawling peg
- Frequent exchange rate adjustments
9. Unilateral fixed exchange rates
10. Fixed rates by multilateral agreement (EMS, BW)
11. Currency board
12. Currency union (EMU)
EMS : European monetary system

Example: Lira/Deutsche mark

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If the exchange rate fluctuates within band with, all is fine.
however, it could be the case that the exchange rate is increasing beyond the band with.
Then 2 things could happen:
13. Both the German- and Turkish central bank could sell lira and buy Deutsche Mark.
14. The interest rate of the lira can increase (short term fix).

The open economy

trilemma: it provides a
framework that
management can use to
think about how the
government thinks.

Why are they relevant:

15. Exchange rate stability; especially for small countries which are very much dependent on
world trade rates, highly volatile exchange rates can be very damaging. However, this point is
not applicable for all countries; e.g. U.S. as this is a very closed country economy, so they have
everything they need within their own country. Therefore, managing change rate stability is not
a priority unless hell breaks loose.
16. Financial integration (free capital flows): Are you going to allows capital mobility between
you and another country? Or are you going to instate capital control? For example, we have
huge savings in the Netherlands (e.g. pension funds), therefore we benefit from investing this
money abroad. However, for a poor developing country there are many risks associated to
foreign capital flows, as this might unstable the economy (introduce instability).
17. Monetary policy autonomy (no loss of sovereignty): This is about the ability of your country
to independently set monetary policy (I.e. interest rates, of the exchange rate). If you have
monetary policy autonomy, it can be valuable, because you can target your monetary policy in

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 your country. This also has
to do with one size fits all,
because the housing market
in the Netherlands needs
cooling down, while the
tourist market in Greece
needs heating up.
This dilemma can be used to talk
about real world choices. See next slide
for example.

Everything in blue as an example.

EMU is on the left because you
compare two different euro countries
from within the countries. While Yen
and euro are on the bottom because
you look at the euro zone as a whole
and compare it to a non-euro country.

The open economy trilemma:

This only works if you have the same interest rate, because otherwise you will get arbitrage;
especially when there is similar exchange rate.

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 This means that they can set separate
exchange rate stability —> no
exchange rate stability.

When you short something: you borrow something from a bank, you sell it, you hope that the value
goes down, you buy it back for less, and hope to sell it back to the bank for less.
It is speculating when you expect a downward movement.

When you have: lira/Deutsche Mark

!when your interest rate goes up, your currency (Lira) is weakened.

Short-term policy instruments to influence (defend) the currency:

18. Central bank intervention in forex markets
- Buying own currency when it is weak
- In spot or forward markets
19. Changing the interest rate
- Increasing the interest rate when own currency rate is weak
- May lead to extremely high short-term interest rate
It typically does not work when:
- Fiscal policy is at odds with fixed currency (Brazil, Russia 1992)
- The currency is perceived to be overvalued (UK, Italy 1992)
Calculation example; in how much the interest rate should be increased to defend the currency
Idm (weekly loan): 8%
Dm: Deutsche Mark
Assume that during the crisis in which there is 1 week in which there is a lot of uncertainty in the
market. In this week it is expected that the exchange rate is 10% (they expect the parity to collapse)
(%changeS = 10%). So how does the government convince investors to keep their money in pound
sterling:
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 Ips (weekly loan)
Ps: Price sterling
UIP: %changeS = Ips - Idm
%changeS = Ips - 8%
!!!you have weekly and annual interest rate, so change everything to annual.
520%changeS = Ips - 8%
(10*52weeks) = 520%
So, the interest rate on Ips = 528%
520%changeS = 528% - 8%
See example from Sweden.

Currency risk management by businesses

The major difference with currency risk is whether you are looking at the future or the past.

FX management by business:
Types of risk
20. Retrospective
- Translation risk
21. Prospective
- Transaction risk
- Economic risk ; example;
You have problems when you need to convert the value of your assets to a certain currency.

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Let’s say you are in Europe, but you have a factory in Venezuela. You can see that the Venezuelan
currency has an extreme high level of inflation. So how do you value this asset? Because valuing at
0 is also not an option. It is no problem in the local currency, because if the factory produces goods
and sells it on the local market, the price of the goods will also be pushed (increased) by the
inflation. So, you won’t have to worry because the weakening of the Bolivar (currency of
Venezuela) is evened out by the price increase of the products.

Relevance of translation risk:

- Uses accounting measures based on book values
- Tells little about firm value
- If PPP holds in the long run, a decline in the book value of a foreign subsidiary following
devaluation will be compensated by higher cash flows in the local currency (inflation)
However, managers like to smooth accounting earnings using:
- Reserves for unrealised translation gains/losses
- Financial instruments (but expensive)

Prospective: economic risk and transaction risk.

2 types;
1. Economic risk
Measuring a firm’s exposure to economic risk requires a longer-term perspective, viewing the firm
as an ongoing concern with operations whose cosy and price competitiveness could be affected by
exchange rate changes.
2. Transaction risk
- Relates to known contractural obligations
- Managing transaction risk:
- Forwards contracts
- Futures contracts
- Options
- Swaps
Similarity: Both involve currency risk relating to future cash flows.
Difference:
- Transaction risk: Relates to one easily identifiable transaction; easy to measure and manage

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- Economic risk: Relates to all future cash flows which determine firm value; difficult to measure
and manage.

How to identify economic risk:

- Where is the company selling?
- Domestic vs foreign sales breakdown
- Wh are the company’s key competitors?
- Domestic vs foreign companies
- How sensitive is demand to price (price elasticity)?
- Where is the company producing?
- Domestic vs foreign production
- Where are the company’s inputs coming from?
- Domestic vs foreign inputs
- How are the company’s inputs or outputs priced?
- Priced in world markets or in the domestic market

Managing exposure to economic risk:

It involves strategic decision making
22. Demand side
- Market selection
- Product and pricing strategy
23. Supply side
- Input mix (purchasing abroad)
- Plant location/product shifting
- Raising productivity

Who is involved?
- Translation risk: Accountant
- Transaction risk: Treasury/finance department
- Economic risk: Strategy department & Finance department

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Lecture 4

Optimal Currency Agency Theory (OCA): Is a geographic region which benefits from having only
one currency.
The benefits of two regions sharing a single currency are increasing in:
- The extent to which they trade
- The similarity of economic shocks they experience
- The degree of labour mobility between regions
- The scope to which cross-regional fiscal transfers are possible

Why do we have the EMU:

- Flexible exchange rates show high volatility; also substantial evidence of prolonged medium
term misalignment
- With capital controls not an option and fixed exchange rate systems vulnerable to speculative
attack a single currency are appears attractive
Aims of emu:
24. End exchange rate volatility
25. Support liberalisation financial markets
26. Increase competitiveness and enhance single market
27. Increase investment and growth
28. Increase political integration.
!Even though many people don’t find the euro a good idea, there is no better alternative at this
moment

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 Main
benefit
from the euro is that it protects the market from falling apart, furthermore, it also reduces exchange
rate uncertainty:
- Empirical evidence suggests that exchange rate uncertainty does adversely affect international
trade.

Macro-economic benefits: Monetary stability?

- Germany had an excellent reputation in controlling inflation. If this credibility is extended to
other participants in EMU then all will benefit from lower interest rates and lower debt
payments.
- This could have substantial benefits for UK, Italian and Spanish growth

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- But if German voice is weak in European central bank then credibility gains could be small and
Germany would lose out and others would not gain.
!! The major problem for the euro: LOSS OF MONETARY AUTONOMY
In a single currency bloc exchange rates can not change and so interest rates must be the same.
Countries must operate under the same monetary policy.
- If country specific shocks occur then it is desirable to have separate national monetary
policy/exchange rate. Particularly if labour and product markets are inflexible. If countries have
similar business cycles then it is not a problem.
Then there is the empirical question: Will one size fits all?
Dependent on:
29.
C

onvergence of their economies (no regional assymetric shocks)

30. Synchronisation of their business cycles
31. Sensitivities to high interest rates
What you see is the introduction of a shock. In the example it is a regional shock. Take COVID for
example (which is a regional shock as some countries are hit harder).
Here it shows the asymmetric shock, because France has a high number of infections while
Germany barely has any.
So due to covid this summer no dutch tourists can go to France and therefore will all go to
Germany.
So how can this problem be fixed, because this is leading to a problem?
If governments would do nothing it would mean that GDP would continue to decrease —> more
unemployment —> profits going down —> businesses going down —> bankruptcy

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The problem in France is that the GDP is down, and that people are becoming unemployed.
So how can we do something about the unemployed in France?
So what is being done; the French government is subsidising the French tourist industry.
There is a list of alternative solutions:
- Move a lot of workers to Germany

ESM: European stability mechanism

So

how to deal with a regional shock:

Adjustment without the exchange rate in the presence of flexible wages and prices.

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This is only if the mechanism works perfectly.
How to deal with regional shocks in the EMU?
- Devaluation of the currency is no longer possible in the EMU.
- In the absence of exchange rate changes then adjustment has to come from:
a. Labour mobility
b. Flexible wages and prices or
c. Redistributive fiscal policy
However, compared to the United States
- Europe has low flexibility of wages and prices
- European labour mobility is extremely low
- The federal budget (EU-budget) is relatively small

The Euro’s honeymoon: History

Before the sovereign debt crisis, EMU was seen as a success story.
- It seemed as a zone of macroeconomic stability
- Extra trade within the union (approximately 20%)
- Low inflation under the guidance of the ECB
- Superficial signs of economic convergence
However, behind the success, built-up structural weaknesses and imbalances.

There was high growth in peripheral countries:

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 - D
e
f
i
c
i
t

is financed thought North-South capital flows

- But there are “bad” and “good” capital flows

So Summing up:
South reaped benefits of low real interest rates..
However, it failed to implement structural (micro-economic) reforms
- Northern financial institutions invested in housing bubbles and government consumption
- However, they failed to assess risk and invest in productive investment opportunities

Then we have the legacy of the honeymoon:

It has huge macro-economic imbalances & divergences.
Then it increased their financial interconnectedness.
In the end the Eurozone financial system was held hostage by the likes of Greece and Italy.
Combined failure of financial intermediation, financial supervision and government policies.

The Euro criris:

Five interconnected crises:
32. Bond crisis
33. Solvency crisis
34. Competitiveness crisis
35. Governance crisis
36. Banking crisis

Bond crisis:
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 Where the eurocrises became most visible was in the
bond markets, therefore it is called the bond market
crises.

The red line are countries which had trouble with their
creditworthiness.

High interest rates are not sustainable with inflation

below 3% and economic growth <0%.

Bond crisis and government policy:

- Solvency concerns in peripheral countries.
- There was a huge policy shift in treatment of bank holdings of public debt: from preferential
treatment to private sector involvement.
Preferential treatment: Zero risk weighting’s —> large exposures allowed —> no
differential treatment of ECB collateral.
!Banks pile up public debt.

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Fundamental uncertainty in bond markets:
Point 1: risky debt in a foreign currency is correct.

Bond crisis: Solvency issues

!!With sovereign defaults, it is always about willingness to pay instead of ability to pay.
Debt structuring:
- Who pays the price?
- What is the least damaging way of restructuring, taking into account
- Contagion
- Incentives for reform

Competitiveness during the crisis period:

This often happened in wages, however what goes up must come down again.
This meant, internal devaluation (wage reduction) vs external devaluation (exiting the euro
area).
- It also showed the importance of structural reforms

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 - Important notice;
reforms take time,
while financial
markets are
impatient.

This graph shows the

slow response of the
response of the government.

Governance crisis:
!!Pace of democratic decision making differs from pace in financial markets.
- There are many players involved —> crisis resolution is hostage to small players.
In the Eurozone there is a lack of:
37. Adequate mechanism for enforcing fiscal discipline.
38. Effective banking supervision.
39. Institution that can act as a lender of last resort.

Lecture 5: Banking crisis an banking integration

If bonds are bought, the price goes up and the yield goes down.
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This is an inverse relationship; when bond prices go up, yield goes down, when bond prices go
down the yield goes up.

Quantitative easing: Quantitative easing (QE) is a form of unconventional monetary policy in which
a central bank purchases longer-term securities from the open market in order to increase the money
supply and encourage lending and investment. Buying these securities adds new money to the econ-
omy, and also serves to lower interest rates by bidding up fixed-income securities. It also expands
the central bank's balance sheet.
Two problems with quantitative easing:
40. Banks their interest margin decreases
41. There is a government dependency on cheap funding
Due to corona, it would be a major problem if the interest rate would increase, as this increases the
costs of obtaining debt, that results in a problem for governments who rely on cheap funding.
So why didn’t the ECB just let Greece get bankrupt when they were in a major financial crisis?
Because all debt was all over the financial systems (which all had huge amounts of debt), if you
then would have let the country go bankrupt, this would be a domino effect for all companies in the
financial systems (banks, insurance companies etc.). And as these financial systems play a major
part in the economy, it means that if the ECB does not step in, that it would have cost major
damage.

Topics for today:

42. Bank business models
43. Pre-crisis approach
44. Issues during crisis
- Sovereign - Bank Nexus
- Financial fragmentation
45. Towards banking union

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Before starting on the first subject we need to recognise that banking is big across the world.
Financial intermediation can be done in several ways:
- In Europe we rely on the fact that banks do this
- Therefore, europeans have a lot of savings in the bank.
- When looking at the graph it can be seen that europeans have a lot of privacy credit which is
deposited by banks.
- When comparing this to the US, you can see that this plays a more smaller role, and that they
have a lot of ways; a lot of money is transferred through the market, whereas in Europe, it is
mostly transferred through the banks.
- !!when there is a problem with the banks in Europe, you always immediately have a problem in
the entire market.

Subject 1: Business models in banking:

46. Relationship-oriented model (ROM)

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 Old fashioned bank; most money
comes from savings.

Relationship banking is financial intermediation that invests in obtaining proprietary information

about its clients, evaluating the profitability of its investments by engaging into multiple
transactions with one client, either across product ranges, or over time.

When timeas are good, this is a highly attractive business model.

Also known as the 3-6-3 business model.
You pay 3% on your deposits
You get 6% on your loans (interest rate margin)
And you’ll be at the golfcourse at 3 pm.

One drawback of this model:

- If you want to grow very quickly and if you want to have extra funding, this is not possible
because the deficit money is not changing very rapidly. Because the deficit is not growing, so it
takes a lot of time before you have a larger amount of money that you can invest.
- Very nice and earns you a nice interest margin, but growth is slow. Because it is very difficult to
double the size of your balance sheet very quickly. If you want to do that you probably need to
have to merge with another company.

ROM expansion is easier in domestic markets

- Cost saving - Market power - Trust & proximity & asymmetric information

47. Transactions-oriented model (TOM)

Therefore, the switch was made to the TOM model.

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 This focuses on
independent, often
impersonal
transactions, whereby
financial services are
commoditised and
marketed.

This can either be short-term or long-term funding, and is often issued in the market. Next it can be
issued in securities.

What was done in the US in the time of the crisis: a lot of mortgages were bound together in 1 bond,
and sold on the financial market; better known as asset-

The difference between selling it as a bond and registering it as a single entity; the bond can have
diversification, hence eliminating the risk and selling it as a risk free asset even though it has a high
level of risk.

In good times TOM allows for fast growth (because you can raise a lot of money in the bond market
and invest this money in risky assets for example):
- But there is higher risk
- During crisis: market liquidity & funding liquidity issues.
They want to keep the equity very low so they could gamble with money on the market —> every
euro you make has a very high return on equity.
—> Leveraging up, if it went good all was well, if it went bad they hoped the banks would step in.

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!Often in real life there is a combination of the two systems.
General issues in banking:
- There is too much leverage and too little equity —> Flawed RWA (risk-weighted assets)
approach (e.g., zero risk weightings for sovereign debt).

However after the banking crisis this system of high leveraging changed.
In the US right before the crisis, people who wanted to buy a House leveraged themselves, because
they obtained multiple mortgages, and furthermore it was very easy to leverage money to buy a
house.
—> when the housing prices decreased in the US, people were not able to pay back their mortgages,
so they gave the house back to the bank and told the bank that they were not going to pay back their
mortgage anymore.
However, this not only resulted in the decrease of housing prices, but it also lowered all securities.
Banks were unable to fund themselves in the money market, hence indicating that banks were a bad
investment from that moment on.

Pre-crisis approach:
Aim: Single market in financial services:
Approach:
- Home control with minimal harmonisation of national regulation
- Common passport (2nd banking directive 1989)
- Comitology (culminating in lamfalussy process)
- Slow harmonisation ( CRDs)
Key elements:
- Home country control on solvent
- Distinction branch - Subsidiary determines DGS

Problem with home control with minimal harmonisation of national regulation.

In the beginning you had Fortis, which was a conglomerate between a dutch and a Belgian bank. It
consisted between ABN-AMRO and a Belgian firm. When there were problems, the bank wanted to
split. However, at that time, there was no European supervisor that could lead this split and that
considered European interests. Instead, it immediately became a national crisis; as every country
was represented separately.

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Credit crisis hits EU banking sector:
- There was evaporation of the market & funding of the liquidity:
- ECB steps in, effectively taking over the function of the money market
- There was a slow recognition & resolution of bad assets
- This slow recognition is because they were not really pushed by regulators.

Euro are had specific problems:

48. Sovereign - Banking Nexus
Banks and governments are linked in 2 ways
If you have an Italian bank you will have government bonds (national government bonds), this
means that there always is a domestic bias in the portfolio of a bank.
So why should be so heavily be exposed to Italian government bonds:
- Governments have close connections with banks and pushes the banks to invest in their own
bonds. —> easy funding.
- This system is highly active in the Euro area —> if these holdings are very large, and larger than
the equity buffer. This means that if the Italian government would go bankrupt, the Italian banks
will go bankrupt as well; hence creating a spillover effect.
- In this way the fate of the banks is connected with the fate of the government.
In the second situation, if the problem would arise in the bank, then the situation arises where the
government will come to rescue.

Sovereign risk in bank portfolios

Even at the beginning of the euro, the banks still had
more money invested in local government debts than
there was available in the bank. Hence, indicating
that the government and the bank were still linked
—> if either one falls, they both fall.

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 Sovereign - Bank
nexus

When the banking risk

and the sovereign risk
are close, it means that
these banks hold a lot
of government debt,
hence indicating and
supporting the
relationship between
the bank and the
government.

CDS can be seen as a default risk premium. The higher the CDS line the higher the default risk,
hence the higher the premium.

49. Financial fragmentation

What happened during the crisis; financial institutions withdrew their money from foreign markets.
Banks tried to sell their Italian, French etc debt, because it became too risky. This resulted in money
being tight —> interest rates diversed (also known als financial fragmentation).
- Money markets dried up in 2007
- Private capital flows repatriated from GIIPS countries
- Flight to quality of deposits
- !Breakdown of bank lending channel of monetary transmission
- Regulatory nationalism, fend-for-yourself approaches to insulate own banks.
- German supervisor BaFin ordered Italian bank Unicredit to stop borrowing for German
subsidiary.
- Euroshstem fills the gap (TARGET exposures)

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!See slide on financial fragmentation
- In the past; financial integration may have gone too far
- There was too much interconnectedness, especially via the banking system, exacerbating boom-
bust cycles
- Ring-fencing may be inefficient, but possibly more stable

The type of capital flow is important:

If financial integration returns, better through:
- Markets
- Foreign direct investments

Banking union:
! Prevents negative feedback loop between sovereign & banks
- Prevents fragmentation of single financial market along national boundaries and thus preserve
single market
- Break regulatory capture and regulatory forbearance
- Level-playing field; this has to do with the fact that a dutch regulator would impose other rules
than regulations that an Italian one, hence imposing competitive advantages.
- Stop inter-agency conflict between supervisors.

What would a banking union imply;

Aim was to:
50. Create a single rulebook (EBA). This set the rules for the European Union.
51. All are part of a single supervisory mechanism (SSM, ECB). The ECB is in charge in which the
largest banks are directly supervised by the ECB itself, while smaller companies are managed
by a sub-division.
52. A single European bank resolution mechanism (ERM). Then the ECB will take a look at the
bank, how they can get the bank back to a financially healthy situation.
53. A single deposit guarantee scheme; it means that if the bank goes bankrupt you will still get a
certain amount back of the money.
The deposit guarantee in the Netherlands are backed by all the other banks in the
Netherlands. This might form a problem when one of the largest banks fails, because the losses
might be so high that the other banks fall too (domino effect).

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Crypto currencies: are they really money?

Role of money:
54. Unit of account; easy to use as a denominator; can be used as a thing to value something in

numbers.
55. Medium of exchange
56. Store of value
Currently central banks are looking to develop their own digital currency. This means that this
currency is guaranteed by the central bank. This would function as an alternative for coins.
However, this would have major implications for normal banks as they would need to find other
fundings.

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Lecture 8; wrap-up
This course is about the relationship between the real world and the financial world.

2 forces driving the exchange rate:

57. Current account
About uses and funding
The driver is the real exchange rate, which is influenced by the competitiveness.
Has to do with Purchasing power parity
58. Capital financial account
There should be a good investment climate withe expected economic growth.
It has to do with uncovered interest parity, covered interest parity.
There is capital mobility, capital substitutability, risk premier

Absolute PPP, Q should be 1.

Q = (S€/$*P$)/P€
For relative PPP, Q does not need to be 1, but it need to be constant
Q=%S
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How to manage the exchange rate:
By Government:
- The economy trilemma
- Exchange rate systems, from freely floating to monetary union
- Intervention and interest rate policy to defend the currency

Example, when you look at euro per dollar (€/$)

The interest rate weakens over the long term; because for example, when the interest rate of the
euro increases S decreases because you pay more euro per dollar. Then if you look at UIP, S
decreases even further because the change in interest rate is positive.

Euro crisis:

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