Back Matter

Back Matter

Author(s):
Garry Schinasi
Published Date:
December 2005
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    Glossary

    Barrier options: Also known as knock-out, knock-in, or trigger options. Path-dependent options that are either activated (knocked in) or terminated (knocked out) if a specified spot rate reaches a specified trigger level or levels between inception and expiry. Before termination, knock-out options behave identically to standard European-style options, but carry lower initial premiums because they may be extinguished before reaching maturity. By contrast, knock-in options behave identically to European-style options only if they are activated and so also command a lower premium.

    Book value: The value of an asset that appears on a balance sheet based on historic cost or the original purchase price.

    Broker: An intermediary between buyers and sellers who acts in a transaction as an agent, rather than a principal; charges a commission or fee; and—unlike a dealer—does not buy or sell for his or her own account or make markets. In some jurisdictions, the term “broker” also refers to the specific legal or regulatory status of institutions performing this function.

    Cherry picking: A practice in some bankruptcy proceedings of enforcing contracts favorable to the bankrupt and abrogating related obligations to the unsecured creditors.

    Clearing and settlement: The process of matching parties in a transaction according to the terms of a contract and the fulfillment of obligations (for example, through the exchange of securities or funds).

    Clearinghouse: An entity, typically affiliated with a futures or options exchange, that clears trades through delivery of the commodity or purchase of offsetting futures positions and serves as a central counterparty. It may also hold performance bonds posted by dealers to assure fulfillment of futures and options obligations.

    Closeout netting (see Netting arrangement): A written contract to combine offsetting credit exposures between two or more parties when a contract is terminated.

    Closeout procedures: Steps taken by a nondefaulting party to terminate a contract prior to its maturity when the other party fails to perform according to the contract’s terms.

    Collateral: Assets pledged as security to ensure payment or performance of an obligation.

    Collateralized debt obligation (CDO): Securitized interests in pools of assets, usually comprising loans or debt instruments. A CDO may be called a collateralized loan obligation or collateralized bond obligation or a collateralized mortgage obligation if it holds only loans or bonds or mortgages, respectively. Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO, offering investors various maturity and credit risk characteristics, categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO’s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches.

    Credit derivative: A privately negotiated agreement that explicitly shifts credit risk from one party to the other. A bilateral financial contract that isolates credit risk from an underlying instrument and transfers that credit risk from one party to the contract (protection buyer) to the other (protection seller). There are two main categories of credit derivatives: instruments such as credit default swaps in which contingent payments occur as a result of a credit event; and instruments including credit spread options, which seek to isolate the credit spread component of an instrument’s market yield.

    Credit exposure: The present value of the amount receivable or payable on a contract, consisting of the sum of current exposure and potential future exposure.

    Creditor stay exemption: The exclusion of certain creditors from the automatic stay provision of the bankruptcy code, which generally limits creditors’ capacity to directly collect debts owed by a bankrupt party, including through netting of outstanding contracts. An example is the U.S. Bankruptcy Code statutory exceptions for repurchase agreements, securities contracts, commodity contracts, swap agreements, and forward contracts, where counterparties can close out exempt OTC derivatives positions outside of bankruptcy procedures.

    Credit risk: The risk associated with the possibility that a borrower will be unwilling or unable to fulfill its contractual obligations, thereby causing the holder of the claim to suffer a loss.

    Cross-currency swap (or Currency coupon swap): A variant of the standard interest-rate swap in which the interest rate in one currency is fixed, and the interest rate in the other is floating.

    Currency carry trade: A strategy in which an investor borrows in a foreign country with lower interest rates than the home country and invests the funds in the domestic market, usually in fixed-income securities.

    Currency derivatives: Derivatives contracts involving the exchange of two or more currencies at a specified price and date. For example, see currency option.

    Currency option: The right, but not the obligation, to buy (call) or sell (put) a currency with another currency at a specified exchange rate (strike price) during a specified period ending on the expiration date.

    Dealer: An intermediary who acts as a principal in a transaction, buys (or sells) on his or her own account, and thus takes positions and risks. The dealer earns profit from bid-ask spreads. A dealer can be distinguished from a broker, who acts only as an agent for customers and charges commission. In some jurisdictions, the term “dealer” also refers to the specific legal or regulatory status of institutions performing this function.

    Derivatives (exchange-traded and over-the-counter): Financial contracts whose value derives from underlying securities prices, interest rates, foreign exchange rates, market indexes, or commodity prices. Exchange-traded derivatives are standardized products traded on the floor of an organized exchange and usually require a good faith deposit, or margin, when buying or selling a contract. Over-the-counter derivatives, such as currency swaps and interest rate swaps, are privately negotiated bilateral agreements transacted off organized exchanges.

    Dollar (or other currency) put option: A contract that gives the holder the right to sell dollars (or other currency) at a predetermined price.

    Down-and-out call (put) option: A call (put) option that expires if the market price of the underlying asset drops below (rises above) a predetermined expiration price.

    Equity swap: A swap in which the total or price return on an equity is exchanged for a stream of cash flows based on a short-term interest rate index.

    Foreign-exchange forward: A contractual obligation between two parties to exchange a particular currency at a set price on a future date. The buyer of the forward agrees to pay the price and take delivery of the currency and is said to be “long the forward,” while the seller of the forward agrees to deliver the currency at the agreed price on the agreed date. Collateral may be deposited, but cash is not exchanged until the delivery date.

    Forward contract: A contractual obligation between two parties to exchange a particular good or instrument at a set price on a future date. The buyer of the forward agrees to pay the price and take delivery of the good or instrument and is said to be “long the forward,” while the seller of the forward agrees to deliver the good or instrument at the agreed price on the agreed date. Collateral may be deposited, but cash is not exchanged until the delivery date. Forward contracts, unlike futures, are not traded on organized exchanges.

    Forward rate agreement (FRA): A contract determining an interest rate to be paid or received on a specified obligation beginning at a start date in the future. A notional principal contract such as an FRA need not be with the party on the other side of the obligation that the FRA contract is linked to. Any given gain or loss on the FRA is similar to a gain or loss on an option or futures contract with regard to its impact on the return of an underlying position.

    Futures: Negotiable contracts to make or take delivery of a standardized amount of a commodity or security at a specific date for an agreed price, under terms and conditions established by a regulated futures exchange where trading takes place. Futures are essentially standardized forward contracts that are traded on an organized exchange and subject to the requirements defined by the exchange.

    Haircut: The difference between the amount advanced by a lender and the market value of collateral securing the loan. For example, if a lender makes a loan equal to 90 percent of the value of marketable securities that are provided as collateral, the difference (10 percent) is the haircut.

    Hedging: The process of offsetting an existing risk exposure by taking an opposite position in the same or a similar risk, for example, through purchasing derivatives.

    Intermediation: The process of transferring funds from an ultimate source to the ultimate user. A financial institution, such as a bank, intermediates credit when it obtains money from a depositor and relends it to a borrowing customer.

    Knock-in options: See Barrier options.

    Knock-out options: See Barrier options.

    Legal risk: Risks that arise when a counterparty might not have the legal or regulatory authority to engage in a transaction or when the law may not perform as expected. Legal risks also include compliance and regulatory risks, which concern activities that might breach government regulations, such as market manipulation, insider trading, and suitability restrictions.

    Leverage: The magnification of the rate of return (positive and negative) on a position or investment beyond the rate obtained by direct investment of own funds in the cash market. It is often measured as the ratio of on- and off-balance-sheet exposures to capital. Leverage can be built up by borrowing (on-balance-sheet leverage, commonly measured by debt-to-equity ratios) or through the use of off-balance-sheet transactions.

    LIBOR (London Inter-Bank Offered Rates): The primary fixed income index reference rates used in the Euromarkets. Most international floating rates are quoted as LIBOR plus or minus a spread. In addition to the traditional Eurodollar and sterling LIBOR rates, yen LIBOR, Swiss franc LIBOR, and so forth, are also available and widely used.

    Liquidity: The ability to raise cash easily and with minimal delay. Market liquidity is the ability to transact business in necessary volumes without unduly moving market prices. Funding liquidity is the ability of an entity to fund its positions and meet, when due, the cash and collateral demands of counterparties, credit providers, and investors.

    Loss given default: Usually refers to the loss on the principal of a loan once the borrower defaults.

    Margin: The amount of cash or eligible collateral an investor must deposit with a counterparty or intermediary when conducting a transaction. For example, when buying or selling a futures contract, it is the amount that must be deposited with a broker or clearinghouse. If the futures price moves adversely, the investor might receive a margin call—that is, a demand for additional funds or collateral (variation margin) to offset position losses in the margin account.

    Market maker: An intermediary that holds an inventory of financial instruments (or risk positions) and stands ready to execute buy and sell orders on behalf of customers at posted prices or on its own account. The market maker assumes risk by taking possession of the asset or position. In organized exchanges, market makers are licensed by a regulating body or by the exchange itself.

    Market risk: The risk that arises from possible changes in the prices of financial assets and liabilities; it is typically measured by price volatility.

    Mark-to-market: The valuation of a position or portfolio by reference to the most recent price at which a financial instrument can be bought or sold in normal volumes. The mark-to-market value might equal the current market value—as opposed to historic accounting or book value—or the present value of expected future cash flows.

    Master agreement: Comprehensive documentation of standard contractual terms and conditions that covers a range of OTC derivatives transactions between two counterparties.

    Moral hazard: Actions of economic agents that are to their own benefit but to the detriment of others and arise when incomplete information or incomplete contracts prevent the full assignment of damages (or benefits) to the agent responsible. For example, under asymmetric information, borrowers may have incentives to engage in riskier activities that may be to their advantage, but which harm the lender by increasing the risk of default.

    Netting arrangement: A written contract to combine offsetting obligations between two or more parties to reduce them to a single net payment or receipt for each party. For example, two banks owing each other $10 million and $12 million, respectively, might agree to value their mutual obligation at $2 million (the net difference between $10 million and $12 million) for accounting purposes. Netting can be done bilaterally—when two parties settle contracts at net value—as is standard practice under a master agreement, or multilaterally through a clearinghouse. Closeout netting combines offsetting credit exposures between two parties when a contract is terminated.

    Notional amount or principal: The reference value (which is typically not exchanged) on which the cash flows of a derivatives contract are based. For example, the notional principal underlying a swap transaction is used to compute swap payments in an interest rate swap or currency swap.

    Off-balance-sheet items: Financial commitments that do not involve booking assets or liabilities, and thus do not appear on the balance sheet.

    Off-the-run (U.S. Treasury bonds): All Treasury bonds and notes issued before the most recently issued bond or note of a particular maturity. Once a new Treasury security of any maturity is issued, the previously issued security with the same maturity becomes the off-the-run bond or note. Because off-the-run securities are less frequently traded, they typically are less expensive and therefore carry a slightly greater yield.

    On-the-run (U.S. Treasury bonds): The most recently issued U.S. Treasury bond or note of a particular maturity. The on-the-run bond or note is the most frequently traded Treasury security of its maturity. Because on-the-run issues are the most liquid, they typically are slightly more expensive and, therefore, yield less than their off-the-run counterparts.

    Operational risk: Risk of losses resulting from management failure, faulty internal controls, fraud, or human error. It includes execution risk, which encompasses situations where trades fail to be executed, or more generally, any problem in back-office operations.

    Option: A contract granting the right, and not the obligation, to purchase or sell an asset during a specified period at an agreed price (the exercise price or strike price). A call option is a contract that gives the holder the right to buy from the option seller an asset at a specified price; a put option is a contract that gives the holder the right to sell an asset at a predetermined price. Options are traded both on exchanges and over the counter.

    Over-the-counter (OTC) market: A market for securities where trading is not conducted in an organized exchange but through bilateral negotiations. Often these markets are intermediated by brokers or dealers. Examples of OTC derivatives transactions include foreign exchange forward contracts, currency swaps, and interest rate swaps.

    Performance bonds: Bonds that provide specific monetary payments if a counterparty fails to fulfill a contract, thereby providing protection against loss in the event the terms of a contract are violated.

    Potential future exposure: The amount potentially at risk over the term of a derivatives contract if a counterparty defaults. It varies over time in response to the perceived risk of asset price movements that can affect the value of the exposure.

    Replacement value or replacement cost: The current exposure adjusted to reflect the cost of replacing a defaulted contract.

    Repurchase agreement: To buy (sell) a security while at the same time agreeing to sell (buy) the same security at a predetermined future date. The price at which the reverse transaction takes place sets the interest rate (or repo rate) over the period of the contract.

    Swap: A derivatives contract that involves a series of exchanges of payments. Examples are agreements to exchange interest payments in a fixed-rate obligation for interest payments in a floating-rate obligation (an interest rate swap), or one currency for another (a foreign exchange swap) and reverse the exchange at a later date. A cross-currency interest rate swap is the exchange of a fixed-rate obligation in one currency for a floating-rate obligation in another currency.

    Tesobono swap: A popular instrument used by Mexican banks in the period prior to the Mexican crisis of 1994–95. Tesobono swaps allowed Mexican banks to leverage their holdings of exchange-rate linked Mexican treasury bills (Tesobonos). A bank received the tesobono yield and paid U.S. dollar LIBOR plus a premium (in basis points) to an offshore counterparty, which in turn hedged its swap position by purchasing tesobonos in the spot market.

    Total return swap: A form of credit derivative. A bilateral financial contract in which one party (the total return payer) makes floating payments to the other party (the total return receiver) equal to the total return on a specified asset or index (including interest or dividend payments and net price appreciation) in exchange for amounts that generally equal the total return payer’s cost of holding the specified asset on its balance sheet. Unlike with a credit default swap, the floating payments are based on the total economic performance of a specified asset and are not contingent upon the occurrence of a credit event.

    Value at Risk (VaR): A statistical estimate of the potential mark-to-market loss to a trading position or portfolio from an adverse market move over a given time horizon. VaR reflects a selected confidence level, so actual losses during a period are not expected to exceed the estimate more than a pre-specified number of times. VaR is the maximum potential loss that can be incurred on a given financial position over a determined time period, and at a certain level of probability.

    Note: Many of the items in this glossary were adapted from G. L. Gastineau, 1992, Swiss Bank Corporation Dictionary of Financial Risk Management; JP Morgan/Risk Management, 2001, Guide to Risk Management; Schinasi and others (2000); selected issues of IMF, International Capital Markets: Recent Developments, Prospects, and Key Issues; and selected issues of IMF, Global Financial Stability Report.

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      United States, President’s Working Group on Financial Markets, 1999a, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report of the President’s Working Group on Financial Markets (Department of the Treasury, Board of Governors of the Federal Reserve System, Securities and Exchange Commission, Commodity Futures Trading Commission) (Washington).

      United States, President’s Working Group on Financial Markets, 1999b, “Over-the-Counter Derivatives Markets and the Commodity Exchange Act,” Report of the President’s Working Group on Financial Markets (Department of the Treasury, Board of Governors of the Federal Reserve System, Securities and Exchange Commission, Commodity Futures Trading Commission) (Washington).

      Van derZwet, 2003, “The Blurring of Distinctions between Financial Sectors: Fact or Fiction?” Occasional Studies No. 2 (Amsterdam: De Nederlandsche Bank).

      Van Hedge Fund Advisors LLC, 2005, “Size of the Hedge Fund Universe.” Available via the Internet: http://www.hedgefund.com/abouthfs/universe/universe.htm

      Volcker, Paul A., 1984, “The Federal Reserve Position on Restructuring of Financial Regulation Responsibilities,”Federal Reserve Bulletin, Vol. 70 (July), pp. 54757.

      Volcker, Paul A., 1998, “Emerging Economies in a Sea of Global Finance,” The Charles Rostov Lecture at the Paul H. Nitze School of Advanced International Studies, Johns Hopkins University (Washington DC: April9). Available via the Internet: http://www.house.gov/jec/hearings/imf2/volker.htm

      Volcker, Paul A., 1999, “The Implications of Globalism is Globalism,” The Joseph I. Lubin Memorial Lecture, Stern School of Business (New York: April20). Available via the Internet: http://www.trilateral.org/membship/membtxts/pv/990420.htm

      Volcker, Paul A., 2002, “Accounting, Accountants, and Accountability in an Integrated World Economy,” Remarks to the World Congress of Accountants (Hong Kong: November19). Available via Internet: http://www.iasb.org/uploaded_files/documents/8–128–021119-pav.pdf

      Wellink, Nout, 2002, “Central Banks as Guardians of Financial Stability,” speech at the seminar “Current Issues in Central Banking,”Oranjestad, Aruba, November14.

      White, William, 2003, “Are Changes in Financial Structures Extending Safety Nets?”in Macroeconomics, Monetary Policy and Financial Stability: A Festschrift for Charles Freedman, BIS Working Papers No. 145 (Basel: Bank for International Settlements).

      World Bank, 1999, “Processing the Economy’s Financial Information”, in World Development Report 1998–99 (Washington: World Bank).

      Worrell, DeLisle, 2004, “Quantitative Assessment of the Financial Sector: An Integrated Approach,”IMF Working Paper WP/04/153 (Washington: International Monetary Fund).

      Worrell, DeLisle, and LeonHyginus, 2001, “Price Volatility and Financial Instability,”IMF Working Paper WP/01/60 (Washington: International Monetary Fund).

    Index

    absorptive capacity, 123

    adverse selection, 54

    alternative risk transfer (ART) market, 257, 259, 268

    American Express, 233, 243

    Argentina: debt exchange, 235;

    • default and devaluation (2001), 201

    Asian crisis (1997–98), 199–200

    assessment process: confidence intervals, 127;

    • design and implementation challenges, 129–33;

    • disciplining, 118–21;

    • measurement and modeling, 122–29;

    • partial equilibrium analysis, 121;

    • practical challenges, 118–28

    asset-price bubbles, 72, 129

    asset-price misalignment, 72

    assets: growth, 7;

    • institutional investors, 162–63

    authorities, 176

    Bank for International Settlements and Financial Stability Forum, financial stability definition, 94

    Bank of Canada, financial stability definition, 94

    Bank of England, 134, 146–48;

    • lender of last resort, 144;

    • role, 136

    bank-based systems, 174

    banking policy view, 140

    banking supervision, 140–42

    bankruptcy: credit derivatives market, 242;

    • legal framework for, 142, 143. See also Enron

    banks and banking: deposits, commercial banks, 160;

    • franchise, 42;

    • loans, commercial banks, 161;

    • OTC derivatives markets and, 184–95;

    • securities, 161;

    • solvency, 123, 125. See also central banks

    Barings plc, 147–48

    barrier options, 277;

    • barter, 30, 33, 78

    Basel Accord, 133, 206

    Basel Committee, 115

    benefits: modern finance, 151–52;

    • private vs. social, 47, 69

    bonds, 265;

    • corporate and foreign, 252;

    • cross-border transactions, 10, 154

    book value, 277

    boundaries, measurement, 124

    broker, 277

    Bundesbank. See Deutsche Bundesbank

    capital, 170;

    • accumulation, 36–37;

    • insurance companies, 266–68;

    • non-traditional sources, 240–41;

    • risk and, 263

    catastrophic risk (Cat) bonds, 257, 259

    central banks: crisis resolution and, 142–43;

    • effective execution, 139–43;

    • evolving issues, 144–47;

    • prevention and, 140–42;

    • role, 134–49. See also banks and banking

    challenges, 19–20;

    • modern finance, 151–52;

    • national and global, 271–76

    changes, forecasting, 90–91

    Chant, John, financial stability definition, 94

    cherry picking, 277

    claims, insurance, 248, 256

    clearing and settlement, 277

    clearinghouse, 203–204, 223–24, 277–78

    closeout: netting, 234, 278;

    • procedures, 215–16, 224, 278

    collateral, 278

    collateralized debt obligation (CDO), 233, 235, 243, 268, 278

    Columbia University, financial stability definition, 96

    commodities, 201;

    • exchange, 29

    Commodity Futures Trading Commission (CFTC), 201, 217, 218–19

    common good. See public good

    common-pool resource, 56

    competition: dynamic, 175–76;

    • imperfect, 49

    complexity, 8, 89–91, 165

    confidence, 127

    conglomerates, 7, 170

    Conseco, 233

    consolidation, 160, 165

    contracts: exchange-traded, 195–203;

    • OTC derivatives, 219

    control, 91;

    • policies, 91

    cost: estimates, 127–29;

    • marginal cost, private vs. social, 47, 70

    Counterparty Risk Management Policy Group II, 207

    credit, 164, 167;

    • available, 209–10;

    • change in value, 187;

    • default swaps, 234–36;

    • demand for, 67;

    • exposure, 278;

    • markets, 260;

    • OTC derivatives, 209–10;

    • protection, 240;

    • rating agencies, insurers and, 263;

    • risk, 185, 187, 279

    credit derivatives market, 278;

    • corporate downgrades (2005), 235;

    • key characteristics, 230;

    • leverage of, 240;

    • market size and structure, 229;

    • OTC derivatives and, 231;

    • slowdown (2001–02), 232–35

    creditor stay exemption, 278–79

    credit risk transfer vehicles, 274;

    • industry challenges, 238–42;

    • market for, 228–44;

    • market tests, 232–38;

    • retail investors and, 242–44

    crises, 72, 138;

    • Asia, 148–49

    crisis resolution, 144;

    • central bank and, 142–43

    Crockett, Andrew, financial stability definition, 94

    cross-border transactions, 164;

    • bonds and equities, 10, 154;

    • OTC derivatives markets, 210–11

    cross-currency swap, 279

    currency, 55;

    • carry trade, 279;

    • derivatives, 279;

    • option, 196–97, 279

    data, financial stability, 129

    De Nederlandsche Bank, financial stability definition, 97

    dealer, 279

    debt ratios, 125

    decentralization, OTC derivatives, 205

    default, risk, 187

    demand, private vs. social, 68–69

    derivatives, 279;

    • markets, 160. See also over-the-counter derivatives

    Derivatives Policy Group, 207

    Deutsche Bundesbank, 135, 176;

    • financial stability definition, 94

    developing country market, 16

    disclosure, 168–69, 276;

    • insurance companies, 263–64;

    • OTC derivatives, 224–25

    disequilibrium, stable, 70–71

    disturbances, degree of, 113

    diversification of banking, 160

    dollar, 279

    dollar-yen market, OTC currency options and, 196–97

    dot-com bubble, 171, 177

    “double coincidence of wants,” 42, 79

    down-and-out call (put) option, 280

    Duisenberg, Wim, financial stability definition, 95

    economic efficiency, 47, 67–69

    economic processes, intertemporal facilitation, 36–37

    economic resources, allocation, 36

    economic value, 172

    efficiency, 19, 67–69, 172;

    • economic or financial, 69–71;

    • loss of, 66;

    • stability and, 101–102

    emerging markets, 16, 172, 178;

    • credit default swaps, 235;

    • OTC derivatives, 191, 194–95, 198–201

    end users, global financial markets, 164

    endogenous threats, 87–88, 106

    Enron, 233–37, 243, 265, 274

    equities: cross-border transactions, 154;

    • international issues, 156–57

    equity markets, 260;

    • Hong Kong, 148–49

    equity swap, 280

    European Central Bank (ECB), 135, 145;

    • financial stability and, 144;

    • financial stability definition, 95, 96

    European financial system, 101–102

    European Monetary Union, 146

    European System of Central Banks (ESCB), 145;

    • functions, 145–46

    exchange markets: derivative financial instruments, 12;

    • finance vs., 32;

    • organized, 203–204;

    • OTC derivatives markets vs., 195–208

    exit strategies, 143

    exogenous risk, 106, 109–10

    externalities, 48–50, 57–58, 88;

    • legal tender, 55;

    • negative, 60;

    • network, 50

    facilitation of economic progress, 83–84

    Federal Reserve Bank of New York, 182–83

    Ferguson, Roger, financial stability definition, 95

    fiat money, 23–24, 29–31, 32, 34, 78;

    • 17th century, 59;

    • public good, 55–58. See also money

    finality of payment, 29, 137, 139

    finance, 24, 57, 58;

    • benefits, 28, 79;

    • characterization, 15;

    • costs, 79;

    • defined, 27–28, 33;

    • essence of, 32–34;

    • evolution, 41;

    • exchange vs., 32;

    • improper performance, 28–29;

    • money and, 27–35, 79;

    • private and social economic benefits, 35–42;

    • strengths and weaknesses, 78–80;

    • temporary exchange of services, 33

    financial aggregates: change, 4–5;

    • composition (1970 vs. 2000), 6;

    • growth, 7

    financial architectures, 9

    financial deepening, 3, 6–7

    financial markets: insurance and, 249, 255–56;

    • shift, 257–60

    Financial Sector Assessment Program (FSAP), 126

    financial soundness indicators, IMF’s core and encouraged, 112

    Foot, Michael, financial stability definition, 95

    foreign-exchange forward, 280

    forward contract, 280

    forward rate agreement (FRA), 280

    fragility, 39–40, 72;

    • OTC derivatives, 185, 208–12

    framework, analytical, 98–133;

    • defining and operationalizing, 102–18;

    • development, 2–3, 276;

    • illustration, 104, 106;

    • meaning of, 73–74;

    • need for, 9–14;

    • overview, 103–105;

    • policy-oriented, 19;

    • purpose, 98;

    • standards, 73–74

    futures, 280

    global financial market, 164;

    • changes, 182

    globalization, 151, 153–80, 272;

    • challenges, 165–76;

    • future, 177–80;

    • international financial system and, 154–65;

    • market dynamics and, 169–73

    Gramm-Leach-Bliley Act, 144

    Great Depression, 16

    Group of 30, 207

    Group of Seven, 168

    Group of Ten, 137, 168, 176, 179

    haircut, 280

    hedging, 240, 242–43, 269, 281

    Herstatt risk, 115

    Hollywood Funding transactions (2001), 265

    Hong Kong equity market, 148–49

    Hong Kong Monetary Authority (HKMA), 148–49

    hybrid entities, 160

    imbalances, analytical and measurement tools, 113;

    • dissipating, 83

    IMF financial soundness indicators, core and encouraged, 112

    industry: credit risk transfer vehicles, 238–42;

    • employment and production, 35

    inflation, 8

    information, 169;

    • aggregating, 124;

    • asymmetries, 209, 211, 221;

    • crisis resolution, 118–119;

    • disclosure coordination, 224–25;

    • gathering and monitoring, 105–106, 118;

    • incomplete, 49, 53–54;

    • insurers and reinsurers, 270;

    • lender of last resort, 145;

    • OTC derivatives, 209,211,213, 221;

    • supervisory, 149

    infrastructure, 80–81;

    • credit risk transfers, 241;

    • OTC derivatives market, 212–17, 219–21;

    • risk, 109

    insolvent institutions, 143;

    • illiquid vs., 144

    instability, 116–17;

    • intermittent with inefficiency, 72;

    • OTC derivatives, 211;

    • prevention, 99;

    • range of, 89;

    • stability vs., 91–93

    institutions, 40–42, 81, 170;

    • blurring of distinctions, 160;

    • difficulties with, 104;

    • nonbank, 160;

    • risks in, 108

    instruments, 31

    insurance, 151–52, 246–60, 275;

    • asset holdings, 162, 246–48;

    • balance sheet assets, 253;

    • claims, 248, 256;

    • diversification, 259–60;

    • financial contracts and legal risks, 264–66;

    • financial efficiency and stability, 260–68;

    • financial securities, 249;

    • global industry results, 255;

    • leverage, 266–67;

    • loss ratios, 250, 258;

    • systemic financial problems and, 267–68;

    • systemic implications, 245–70.

    • See also reinsurance

    insurance, life, 246–47;

    • premium growth rates, 256

    insurance, nonlife, 253–54;

    • capitalization, 267;

    • profitability, 258–59

    integration, 7–8, 155

    intermediaries, 80;

    • credit risk transfers, 244

    intermediation, 281

    International Association of Insurance Supervisors (IAIS), 262, 264

    International Capital Markets, IMF (1999), 142

    international cooperation and coordination, 276

    International Swaps and Derivatives Association (ISDA), 207, 234;

    • contracts, 265

    internationalization, 7–8.

    • See also globalization

    investment companies, assets, 162

    investors, 163;

    • credit risk transfers and, 242–44;

    • total assets, 163

    Joint Forum, 262

    JP Morgan Chase, 234–35, 265, 274

    knock-in options, 281

    knockout options, 197, 281

    Lamfalussy Standards, 115, 133

    Large, Andrew, financial stability definition, 96

    legal and regulatory environment, 61, 64–65;

    • certainty, 276

    legal risk, 281;

    • financial insurance contracts, 264–66;

    • OTC derivatives, 217;

    • reducing, 222–24

    legal tender. See fiat money;

    • money

    lender of last resort, central bank as, 143–45

    leverage, 39–40, 281;

    • insurance companies, 266–67

    LIBOR, 281

    links, 131;

    • unexpected, 127–28

    liquidity, 18, 23–24, 38–40, 50, 87–88, 119, 125, 137, 170–72, 272, 281;

    • insurance, 268;

    • OTC derivatives, 185, 209–10, 213–15;

    • temporary, 143

    “lock-up” rules, 242–43

    Long-Term Capital Management (LTCM), 127, 141, 144, 148, 176, 182,192–95, 212–13, 220–21, 233–34, 273–74;

    • global capital market and, 192–94

    loss given default, 281

    Maastricht Treaty, 146

    macroeconomics, 105;

    • models, 127;

    • policy objectives, 122–23

    macro-prudential analysis, 111

    margin, 281–82

    market-based systems, 174

    market discipline, 140–42, 167–69, 172, 173, 175, 176, 179;

    • Enron, 237;

    • insurers, 260–63;

    • OTC derivatives, 206–208, 219–21

    market maker, 282

    market-making, 170, 172

    market-oriented forms of finance, 160

    markets, 40–42, 80;

    • adverse dynamics, 182;

    • dynamics, 165, 169, 171–72;

    • failure, 49, 60;

    • globalization, 169–73;

    • imperfections, 16–17, 19, 47–55, 59–60, 66;

    • incentives, 276;

    • incomplete, 49, 54–55;

    • inter-dependencies, 272

    market surveillance, 140, 141–42;

    • organization, 203–208;

    • OTC derivatives, 202, 204–208, 213–15;

    • psychology, 170–71;

    • risk, 108–109, 167–68, 282;

    • spillover, 239–40;

    • structure, 182–83, 202, 204–208;

    • turbulence and crises, 13

    mark-to-market, 282

    master agreement, 282

    material disclosure provisions, 266

    measurement and modeling, 122–28, 132–33;

    • models, 130–31

    merchant banking group, 147–48

    mergers and acquisitions, 8;

    • distribution, 9

    Mexican crisis (1994), 198–99

    micro-prudential indicators, 111

    Minsky (1977) financial instability hypothesis, 124

    Mishkin, Frederick, financial stability definition, 96

    models, 130–31;

    • issues, 122–28

    monetary aggregate, 138

    monetary policy, 137;

    • objectives, 122–23

    monetary stability, 31, 85;

    • defined, 135–36;

    • financial stability and, 138. See also stability

    monetary system, 81

    money: finance and, 27–34, 79;

    • intrinsic value, 30;

    • stock, 138;

    • supply, 138–39. See also fiat money

    monitoring, 105–106, 113, 132–33;

    • OTC derivatives, 208

    moral hazard, 54, 136, 222, 282;

    • role of, 173–74

    Nash equilibrium, 56

    National Bureau of Economic Research, financial stability definition, 96

    Netherlands, housing market boom, 117

    netting arrangement, 216, 224, 282

    network externalities, 50

    nonbank financial institutions, 160, 239

    nonfinancial firms, 164, 169–70. See also Enron

    nonlinearities, 113

    Norges Bank, financial stability definition, 96

    normative functions, 88–89

    notional principal, 228, 282–83

    off-balance-sheet items, 283

    Office of the Comptroller of the Currency (OCC), 228

    official oversight, 168–69

    off-the-run, 283

    on-the run, 283

    open market operations view, 139

    operational risk, 283

    option, 283

    oversight: Enron, 236–37;

    • insurers, 260–63;

    • prudential, 173

    over-the-counter (OTC) derivatives, 151, 181–27, 273, 283;

    • banking and, 184–95;

    • commoditized, 201–202;

    • contract structure, 195–203;

    • contraction and expansion, 190;

    • currency options, dollar-yen market, 196–97;

    • decentralized, 204–208;

    • emerging markets and, 198–201;

    • exchange vs., 195–208;

    • features, 209;

    • fragility, 208–12;

    • infrastructure weaknesses, 212–17;

    • international institutions, 210;

    • legal and regulatory uncertainties, 215–17, 222–24;

    • market discipline, 206–207;

    • monitoring, 208;

    • organization, 203–208;

    • price volatility, 190–91;

    • private and public roles, 225–27;

    • regulation, 205–208;

    • risk, 183, 191, 194–95, 225–27;

    • size, 187;

    • strengthening, 217–27;

    • structure (2004), 202;

    • swaps markets (1990s), 241;

    • top 20, 186;

    • transparency, 205;

    • value, 187–89;

    • volatility, 208–11;

    • vulnerabilities and, 182;

    • weaknesses, 212–17

    Padoa-Schioppa, Tommaso, financial stability definition, 96

    Parmalat, 235

    partial equilibrium analysis, 121

    payment: finality of, 29, 137, 139;

    • services, 18;

    • system, 137

    pension funds, 243;

    • assets, 162

    performance bonds, 283

    policy, 60–66;

    • financial stability and, 114–28;

    • instruments, 116, 176;

    • public policy, 17–18, 43–66, 132

    policymakers, 3, 173–74, 176

    potential future exposure, 283

    premium, 240;

    • insurance, 249, 255, 256

    prevention, 105–13;

    • central bank and, 140–42;

    • key elements of, 140–42;

    • policy implications, 114–18

    prices, 37–38, 129;

    • movements, 172

    prisoner’s dilemma, 44–46

    private benefit, 47;

    • finance, 35–42

    private sector, 177, 180;

    • financial contracts, 61

    protection, market participants and, 229

    property rights, assignment of: 51–52

    psychological dynamics, 170–71

    public good, 49, 50–53, 56, 57–58, 173, 179–80;

    • fiat money, 55–57;

    • finance and financial stability, 57–58;

    • private good vs., 51–52

    public policy. See policy

    Railtrack, 233–34, 274

    real economic processes, facilitation, 83–84

    reform, 152, 174, 178–79;

    • need for, 20–21, 276

    regulation and regulators, 168, 175;

    • banks vs. insurers, 259;

    • frameworks, 179;

    • incentives, 276;

    • insurers, 261–63;

    • OTC derivatives, 205–208, 215–21;

    • reducing uncertainty, 218–19, 222–24;

    • reinsurance, 261–62

    regulatory arbitrage, 238–39

    reinsurance, 275;

    • financial stress, 269;

    • regulation, 261–62. See also insurance

    remedial action, 106, 114, 116;

    • Netherlands housing market, 117

    replacement value or cost, 284

    resolution, 99, 106, 114, 116–19

    resource: allocation, 36, 123;

    • common-pool, 56;

    • economic, 36

    retail investors, 274–75;

    • credit risk transfer vehicles and, 242–44

    retirement savings, Enron, 237

    risk and risk management, 24–25,31,34, 102, 103, 105, 123, 165, 212–13, 263–64, 273–74: allocation, 37–38;

    • assessment, 120;

    • central banks, 149;

    • concentrations, 111;

    • development, 8;

    • distribution, 165;

    • financial market, 108–109, 165;

    • insurers and, 263–64;

    • measurement and modeling, 122–29;

    • migration, 264;

    • OTC derivatives, 212–13;

    • partial equilibrium analysis, 121;

    • plausibility, 120;

    • pricing, 123;

    • risk-taking, 173–74;

    • single-indicator analyses, 125;

    • sources of, 106–107;

    • systemically relevant, 120–21, 174–76;

    • time-consistency, 121;

    • transfers, 8, 151

    Russia’s default and devaluation (1998), 200–201

    safety nets, 173;

    • OTC derivatives, 222

    Samuelson’s Model, 62–64

    savings, institutional, 163

    Schwartz, Anna, 138;

    • financial stability definition, 96

    Securities and Exchange Commission (SEC), 201, 219

    securities, 170, 201;

    • holdings, 250–51;

    • international debt by country, 158–59;

    • prices, 129–30;

    • tradable holdings, 161

    securitized finance, 160, 169, 174–75

    September 11, 119, 177, 260

    services provided by money, 79

    settlement risk, 115

    shocks, 172

    shock-transmission approach, 98–99

    simulations, 127

    social arrangements, 40–42

    social benefit, 47;

    • finance, 35–42

    social contrivance, 62–64

    social cost, 47

    Solvency Accord, 133

    “Solvency I and II” Directives, 262

    solvency, insurance companies, 268

    soundness indicators, IMF, core and encouraged, 111–12

    spread, credit derivatives premium and bond, 241

    stability, 19, 58, 69–71, 271;

    • arguments, 23–25;

    • assessments, 118–29;

    • challenge, 100–102;

    • continuum, 85–87;

    • defining, 77–97;

    • definitions, 15, 82–83, 93–97;

    • developments, 89–90;

    • efficiency and, 101–102;

    • importance, 3–9, 11;

    • instability vs., 91–93;

    • insurance or reinsurance, 269;

    • issues, 18, 23;

    • OTC derivatives, 191, 222;

    • perpetual with efficiency or inefficiency, 71–72;

    • questions, 1–3;

    • range of, 83, 86–87

    store of value, 30–31, 32;

    • Samuelson’s Model, 62–64

    stress testing, 113–14, 125–26, 133;

    • limitations, 126–27

    structural changes, 133, 160, 164

    supervision, 118, 132–33, 168, 176, 179, 272–73

    supply, private vs. social, 68–69

    surety bond, 234, 265

    surveillance, 115, 118

    swap agreements, 218–19

    swap transactions, 185, 223, 284

    system, 80–81, 132;

    • performance, 102–103

    systemic risk, 81, 137;

    • insurance, 267–68;

    • OTC derivatives, 191, 194–95;

    • private and public roles, 225–27

    systems, expansion, 3

    TARGET, 135

    taxpayer costs, 175

    technical capability, 160

    Tesobono swap, 284

    Thornton, Henry, 135–36

    threats, to stability, changed, 174–76

    Tietmeyer, Hans, 176

    time consistency, 121

    tools, analytical and measurement, 113–14

    total return swap, 284

    transaction costs, 169

    transparency, 115, 166–69, 276;

    • credit derivatives, 238;

    • credit risk transfers, 241;

    • insurance companies, 263–64;

    • OTC derivatives, 205

    Treasury bonds, 283

    trust, human, 18–19, 31, 79;

    • fragility, 80

    uncertainty, 16;

    • finance, 65

    underwriting losses, investments and, 248–57

    United Kingdom Financial Services Authority, 134, 144;

    • financial stability definition, 95

    United States: Federal Reserve System, 95, 136–37, 145, 148;

    • financial stability definition, 95;

    • financial system, 101–102;

    • repurchase market, 148

    unit-of-account service, 61

    universal acceptability, 56

    value at risk (VaR), 284

    value of services, relative, 34

    variables, distribution, 113

    volatility, 72;

    • OTC derivatives, 190–91, 208–13

    Volcker, Paul, 136–37

    vulnerabilities, 182;

    • judging scope and impact, 110–13. See also risks

    wealth accumulation, 36–37

    Wellink, Nout, financial stability definition, 97

    willingness to pay, 266

    worker-owner promise, 34

    yen, OTC currency options, 196–97

    About the Author

    Garry J. Schinasi is an Advisor in the Finance Department of the International Monetary Fund (IMF). He received his Ph.D. in economics from Columbia University in 1979, and, before joining the IMF, he was on the staff of the Board of Governors of the U.S. Federal Reserve System from 1979 to 1989. From 1992 to 2001, Mr. Schinasi held various positions in the IMF’s Research Department. He contributed to the IMF’s semiannual World Economic Outlook (1992–94), was a comanager of the IMF’s capital market surveillance exercise (1994–2003), and was coauthor and coeditor of International Capital Markets: Developments, Prospects, and KeyPolicy Issues (1994–2001) and the Global Financial Stability Report (2002–03). Mr. Schinasi has published articles in The Review of Economic Studies, Journal of Economic Theory, Journal of International Money and Finance, and other academic and policy journals.

    “The economic and institutional transformation of central banking that has taken place over the past four decades has been driven mainly by monetary policy issues. However, it has profoundly affected another historical mission of central banks—the preservation of financial stability. Financial stability is gradually emerging as a distinct policy function, requiring its own body of scholarship, not to be confused with monetary policy on the one side, and supervision on the other side, although it is related to both.

    “Building an analytical approach and a policy paradigm consistent with this new setting as well as with the changing landscape of financial markets and institutions is one of the tasks of today’s research and policy agenda.

    “Garry Schinasi takes us a big step forward in the fulfilment of this task. His book Safeguarding Financial Stability represents a brilliant attempt to provide solid and updated foundations to policies aiming at financial stability. The book is based on a thorough acquaintance with the literature, understanding of the real world, analytical skill, sense of the policy issues, familiarity with the diversity of country situations, and good judgment.

    “The book can already be considered required reading for anyone interested in the subject of financial stability. Its clarity makes it accessible to policymakers as well as practitioners. At the same time the book will stir debate and further research in academic circles.”

    —Tommaso Padoa-Schioppa,

    Executive Board Member (1998–2005),

    European Central Bank

    More endorsements of Safeguarding Financial Stability may be found inside (p. v–vi).

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