Global Markets, Global Risks

Systemic Risk Conference: What Are the Odds of a Financial Collapse?NY Society of Security Analysts and CFA Institute

New York, NY

December 3, 2014

Important Notice

Proprietary and Confidential

This presentation and any information and discussions concerning its contents, are the proprietary information of the Center for Financial Stability (CFS). Disclosure of this information is accompanied by an obligation

that the recipient receive and hold this information in confidence, and not use or disclose it except for the purposes of conducting business with CFS or except with the prior written permission of CFS.

Copyright © 2014 CFS as an unpublished work. All rights reserved.

Lawrence GoodmanPresident - Center for Financial Stability

2

Global Markets, Global Risks

I. The odds of a financial crisis are worth active monitoring.

II. Unintended risks from recent policy measures actual threaten

financial stability and hinder growth.

- Despite ample monetary liquidity, there is a shortage of

financial market liquidity.

- Backdoor currency wars risk sharp market gyrations.

III. Solutions are in sight.

3

Lessons from Parenting for Global Markets:

Behaviors and Consequences

Source: Gail Smith / Gael’s Treasures.

4

Global Risks for Economies and Markets…

Source: Center for Financial Stability.

Growth & Jobs

Consequences

• Currency moves

• Market moves

• Economic growth

GEOPOLITICS

Behaviors

• Government spending

• Monetary ease

• Financial Regulation

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

-2%

0%

2%

4%

6%

8%

Jan

-11

Ma

r-11

Ma

y-1

1

Jul-1

1

Se

p-1

1

No

v-1

1

Jan

-12

Ma

r-12

Ma

y-1

2

Jul-1

2

Se

p-1

2

No

v-1

2

Jan

-13

Ma

r-13

Ma

y-1

3

Jul-1

3

Se

p-1

3

No

v-1

3

Jan

-14

Ma

r-14

Ma

y-1

4

Jul-1

4

Se

p-1

4

Divisia M4 - lhs Growth Threshold (DM4) - lhs Monetary Base - rhs

Emergence from

Liquidity Trap

Stall in Financial System

5

It’s the Financial System that Matters:

Monetary Ease and CFS Divisia Financial Data (y/y)

With thanks to William Barnett, Director of Advances in Monetary and Financial Measurement at the Center for Financial Stability Inc.

Source: Federal Reserve Board, Bankrate, and the Center for Financial Stability.

“There is too little

economic risk-taking,

and too much financial

risk-taking.”

Christine Lagarde

Managing Director, IMF

October 12, 2014

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Jan

-67

Jan

-69

Jan

-71

Jan

-73

Jan

-75

Jan

-77

Jan

-79

Jan

-81

Jan

-83

Jan

-85

Jan

-87

Jan

-89

Jan

-91

Jan

-93

Jan

-95

Jan

-97

Jan

-99

Jan

-01

Jan

-03

Jan

-05

Jan

-07

Jan

-09

Jan

-11

Jan

-13

Re

al O

cto

be

r 2

01

4,

US

D m

illi

on

sRecessions

Linear Trend

Overly steep slide in

"Market Finance"

Excessive growth of

"Market Finance"

6

Plunge in Market Finance (Shadow Banking)

Overshoots

Note: The CFS definition of market finance includes: money market funds, repurchase agreements, and commercial paper.

Source: Federal Reserve Board, Bankrate, and the Center for Financial Stability.

CFS Measure of Market Finance,

Real October 2014, USD millions

1/ Cyclical peak-to-trough in months.

1/ Cyclical peak-to-trough in months.

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

20

09

Q1

20

09

Q2

20

09

Q3

20

09

Q4

20

10

Q1

20

10

Q2

20

10

Q3

20

10

Q4

20

11

Q1

20

11

Q2

20

11

Q3

20

11

Q4

20

12

Q1

20

12

Q2

20

12

Q3

20

12

Q4

20

13

Q1

20

13

Q2

20

13

Q3

20

13

Q4

20

14

Q1

20

14

Q2

Pu

rch

ase

of

Tre

asu

ry D

eb

t, %

of

Tre

asu

ry N

et

Issu

an

ce

Federal Reserve

Private Sector

7

Market Distortions from Quantitative Easing (QE)

Source: Federal Reserve Board and the Center for Financial Stability.

“Demand for U.S.

Debt Is Not Limitless”

The Wall Street Journal

March 28, 2012

http://online.wsj.com/art

icles/SB100014240527

0230445000457727975

4275393064

0

10

20

30

40

50

60

70

Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Pri

ce-t

o-E

arn

ing

s o

r P

rice

-to

-Yie

ld

Va

lua

tio

n

UST Bond Valuation

S&P Price-Earnings Ratio

Average PE = 17

8

Policy Distortions: Risks for Markets

Source: Robert Shiller (Yale University), Bloomberg LP, and Center for Financial Stability.

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Euro Japanese yen US dollar

“We’re in the midst of an international

currency war, a general weakening of

currency. This threatens us because it takes

away our competitiveness.”

Guido Mantega

Brazil's Finance Minister

September 27, 2010

“International

monetary cooperation

has broken down.”

Raghuram Rajan

President

Reserve Bank of India

January 31, 2014

9

Mantega was right…

“Beggar-thy-Neighbor” Currency Depreciation

Source: IMF, Bloomberg LP, and the Center for Financial Stability.

Ove

rva

lue

dU

nd

erv

alu

ed

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Aussie dollar Brazilian real Chinese yuan

Currency War Quote by Guido Mantega

Brazil's Finance Minister

September 27, 2010

10

Slightly Different “Beggar-thy-Neighbor” Picture in

Emerging Markets

Source: IMF, Bloomberg LP, and the Center for Financial Stability.

Ove

rva

lue

dU

nd

erv

alu

ed

11

Concluding Views

Policy behaviors will have consequences – shaping the

future for global markets.

…to reduce risks…

I. Implement measures to partially restore financial market liquidity.

II. Exit smoothly and resolutely from distortionary monetary policies.

III. Embrace international cooperation.

IV. NYSSA / CFA: Systemic Risk Conference!!!!

12

About CFS and Disclosure

The Center for Financial Stability (CFS) is a private, nonprofit institution focusing on global finance

and markets. Its research is nonpartisan.

The CFS is dedicated to the integration of finance, law, and economics. The organization is unique,

as it focuses on market mechanics and linkages while serving as a private sector check on

government actions.

This publication reflects the judgments and recommendations of the author(s). They do not

necessarily represent the views of Members of the Advisory Board or Trustees, whose involvement

in no way should be interpreted as an endorsement of the report by either themselves or the

organizations with which they are affiliated.

The organization’s website is www.CenterforFinancialStability.org.

The Center for Financial Stability is a non-profit 501(c)(3)

organization formed for educational purposes.