The global financial system shows signs of stress, but why should policy-makers care?
After all, this is financial turmoil, not a systemic financial crisis. There has been no failure of a large complex financial institution, nor a widespread decline of asset prices. True, many investors lost money and the problems are not over. Risk is being repriced, funding vehicles unwound, and liquidity restricted in some markets. But this turmoil follows three years of unusually low volatility of short-term interest rates, long-term bonds, stocks, exchange rates and corporate spreads (Panetta et al 2006). Financial crisis had become less frequent and international financial markets seem quiescent. Markets are more complete and market information is more generally available.
Policy-makers should be concerned precisely because financial markets have been such a success. As the complexity and scale of the international finance system grows, so too does the downsize risk for the real economy.1 The value of traded assets rose form 1.6 times to 2.5 times GDP in the major industrial nations in 15 years. A major bank failure or asset price drop now can cause much more disruption than when the financial sector was smaller. Moreover, systemic risk in banking has increased in the US and euro area (Hartman et al, 2005).
Whether the subprime problems dwindle away or get fanned into a full-blown crisis, they are a wake-up call. We should think carefully about longer-term reforms needed to improve the stability of the international financial system.
A new Report from CEPR outlines an ambitious agenda for reform that would design stability, moving the international financial system towards a more balanced, market-based model.2
In many respects, financial markets are better regulated and more stable today than 20 years ago. For example, the volume of derivatives outstanding and the scale of hedge fund activity are at levels unimaginable then, yet the frequency of derivatives disasters and large hedge fund failures is no greater. Still, the risks are there: global imbalances, the carry trade, asset price bubbles, the rise in household indebtedness, financial consolidation and the rise of systemically important financial institutions with extensive cross-border reach, and a proliferation of new and often opaque financial instruments (associated with the banks’ shift from ‘buy and hold’ to ‘originate to distribute’). Many of these risks arise from the rapid pace of financial innovation over the past decade. These changes cannot now be reversed, and regulators should not attempt such reversal. Instead, the right approach is to make them work properly, by pushing the system towards a well-behaved market-based model.
First, consider some of the much-discussed issues that we believe should not be the focus of reform: volatility, hedge funds and the carry trade.
Recent volatility spikes have not been especially large
From 2004 until very recently, volatility was exceptionally low across all asset classes and markets, and risk premia (yield spreads, premia on credit default swaps) were also very low. The Report identifies several structural factors underlying what seems to be a secular downward shift in volatility. Some of these factors may, however, tend to undermine financial stability. Market liquidity may be higher on average but more vulnerable to sudden shifts. Low volatility and low interest rates have led to a search for yield that may have encouraged excessive risk-taking. If market prices and portfolio choices rest on expectations of low volatility, investors may be vulnerable to volatility spikes. Nevertheless, the spikes of May 2006, February/March 2007, and summer 2007 were not especially large and do not appear to have been a source of financial instability.
Hedge funds do not seem to have played a significant role
Many regulators in the US and other major markets believe that the best way to monitor hedge fund activity is indirectly, through their sources of funds. Banks must regularly assess the creditworthiness of their hedge fund borrowers and counterparties, and brokers must actively monitor the positions of hedge funds and manage their exposure to them. Regulators have reached no international consensus on the need for further oversight.
We see no clear benefit from additional regulation. Hedge funds do not seem to have played a significant role in setting off the current financial turmoil. Some have suffered from it and others have profited, but their problems have had little systemic impact. Banks and brokers should share more information about their counterparty exposures to hedge funds. Regulators should insist that prime brokers and investors know better the positions and strategies of the hedge funds with which they transact. Market participants would also benefit from greater emphasis on “tail risk”, which is of particular systemic relevance. And a ‘Capital Markets Safety Board’ that investigates, reports and archives information on hedge fund (and other financial sector) debacles may likewise offer valuable benefits in combating systemic risk.
Carry trade is unlikely to pose a systemic risk
Cross-border financial integration has accelerated dramatically over the past fifteen years, mainly among industrial countries. That has not, in our view, raised the probability of a systemic event. For the particular case of China and India, we find that a domestic financial crisis is unlikely to induce strong financial contagion in other major countries. The carry trade is another potential source of instability. Its profitability is very sensitive to changes in the level and volatility of exchange rates, so it could unwind abruptly, especially in a large volatility spike. It seems unlikely, however, that this would pose a systemic risk.
The reform agenda should focus on three issues:
- large complex financial institutions
- new financial instruments
- the consequences of banks’ shifting from a ‘buy and hold’ to ‘originate-to-distribute’ business model.
Regulating large complex financial institutions: more central bank cooperation needed
The growing role of large complex financial institutions may have made them ‘too big to fail’ – or conversely, ‘too big to rescue’. It also raises the issue of regulatory capture. When financial institutions become very large and local markets very concentrated, their lobbying power increases significantly. This suggests a potential weakening of market discipline, which calls for greater disclosure. Cross-border financial consolidation also raises coordination problems for supervisors, regulators, and lenders of last resort. Moreover, liquidity pools are more likely now to be international: the evaporation of liquidity may quickly extend across borders, while large complex financial institutions may access liquidity wherever it may be. This suggests that not only regulators, but also the major central banks must cooperate more closely in dealing with liquidity shocks.
Coping with new financial instruments: some useful lessons from the derivatives market
Given all the benefits from innovative financial instruments, the appropriate question is how to make these instruments safer. First, market-driven, but regulatory- and supervisory-authority-guided, approaches are necessary for successful financial risk management. As new instruments are designed, regulation must keep pace. Second, financial risk-management solutions must be global.
The derivatives market may offer some useful lessons for regulators. During 1993-5, there were several major derivatives disasters. But the derivatives market appears safer today than it was in the 1990s, even as it has expanded from an already remarkable $12 trillion by a factor of 30 over the past 15 years. This spectacular growth suggests that derivatives are meeting the market test of fulfilling a genuine purpose. Meanwhile, the lower frequency of major disasters despite this rapid growth suggests that market participants are using derivatives more responsibly. The Counterparty Risk Management Policy Group exemplifies these principles. In the wake of the Long Term Capital Management failure, this group of 12 global financial firms examined how to improve risk management procedures. Because of its recommendations, firms can now better measure their aggregate counterparty risk exposures, documentation standards have improved, the use of collateral to mitigate risk has increased, and stress testing procedures are commonplace. Also, much progress has been made on documenting the backlog of unconfirmed credit derivative trades, increasing the use of electronic trade documentation, and improving the settlement protocol. The reforms in the derivatives market in the 1990s may offer useful lessons for regulators today.
Transactions that do not transfer risk should not be treated by regulators as if they do
The business model of banks is evolving from the traditional 'buy and hold' model, in which banks are funded with short-term deposits and invest in loans held until maturity, to the 'originate to distribute' model, in which banks originate loans and then repackage and sell them to other investors, distributing risks throughout the economy. Most of these risks are passed to other banks, insurance companies and leveraged investors, who are the main buyers of structured finance and credit derivative products.
The wider distribution of risks within the global financial system offers many potential benefits. It makes many assets more liquid, frees additional resources for investment and reduces the volatility of asset prices. Because it distributes risk across a diverse universe of investors, it should in principle reduce the likelihood of systemic events. Recent developments in the US subprime market suggest, however, that the 'originate to distribute' model also has weaknesses that might create new forms of risk or magnify existing ones. Banks have less incentive to monitor borrowers ex post, although in principle they have more incentive to screen them ex ante. They have switched from relying on ‘soft information’ and long-term relationships with borrowers to model-based pricing. Many of the new instruments are illiquid, and the role of ratings firms in evaluating them is highly controversial. There has been a transfer of activity from regulated to unregulated investors. To sum up, this model may be more efficient, but more complex, with more tail risk, operational risk, and legal risk. This is the area on which reforms should focus over the medium-term.
The shift from 'buy and hold' to the 'originate to distribute' model should not (and probably cannot) be reversed. Policy-makers and industry bodies can try to make it work better, to push it towards a more balanced, market-based model through reforms that include:
- Regulators and market participants should pay particular attention to “tail risk”
- New regulations could require originators to retain equity pieces of their structured finance products.
- Regulators need aggregate information on structured finance instrument holdings and on the concentration of risk to assist in the regulatory process.
- Industry bodies should promote product standardisation and accurate pricing in the structured finance market.
- Credit market transactions that do not definitively transfer risk should not be treated by regulators or risk managers as if they do.
- Ratings firms should provide a range for the risk of each instrument rather than a point estimate, or should develop a distinct rating scale for structured finance products.
F. Panetta, P. Angelini, A. Levy, G. Grande, R. Perli, S. Gerlach, S. Ramaswamy, M. Scatigna,(2006). "The Recent Behaviour of Financial Market Volatility," BIS Paper, No. 29, August 2006, Bank for International Settlements.
Hartmann, P. S,. Straetmans and P. de Vries (2005). “Banking system stability: A cross Atlantic perspective.” NBER WP. 11698.
1 R. Rajan (2005), ‘Has financial development made the world riskier?’, Jackson Hole Symposium.
2 'International Financial Stability', the ninth Geneva Report on the World Economy, published on 12 November by CEPR and the International Centre on Money and Banking Studies in Geneva. The material is joint work by the authors of the Report: Roger Ferguson, Jr., Phillip Hartmann, Fabio Panetta, and Richard Portes.