CMM 0911

Capital Markets Monitor
September 2011
CONFIDENTIAL
Highlights
Mensis Horribilis! The month of August witnessed many extreme events, including
wild gyrations in equity markets almost on a daily basis as well as a strong earthquake and hurricaneboth within the space of a week affecting the northeastern seaboard of the U.S. Despite some signs of stability by the end of the month, the global economy and financial markets must still navigate through a challenging phase of acute uncertainty, at times approaching disorientation on the part of investors.
Capital Markets Monitor and other IIF publications are available on the Institutes website: http://www.iif.com Questions or comments regarding this publication may be addressed to: Hung Tran
+1.202.682.7449 htran@iif.com
Sonja Gibbs
+1.202.857.3325 sgibbs@iif.com
In a pattern echoing that of the 2007-09 financial crisis, there is a

growing risk of the real economy and financial conditions being locked into a mutually-reinforcing downward spiral. This concern is reflected in the recent downturn in equity markets. Particularly worrisome is the fact that the challenges ahead seem intractable, driven by the interaction between slowing growth in the mature economies after an already-lackluster recovery and sovereign debt levels which are seen as unsustainable in several European countriesand the impact of both on the health of banks.
Elif Aksoy Julien Mazzacurati
+1.202.857.3647 zaksoy@iif.com +1.202.857.3308 jmazzacurati@iif.com
Fiona Nguyen
+1.202.682.7443 fnguyen@iif.com
Contents
Key issues of the month.......................................................................2 Special Feature I: European Bank Funding Strains ..............................6 Special Feature II: Based Capital and Leverage Ratios for Banks .......9 Special Feature III: Deleveraging........................................................10 Special Feature IV: The Fed and ECB Balance Sheets ......................11 Asset performance in perspective......................................................12 European sovereign debt markets .....................................................13 Bank health monitor ...........................................................................15 Bank health monitor II: Focus on Europe ...........................................16 BIS banking statistics.........................................................................17 FDIC Quarterly Banking Profile Q2 2011 ............................................18 Credit markets....................................................................................20 Hedge Fund Performance ..................................................................21 Emerging markets ..............................................................................22 BRIC Monitor I....................................................................................23 BRIC Monitor II: Focus on nonperforming loans ................................24 Equity markets ...................................................................................25 Currency trends..................................................................................26 Commodities ......................................................................................27 Volatility ..............................................................................................28 Mutual fund flows ..............................................................................29 Issuance and flows............................................................................30 Glossary .............................................................................................32
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Copyright 2011. The Institute of International Finance, Inc. All rights reserved. The contents of this report may be neither reproduced nor distributed in whole or in part outside the membership without the prior written approval of the Institute of International Finance, Inc.
Capital Markets Monitor September 2011 2
Key Issues of the Month: Mensis Horribilis!

The month of August witnessed many extreme events, including wild gyrations in equity markets almost on a daily basis as well as a strong earthquake and hurricaneboth within the space of a weekaffecting the northeastern seaboard of the U.S. Despite some signs of stability by the end of the month, the global economy and financial markets must still navigate through a challenging phase of acute uncertainty, at times approaching disorientation on the part of investors. In a pattern echoing that of the 2007-09 financial crisis, there is a growing risk of the real economy and financial conditions being locked into a mutually-reinforcing downward spiral. This concern is reflected in the recent downturn in equity markets (Chart 1). Particularly worrisome is the fact that the challenges ahead seem intractable, driven by the interaction between slowing growth in the mature economies after an already-lackluster recovery and sovereign debt levels which are seen as unsustainable in several European countriesand the impact of both on the health of banks. No growth is sustainable if every sector is deleveraging simultaneously... Recent U.S. GDP benchmark revisions show that the 200809 recession was deeper, and the recovery from the trough has been shallower, than previously reported. On top of that, recent data have portrayed a slowing of activity, leading to a downward revision of our GDP growth forecasts for mature markets to 1.5% and 2.2% for this year and 2012 respectively (from 1.8% and 2.6% previously). Similarly, growth in the Euro Area has also slowed; the ECB has estimated that GDP growth may be just 1.9% in 2011, cooling to 1.7% in 2012. No wonder consumer confidence dropped in August to multi-year lows in both the U.S. and Europe. Behind this poor growth performance is the broad phenomenon of de-leveraging by the private sector (including the household, financial and to a lesser extent, corporate sectors) during and after the financial crisis (Chart 2). Until the end of 2009, private sector crisis-related losses and subsequent deleveraging had been compensated by significant fiscal measures to stabilize financial systems and support growth. However, these measures have boosted sovereign debt to levels seen by markets as unsustainable (as in several Euro Area countries) or worrisome (as reflected in the U.S. sovereign downgrade by S&P). In the past year, there has been fiscal consolidation in Europe and going forward, in the U.S. as well. As a consequence, with both the private and public sectors de-leveraging at the same time, it is very difficult to see how growth can be sustained, especially a level sufficient to reduce currently high unemployment. Across mature markets, the inconsistency between the goals and thrusts of fiscal/monetary policies (stimulative) and regulatory policy (cautionary) has contributed to the pressure on financial institutions to deleverage (Chart 3). While broadly welcome, regulatory reform has added burdens on financial
U.S. Financial Conditions and Equity Performance Bloomberg Financial Conditions Index, Z-scores 4 1600 1500 2 1400 0 1300 1200 -2 1100 -4 1000 900 -6 800 Financial conditions index -8 700 S&P 500 (rhs) -10 600 00 01 02 03 04 05 06 07 08 09 10 11
Source: Bloomberg, IIF calculations
U.S. Domestic Debt Outstanding percent of GDP 130 120 110 100 90 80 70 60 2000 2002 2004 2006 2008 2010
Ho useho lds B usinesses Financial Secto r To tal do mestic debt (rhs)
380 360 340 320 300 280 260 240 220
Source: Flow of Funds, Datastream
G4 Financial Sector Debt Outstanding percent of GDP U.K. 180 U.S. Euro Area 160 Japan (rhs) 140 120 100 80 60 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
180 175 170 165 160 155 150 145 140
Source: Federal Reserve Flow of Funds, BoE, ECB, BoJ, IIF calculations
Key Issues of the Month, continued

firms, especially with additional requirements such as surcharges on large institutions and with the way some regulators and markets have pushed for an accelerated implementation of the Basel 3 framework despite the announced timetable. What is unnerving for investors is the fact that, confronted with such dismal prospects, policymakers have little ammunition left in their arsenalbeing under pressure to cut budget deficits and debt at a time when growth is slowing and policy rates have been near zero for an already long period (Chart 4). This does not mean that nothing can be done, but policymakers face very demanding challenges. They must develop a wellcoordinated and correctly sequenced series of fiscal and monetary measures, designed to address both medium-term fiscal sustainability and near-term growth concerns. Whats more, those measures have to command domestic political support to be credible. The jury is still out on whether policymakers can rise to the occasion to deliver what is needed to stabilize the global economy and financial system. making it very difficult to reduce debt/GDP levels Slow growth and high sovereign debt is a lethal mixture. Under the current circumstances, the more a country cuts its budget deficit, the more it could dampen activity. Such an exercise may therefore result in an increase in the debt/GDP ratio, instead of reducing it. This line of reasoning has helped spread market concerns about sovereign debt from the Euro Area program countries (Greece, Ireland and Portugal) to Italy and Spain and possibly others. CDS spreads on sovereign debt have widened substantially, not only for the countries mentioned but also for France and, to a much lesser extent, the U.S. (Chart 5). Even Germany has seen its spread widening beyond that of the downgraded U.S. as investors are concerned that additional fiscal support to a growing list of problem countries could eventually compromise even Germanys creditworthiness. Implementation risk for the second Greek package Against this troubled backdrop for sovereign debt, the demand for collateral by several Euro Area (EA) countries have greatly complicated the parliamentary approval process for the July 21 deal and increased its implementation risk. The collateral discussion has moved from Finlands demand for cash to collateralize its 790 million contribution to a variety of noncash collateral available to all EA members. The latest idea involves Greece giving EA member countries, as collateral, shares in Greek banks that have been re-capitalized by the state (with European assistance). No matter how this issue is resolved, it has demonstrated the extent to which popular resistance to further financial assistance to program countries has grown in several EA countries. Therefore, while parliamentary approval of the July 21 package is likely, the process is probably not going to be smooth and trouble-free. Moreover, the chances for EA
Matu re Econ omies Govern ment Debt & Policy Rates % of GDP percent 125 5 Gross government debt 115 105 95 85 75 65 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Source: IMF WEO (G7 gross debt to GDP), national central banks, Bloomberg, Datastream, IIF calculations
Policy rates (rhs )
4 3 2 1 0
Selected Sovereign CDS Spreads 5-year CDS spreads bp s 180 U.S. France 160 Germany Italy (rhs) 140 120 100 80 60 40 20 Jan-10 Jul-10 Jan-11 Jul-11
450 400 350 300 250 200 150 100 50 0
Source: Bloomberg
Euro Area and Greece: Equity Performance index, rebased 1/1//2010 = 100 Euro area 120 Greece 110 Greek banks 100 90 80 70 60 50 40 30 20 Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
Source: Bloomberg

countries promptly coming to the rescue of another fellow member in distress are seen as visibly reduced. Economies and financial systems operating without a sovereign safety net The perceived stress on sovereign balance sheets of many mature countries highlights the key vulnerability at present. Slowing growth and deterioration in the credit worthiness of European government bonds have impacted negatively banks profitability and the strength of their balance sheets (Chart 7). The problem is less with the numerator of the capital ratio since 2008 European banks have raised a total of $414 billion of equity capital, compared with $314 billion by U.S. banks (Chart 8). The concern is more with the denominatorexposure to sovereign debt. The problem is quite important for European banks as they hold a much larger amount of government bonds (of European countries including their own) for the 90 stresstested banks, government bond holdings amount to roughly 3.0 trillion or nearly 8% of total assets. By comparison, U.S. banks hold only about $163 billion of U.S. Treasury securities (1.2% of total assets), and a further $265 billion in foreign debt securities (2% of total assets), only some of which are sovereign obligations. This significant exposure to government bonds has hurt European banks in two ways. First, substantial declines in the market price of some government bonds will eventually lead banks to take impairment. This is what they did for their holding of Greek government bonds in their financial reports for the second quarterhowever, the inconsistent way different banks accounted for impairment has given rise to questions. The concern of investors is that for some European banks, their exposures to other problem countries are much larger than to Greece, therefore the scale of any potential impairment is much bigger. Second, while most European banks have passed the EBA stress test, the regulatory capital ratios are premised on zero risk weights for EU government bonds. If the market perception is that some government bonds carry credit risk above zero, the volume of risk-weighted assets will increase and capital ratios may look less solid than reported. These concerns have led to substantial declines in the prices of developed market bank stocks, both in absolute terms (-35% from this years peaks) and relative terms (over 13% underperformance relative to the broad marketChart 9). While the price-to-book ratio of many European and U.S. banks have been trading below 1 following the financial crisis, in recent weeks, for some institutions this ratio has fallen to below 0.5, reflecting serious market concerns about their solvencyregardless of reported regulatory capital ratios. In the 2008-09 financial crisis, a price-to-book ratio below 0.5 signified severe stress on an institution. As was the case in the financial crisis, such concerns have manifested through stress in the funding market especially for
European Bank Stocks and GIIPS Sovereign Risk index bps 105 0 GIIPS sovereign CDS spreads 100 (red line, rhs, inverted) 200 95 400 90 600 85 80 800 75 Performance of European 1000 banks relative to the 70 1200 overall market (blue) 65 60 Sep-09 Mar-10 Sep-10 Mar-11 1400 Sep-11
Source: Morgan Stanley, Bloomberg, IIF calculations.
U.S. and European Banks: Equity Capital Raised USD billions 110 100 Europe 90 80 US 70 60 50 40 30 20 10 0 05 06 07 08 09 10 11
Source: Thomson Reuters, Bloomberg, IIF calculations
Developed Mkt. Equities: Financials vs. Broad Market index, rebased 1/1/2010 = 100 120 115 110 105 100 95 90 85 80 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Financials Broad Market
Source: MSCI, Bloomberg

the problem banks. However, it is important to take note of the differences. In general, banks in the U.S. and Europe have been profitable in the past two years, have raised substantial amounts of equity capital as well as debt. In fact, European banks have raised $544 billion of debt so far this year (Chart 10)some institutions have covered 90% of their 2011 funding need. Given these rather positive developments, it is quite striking that many banks experienced substantial equity sell-offs and their CDS spreads widened significantly in Augustbefore recovering somewhat by month end. Concerns about potential losses for bank creditors... One possible explanation for the severe market reactions is that creditors of banks have been so sensitized to the potential of being vulnerable to losses that their reaction functions have been much shortened. Contributing to this observed change in market behavior could be the debate about imposing losses on bank creditors under reformed resolution regimes as well as other regulatory changes requiring creditors to be more prudent. ...have generated funding pressures for banks In particular, U.S. money market funds have been required to reduce the average maturity and improve the quality of their holdings. As a consequence, they have been quick to reduce exposure to short-term liability of any financial institutions perceived to be in trouble. Specifically, they have withdrawn funding from many European banks by about $70 billion during June and July. Withdrawals have been particularly marked for Italian and Spanish banks, where U.S. money market funds exposures have been cut to virtually nil (Chart 11). This has compounded the stress in the interbank markets. The traditional indicator of stressthe Euribor-OIS spreadhas widened visibly in recent weeks (see Chart 3, page 6). Both deposit and borrowing with the ECB have risen. In addition, the Euro-USD basis swap has widened significantly, reflecting the stress experienced by many European banks borrowing in Euro to swap into USD (Chart 12). As such, the Feds currency swap line to the ECBreactivated last May to run until August 1, 2012may come in handy to meet European banks need for USD funding. Conclusions Given the difficult challenges outlined above, it is important that the inconsistency between fiscal/monetary policies and regulatory policy be rectified. A more complementary approach would help stimulate a prudent re-leveraging by the financial sector. This in turn would restore the efficacy of the monetary transmission mechanism so that easing actions by key central banks could gain more traction in supporting growth. After allgrowth is the key ingredient in addressing both the sovereign debt and banking problems.
U.S. an d European Bank Debt Issuance USD billions 600 500 400 300 200 100 0 '05 '06 '07 '08 '09 '10 '11
10
Europe U.S.
11
U.S. MMF Exposure* to Eu ropean Ban ks p ercent, change between 05/30 and 07/30 0 -20 -40 -60 -80 -100 UK France Germany Italy and Spain European Av erage -20.4%
* on USD basis. Source: Fitch Ratings
12
One-year Cross-currency Basis Swaps* bps -10 -40 -70 -100 -130 EUR** GBP***
-160 Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11

* Swap rat e ref lect s the premium/discount paid on non-U.S. dollar interest rate. ** 6m Euribor/ 3m USD Libor. *** 3m GBP Libor/3m USD Libor.
Source: Bloomberg
Special Feature I: European Bank Funding Strains

Concerns about sovereign risk and asset valuation are reflected in growing funding strains
The growing stress on mature market sovereign balance sheets is a serious risk for banks with significant exposure to sovereign debt. Investors concerns have been reflected in the market valuation of banksparticularly for European banks, which in aggregate hold some 3 trillion (nearly 8% of their total assets) of European sovereign debt. As debate over the appropriate valuation of these assets continues (see Special Feature II, page 9), bank creditors have become more reluctant to lend to European banks perceived to be at risk. This has created funding strains for some European banks, especially smaller or regional banks based in highly-indebted countries. Euro Area banks have been hardest hit by concerns about creditworthiness, but U.K. and Swiss banks have also been affected (Chart 1). The 20% drop in European bank share prices in August thus reflects not only unease about asset valuation and banks future earnings potential, but also the risk of a freeze in European funding markets. A range of other market indicators, including the traditional Libor-OIS spread and cross-currency basis swaps, also point to rising funding strains. The ECB continues to provide a cushion for short-term funding needs, both in euro and U.S. dollars (Chart 2). However, if these market strains persist, meeting funding needs will become increasingly challengingas of end-2010, the 90 stress-test banks reported 4.8 trillion of wholesale and interbank funding expiring this year and nextover 12% of their total liabilities and shareholders equity. Increased Reliance on the European Central Bank For many banks, especially smaller and regional ones, the ECB is now the last remaining source of liquidity. Under its open market operationsused during the crisis to pump liquidity into the regions banksmember central banks provide unlimited repo capacity for certain eligible assets (generally BBB- and above with some exceptions). Demand for this source of funding has picked up sharply as private credit lines dried up. For instance, Italian banks borrowed 81 billion in August, nearly doubling their ECB borrowing compared with that of July. Spanish and Greek banks have also increased their borrowing from the ECB (Chart 2). Total use of the ECBs main refinancing and long-term refinancing facilitiesboth part of their open market operationsis now around 500 billion, up from around 400 billion last spring. Although this is significantly below the almost 900 billion used in 2009, the uptick is worrisome. Further, European banks borrowed from the ECBs emergency lending facility with peaks up to 4 billion on August 10, although the ECB charges a punitive interest rate of 2.25% as opposed to 1.5% for regular ECB borrowing. It is also worrisome that bank deposits at the ECB recently hit 145 billion (the highest level in six months); this suggests banks prefer the safety of the ECB instead of lending in the interbank market (Chart 3).
European Bank CDS Spreads basis points, 5-year CDS 300 250 200 150 100 50 0 2006 2007 2008 2009 2010 2011 Euro Area U.K. Switzerland
Source: Markit, Bloomberg
ECB Funding to Greece, Ireland, Portugal and Spain EUR billions 140 Greece Ireland 120 Portugal 100 Spain 80 60 40 20 0 2008 2009 2010 2011
Source: ECB, National Central Banks
ECB Deposit F acility Usage EUR billions 400 350 300 250 200 150 100 50 0 Jan-08 Sep-08 May -09 Jan-10 Sep-10 May-11
Source: Bloomberg

Both short and long-term borrowing costs have been rising
Interbank Lending Strains Interbank lending indicators now reflect stress at levels not seen since the post-Lehman peak in March 2009. Although still well below 2008 levels, the 3-month Euribor-OIS spread spiked to 72 bps in late August. This spread widening reflects rising concerns about counterparty risk (notably for Italian and Spanish banks); although the OIS rate has plunged by some 30-40bp over the past several weeks as the market moved to price in a shift to an easier ECB monetary policy stance, the Euribor rate has not followed suit (Chart 4). Efforts to build deposits Funding pressures on European banks are also reflected in the higher interest rates that many banks are now offering on deposits. This has had the beneficial effect in many cases of reducing reliance on official support; however, the cost of luring funds from wary savers cuts into margins and profitability. Euro Area banks have gradually increased their deposit-to-liabilities ratio since the financial crisis; currently around 33% of their funding is financed by deposits, up from 30% in early 2008 (Chart 5). Nevertheless, they remain reliant on wholesale funding. Bond market funding The cost of insuring European bank debt against default has risen beyond previous recordsnearly 450bp for senior debt and 250bp for subordinated debt, while bank cash bond spreads have risen over 100bp in recent weeks. Banks did take advantage of favorable market conditions earlier this year, issuing nearly 545 billion in bonds year-to-datethus meeting nearly all of their estimated 560 billion of medium-to-long refinancing needs for 2011 (Chart 6). However, in anticipation of potential future funding pressures, the EBA recently proposed a new guarantee scheme for bank bonds (though the proposal is controversial, requiring new powers for the European Financial Stability Facility). Covered bondsconsidered ultra-safe by investors may also offer an alternative to European banks for medium-to longterm financing. After a strong start in January, covered bond issuance had slowed sharply over the course of the year. However, during the last week of August a bank sold 1.75 billion in 10-year covered bonds at a premium of only 15bp over the yield on its existing bonds. U.S. dollar funding pressures Dollar funding pressure for European banks has also risen, as reflected in the dollar-euro basis swap spread (see Chart 12, page 5). Market participants point to reduced access to U.S. commercial paper and deposit funding for European banks as the main drivers of wider basis spreads. The outstanding level of U.S. commercial paper issued by foreign banks and financial
Term Interbank Market 3-month Libor/Euribor less overnight index swaps, bps 120 100 80 60 40 20 0 Jan-09
Source: Bloomberg
Euro Area U.S.
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
F unding Structu re of Eu ro A rea Ban ks % of total liabilities 50 45 40 35 30 25 1998 Wholesale Funding Dep osit Funding
2000
2002
2004
2006
2008
2010
Source: ECB
Bank DebtCross-currency Basis Swaps* One-year Maturity Profile USD billions bps 900 U.S. (green) and Europe -10 800 (orange) bank bond issuance ytd. -40 700 600 -70 500 -100 400 EUR**Europe U.S. 300 -130 GBP*** 200 -160 100 Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11 0
* Swap rate ref lect s t he premium/ discount paid on non-U.S. dollar interest rat e. 2014 2018 2022 2026 2030 ** 6m2011 3m USD Libor. *** 3m GBP Libor/ 3m USD Libor. Euribor/

Funding strains can also be seen in higher USD borrowing costs and U.S. MMF withdrawal
companies (much of which is issued by European banks) has fallen precipitously over the past several weeks, falling by nearly 90 billion since mid-June (Chart 7). Both foreign banks and their U.S. branches and subsidiaries have seen outstanding levels of commercial paper decline in recent weeks. These short-term USD funding problems have been somewhat eased by official sector assistance. The ECB still offers a back-stop facility for European banks with U.S. dollar liquidity need (which in mid-August was tapped by one institution for $500 million). The Bank of England also reported that its emergency lending facility was used in July. However, the problem should not be overstateddollar-denominated debt represents only 9.5% of all European bank debt securities. Moreover, dollar cash holdings of foreign banks held by U.S.-domiciled depository institutions rose to $853 billion on August 17 from $758 billion on August 3, which may indicate that at least in the aggregate foreign banks are not squeezed in terms of U.S. dollar funding. U.S. money market funds wary of European banks One of the reasons for the decline in European banks commercial paper issuance is the fact that U.S. money market funds have been withdrawing from Euro Area banks. Although a relatively modest source of short term funding for European banks (2-3% of total deposits, money market and short-term funding), the ten biggest U.S. money market funds reduced their exposure to European banks by about 9% in July (a decline of $30 billion), following a cutback of 20% in June. Exposure to Italian and Spanish banks fell by over 95% in July from end-June levels; exposure to Italian and Spanish banks has fallen from 6% of total U.S. MMF assets under management (AUM) in Q409 to virtually nil (Chart 8). U.S. money market funds also cut their exposure to core Euro Area banks: Exposure to German banks fell over 20% in July from end-June levels, and is down over 42% since end of May. German bank exposures constitute now only about 4% of U.S. MMF assets under management, down from 8% in Q111. Exposure to French banks, however, has declined less7.2% in July and 18.4% since end of May. French bank exposure is still relatively high at over 14% of AUM, down from 16% in early 2009. Further, it is noteworthy that U.S. money market funds have not only reduced their overall exposure to European banks but also the maturity of their existing exposure. For instance, over 20% of U.S. MMF exposure to French bank CDs is now of 0-7 day tenure, and 65% is 60 days or less, up from 7% and 45% respectively at end-June (Chart 9). This trend of shortening maturities can also be seen in U.S. MMF exposure to Dutch and U.K. bank CDs, although to a lesser extent. As funding terms become shorter, banks are forced to roll over greater amounts of debtcontributing to a higher level of risk for the financial system as a whole.
Non-U.S. Financial Commercial Paper (U.S. Market) USD billions, outstanding levels, latest 8/17/11 275 250 225 200 175 150 125 100 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11
Source: Federal Reserve, Bloomberg
U.S. MMF Exposure to European Banks p ercent of total MMF AUM 20 France Germany 18 UK Italy and Spain 16 14 12 10 8 6 4 2 0 H206 H207 H208 H209 H210 11-Jul
Source: Fitch Ratings
U.S. MMF Exposure to French Bank CDs: Average Maturity percent of total CD exposure Jun-10 70 Jul-11 60 50 40 30 20 10 0 0-60 61+
Source: Fitch Ratings
Special Feature II: Market Based Capital and Leverage Ratios for Banks
Easier to observe in real time and currently flashing warning signals
With market concerns about the health of the European banking sector on the rise, market-based solvency ratios such as the price-to-net book value and market capital to total assets ratio can give a real-time reading of the health of banks rather than accounting-based solvency ratios calculated by complex models*. Since these measures are simple and transparent, they can be observed by regulators and market participants in real time. These market-based solvency ratios deteriorated between 2005 and 2008, giving a clear early warning for the 2008-09 crisis. An update of these very same measures shows deterioration across the board, reflecting concern about banks health. Market-based capital measures are flashing warning signals Although price-to-book ratios of both U.S. and European banks recovered in 2009 to some extent, they have fallen back below 1 since early 2010, indicating that bank balance sheets are currently under question. Although the average price-to-book ratio of U.S. banks is currently 0.64, the lowest price-to-book ratio among large U.S. banks is 0.40, reflecting serious investor concerns. Investor concern about the health of European banks runs even deeper, as the average price-to-book ratio of European banks is currently 0.52 (Chart 1). Banks market capitalization relative to total asset value although this ratio improved slightly after 2009is currently also at relatively low levels on both sides of the Atlantic (Chart 2). These lower levels reflect investor concern about the market value of bank assets, largely due to exposure to sovereign debt in Europe and depressed commercial and residential property real estate in the U.S. European bank funding pressures (see Special Feature I, pages 6-8) are also contributing to investor concerns about the creditworthiness of these institutions. Falling operating revenue Broadly, markets seem to be valuing equity, assets, and earnings potential less highly than before, as reflected in the clear declines in price-to-forward earnings ratios (Chart 3). According to FDIC data, Q211 earnings at U.S. banks posted a yearon-year increase for the eighth consecutive quarter. However, this rise stemmed from a drop in provisions for loan losses; net operating revenue was lower than a year ago for the second quarter in a row. Investment-banking and trading revenue declined in H1 2011 on a year-on-year basis. Moreover, low interest rates are compressing bank profits, and low growth creates fears of increasing losses on loans. Also as new regulatory requirements encourage banks to hold more and more sovereign debt, bank net interest margins are squeezed as lower yielding assets become a larger part of the total book. Banks continue to de-leverage: currently lending growth is lower than GDP growth, thus not supporting recovery.
Large U.S. and European Banks: Price to Book Ratio index level 3.0 2.5 2.0 1.5 1.0 0.5 0.0 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 Europe U.S. Series3
Source: Bloomberg, IIF calculations.
U.S. & European Banks: Market Capitalization to Total Assets percent 20 16 12 8 4 0 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 U.S. Europe
Source: Bloomberg, Datastream
U.S. and European Banks: Forward Earnings MSCI indices, Price to 12M forward earnings estimates 30 25 20 15 10 5 2008 U.S. Europe
2009
2010
2011
Source: DataStream
*Haldane, Andrew G., Bank of England: Capital Discipline., Speech at the American Economic Association, January 2011.
Special Feature III: Deleveraging

Until the end of 2009, private sector crisis-related losses and subsequent deleveraging had been offset by significant fiscal measures. However, this has boosted sovereign debt to levels seen by markets as unsustainable or worrisome. With little room left for fiscal maneuver, private sector deleveraging will remain a major headwind to growth in the years ahead. To reduce debt levels, higher household saving rates, lower business investment rates, and slow bank lending growth will weigh on economic activity. Debt sustainability at risk Synchronized financial sector deleveraging is already affecting activity as reflected by the disappointing recovery. Financial sector debt is now down a wholesome 40 percentage points of GDP in the U.K. and 27 points in the U.S. (Table 1). At 113% and 94% of GDP, respectively, U.K. and U.S. financial sector debts still remain high by historical standards. A major risk stemming from the generalized reduction of debt is the creation of a self-reinforcing downward spiral. A negative feedback loop across sectors could damage the growth potential of mature economies. Due to synchronized deleveraging, the lack of external growth opportunities could contribute to a low nominal growth environment, putting debt sustainability at risk. With the lack of political and market appetite for further fiscal expansion, options are limited to offset the headwinds from debt overhang. Deleveraging across the major mature economies Deleveraging is most advanced in the U.S., where debt peaked in early 2009. In two years, U.S. households have cut outstanding debt by $500 billion, bringing the sectors debt-toGDP ratio down to 89.6%, from 99.5% (Chart 2). U.S. businesses reduced their debt by 6 percentage points, to 73.9% of GDP. In the U.K., nonfinancial private sectors started deleveraging later, in mid-2010. In particular, U.K. businesses have cut their debt-toGDP ratio by 10 percentage points in just 4 quarters, despite poor nominal growth performance. The Euro Area is a mixed bag: in aggregate, nonfinancial sector debt seems to have leveled off for both households and businesses (Chart 3). But this hides different realities: German households and businesses do not suffer from the same excesses as the periphery, and have scope for ramping up spending; in contrast, Spanish businesses have 150% of GDP worth of debt for example, up from 50% in 1999Q1. Treading a fine line While deleveraging is a natural process following a financial crisis, a key question is how much of it is necessary? While there is no straight answer to this, the possibility of getting trapped into a Japanese-style low-growth environmentwhere continued deleveraging by households and businesses matches high fiscal deficitsshould make policymakers think twice before putting further strains on the economy. The inconsistency between the goals and thrusts of fiscal/monetary policies and regulatory policy has contributed to the pressure on financial institutions to deleverage.
Deleveraging by Sector
1 change in outstanding debt, % point of GDP,

Corporates U.S. U.K. Germany France Italy Spain -6.3 -13.1 -4.6 -1.2 0.0 -5.9 Households -9.9 -5.1 -12.7 -0.1 0.0 -3.3
peak to 2011Q1 Financial Sector -27.0 -39.9 -8.8 0.0 -1.4 0.0
Source: Federal Reserve, European Central Bank, Bank of England, IIF calculations
U.S. and U.K. Household Debt Outstanding percent of GDP 105 100 95 90 85 80 75 70 65 60 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 U.K. U.S.
Source: Federal Reserve, Bank of England, IIF calculations
Euro Area Nonfinancial Private Sector Debt percent of GDP 110 105 100 95 90 85 80 75 70 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 Businesses Households (rhs)
68 66 64 62 60 58 56 54 52 50 48
Source: European Central Bank, IIF calculations
Special Feature IV: The Fed and ECB Balance Sheets

After four years of engagement in unconventional monetary policy, the size and composition of the Fed and ECB balance sheets have changed dramaticallyand there could be more to come. Federal Reserve: the quantitative approach The Feds intervention can be summarized in two acts. The first started in early 2008 and was aimed at providing liquidity relief to markets through a variety of facilities, as well as supporting the housing sector by relieving the GSEs of their MBS holdings. The second act began in 2010 and was aimed strictly at providing additional policy stimulus through the purchase of long-dated U.S. Treasuries. With the completion of the latter actpartly financed by reinvesting maturing MBS from the first actFed assets totaled $3 trillion, three times the size it was three years ago (Chart 1). The lions share of Fed assets is holdings of Treasury and agency securities. From here, two basic scenarios can be sketched out for the future:
Federal Reserve: Assets USD billions 3,000 Other assets 2,500 2,000 1,500 1,000 500 0 Jun-07 Apr-08
CP market support M aiden Lane LLCs & credit t o AIG Central bank liquidit y swaps Term auct ion credit Repo loans Discount loans Agency securities U.S. Treasuries
Feb-09 Dec-09
Oct-10
Aug-11
Source: Federal Reserve, IIF calculations
The US economy enters another recession phase and markets remain bearish: The Fed would decide on another round of asset purchases, likely focused on long-term securities. With core inflation higher than a year ago, pressure from Congress and global aversion to short-term capital inflows, a QE3 program would probably be smaller, and spread over a longer period. It could also be financed by reinvesting maturing securities from previous rounds of QE, thereby limiting the extra money supply and risk of inflation. Growth picks up and confidence returns. Securities would be left to mature on the Fed balance sheet for the time being, with excess liquidity on the liabilities side progressively drained through large reverse repos.
European Central Bank: Assets Claims on euro area resident s in foreign currency EUR billions 2,500 2,000 1,500 1,000 500 0 Jun 07
Gold and ot her asset s* Claims on non-euro area resident s Securities of euro area resident s in euro Lending to euro area credit inst it ut ions in euro
European Central Bank: the qualitative approach Although its balance sheet expanded too, the ECB has focused on providing short-term relief to the banking sector and restoring the transmission of monetary policy (i.e., calming markets) by intervening in secondary sovereign bond markets. Thanks to reduced lending to bankssave for the GIPSthe size of the ECB balance sheet has been little changed since 2009. However, its composition has evolved: the average portfolio maturity has increased in favor of longer-term financing; the list of eligible collateral for ECB funding has been repeatedly enlarged, and holdings of securities of Euro Area residents have increased with the Securities Markets Program (SMP; Chart 2). The SMP was recently reactivated to buy Spanish and Italian sovereign debt, presumably until the newly reformed EFSF becomes fully operational to buy government debt on secondary markets. With inflation above 2%, the ECB will likely continue to neutralize the injection effect on money supply by draining liquidity elsewhere in the system. Excess reserves: how to kick-start bank lending again? The surplus of liquidity injected in the past few years now sits on the Fed and ECB balance sheets. In the US, the deleveraging process of the nonfinancial private sector has depressed demand, while in Europe banks remain very cautious about lending in general, as illustrated in recent Euro Area lending surveys. This has resulted in large excess reserves held at both central banks (Chart 3).
Apr 08
Feb 09
Dec 09
Oct 10
Aug 11
Source: ECB, IIF calculations
Excess Reserves of Financial Institutions USD billions EUR billions,10-day MA 1800 350 Fed 1600 300 ECB* (rhs) 1400 250 1200 200 1000 800 150 600 100 400 50 200 0 2007 0 2008 2009 2010 2011
* ECB deposit facility less marginal lending facility plus current account reserves in excess of required reserves. Source: Federal Reserve, ECB, IIF calculations
Asset Performance in Perspective 1

Go ld*
The recent sharp rise in volatility has prompted renewed safe-haven flows to gold, higher-rated corporate bonds and longer-dated U.S. Treasuries. Concerns about global growth are weighing on EM currencies and equities.
Annual Returns for Selected Asset Classes percent, 2011 ytd
Annual Bond Returns* percent, 2011ytd

1 U.S. Treasury 0yr
Crude o il* Co ffee* Grains* Leveraged lo ans*** Co mmo dities* GIP S so v. bo nds**** U.S ho use prices M M equities**
A AA co rpo rate IG EM so vereign A co rpo rate EM so vereign Glo bal IG co rpo rate B BB co rpo rate AA co rpo rate HY EM so vereign IG EM co rpo rate BB co rpo rate
Co pper* U.S. do llar U.S. CRE EM equities**
EM co rpo rate Glo bal HY co rpo rate 2yr U.S. Treasury B co rpo rate HY EM co rpo rate
Co tto n*
CCC & lo wer co rpo rates
-15 -10 -5
10
15
20 25 30
-4 -2
8 10 12 14
* GSCI; t ot al ret urns. ** M SCI; t ot al ret urns. *** Credit Suisse; t ot al ret urns. Loan Perf ormance, ytd. M oody's/ REAL, yt d. DXY index ****weight ed avg of GIPS sov. bond price changes
* Ranked by 2011 t ot al ret urns; global corporat e and U.S. Treasuries: Bank of America/M errill Lynch indices; EM sovereign (EM BIG) and EM corporat e (CEM BI Broad): JP M organ indices.
With the renewed flight to safe-haven assets, gold has seen the highest returns ytd; oil and other commodities have lost ground in recent weeks on fears about growth prospects.
Emerging Market Equity and Sovereign Bond Returns percent, 2011ytd
Indonesia Colombia Philippine M alaysia Russia Hungary Poland M exico Sout h Chile China Brazil Peru Turkey
Boosted by increased risk aversion, returns on Treasuries and higher-rated bonds have surged; in contrast, higher-yielding debt markets (e.g. junk bonds) have suffered.
Change in Value of U.S. Dollar percent, 2011ytd
Turkish lira So uth African rand M exican peso Chilean peso B ritish po und Indian rupee Chinese renminbi B razilian real Ko rean wo n Russian ruble Yen Euro
Red and blue, vertical lines are sov. Bonds and EM equity benchmarks respectively.
Sovereign bonds* Equities**
-30 -26 -22 -1 -1 -1 8 4 0
-6
-2
1 0
1 4
1 8
22
-8
* EM BIG index t ot al returns. ** M SCI index t ot al returns in USD-terms.
USD depreciatio n
-6
-4
-2
USD appreciatio n
1 0
1 2
EM equities have posted significant across the board with biggest losses in Turkey, Peru and Brazil. However, EM sovereign bonds have returned on average 6% ytd.
The dollar has extended ytd losses against the yen and euro; however, many EM currencies have given back some of this years strong gains on concerns about weaker global growth.
Source for all data is Bloomberg LP, Datastream, J.P. Morgan and IIF calculations, unless otherwise noted.
Sovereign Debt Markets I: Focus on Europe 1

European Government Bond Spreads* spread over German bunds, bps 1,600 Greece 1,400 Ireland 1,200 Portugal 1,000 Spain 800 Italy 600 400 200 0 Jan-09 Jul-09 Jan-10 Jul-10
The focus in recent weeks has been on the negative implications of high sovereign debt levels coupled with weak growth prospects; tensions have spread to Europes corporate sector as well.
Jan-11 Jul-11
* 10-year government bonds.
Selected Euro Area Sovereign CDS Spreads 5-year CDS spreads bps 2,600 2,400 Greece 2,200 Ireland 2,000 1,800 Portugal 1,600 Spain 1,400 Italy 1,200 1,000 800 600 400 200 0 Jan-09 Nov-09 Sep-10
Jul-11
In volatile trading conditions, cash bond spreads for Portugal Ireland, Spain and Italy have narrowed modestly in recent weeks; however, Greek government bond and
Selected Euro Area Countries Public Debt Outstanding percent of GDP 90 Germany France Finland 70 Netherlands
CDS spreads have widened in concerns about implementation risk for the July 21 support package, amidst collateral demands by Finland and other Euro Area countries.
CDS Spreads of Selected European Countries bps, 5-year 180 France 160 Germany Finland 140 Netherlands 120 100 80 60 40 20 Jan-10
50
30 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Jul-10
Jan-11
Jul-11
Market concerns about high sovereign debt levels coupled with weak growth prospects have seen market concerns affect the Euro Areas less-indebted countries as well...
Selected European Countries' Bond Yields, Current and Expected percent, 5-year yields now and expected in 10 years' time 20 15 10 5 0 DE UK FR ES IE PT GR Current 5-year yield 10-year forwards
France in particular has seen a sharp widening in its CDS spread over the past few months.
W. European Sovereign, Fin'l & Corp. CDS spreads basis points, ITraxx WE SovX & IG corporate CDS spreads 280 220 160 100 40 Oct-09 Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 Sovereign Corporate Financial
Forward markets suggest 5yr yields in most EU countries will rise over the next several years from current low levels; conversely, Greek yields are expected to normalize.
A very striking development in recent weeks has been the jump in European investment-grade corporate CDS spreads, as tensions escalate amidst concerns about growth prospects.
Source for all data is Bloomberg LP, Datastream, J.P. Morgan, Thomson Reuters and IIF calculations, unless otherwise noted.
Sovereign Debt Markets II 1

Path of Policy Rates Implied by Overnight Index Swaps percent U.S. 0.30 0.25 0.20 0.15 0.10 0.05 0.00 Target 2m 4m 6m Japan (rhs)
Growing concern about global growth prospects has prompted a shift in rate expectations; U.S. and Japanese rates are seen staying low or easing further, while many anticipate that the ECB might also have room for easier monetary policy.
2
0.11 0.10 0.09 0.08 0.07 0.06 0.05 8m 10m 12m
U.S. and Japan Government Yield Curves percent 3.5 U.S. June 3, 2011 3.0 U.S. August 31, 2011 2.5 Japan August 31, 2011 2.0 1.5 1.0 0.5 0.0 3m 6m 1y 2y 3y 4y 5y 7y 8y 9y 10y
Bernankes Jackson Hole speech reinforced expectations of continued ultra-low rates; concern about yen appreciation and weak growth continue to limit the BoJs room for maneuver.
Spread between 2-year U.S. and Japanese Bonds bps 700 600 500 400 300 200 100 0 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
Though not at Japanese levels, the recent flattening of the Treasury yield curve suggests concern about a Japan-style extended slump in economic growth and...
U.S. and Japan CDS Spreads 5-year CDS spread bps 120 U.S. 110 Japan 100 90 80 70 60 50 40 30 Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11
the Feds lack of room for maneuver. The UST-JGB 2yr spread has shrunk to 4bp, the lowest since 1993, prompting some to express concern about a deflationary environment.
ECB Policy Rate and Inflation* percentage 5 Policy rate Inflation 4 3 2 1 0 -1 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Source: ECB. *year over year change
Although Japans CDS spreadslike those of Europes highly indebted economieshave widened in recent weeks, U.S. CDS spreads have tightened post-downgrade.
Path of Euro Area Policy Rates Implied by Overnight Index Swaps percent 1.6 5/30/2011 1.4 1.2 1.0 0.8 0.6 Target 2m 4m 6m 8m 10m 12m 8/30/2011
Amid signs of weaker EU growth and ongoing sovereign debt market strains, the ECB kept rates on hold on August 4 but said it would closely monitor the situation.
Forward markets are now pricing in expectations of lower ECB policy rates over the next twelve monthsa big shift in expectations since late spring.
Bank Health Monitor I 1
Concerns about European banks deepened in August. Banking sector turmoil risks slowing lending activity further.
U.S. & International Banks: Equity Market Returns MSCI indices (USD returns), end-2009=100 125 115 105 95 85 75 65 55 Jan-10 May-10 U.S. Emerging markets Europe Sep-10 Jan-11 May-11 Sep-11
International Banks' CDS Spreads basis points, 5-year CDS 290 270 250 230 210 190 170 150 130 110 90 70 50 Jan-10 Global Europe U.S. Japan
May-10
Sep-10
Jan-11 May-11
Sep-11
The decrease in U.S. and European bank equity prices since the beginning of the year accelerated abruptly in August, dragging EM banks down with them.
Selected Euro Area Countries' Lending to Businesses percent, yoy 35 30 25 20 15 10 5 0 -5 -10 '04 '05 '06 '07 '08 '09 '10 '11 Germany France Italy Spain
Concerns over potential bank losses and funding strains have pushed bank CDS spreads sharply higher across the board over the past several weeks.
U.S. and U.K. Lending to Businesses percent, yoy 30 25 20 15 10 5 0 -5 -10 -15 -20 '04 '05 '06 '07 '08 '09
U.K U.S.
'10
'11
Lending in the major European economies has been only modestly increasing, while in Spain lending is contracting. Euro Area lending to businesses rose to 1.6%y/y in July.
Selected Euro Area Countries' Household Lending percent, yoy 25 Germany 20 France Italy 15 Spain 10 5 0 -5 '04 '05 '06 '07 '08 '09 '10 '11
U.S. lending to businesses has accelerated, albeit from a very low base due to the sharp credit contraction in 2009. U.K. loans to businesses are still contracting (-9.4%y/y in June).
U.S. and U.K. Household Lending percent, yoy 12 8 4 0 -4 -8 -12 '04 '05 '06 '07 '08 '09 '10 '11
* adjust ed f or the impact of account ing changes in April 2010
U.K U.S.*
Spanish household borrowing remains subdued as the country continues to recover from the hangover of its credit spree. Household credit has recovered somewhat in other countries.
The situation is much starker in the U.S. and U.K. where household credit is still deep in negative territory (-6.5%y/y and -4.1%y/y, respectively).
Bank Health Monitor II: Focus on Europe 1
European financial spreads have reached new record levels and European financial equities lost all the gains they made year to date in recent weeks as European banks struggle with funding pressures.
Sov. Risk and European Banks' Relative Performance European Banks' Relative index bps Performance to Overall 105 0 European Market 100 200 Peripheral Sovereign 95 Average 5 Year CDS(rhs) 400 90 600 85 80 800 75 1000 70 1200 65 60 1400
Sep-09 Jan-1 0 M ay-1 0 Sep-1 0 Jan-1 1 M ay-1 1 Sep-1 1
West European Financial CDS Spreads bps 250 200 150 100 50 Jan-08 Lehman Collapse First Greek Crisis Irish Program
Nov-08
Sep-09
Jul-10
May-11
Slowing growth and deterioration in the creditworthiness of several EU government bond markets have hurt banks profitability and the strength of their balance sheets
European Bank Equity Performance vs. 3-month Dollar Basis Swap index bps 450 -20 400 -60 350 Euro Stoxx 600 Financial -100 300 3-M o nth Euro 250 200 150 2008 2009 2010 2011
Basis Swap (rhs)
as a result, European financial spreads have reached new record levels
Greek Bank Equity Performance and CDS Spreads bps index level 2000 1800 1600 1400 1200 1000 800 Jun-11 Jul-11 5 year bank CDS Bank equity (rhs) Aug-11 15 Sep-11 25 20 40 35 30
-140 -180 -220
and European financial equities have given back all this years gains (and more) in recent weeks as European banks struggle with funding pressures.
Greek Retail Deposit Base and ECB Borrowing EUR billions EUR billions 240 230 220 210 200 190 Domestic Bank Deposits ECB Borrowing (rhs) 120 100 80 60 40 20 0
Merger plans for two major Greek banks gave a sharp but temporary lift to share prices; the bank CDS market was unconvinced, and spreads remain at very elevated levels.
Portugese Retail Deposit* Base and ECB Borrowing EUR billions EUR billions 124 60 Domestic Bank Deposits 122 50 ECB Borrowing(rhs) 120 40 118 30 116 20 114 10 112 110 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 0 Aug-11
180 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11

Source: Bank of Greece
* of 3 largest public banks. Source: ECB and Central Bank of Portugal
Greek banks seem to have replaced the significant decline in their deposits with ECB borrowing.
The deposit base of Portugals three largest public banks rose over last 6 months, although Portuguese bank borrowing from ECB remains near record levels.
BIS Banking Statistics 1
International bank exposure to both developed and developing countries increased by $1.4 trillion in Q1 2011. International bank lending to developing country banks grew over 20% on a year on year basis for the third consecutive quarter.
International Bank Exposure to Developed Countries* Banks*** Public sect or*** USD trillions Non-bank privat e sect or*** Ot her*** 36 Local claims**** Net risk t ransf ers 30
Total f oreign claims**
Cross-border Claims on Developed Countries year-on-year percent change 40 30 20 10 0 -10 -20 Banks Non-bank private sector '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
30.229.2 24 27.5 18 12 6 0 Mar-08
24.5 24.3 23.924.924.924.024.222.924.4 23.2
Mar-09
Mar-10
Mar-11
-30
Source: BIS; IIF calculat ions. *** Cross-border claims by sect or, immediat e borrower basis (consolidat ed claims).
Source: BIS consolidat ed banking st at ist ics; IIF calculat ions. * All BIS-report ing banks. ** Ultimat e risk basis. *** Cross-border claims, immediat e borrower basis. **** Local currency claims of banks' f oreign of f ices on local resident s.
Unadjusted for exchange rate movements, international bank exposure to developed countries increased by over $1 trillion in Q1 2011 from previous quarter.
International Bank Exposure to Developing Countries* Banks*** Public sector*** USD billions Non-bank private sector*** Other*** 6,000 Local claims**** Net risk transfers 5,000 4,000 3,000 2,000 1,000 0 -1,000 Mar-08
Total foreign claims**
Lending to developed market non-bank private sector increased in Q1 2011 on a yoy basis for the first time since 2008.
Cross-border Claims on Developing Countries year-on-year percent change 50 Non-bank private sector 35 20 5 -10 Banks
5,282 4,746 4,565 4,355 4,301 4,899 4,1 4,243 3,888 3,847 4,052 70 4,368 4,397
Mar-09
Mar-10
Mar-11
-25 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Source: BIS; IIF calculations. *** Cross-border claims by sector, immediate borrower basis (consolidated claims).
Source: BIS consolidated banking statistics; IIF calculations. * All BIS-reporting banks. ** Ultimate risk basis. *** Cross-border claims, immediate borrower basis. **** Local currency claims of banks' foreign offices on local residents.
Unadjusted for exchange rate movements, international bank exposure to developing countries increased for the ninth quarter to $5.3 trillion in Q1 2011.
Change in External Claims of BIS-reporting Banks on Non-banks*, USD billions 100 80 60 40 20 0 EM Asia -20 EM Europe -40 Latin America -60 Developing countries -80 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
Source: BIS locational banking statistics; IIF calculations. * Claims on non-bank sector; exchange rate-adjusted changes.
International bank lending to developing country banks grew in Q1 2011 over 20% on a year on year basis for the third consecutive quarter.
Int'l Bank Claims on Selected European Countries* USD billions, March 2011** Spain Ireland Portugal Greece 0 213 138 300 473
British German Other Euro pean Dutch French Swiss Other US
726
600
Source: BIS. *Consolidated foreign claims, ultimate risk basis. **Provisional data
Bank lending to non-bank private sector across all EM regions increased in Q1 2011;exposure to banks in EM Asia grew the most.
Unadjusted for exchange rate movements, bank exposure to Greece, Ireland, Portugal and Spain increased by $31 billion in Q1 2011.
FDIC Quarterly Banking Profile, Q2 2011 page 1 1

Net Income of FDIC-insured Institutions USD billions 40 30 20 10 0 -10 -20 -30 -40
Although the net income of FDIC insured U.S. banks continued to rise in Q2 2011, gains in net income in recent quarters have been driven primarily by the release of loan loss reserves, rather than top-line revenues.
Reserve Coverage Ratio of FDIC-insured Institutions USD billions percent Loan-loss reserves 190 Noncurrent loans 400 Coverage ratio* (rhs) 160 300 200 130 100 70 40 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11
Securities & other gains/losses, net Net operating income Net income '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
100 0
Source: FDIC; IIF calculat ions.
Source: FDIC; IIF calculations. * Ratio of loan-loss reserves t o noncurrent loans.
Although the net income of FDIC insured U.S. banks continued to rise in Q2 2011 for the eighth consecutive quarter reaching $28.8 billion
"Top-Line" Revenues of FDIC-insured Institutions USD trillions 200 180 Interest income 160 Noninterst income 140 120 100 80 60 40 20 0 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11
Source: FDIC; IIF calculations.
the gains in net income in recent quarters continue to be driven primarily by the release of loan loss reserves, rather than
Change in Total Assets of FDIC-insured Institutions year-on-year percent change 12 9 6
3.04
3 0 -3 -6 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
top-line revenues; both interest and non-interest revenues have decreased for the 5th quarter in row.
Total assets of FDIC insured institutions increased modestly by 3% in Q2 2011 on a year over year basis
Balance Sheet of FDIC-insured Institutions percent of total assets percent of total assets 64 24 62 60 58 56 54 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
Source: FDIC; IIF calculat ions.
FDIC-insured Institutions' U.S. Treasury Holdings percent of total assets 7 6 5 4 3 2 1 0 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
21 18 15 Total loans & leases Securities (rhs) Cash (rhs) 12 9 6 3
The share of loans and leases in banks total assets continued to decline in Q2 2011. Banks continued piling up cash
although they shied away from U.S. Treasuries.
FDIC Quarterly Banking Profile, Q2 2011, page 2 1

Risk-based Capital of FDIC-insured Institutions* percent 85 84 83 82 81 80 79 78 77
Reliance of FDIC insured U.S. banks on deposit funding continues to increase, as interbank lending remains under pressure. Non-performing real estate loans continue to rise.
Funding Structure of FDIC-insured Institutions percent of total assets 80 70 60 50 40 30 20 Deposit Funding Non-Deposit Funding
'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
Source: FDIC; IIF calculations. * Ratio of Tier 1 risk-based capit al t o total riskbased capit al.
10 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Tier 1 risked based capital continued to increase relative to total risk-based capital as banks continue preparing for new capital requirements.
Loan Performance at FDIC-insured Institutions* percent of loans outstanding 6 5 4 3 2 1 0
Source: FDIC; IIF calculations. * Total loans and leases. ** Loans 90 days or more past due or in nonaccrual status.
Reliance of FDIC insured U.S. banks on deposit funding continued to increase in Q2 2011, as interbank lending remains under pressure.
Share of "Severely Delinquent" Borrowers* ratio** 3.5 3.0
30-89 days past due Noncurrent rate**
2.5 2.0 1.5 1.0 0.5
'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
Source: FDIC; IIF calculat ions. * Tot al loans and leases. ** Ratio of loans eit her 90 days or more past due or in nonaccrual st at us t o loans 30-89 days past
Although share of non-performing loans of FDIC insured institutions continued to decrease in Q211,
share of non-performing real estate loans rose above 9%, as housing market continues to struggle.
Unprofitable FDIC-insured Institutions* as a percent to total reporting institutions 35 30 25 20 15 10 5 0 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
Source: FDIC; IIF calculat ions. * Dark line is 4-quarter moving average.
FDIC-insured "Problem" Institutions number of institutions 1,600 Number (lhs) 1,200 800 400 Assets (rhs)
USD billions 900 750 600 450 300 150
0
'90
Source: FDIC.
0
'93 '96 '99 '02 '05 '08 '1 1
Although share of unprofitable FDIC insured U.S. banks continued to decline in Q211, still nearly 1 out of every 5 banks is unprofitable.
The number of problem institutions decreased by in Q2 2011 by 23 to 865, the first decline since 2006.
Credit Markets 1
Corporate spreads have spiked both in the U.S. and Europe. As Euro Area sovereign debt problems intensify, both European high yield and investment grade corporate spreads have risen above those of their U.S. counterparts.
High-Yield Corporate Bond Spreads bps, option-adjusted spreads 2,200 1,900 1,600 1,300 1,000 700 400 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 U.S. Europe
High Grade Corporate Bond Spreads bps, option-adjusted spreads 600 500 400 300 200 100 Jan-09 U.S. Europe
Source: M errill Lynch
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Source: M errill Lynch
Corporate spreads have spiked up both in the U.S. and Europe. As Euro Area sovereign debt problems intensify, both European high yield and
European Crossover & Corporate CDS spreads bps, ITraxx WE Crossover & IG corporate CDS spreads 700 650 600 550 500 450 400 350 Jan-10 May-10 Sep-10 90 70 Jan-11 May-11 Sep-11 iTraxx Crossover (HY) Corporate (HG) (rhs) 170 150 130 110
investment grade corporate spreads have risen above those of their U.S. counterparts.
S&P Corporate Ratings Upgrades as percent of total ratings actions 75 65 55 45 35 25 15 5 2000 2002 2004 2006 2008 2010 U.S. Europe
Cost of insuring against corporate default has increased significantly for both high yield and investment grade corporates.
S&P Leveraged Loan Price Index index level 97 95 93 91 89 87 85 Jan-10 Jul-10 Jan-11 Jul-11 U.S. Europe
The current unfavorable environment for non-financial corporates has helped corporate ratings downgrades to outpace upgrades in Europe.
U.S. High Yield vs. High Grade Bond Funds USD billions, 4wks mav 1.5 1.0 0.5 0.0 -0.5 High yield corp bonds -1.0 -1.5 -2.0 Jul-10 Nov-10 Mar-11 Jul-11 High grade corp bonds
As global risk aversion has increased, leverage loan prices have decreased sharply; U.S. leveraged loans do not outperform their European counterparts anymore.
Both U.S. high yield and high grade bond funds have experienced outflows in recent months.
Hedge Fund Performance 1

Hedge Fund vs. S&P 500 Performance percent 40 30 20 10 0 -10 -20 -30 -40 1990 1993 1996 1999 2002 2005 Hedge Fund Composite S&P500
Hedge funds have had difficulty beating the market this year; their returns have been only slightly above S&P 500 returns.
Equity Hedge Fund Performance index level, rebased 12/10=100 105 100 95 90 85 80 Jan-11
HFRX Hedge Fund Index HFRX Equity Hedge Fund Index
2008
2011
Mar-11
May-11
Jul-11
Hedge funds have had difficulty beating the market this year; hedge fund returns have been only slightly above S&P 500 returns.
Global Hedge Funds: Assets Under Management USD billions, 2011 as of end-June 2000 1600 1200 800 400 0 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10
Equity hedge funds, running strategies based on relative value of different shares or trading around corporate events, have had the worst performance so far.
Monthly Asset Flows to Hedge Funds USD billion 18 12 6 0 -6 -12 -18 -24 Jan-10 May-10 Sep-10 Jan-11 May-11
Source: TrimTabs and FT
Although global hedge fund assets under management rose to over $2 trillion by the second quarter of 2011
flows to hedge funds have slowed decreased in recent months.
Hedge Fund Performace: EM vs DM percent, through June 2011 40 30 20 10 0 -10 -20 -30 -40 2000 2002 2004 2006 2008 2010 Emerging Markets Developed Markets
BRIC Hedge Fund Performance index level, rebased 01/08=100 140 130 120 110 100 90 80 India 70 China 60 Russia 50 Brazil 40 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11
While emerging market hedge funds have posted negative returns year to date through June, developed market hedge funds have registered positive but very low returns.
Chinese hedge funds have been outperforming their counterparts in India, Russia and Brazil.
Emerging Markets 1
Over the past several weeks, emerging market equities have given back all this years gainsand more. The EMBIG spread has spiked higher, due to sharply declining Treasury yields.
Emerging Market Equity Indices by Region MSCI indices (USD returns), end-2009=100 135 EM Europe 130 EM Asia 125 Latin America 120 115 110 105 100 95 90 85 80 Jan-10 Jul-10 Jan-11 Jul-11
Emerging Market Sovereign Bond (EMBIG) Spreads percent bps EMBIG yield 13 900 Treasury yield 11 Spread (rhs) 700 9 7 5 300 3 1 2007 100 2008 2009 2010 2011 500
In recent months, emerging market equities have lost more than what they gained this year; commodity-driven Latin American equities have underperformed other regions.
EM Debt Trade Volume USD billions 2000 1600 1200 800 400 0 Q200 Q202 Q204 Q206 Q208 Q210
Although the EMBIG yield has edged lower in recent weeks, the EMBIG spread has spiked due to sharply declining Treasury yields.
Emerging Market CDS Trade Volume* USD billions 500 400 300 200 100 0 Q109 Q309 Q110 Q310 Q111
Source: EM TA, *Constructed using survey data of 12 major international banks and broker/dealers' CDS trading in 19 EM s
Source: ETM A Survey of 54 leading investment and commercial banks, includes over 90 EM s
Emerging market debt trading volumes in Q1 2011 decreased for the second consecutive quarter, by $123 billion to $1.7 trillionstill well above depressed crisis levels.
Dow Jones Sukuk Bond Price Index index, 10/05=100 135 130 125 120 115 110 105 100 95 90 85 2008 2009 2010
Emerging market CDS trading in Q2 2011 stood at $240 billion, a 7% decline from the previous quarter.
Sukuk Issuance USD billions 12 10 8 6 4 2 0 Q309

*quarter to date
2011
Q110
Q310
Q111
Q311*
Despite global uncertainties and ongoing Middle East tensions, prices of sukuk bonds (tailored to comply with the Islamic ban on interest) continue to increase
Reflecting market interest, Q2 2011 saw a high level of sukuk issuancethe highest since mid-2009.
BRIC Monitor I 1
BRIC markets were battered this month as global investors sought refuge in traditional safe assets. Political turmoil in India has also weighed on sentiment.
Equity Performance of BRIC Countries index, rebased end-2009 = 100 150 140 130 120 110 100 90 80 70 Jan-10 Jul-10 Jan-11 Jul-11 Brazil Russia India
Selected Emerging Market Countries CDS Spreads spreads 230 Brazil Russia 200 China 170 140 110 80 50 Jan-10
Jul-10
Jan-11
Jul-11
Like other equity markets, the BRICs had a difficult month of August. Russia suffered the most, down 14% as oil prices fell.
BRICs Countries Currencies index, rebased end-2009 = 100, vis--vis USD 115 110 105 100 Brazil India Russia China
The return of risk aversion saw a spike in CDS spreads. By the end of August, China was up 24bp, Brazil 31bp and Russia 48bp compared to a month earlier.
BRICs Corporate Bond Spreads index, rebased end-2009 = 100 125 Brazil Russia 120 India 115 China 110 105
95 90 Jan-10
100 95 Jan-10
Jul-10
Jan-11
Jul-11
Jul-10
Jan-11
Jul-11
Russia and India took a hit in FX markets, with the ruble and the rupee losing over 4% in a month. Local scandals and political turmoil in India also weighed on market sentiment.
BRICs Headline Inflation percent 18 15 12 9 6 3 0 -3 2007 2008 2009 2010 2011 Brazil Russia India China
The corporate sector has been remarkably resilient to recent global market turmoil with very little change on a net basis in August.
BRICs Policy Rates percent 15 12 9 6 3 0 2007
Brazil selic rate Russia 1 depo sit rate w India repo rate China 1 lending rate y
2008
2009
2010
2011
Inflation rates remain preoccupying in the BRICs. The stabilization of food prices in recent months, that have a large weight in EM CPI baskets, should help in that regard.
EM policymakers have signaled in most countries a pause in the tightening cycle due to global manufacturing slowdown. Brazil went one step further by cutting the Selic rate.
BRIC Monitor II Focus on Nonperforming Loans 1

Brazil: Domestic Private Financial Sector NPLs % of credit operations 8 7 6 5 4 3 2 2001 2003 2005 2007 2009 2011
P ayments delayed between 61and 1 days 80 P ayments delayed o ver 1 days 81
Brazil: Domestic Private Financial Sector NPLs R$ billion 70 60 50 40 30 20 10 0 2001 2003 2005 2007 2009 2011 Housing Rural Other services Industry Commerce Individuals
Source: Banco Cent ral do Brasil
Source: Banco Cent ral do Brasil
In the Brazilian domestic private financial sector, the growth in NPLs is now outpacing credit growth. The ratio of NPLs to total credit rose to 9.1%, up from 8.4% last December.
India: Gross Nonperforming Assets by Bank Group % of total advances by bank group 6 5 4 3 2 1 0 2005 2006 2007 2008 2009 2010
Source: Reserve Bank of India
The main sector in cause is commerce, where the NPL ratio has hit a 12-year high of 13.5%. In contrast, NPLs to individuals have remained somewhat stable since mid-2009.
India: Top 10 Banks Nonperforming Loans % of total advances Public 3.5 Private 3.0 2.5 2.0 1.5 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11
Source: Quarterly f inancial st atement s
Public Sector Banks Private Sector Banks Foreign Banks All Commercial Banks
The overall NPLs ratio was cut by half since 2005, partly thanks to improved public sector banks balance sheet. The latter is expected to remain around 2.3% in 2011.
China: Share of Loans by Quality Categories % of total loans, all commercial banks 2.5 Loss 2.0 1.5 1.0 0.5 0.0 08Q4 09Q2 09Q4 10Q2 10Q4 11Q2
Source: CEIC, China Banking Regulat ory Commission
However, NPL ratios among the top public sector Indian banks have started deteriorating lately.
Russia: Share of Loans by Quality Categories % of total outstanding loans, end of period 60 50 40 30 20 10 '07 '08 '09 10Q1 10Q2 10Q3 10Q4 11Q1 11Q2
Source: Cent ral Bank of Russia
Suspect Second Class
Lo ss (1 00% impairement) Pro blem (51- 99% impairement) Do ubtful (21- 50% impairement) Substandard (1- 20% impairement)
The amount of nonperforming loans has decreased by 24% since 2008Q4, to RMB423 billion. The NPLs ratio remains very low among Chinese commercial banks.
The NPLs ratio is still very high in Russia compared to the other BRIC countries. The decrease in substandard loans has been offset to some extent by an increase in doubtful loans.
Equity Markets 1
Global risk aversion prompted investors to shed risky assets in August. Equities took the brunt of the flight to quality, across all sectors.
Global Equities: Developed and Emerging Markets MSCI indices (USD returns), end-2009=100 120 115 110 105 100 95 90 85 Jan-10 Jul-10 Jan-11 Jul-11 Emerging markets Mature markets
U.S. vs. Euro Area Equities MSCI indices (USD returns), end-2009 =100 130 U.S. 120 110 100 90 80 70 Jan 10 Jul 10 Jan 11 Jul 11 Euro Area
Mature markets lost 6.6% and emerging markets lost 10% in August; day-to-day volatility reached levels unseen since early 2009.
Mature Market Equity Indices by Sector MSCI indices (USD returns), end-2009=100 140 Energy 130 120 110 100 90 80 Jan-10
Consumer discretionary Healt hcare Financials Inf ormat ion t echnology Ut ilit ies
Underperforming most other equity markets since the beginning of the year, European equities had a tough month, down 9.5% and back to year-ago levels.
Emerging Market Equity Indices by Sector MSCI indices (USD returns), end-2009=100 150 140 130 120 110 100 90
Energy Consumer discret ionary Healt hcare Financials Informat ion t echnology Utilit ies
Jul-10
Jan-11
Jul-11
80 Jan-10
Jul-10
Jan-11
Jul-11
Cyclical sectors and financials lost the most, although no sector was spared.
The same is true of emerging markets, although some sectors have made substantial gains on a net basis since the beginning of 2010.
Western Europe Financial Equity Indices MSCI indices (USD returns), end-2009 = 100 120 100 80 60 Commercial Banks Diversified Finance Insurance Real Estate
Global Financial Equity Indices MSCI indices (USD returns), end-2009 = 100 130 120 110 100 90 80 70 60 Jan 10 US EM Asia Latin America Jul 10 Jan 11 W. Europe EM Europe Jul 11
40 20 2007
2008
2009
2010
2011
European banks were at the forefront of the turmoil. The contagion spread to other areas, due in part to cross-border exposures to European losses.
European financial stocks are now worth about a third of their early 2007 value.
Currency Trends 1
Amid volatile trading conditions in recent weeks, most EM currencies lost ground against the U.S. dollar as concerns about global growth mounted; the yen continued to strengthen despite early-August intervention.
U.S. Dollar Exchange Rate index, end-Dec 2008, decline=USD depreciation 120 Euro 115 Yen 110 105 100 95 90 85 80 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
Selected Emerging Asian Currencies index, end-Dec 2008 = 100, vis--vis USD 120 115 110 105 100 95 90 85 80 75 Jan-09
Indian rupee Korean won Malaysian ringgit Nov-09 Sep-10 Jul-11
The U.S. dollar has been range-bound vs. the euro and broadly weaker against the JPY over the past several weeks, despite BoJ intervention in early August.
Selected Latin American Currencies index, end-Dec 2008 = 100, vis--vis USD 155 145 135 125 115 105 95 85 Jan-09 Brazilian real Mexican peso Nov-09 Sep-10 Jul-11 Chilean peso
However, most EM Asian currencies were weaker against the U.S. dollar, led by the Indian rupee, as signs of slower growth emerged.
Selected Emerging European Currencies index, end-Dec 2008 = 100, vis--vis EUR 115 110 105 100 95 90 85 80 Jan-09 Turkish lira Polish zloty Hungarian forint Nov-09 Sep-10 Jul-11
Weaker commodity prices weighed on many Latin American currencies
while EM European currencies also slumped, notably the Turkish lira in the wake of an unexpected rate cut.
Selected Dollar Bloc Currencies index, end-Dec 2008 = 100, vis--vis USD 160 150 140 130 120 110 100 90 80 Jan-09 Nov-09 Australia New Zealand Canada Sep-10 Jul-11
Russian Ruble Appreciation Against U.S. Dollar percent 12 8 4 0 -4 -8 -12 -16 -20 J F M A M J 2008 2010 J A S O 2009 2011 N D
These bellwether currencies faltered as global growth prospects were questioned, but have picked up with other risk assets post-Jackson Hole.
Having started the year on a very strong note, the ruble has given back gains in recent weeks, hurt by the decline in oil prices.
Commodities 1
Commodity prices have gained in recent months some of the ground they lost in H111. Parallel to this, commodity assets under management increased by $22 through July and August.
Commodity Spot Prices S&P GSCI indices, end-2007=100 200 180 160 140 120 100 80 60 40 Jan-08 Oct-08 Jul-09 Apr-10 Jan-11
Overall Energy Industrial M etals A griculture P recio us metals
Commodity Assets Under Management USD billions 450 Exchange-traded products 400 Medium-term notes 350 Indices 300 250 200 150 100 50 0 2005 2006 2007 2008 2009 2010
Source: Bloomberg, M TN-I, ETP issuer data, Barclays Capital
2011
Although commodity prices (except precious metals) lost momentum in H111, in recent months they have gained some of the ground they lost
Gold and Platinum Prices USD per troy ounce 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 Jan-10 Jul-10
Parallel to this, commodity assets under management, which shrank for the first time in Q211 since early 2009, increased by $22 in July and August.
U.S. Oil Inventories and Spot Price millions of barrels USD per barrel U.S. crude oil inventory (lhs) 160 WTI spot price (rhs) 380 140 360 340 120 100 80 60 40 20 Oct-08 Jul-09 Apr-10 Jan-11
Platinum Gold
320 300 280 Jan-08
Jan-11
Jul-11
Difference between platinum and gold has almost disappeared as slow growth in car industry keeps platinum prices low and flight to safe heavens continues to surge gold prices.
U.S. Fuel Ethanol Consumption and Crude Oil Imports from Saudi Arabia millions of barrels 70 60 50 40 30 20 10 0 00 01 02 03 04 05 06 07 08 09 10 11
Source: IEA
Crude oil price has been on the rise in recent weeks, erasing loses it had during the first week of August.
Fuel Ethanol Consumption U.S. Crude Oil Imports from Saudi Arabia
Corn: World Stocks and millions of tonnes 180 160 140 120 100 80 60 40 20 0 01 02 03 04 05
* f orecast . Source: USDA and JPM
Price Rest of World US Corn price(rhs) $/bushel 8 7 6 5 4 3 2 1 0 06 07 08 09 10 11* 12*
Corn growers are catching up with Saudi Oil as U.S. fuel; the difference shrank to 8.4 million barrels from 45 million barrels in 2000.
Pressured by ethanol production, U.S. corn stocks are estimated to shrink this year and 2012.
Volatility 1
As a result of heightened level of uncertainties in Europe and the U.S. sovereign debt markets, Volatility across all asset classes has increased sharply in August.
Equity Market Volatility percent 80 65 50 35 20 5 Jan-07
2
VIX (S&P 500-U.S.) VDAX (DAX-Germany)
Interest Rate Volatility percent, implied from 3m x 10yr ATM swaptions 50 USD Euro 45 Pound 40 35 30 25 20
Jan-08
Jan-09
Jan-10
Jan-11
15 Jan-10
Jul-10
Jan-11
Jul-11
Equity volatility both in Europe and U.S.
and interest volatility across the board have increased sharply in August as a result of heightened level of uncertainty in Europe and the U.S. sovereign debt markets.
Commodity Price Volatility 30-day historical volatility of GSCI indices, percent 45 Composite Energy 40 Metals Petroleum 35 30 25 20 15
European CDS Indices and Equity Volatility* spread, bps 140 120 100 80 60 40 Jan-10
Jul-10
Jan-11
Jul-11
* Diff erence between 5-year iTraxx Europe spread and VDAX index.
10 Jan-10
Jul-10
Jan-11
Jul-11
Volatility of European corporate CDS has increased sharply relative to that of European equities in recent months.
Affected by uncertainties related to global growth, commodity price volatility has increased in recent months.
Currency Implied Volatility* percent 18 16 14 12 10 8 Jan-10
35 25 15 5 '00 '02 '04 '06 '08 '10
G7 Emerging markets Jul-10 Jan-11 Jul-11
* JP M organ currency implied volat ilit y indices (G7: VXY; emerging market s: EM -VXY), based on 3-mont h at -t he-money f orward opt ions.
Emerging Market Equity and Debt Volatility 30-day historical volatility of MSCI-EM index (USD returns) and EMBIG returns, percent Equities 35 9 32 8 EMBIG (rhs) 29 7 26 6 23 5 20 4 17 3 14 2 11 8 1 Jan-10 Jul-10 Jan-11 Jul-11
Currency implied volatility against the dollar has increased across the board in August; EM currency volatility has risen to G7 levels.
Emerging market debt and equity volatilities have risen above their early 2011 levels in August.
Mutual Fund Flows 1
As year to date equity gains across the globe got erased in recent weeks, equity funds had sharp outflows both in the U.S. and emerging markets.
Net Flows to U.S. Money Market Funds USD billions, cumulative change since end-2007 600 400 200 0 -200 -400 -600 Jan-08 Oct-08 2010 withdrawals: $395 billion 2011ytd withdrawals: $304 billion Jul-09 Apr-10 Jan-11 2009 withdrawals: $466 billion
Change in U.S. Mutual Fund Assets Outstanding USD billions, cumulative change since end-2008 U.S. equities 400 Emerging market equities 350 U.S. bonds 300 250 200 150 100 50 0 -50 Jan-09
Oct-09
Jul-10
Apr-11
U.S. money market funds had outflows of $171 billion in August; outflows to date amounted to $304 billion compared with $375 billion same time in 2010.
Emerging Market Funds: Debt and Equity Net Flows USD billions, FI includes hard and local currency funds 30 2009 2010 2011 25 20 15 10 5 0 -5 Fixed income -10 -15 Equity -20 J FMAMJ J ASONDJ FMAMJ J ASONDJ FM AMJ J A
U.S. money market funds across the board had outflows in August; affected by equity market losses, U.S. equity MMFs had the highest outflows.
Emerging Market Regional Equity Fund Flows USD billions, from dedicated funds, 3wk mav smoothed 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Jan-09 Latin America EM Europe EM Asia Jul-09 Jan-10 Jul-10 Jan-11 Jul-11
EM equity funds had nearly $15 billion outflows in August as EM equities lost all their year to date gains.
Equity funds across all EM regions had outflows in August. Equity funds in EM Asia had highest outflows, although EM Asian equities have performed relatively better
Fixed Income Flows into Emerging Market Funds USD billions, cumulative flows 79.4 80 2007 2008 2009 2010 70 2011 60 46.2 50 40 30 20 10 0 -10 -3.6 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 41.9
Selected Emerging Markets Net Equity Flows USD millions, 4wk mav Brazil 1,800 South Africa India 1,400 Korea 1,000 600 200 -200 -600 -1,000 -1,400 Jan-10 Jul-10 Jan-11 Jul-11
than their counterparts in Latin America and EM Europe on average. Equity funds in Korea accounted for most of the outflows.
Despite the global uncertainties, EM fixed income funds have had stable inflows year to date, although the pace of their inflows was lower than that of 2010.
Issuance and Flows I 1

Global Corporate Bond Issuance* USD billions 800 600 400 200 0 2007
* Includes f inancials.
As global risk sentiment reversed, issuance of both high yield and high grade bonds has slowed down significantly in July and August. U.S. ABS issuance has been more dynamic year to that compared with European ABS issuance.
USD billions 105 90 75 60 45 30 15 0
Global Equity Issuance USD billions Value 350 Number of issues (rhs) 300 250 200 150 100 50 0 2007 2008 2009 2010 2011
1,600 1,400 1,200 1,000 800 600 400 200 0
2008
High grade
2009
2010
2011
High yield (rhs)
As global risk sentiment reversed, issuance of both high yield and high grade bonds has slowed down significantly in July and August
U.S. ABS Issuance USD billions 800 700 600 500 400 300 200 100 0
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '1 '1 ytd 0 1
Source: SIFM A
whereas pace of equity issuance was more in line with that of previous months.
Other Student Lo ans Ho me Equity Equipment Credit Cards A uto
U.S. MBS Issuance USD billions 3,500 3,000 2,500 2,000 1,500 1,000 500 0
'01 '02
Source: SIFM A
Private-label Agency
'03
'04
'05
'06
'07
'08
'09
'1 '1 ytd 0 1
U.S. ABS issuance amounted to $76 billion by the end of July, compared with $66 billion issuance same time last year.
U.S. MBS issuance amounted to 1$ trillion by the end of July, compared with $900 billion same time last year. However, private-label issuance was only $15 billion.
European Covered Bond Issuance billions 60 50 40 30 20 10 0
European ABS Issuance EUR billions Auto Cards 900 CDO CMBS 800 Consumer Leases 700 RMBS Other 600 500 400 300 200 100 0 '04 '05 '06 '07 '08
2008 2009 2010 2011ytd
'09
'10 '11ytd
Affected by European bank funding pressures, European ABS issuanceamounting to 111 by the end of August, has been weaker relative to that of last year.
Although issuance pace slowed down over the course of the year, covered bonds provide alternative funding to European banks experiencing funding problems in bond markets.
Issuance and Flows II 1
According to TIC data, purchases of U.S. securities by foreigners have declined in the first five months of 2011.
U.S. Net Long-term Cross-border Transactions USD billions, nsa Treasury bonds Government agency bonds 200 160 120 80 40 0 -40 -80 2005 2006 2007 2008 2009 2010 2011
Corporat e bonds Foreign securit ies Corporat e equit ies Total
U.S. Net Long-term Cross-border Transactions USD billions, nsa 150 110 70 30 -10 -50 -90 2005 2006 2007
N. America Asia Lat . Am. & Carib. Africa Europe Other
2008
2009
2010
2011
Source: U.S. Treasury Department ; IIF calculations.
Source: U.S. Treasury Depart ment; IIF calculat ions.
According to TIC data, although purchases of U.S. securities by foreigners have declined in the first five months of 2011
all regions, except from Europe, were still net buyers in May.
Net Private Foreign Purchases of U.S. Securities* 12-month rolling sum, USD billions 1,200 Equities 1,000 800 600 400 200 0 -200 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Source: U.S. Treasury Department ; IIF calculations. * Long-term securit ies.
Net Official Foreign Purchases of U.S. Securities* 12-month rolling sum, USD billions 300 225 150 75 0 -75 -150 '02
Treasuries Co rpo rate bo nds To tal A gencies Equities
Co rpo rate bo nds A gencies Treasuries To tal
'03 '04
'05
'06 '07
'08
'09
'10
'11
Source: U.S. Treasury Depart ment; IIF calculat ions. * Long-t erm securities.
Although private foreign investors have been net buyers of all U.S. asset classes through the first five months of this year,
official sector foreign investors have been net sellers of agencies.
Net Foreign Purchases of U.S. Securities USD billions, nsa Lo ng-term treasuries 250 200 150 100 50 0 -50 -100 2005 2006 2007 2008 2009 2010 2011
Sho rt-term treasuries Lo ng-term agencies Sho rt-term agencies
Change in Foreign Holdings of Short-term Treasuries* USD billions, nsa Official 90 70 50 30 10 -10 -30 -50 2005 2006 2007 2008 2009 2010 2011
B anks Int'l & regio nal o rgs. To tal
Source: U.S. Treasury Department ; IIF calculations.
Source: U.S. Treasury Depart ment; IIF calculat ions. * M ont h-on-mont h change.
Foreign investors have been net buyers of both short and long term U.S. Treasuries and agencies.
Although official sector agents have been net buyers of short term Treasuries in May, banks and international organizations have been net sellers.
Capital Markets Monitor Capital Markets Monitor December 2011 September2008
32
Glossary
ABX.HE Index representing aggregate performance of a basket of credit default swaps on subprime residential mortgage-backed securities (RMBS). The composition is scheduled to change every six months and include a new set of 20 subprime RMBS deals closed in the prior six months. [www.markit.com] Asset-backed commercial paper (ABCP) Commercial paper (CP) whose principal and interest payments are derived from cash flows from an underlying pool of assets. In the event that CP cannot be reissued in order to repay maturing CP, a backstop liquidity facility is typically drawn upon to provide cash to repay investors. Asset-backed securities (ABS) Bonds or notes backed by pools of financial assets. Examples of such assets include residential mortgages (RMBS), commercial mortgages (CMBS), credit card receivables, trade receivables, student loans, and auto loans. Auction rate security (ARS) Securities with usually long-term maturities where the interest or dividend rate resets periodically to the rate produced in an auction. The frequency of periodic auctions varies, with common reset periods being daily, 7 days, 28 days, 35 days, 49 days and six months. [www.sifma.org] Breakeven inflation rate The rate of inflation that would give an investor the same return at maturity on a nominal security and a treasury inflation-protected security. [see Federal Reserves The TIPS Yield Curve and Inflation Compensation.] CMBX Index representing aggregate performance of a basket of credit default swaps on commercial mortgagebacked securities (CMBS). The composition is scheduled to change every six months and include a new set of 25 CMBS deals closed in the prior six months. [www.markit.com] Conforming mortgage Residential mortgage that meets the eligibility requirements for purchase by Fannie Mae or Freddie Mac (US mortgage government sponsored enterprises). The limit for one-unit properties was $417,000 in 2007, but recent legislation has raised this limit in many locations at least through the end of 2008. [www.ofheo.gov] Constant proportion debt obligation (CPDO) An investment vehicle backed by an investment in an index of debt securitiescommonly the sale of credit protection on credit default swap indices such as CDX or iTraxx. Two specific characteristics of CPDOs: (1) they cease investing when their profits are sufficient to ensure return of principal and coupon to their investors; and (2) the further a CPDO is from achieving its profit goal the more leverage it employs. Credit default swap (CDS) A type of credit derivative contract whereby the protection seller agrees to pay the protection buyer the settlement amount upon the occurrence of certain credit events (e.g., bankruptcy). In exchange for this protection, the protection buyer pays the protection seller a premium. The premium is usually quoted in basis points per notional value of the contract one basis point on a credit default swap on debt with a $10 million notional value is equal $1,000 per year. LCDX Index with 100 equally-weighted underlying single-name loan-only credit default swaps (LCDS). The default swaps each reference an entity whose loans trade in the secondary leveraged loan market and in the LCDS market. [www.markit.com] LevX senior Index of the 35 most liquid 1st lien credit agreements traded in the European Leveraged Loan CDS market. [www.markit.com] LevX subordinated Index of the 35 most liquid 2nd and 3rd lien credit agreements traded in the European Leveraged Loan CDS market. [www.markit.com] Jumbo mortgage A conventional single-family mortgage with an original balance above the conforming loan limit (see conforming mortgage). [www.ofheo.gov] Overnight index swap (OIS) A fixed/floating interest rate swap with the floating leg tied to a published index of a daily overnight rate reference (e.g, effective federal funds rate). Terms generally range from one week to two years. The two parties agree to exchange at maturity, on the agreed notional amount, the difference between interest accrued at the agreed fixed rate and interest accrued through geometric averaging of the floating index rate. Stop-out rate The lowest accepted interest rate in a term auction facility auction (see term auction facility). Term auction facility (TAF) A credit facility of the US Federal Reserve that allows a depository institution to place a bid for an advance from its local Federal Reserve Bank at an interest rate that is determined as the result of an auction. The TAF will auction term funds of approximately one-month maturity. All depository institutions eligible to borrow at the discount window are eligible to participate in TAF auctions, and all TAF credit must be fully collateralized. [www.federalreserve.gov] Variable interest entity (VIE) Formerly known as special purpose vehicles, VIEs are leveraged off-balance sheet vehicles that generally hold financial assets, including loans or receivables, real estate or other property, and fund themselves by selling short-term debt backed by the financial assets they hold. Structured investment vehicles (SIVs) are one type of VIE.

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Capital Markets Monitor

In a pattern echoing that of the 2007-09 financial crisis, there is a

+1.202.857.3647 zaksoy@iif.com +1.202.857.3308 jmazzacurati@iif.com

Data cutoff date: September 1, 2011

Capital Markets Monitor September 2011 2

Key Issues of the Month: Mensis Horribilis!

Source: Bloomberg, IIF calculations

380 360 340 320 300 280 260 240 220

Source: Flow of Funds, Datastream

180 175 170 165 160 155 150 145 140

Capital Markets Monitor September 2011 3

Key Issues of the Month, continued

Policy rates (rhs )

450 400 350 300 250 200 150 100 50 0

Capital Markets Monitor September 2011 4

Key Issues of the Month, continued

Source: Morgan Stanley, Bloomberg, IIF calculations.

Source: Thomson Reuters, Bloomberg, IIF calculations

Source: MSCI, Bloomberg

Capital Markets Monitor September 2011 5

Key Issues of the Month, continued

* on USD basis. Source: Fitch Ratings

-160 Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11

Capital Markets Monitor September 2011 6

Special Feature I: European Bank Funding Strains

Source: Markit, Bloomberg

Source: ECB, National Central Banks

Capital Markets Monitor September 2011 7

Special Feature I: European Bank Funding Strains

Euro Area U.S.

Source: Thomson Reuters, Bloomberg, IIF calculations

Capital Markets Monitor September 2011 8

Special Feature I: European Bank Funding Strains

Source: Federal Reserve, Bloomberg

Source: Fitch Ratings

Source: Fitch Ratings

Capital Markets Monitor September 2011 9

Source: Bloomberg, IIF calculations.

Source: Bloomberg, Datastream

Capital Markets Monitor September 2011 10

Special Feature III: Deleveraging

1 change in outstanding debt, % point of GDP,

Source: Federal Reserve, Bank of England, IIF calculations

Source: European Central Bank, IIF calculations

Capital Markets Monitor September 2011 11

Special Feature IV: The Fed and ECB Balance Sheets

Source: Federal Reserve, IIF calculations

Source: ECB, IIF calculations

Capital Markets Monitor September 2011 12

Asset Performance in Perspective 1

Annual Returns for Selected Asset Classes percent, 2011 ytd

Annual Bond Returns* percent, 2011ytd

Co pper* U.S. do llar U.S. CRE EM equities**

CCC & lo wer co rpo rates

Sovereign bonds* Equities**

-30 -26 -22 -1 -1 -1 8 4 0

* EM BIG index t ot al returns. ** M SCI index t ot al returns in USD-terms.

Capital Markets Monitor September 2011 13

Sovereign Debt Markets I: Focus on Europe 1

* 10-year government bonds.

Capital Markets Monitor September 2011 14

Sovereign Debt Markets II 1