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TWN Info Service on Finance and Development (May08/03)
7 May 2008
Third World Network

THE UNFOLDING TURMOIL AND SOME POLICY RESPONSES

The unfolding financial turmoil in the mature economies is best seen as a natural result of a prolonged period of generalised and aggressive risk–taking – which happened to have the sub–prime market at its epicentre – and the policy response to strengthen the financial system on a more structural basis should be firmly anchored to the more enduring factors that drive financial instability.

This was the view put forth by Claudio Borio from the Monetary and Economic Department of the Basel–based Bank for International Settlements (BIS) in a Working Paper issued in March which provides a preliminary assessment of the events of the financial turmoil, and draws some lessons for policies designed to strengthen the financial system on a long–term basis.

Below report on the Borio proposals. It was published in SUNS # 6463, Friday, 25 April 2008. This article is reproduced here with the permission of the SUNS.  Reproduction or recirculation requires permission of SUNS (sunstwn@bluewin.ch).

With best wishes
Martin Khor
TWN

The Unfolding Turmoil and Some Policy Responses
By Kanaga Raja, Geneva, 24 April 2008

The unfolding financial turmoil in the mature economies is best seen as a natural result of a prolonged period of generalised and aggressive risk–taking – which happened to have the sub–prime market at its epicentre – and the policy response to strengthen the financial system on a more structural basis should be firmly anchored to the more enduring factors that drive financial instability.

This was the view put forth by Claudio Borio from the Monetary and Economic Department of the Basel–based Bank for International Settlements (BIS) in a Working Paper issued in March which provides a preliminary assessment of the events of the financial turmoil, and draws some lessons for policies designed to strengthen the financial system on a long–term basis.

In Working Paper No. 251 titled “The financial turmoil of 2007–?: a preliminary assessment and some policy considerations,” Borio said that the unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century.

The paper argued that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk–taking, which happened to have the sub–prime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences that follows the build–up of financial imbalances in good times, in the form of overstretched balance sheets, masked by the veneer of buoyant asset prices and strong economic growth.

The significant idiosyncratic elements, including the threat of an unprecedented involuntary “re–intermediation” wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes, the paper added.

Policies to strengthen the financial system on a sustainable basis, while naturally taking into account the specific weaknesses brought to light by the current turmoil, should be firmly anchored to the more enduring factors that drive financial instability. In this context, the paper highlighted possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.

The areas for action highlighted by the paper include: strengthening transparency, including with specific reference to measures of the uncertainty that surrounds point estimates of value, to multi–dimensional rating classifications and to liquidity risks; encouraging improvements in risk management systems, not least seeking to limit the pro–cyclicality of risk measures; reflecting further on how to promote more prudent compensation schemes; strengthening the macro–prudential orientation of prudential frameworks, building on the important improvements in minimum capital regulation yielded by Basel II; and refining monetary policy frameworks so as to take better account of both the build–up and unwinding of financial imbalances, including by ensuring effective liquidity management operations at times of stress.

“Working along these lines holds out the promise of helping to limit the incidence of serious episodes of financial distress in the future,” stressed the paper.

The paper noted that on 9 August 2007 the interbank markets of the United States and the euro area came under unexpected and severe strains. This prompted an immediate and determined response by the respective central banks aimed at restoring more orderly conditions through large gross injections of liquidity. Similar strains emerged in other developed economy interbank markets, not least those of the United Kingdom, Switzerland, Canada, Australia and, to a lesser extent, Japan.

What until then might have appeared as yet another well absorbed temporary upward adjustment in the pricing of risk, like those already seen in 2005 and 2006, but this time with the US sub–prime segment as the focal point, had turned out to herald much more serious dislocations at the very heart of the global financial system.

Half a year later, at the time of writing (February), said the paper, there are no signs that the turmoil is abating. To be sure, tensions in the interbank market have eased since their peak at year–end, when they were exacerbated by seasonal demands for liquidity. But write–downs by financial institutions have continued, worrisome strains have spread to monoline insurers, and the prospects are for a further deterioration in asset quality as property prices continue to soften, credit terms are tightened and the global economy weakens.

In short, the credit cycle has begun to turn. And what had started as a liquidity crunch has gradually been revealing itself as a deeper asset quality problem, and it is too early to tell how the future will unfold.

The paper outlined some stylized facts and a chronology of the main events of the financial turmoil. It said that the years that preceded the recent turbulence saw an exceptionally strong performance of the world economy – another phase of what has come to be known as the “Great Moderation”. Based on consensus forecasts, as recently as in June 2007, the future looked as bright as the past: both private and official forecasts foresaw a welcome mild reduction in growth rates, closer to estimates of potential growth, with little change in inflation.

Following the global slowdown of 2001, the world economy had recovered rather rapidly, posting record growth rates in 2004, 2005 and 2006. Remarkably, while some potential inflationary pressures could be seen towards the end of the period on the back of rapid increases in commodity prices, inflation had remained extraordinarily quiescent. Based on consensus forecasts, as recently as in June 2007 the future looked as bright as the past: both private and official forecasts foresaw a welcome mild reduction in growth rates, closer to estimates of potential growth, with little change in inflation.

This strength went hand in hand with unusually strong performance in financial markets and the financial system more generally, underpinned by the strength of asset prices. Pretty much globally, residential property prices had been rising rapidly, acting as a critical support for household spending. Their prolonged strength had been especially in evidence in several English–speaking countries, including the United States, in some European economies, including Spain, and in parts of Asia, not least China.

Across a wide spectrum of asset classes, volatilities and risk premia looked exceptionally low, including to varying degrees in fixed income, credit, equity and foreign exchange markets. Against the backdrop of historically low interest rates and booming asset prices, credit aggregates, alongside monetary aggregates, had been expanding rapidly, said the paper.

At a structural level in the financial system, recent years had seen an acceleration of financial innovation. The main manifestation had been the extraordinary expansion of credit risk transfer instruments, which permitted the transfer, hedging and active trading of credit risk as a separate asset class.

Examples included credit default swaps (CDSs) and, in particular, structured credit products, through which portfolios of credit exposures could be sliced and diced and repackaged to better suit the needs of individual investors. This category included, in particular, collateralised debt obligations (CDOs), backed both by cash instruments, such as primitive securities, loans or asset–backed securities, and by derivative claims, such as CDSs and CDOs themselves.

The current financial turmoil took shape against this backdrop, and its unfolding turmoil has proceeded in a number of phases: an initial seemingly orderly repricing of credit risk in the US sub–prime market; a much sharper adjustment following news of losses at troubled hedge funds, downgrades of structured products and strains in the LBO (leveraged buyout) market; a market and funding liquidity squeeze on investment vehicles; serious tensions in the interbank market and strains at some credit institutions; and broader concerns about deteriorating asset quality, including among monoline insurers, exacerbated by a darkening outlook for the real economy.

At the time of writing, the signs are that the financial strains will not disappear so easily. The re–capitalisation of monoline insurers is proving difficult. In the United States, the problems experienced in the sub–prime mortgage market have continued to spread to other forms of household debt, both within the mortgage segment and beyond. In addition, there are indications that the commercial real estate sector is weakening. The outlook in the leveraged loan market, in both the United States and Europe, is worsening, and default rates are expected to rise.

A softening in economic activity has become visible also outside the United States, especially in those countries that have shared the features of the US expansion. The de–leveraging process is bound to be painful. And the turn of the credit cycle is likely to remain a significant source of headwinds for the global economy.

In characterizing the dynamics of the financial turmoil, the paper said that the turmoil represented a sharp repricing of credit risk that, given the leverage built up in the system, led to, and was exacerbated by, an evaporation of liquidity in many markets, including in the interbank market. The repricing, which happened to have the US sub–prime mortgage market at its initial epicentre, followed a prolonged phase of broad–based and aggressive risk–taking. It was amplified by the great opacity of new instruments, such as structured credits, and of the distribution of exposures across the system.

This led to a crisis of confidence in valuations, triggered by unexpected rating agency downgrades, and to a generalised distrust of counter–parties, as market participants wondered about the size and character of their own exposures and of those of others. The crisis of confidence in turn triggered an evaporation of market liquidity for the instruments concerned and of funding liquidity for those institutions suspected of being vulnerable to the market disruption. As time passed, the underlying asset quality weaknesses inevitably became more evident.

The paper noted that the two most salient idiosyncratic aspects of the current turmoil are the role of structured credit products and that of the originate–and–distribute (O&D) business model. The former has to do with the nature of new financial products; the latter with how the products are produced and disseminated within the financial system.

The role of credit structured products has been so prominent that the recent turmoil is turning out to be the first major test of the resilience of the new credit risk transfer instruments spawned by the latest financial innovation wave. The paper said that three characteristics of these products may have contributed to the turbulence – their payoffs can be highly non–linear; the risk profile of structured products can be quite different from that of traditional bonds; modelling the future default and the risk profile of these instruments is itself subject to considerable uncertainty.

These characteristics have likely played a role both during the build–up of risk–taking and during the turmoil. During the build–up, they may have contributed to lulling participants into a false sense of security. During the turmoil, these features no doubt contributed to the loss of confidence and the evaporation of market liquidity.

As to the O&D business model, the paper said that it is the very essence of investment banking. And it has been underpinning the growth of the syndicated loan market for many years. In the United States, it is the model that underlies the mortgage market, which is heavily securitised.

Just like for structured products, the O&D model may have contributed both to the build–up of risk and to the turbulence that followed. During the build–up, it may have added to the forces leading to an underpricing of risks. For example, by appearing to disperse the risks in the system, the O&D model may have allowed the expansion of credit to go further than would otherwise have been the case. When risks materialised, the O&D model added to the crisis of confidence.

The explosive mixture of new financial products and the O&D model largely explain the single most surprising element of the current turmoil, viz the amplitude of the involuntary re–intermediation wave that threatened financial institutions, with its immediate and long–lasting dislocations in the interbank markets, said the paper.

The paper also observed two trends that have been in evidence for quite some time, and which are unlikely to be reversed in the future. The first is the increasingly tight symbiosis between intermediaries and markets – intermediaries such as banks have become increasingly reliant on markets as a source of income and for their risk management, through their hedging operations. Markets in turn have become increasingly dependent on intermediaries for the provision of market–making services and of funding liquidity (e. g credit lines), which underpins their smooth functioning.

The second, is the tight self–reinforcing link between market and funding liquidity. This had already been evident in previous episodes of turbulence. For instance, it was highly prominent in the Long–Term Capital Management (LTCM) crisis of 1998, when, in the presence of counter–party risk, increases in margin requirements and cuts in credit lines (i. e. reductions in funding liquidity) exacerbated the evaporation of market liquidity.

While the idiosyncratic aspects of the current turmoil are easily identifiable, those that it shares with previous such episodes are arguably more important, since they are likely to reflect the more enduring features of the dynamics of financial instability, said the paper.

All episodes of financial distress of a systemic nature, with potentially significant implications for the real economy, arguably have at their root an over–extension in risk–taking and in balance sheets in good times, masked by the veneer of a vibrant economy. This over–extension generates financial vulnerabilities that are clearly revealed only once the economic environment becomes less benign, in turn contributing to its further deterioration. The risk that builds up in good times simply materialises in adversity. The build–up and unwinding of financial imbalances is what can be termed the potential “excessive pro–cyclicality” of the financial system.

The signs of excessive risk–taking were not hard to see, said the paper. Moreover, several observers, including in the official sector – the BIS among them – did not hold back warnings to that effect, the paper noted, adding that the sustained global rapid increase in credit and asset prices, the exceptionally low risk premia and volatilities across asset classes, on the back of a widespread search for yield, and the accompanying evidence of a relaxation of underwriting standards and aggressive pricing were all unmistakable symptoms.

The paper highlighted a number of areas where measures may be desirable. The focus is not on how the turmoil should be managed, but on what policies could be put in place to strengthen the financial system on a longer–term basis, regardless of the specific sources of disturbances.

It stressed that accounting (or financial reporting) standards are a crucial element of the financial infrastructure: they are a key measuring rod for valuations, incomes and cash flows and the main vehicle through which this information is conveyed to the public.

An aspect highlighted by the current turmoil is the wide margin of error, or the uncertainty, that can surround the valuations of instruments for which a liquid underlying market does not exist (or may evaporate at times of stress). To varying degrees, the valuation of these instruments relies on models (marking–to–model). That of complex products, in particular, depends quite heavily on these approximations.

The paper noted that a holistic strategy aimed at raising transparency in financial reporting and disclosure would distinguish clearly three dimensions of the information provided about any firm – the first is point estimates of current value, income and cash flows (“first moment information”). The second is the risk reflected in the statistical dispersion of future outcomes for these estimates (“risk information”). The third is the uncertainty, if any, associated with the imperfect measurement of the first two types of information (“measurement error”).

So far, efforts have mainly focused on the first and, increasingly, second dimensions of this information. While increasing, much more systematic attention could be paid to the third.

This basic framework could also be applied to remedy some of the shortcomings of rating scales highlighted by the recent turmoil. In revising their methodologies and rating categories, rating agencies could explore the possibility of setting up three–dimensional rating systems, covering, respectively, expected loss (probabilities of default), unexpected loss or tail risk, and a measure of the confidence (margin of error) that surrounds the previous two classifications.

In recent years, prudential regulation has been strengthened substantially. In particular, important strides have been made in the area of minimum capital standards. For banks, Basel II represents a major step forward compared with Basel I, said the paper, adding that Basel II has helped to spread and hard–wire best risk management practice within the banking industry. Implementing Basel II should remain a priority.

At the same time, said the paper, there is a risk in relying exclusively on prudential policies to address financial imbalances as a source of financial and macro instability. Monetary policy, too, has a role to play, and not just in softening the impact of their unwinding, but also in constraining their build–up.

The main challenge for monetary policy is that financial imbalances can also build up in the absence of overt inflationary pressures. The paper suggested that it is important for monetary policy frameworks to allow for the possibility of tightening monetary policy even if near–term inflation remains under control – what might be called the “response option”. This would limit the risk of a painful macroeconomic adjustment further down the road, as the unwinding of the imbalances can result in macroeconomic weakness, broader financial strains, unwelcome disinflation and possibly even disruptive deflation.

At the same time, as in the case of prudential policy, serious hurdles of an analytical, institutional and political economy nature exist. For example, issues such as the identification of the imbalances in real time, the calibration of the response, its consistency with mandates and its proper communication and justification are not easily addressed. Even so, the hurdles do not appear insurmountable, said the paper.

[Remarkably, for research essays of this kind, the BIS Working Paper is on a current event – the financial crisis, whose contours are not clear, and show no signs that the turmoil is abating. Central banks and financial authorities are announcing almost daily a variety of measures in attempts to restore confidence in markets and the wider economy, but apparently with no effect beyond a few days.

[However, given the centrality of the financial system to a functioning deregulated market system, and the centrality of the role of the central banks in such a system, it is not clear whether a focus only on the “enduring factors driving financial instability” will suffice. For example, viewing the rapid rise in residential property prices as global (as the paper does in its stylized facts) does not explain why the US housing asset bubble was ignored by the US Fed until it burst.

Note: Recently published minutes of 2002 of the US Fed show that the issue was discussed, but in effect dismissed by Greenspan. Outside the Fed, Dean Baker at the Centre for Economic and Policy Research published a briefing paper in 2002, drawing attention to home sale prices rising more rapidly than overall rate of inflation since 1995, and characterising it as a housing bubble (ala the earlier stock market and dollar value bubbles) and whose collapse would pose a serious danger to the US economy. Could enduring factors of financial instability in the system be addressed, without addressing such fundamental factors in the real economy fuelling such instability? (SUNS)

 


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