A warning on new risks in world financial market
In its recent quarterly report, the Bank of International Settlements (BIS) has voiced its apprehension over the risks to investors of some of the new range of financial securities and instruments which are being floated in the international financial markets. This warning has coincided with expressions of concern by US financial authorities about the dramatic inflation of shares in soaring US stock markets and the risks which new, inexperienced investors may bring to themselves and to the market by their panic reaction to any downturn.
by Chakravarthi Raghavan
IN its recent regular quarterly report and commentary on 'International Banking and Financial Developments, the Bank of International Settlements (BIS) has voiced concern over what it describes as 'untried techniques and instruments of financial risk management'.
In reporting new issuance of international securities, who have broke all previous records, and the proliferation of structures involving repackaging of assets and/or use of derivatives,the BIS has posed the question 'whether the risk and return characteristics of complex structures, as well as the liquidity of underlying assets, have all been properly assessed, particularly in the case of new entrants to the international market-place'.
This expression of concern by BIS comes in the wake of recent warnings by the Chairman of the US Federal Reserve and the Chairman of the US Securities and Exchanges Commission (SEC), and about the irrationality in the market.
Alan Greenspan, in testimony to the US Senate sounded again his warning of December last about the 'irrationality' of equity prices in the US market, being way above what would be justified on the basis of earnings and expectations, and cautioned that, in view of its rousing 'inflationary expectations', it might force the Federal Reserve to raise US interest rates.
The SEC Chairman, Arthur Levitt, had in a speech delivered a day earlier at Boston, announced tighter regulation of US mutual funds (which now manage some $3500 bn of assets on behalf of individuals) obliging them to make the investment risks clearer to the investors. Levitt noted that new investors are being drawn to the market and they are not as informed as they should be, with most having experienced only a bull market of the last decade. Levitt warned that these new investors may act precipitously and carelessly to a downturn and 'at great cost to themselves and to the markets'.
The BIS, not-so-explicitly-stated worry is that the banks - now engaged in old banking business and also in international securities and derivatives, (and, in some jurisdictions, insurance) - in raising money and doing business to earn profits, but without adequate risk weighting for capital adequacy purposes - may suddenly find themselves facing the effects of such risk, and set off a chain reaction affecting the banking system.
The BIS report, its quarterly regular commentary and statistics on recent 'International Banking and Financial Market Developments', reports that ample liquidity, subdued inflation, widespread efforts at fiscal consolidation and the progress towards a European Monetary Union (EMU) have combined to create a favourable climate in the international financial markets.
With limited scope for a further substantial reduction in interest rates in the major fixed income markets, investors' search for higher returns has led to a broadening in the focus of activity to include more 'exotic' sectors in terms of currencies, signatures and instruments.
In testing new products and exploring new niches, investors showed a willingness to take greater market and credit risks. Financial institutions were particularly active - diversifying their funding sources, restructuring their balance sheets and raising capital on an unprecedented scale through increasingly complex instruments.
When seen in relation to the more moderate pace of expansion of net international bank credit recorded last year, the growing buoyancy of securities issuance by financial intermediaries may have represented more a shift in structure of risk management, both on and off-balance- sheet, than a genuine increase in the financing of the real economy.
The report shows that international bank lending by BIS reporting banks to outside area countries in the third quarter of 1996 rose to $34.7 billion (compared to 28.1 billion in the second quarter, and 32.9 billionn in the same period of 1995).
The international securities markets were at the centre of these developments - with new debt issuance breaking all previous records in the fourth quarter with a total of $163.6 billion.
While fund-raising activity of financial institutions accounted for two-thirds of this amount, the search of international investors for higher yields increased their willingness to move down the credit spectrum and lengthen duration, opening new financing and refinancing opportunities for a broadening range of borrowers.
The accompanying reduction in risk premia, in turn, boosted the demand for securities involving the repackaging of assets and/or use of derivative features.
In fact most new issues in the international securities markets, during the period under review, incorporated one or both of these elements.
(Interestingly, Greenspan in his testimony had said that the reduction in risk premia could have contributed to expectations of very strong earnings, but viewing this as a rational one.)
The report brings out that in the efforts of international investors to obtain enhanced returns and moving down the credit spectrum to explore new market niches, there was an increase in the number of currencies used - with Argentine pesos, Croatian kunas and Icelandic kronurs being used in new issues.
With the asset-backed securities (ABSs), offering higher returns than assets of comparable credit standing, the financial institutions have been provided with new opportunities for restructuring balance sheets, economising on capital and maximising income.
There has also been a pervasive use of derivatives - featuring a widening array of debt issues - in the search of investors for higher returns. A large number of subordinated issues launched by financial institutions offered attractive margins over benchmark rates - in exchange for various optional elements and/or equity-like features.
These options - such as calls and step-ups - were often resold by underwriters in the secondary market to reduce borrowers' cost of funds.
More complex features
All these, and ongoing attempts at enticing investors through progressive incorporation of more complex features, and even finer distinction between debt and equity characteristics, culminated in December in the introduction of a preference share issue incorporating call, step-up, perpetual and non-cumulative clauses.
[A call option is one enabling purchase or sale at a future date at a fixed price. A step-up is one taking account of discontinuity in interest rates. Both could provide a high future profit, at a relatively smaller higher purchase price now, if prices go up, but could also mean losses for the institutions, if the market turns.]
Aside from their derivative features, many of these capital-raising instruments offer a number of additional benefits to both issuers and investors. For issuing banks, they provide an opportunity to exploit discrepancies between the tax and regulatory treatment of capital. For investing banks an important incentive is their low risk weighting for capital adequacy purposes, although this is somewhat offset by higher market and credit risks.
In assessing these developments, BIS says that these raise three important issues:
* Firstly, with recent international debt issues incorporating increasingly complex derivative features, it can be asked whether the associated risk and return characteristics are adequately appreciated by investors.
The difficulties faced by rating agencies in evaluating such structures and the reduced market liquidity of the underlying issues by rating agencies provide some indication of the extent of the problems involved.
* Secondly, the large number of issues exploiting the discrepancies arising from differences in the treatment of capital for regulatory and tax purposes may have created inefficiencies in the global allocation of capital.
* Thirdly, the buildup of positions resulting from the strong fund-raising activity of financial institutions and inter-penetration of securities and derivatives markets have considerably reduced market transparency.
This is likely to have made some of the traditional monetary and debt aggregates less relevant in assessing real- side developments. (TWR No. 80, April 1997)
Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) and the Third World Network's representative in Geneva. This article was originally published in the SUNS.