Significant weaknesses have been revealed by the recent financial turbulence. In particular, liquidity evaporated in key markets, reflecting both the complexity and opacity of many structured products and the fact that banks underestimated their true exposure to the credit risk in the products they had securitised. A first challenge is to fix the weaknesses that have become apparent recently without detracting from the large benefits provided by modern financial markets. The second is to avoid adverse spillover effects to the global economy.
Weaknesses revealed by the recent financial turbulence
• The rapid pace of deregulation and financial innovation over the past 15 years – roughly since the late 1980s – has developed more market-based and more diversified channels of intermediation between ultimate savers and borrowers, partly owing to the establishment of new financial products and markets (particularly for securitisation and credit risk transfer).
• These innovations have made the global financial system, by an order of magnitude, more resilient to idiosyncratic shocks – LTCM, Enron, the Argentine default, to mention just a few. However, the current episode of credit market turbulence appears to result from a systemic shock. The systemic shock is that, following an extended period of excessive risk-taking, confidence in a broad range of securitised risk transfer products was severely shaken, and this increased risk aversion quickly spread to the interbank markets at the core of the global financial system. Liquidity in these markets suddenly evaporated - and has still not fully recovered in term money markets.
• Hence, there are two key challenges at the present juncture. The first is to fix the recent weaknesses that have become evident in the global system without detracting from the large benefits provided by modern financial markets. The second is to prevent the recent turbulence in financial markets spilling over to the macroeconomic performance of the world economy.
Two key factors have contributed to this evaporation of liquidity
1. The first is that the complexity and opacity of many structured products made them difficult to price and trade in adverse market conditions. These dysfunctional elements continue to weigh on the system, aggravating doubts about the reliability of valuations and earnings reports. Recent events have also created a “crisis of confidence” in the ratings of structured products produced by the credit rating agencies. Until recently, banks had been able to sell off even the equity tranches of the structured credit transfer products they originated. With little or no exposure remaining on their books, banks had little incentive to effectively screen and monitor borrowers. And non-bank investors have been relying more and more on the combination of credit ratings and asset diversification, rather than credit monitoring, to manage the credit risk in their portfolios.
2. A second weakness is that banks underestimated their true exposure to the credit risk in the products they had securitised, and underpriced their liquidity backup lines for structured finance vehicles.
The upshot of these weaknesses is that banks are now faced with the prospect of a substantial, involuntary and uncertain increase in their balance sheets. While many banks have reasonable capital cushions, this could significantly tighten the flow of credit to the productive sector. And this uncertainty creates a considerable downside risk to the macroeconomy.
Bottom line: the financial system has become leveraged to a greater extent than one could have guessed from looking at the balance sheets of regulated banking institutions alone. The deleveraging process that is now taking place in the system is, to put it mildly, unlikely to be totally smooth.
Let me make a few comments on how these weaknesses might be addressed
• In future, investors will have an incentive to do more due diligence on the assets they buy and hold. But there are large economies of scale in assessing credit risks, particularly risks embedded in structured credit transfer products. So firms that specialise in evaluating credit risk will, I think, continue to be an essential part of the system. The market will need to find a solution that better balances investor due diligence and agency ratings.
• The market innovations of recent years have also created too many idiosyncratic varieties of structured products. It is an illusion to believe that financial engineering can create instruments that are both tailored to the needs of individual investors and tradable in liquid markets. In the months ahead, I think we are going to see an accelerated process of natural selection in which some recently developed instruments become extinct. There may be more emphasis on “plain vanilla” structured products with uniform and relatively simple risk characteristics, which would be more transparent and easier to value and trade. Indeed, there are signs that market mechanisms are already working in this direction: the revival of activity in markets for some less complex structured products suggests that market participants are now putting a premium on reduced complexity.
• The current market turbulence is highlighting the need for a much better management of funding liquidity risk and a better understanding of market liquidity. The economic capital that banks hold against the more exotic instruments that are difficult to value will also have to rise.
• Central banks have done rather well in addressing liquidity shortages in money markets. They were successful in preventing overnight rates from rising above the target. But in term money markets, even large injections of central bank funds could only act to reduce dislocations, whose basic cause has been uncertainty about future liquidity needs at the individual bank level. Central banks will need to reflect on the implications of these market developments for the way they carry out their monetary operations.
Finally, what are the macroeconomic risks in the evolving global economic system?
Thus far, global output growth has remained remarkably robust in the face of financial market turbulence. Have the problems in the financial system increased the downside risks to the global macroeconomic outlook? I would say yes.
• First, the reaction of financial firms and investors to the current, more risk-averse circumstances that we are witnessing could imply a persistent increase in the cost of capital.
• Second, with the deteriorating prices in the housing markets in the United States and a number of other countries, households may try to increase their financial savings, thereby weakening consumption, with negative multiplier effects on domestic demand, economic activity and employment.
• Third, the current financial turbulence is overlaid on persistently large current account imbalances. True, the US trade balance has improved remarkably in the past few quarters, as the dollar has depreciated significantly in weighted average terms. But I think the interaction of disturbed credit market conditions and the large current account deficit of the US economy is now a major uncertainty in the global macroeconomic outlook.
• The euro area and Japan are currently recording healthy GDP growth, and domestic demand seems to have some momentum. Here the key uncertainty concerns the strength of autonomous growth momentum in the Asian region generally. Domestic demand in that region still appears relatively weak and concentrated towards investment, particularly in the export sector. I doubt that strong, export-led growth in the emerging world could be sustained if the US economy were to weaken markedly. Intervention by a number of countries to slow the exchange rate movements needed to adjust the system also cloud the picture.
• Clearly, central banks will have to keep these downside macroeconomic risks in mind in framing their monetary policies.