Markets are likely to go through a protracted adjustment period following recent financial turbulence triggered by the collapse of the U.S. subprime mortgage market, according to the IMF’s latest Global Financial Stability Report (GFSR).
The report, released on September 24, said the turbulence represents the first significant test of innovative financial instruments and markets used to distribute credit risks through the global financial system, with markets recognizing the extent that credit discipline has deteriorated in recent years. This has caused a repricing of credit risk and a retrenchment from risky assets that, combined with increased complexity and illiquidity, have led to disruptions in core funding markets and increased market turbulence in August.
Central banks in several countries have stepped in to help stabilize markets and mitigate the impact on the broader economy. But the GFSR said the period ahead may still be difficult because bouts of turbulence are likely to recur and the adjustment process will take time. “Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change,” it stated.
Slowing global growth
The report, prepared by the IMF’s Monetary and Capital Markets Department, said the turbulence could affect global economic growth. “Although the dislocations, especially to short-term funding markets, have been large and, in some cases, unexpected, the event hit during a period of above-average global growth. Credit repricing and the constriction of liquidity experienced to date will likely slow the global expansion,” it stated. The IMF will give its next forecast for world growth on October 17.
The GFSR noted that systemically important financial institutions began this episode with adequate capital to absorb the likely level of credit losses. “Corporations have, for the most part, been able to secure the financing they need to maintain their operations. However, the adjustment period is continuing and, if the intermediation process stalls and financial conditions deteriorate further, the global financial sector and real economy could experience more serious negative repercussions,” the report added.
Risks to macroeconomy
The report said that tighter monetary and credit conditions could reduce economic activity through a number of channels. A tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the U.S. housing market, while falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment. Capital spending could also be curtailed owing to a higher cost of capital for the corporate sector. In addition, the dislocations in credit and funding markets could slow the overall provision and channeling of credit.
So far, emerging markets have weathered the turbulence relatively well, in part because global growth has been strong and domestic macroeconomic policymaking has improved, though vigilance is still needed (see article on page 185). Lower sovereign risks and their improving balance sheets supported by strong fundamentals are balanced against rising risks in some economies experiencing rapid credit growth, particularly where banks are using capital markets to finance credit growth. Furthermore, some private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing.
Building a stronger system
Jaime Caruana, IMF Counsellor and Director of the Monetary and Capital Markets Department, told reporters in Washington that the task for policymakers and market participants was to learn lessons from the turbulence and use them to help make the global financial system stronger. “This does not require, as some have suggested, a new regulatory paradigm, but we must be ready to reexamine some elements of the framework we have and to enhance it where necessary,” he stated.
That framework includes the following key components:
• Greater transparency. Accurate and timely information about underlying risks is critical for the market’s ability to properly differentiate and price risk. Importantly, financial institutions need to make sure that they have robust funding strategies appropriately suited for their business model and that such funding strategies can accommodate stressful conditions. Greater transparency is needed on links between systemically important financial institutions and some of their off-balance-sheet vehicles.
• Better risk monitoring. Securitization—and financial innovation more generally—has made markets more efficient, enhanced risk distribution, and facilitated the ongoing globalization of markets. But there is a need to understand how securitization contributed to the current situation—in particular, how the incentive structure may have weakened credit discipline, including incentives for originating lenders to monitor risk.
• Improvements by rating agencies. Ratings and rating agencies will continue to be a fundamental component in the functioning of financial markets. Differentiated ratings scales for structured products could alert investors to the scope for a more rapid deterioration of ratings in such instruments, compared, for instance, with traditional corporate or sovereign bonds. Similarly, investors should ensure that their portfolio allocation decisions are not overly reliant on letter ratings and that such ratings are not used as a substitute for appropriate due diligence.
• Better valuation. The valuation of complex products in a market in which liquidity is insufficient to provide reliable market prices requires more consideration, in particular when assessing the appropriate allowance for liquidity risk premiums and financial institutions holding such securities as collateral. More work on best practices in liquidity management is necessary.
• A wider risk perimeter. The relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting or legal perimeters. The result is that risks that appear to have been distributed may yet return in various forms to the banks that distributed them. Reputational risk may force banks to internalize losses of legally independent entities, and new instruments or structures may mask off-balance-sheet or contingent liabilities.