VII Conclusions

International Monetary Fund
Published Date:
January 1994
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1. It is not surprising that the recent surge in government bond yields across the industrial countries has attracted the close attention of policymakers and market participants alike: the size of the increase was very large for such a short time period, it affected many countries simultaneously, and it was largely unanticipated. While the origin of the increase differed somewhat from country to country, there is by now little doubt that the main factor was a large revision of expectations about economic performance and about the future path of interest rates and exchange rates. The events triggering that revision of expectations were varied. They included a slower than expected fall in European interest rates; stronger than expected growth performance in the United States, along with new information about the timing of the long-awaited turn in U.S. monetary policy; an unexpected, episodic intensification of the U.S.-Japan trade dispute; more buoyant than expected performance of Japanese equities, in concert with larger than expected sales of Japanese Government bonds and a less pessimistic outlook for the economy as a whole; and an unexpected fall in bond and equity prices in emerging markets.

In financial markets, it is possible for such a revision of expectations—if it is shared by all market participants—to alter asset prices almost immediately; indeed, the change in asset prices can occur without any transactions even taking place. In this case, however, trading volumes soared along with the rise in bond yields, as a broad spectrum of market participants sought to undo large positions that had been built up under the projections of a continued rise of European and U.S. bond prices and a strengthening of the dollar against the yen and some European currencies. As positions were closed out, selling pressures added to the downward pressure on bond prices, especially in those smaller bond markets where liquidity was relatively limited. The same high degree of leverage that had contributed to the run-up of bond prices in 1993 now acted symmetrically on the downside to encourage a contraction. Risk management systems that incorporated marking to market of positions and explicit loss limits operated as intended to prevent firms from suffering even larger losses—but with the consequence of mandating sales into a declining market.

All the while, interest rate increases were being transmitted from one country to another by the recognition that convergence of long-term interest rates had been high in the 1990s, by the practice of cross-hedging, and by the tendency for losses in one market to generate pressure for liquidation in others. This transmission was most visible after the Federal Reserve’s small increase in interest rates on February 4, 1994, but it operated at other times during the relevant two-month period as well.

To be sure, this latest bout of bond market turbulence will not be the last time that market participants take a large, one-sided bet on the evolution of economic fundamentals and then alter abruptly their view—rightly or wrongly—in response to new information. Indeed, the agility of international capital markets makes it much easier and less costly than it used to be to implement such portfolio shifts. Nor will it likely be the last time that some segment of the investment community takes on a lot of risk, guesses wrong the future path of policies, and suffers losses. The key question that needs to be asked about recent bond market turbulence is, did markets function well overall? The short answer to that question is yes.

Although the increase in bond yields was undeniably large for such a short time period, the markets did receive new information in February and March on economic performance—especially on growth rates—and on the likely future course of macroeconomic policies. Given that new information, there is no reason to presume that a slower adjustment of bond prices to the new equilibrium was to be preferred to the faster adjustment that actually took place. Perhaps with the benefit of hindsight, markets did not pay enough attention to large budgetary imbalances and to the inflationary implications of declining output gaps in driving long-term bond yields so low in 1993, and the rise in yields in the first quarter of 1994 was a correction to that earlier excessive optimism; but this is hard to document with much precision and, even if so, would not necessarily imply that the net effect on the macroeconomy was large. No doubt, during February and March 1994, there was a good deal of uncertainty and volatility in markets, and some liquidity strains were evident, particularly in the smaller cash markets. But there was no seizing-up of markets, participants made good use of greater liquidity available in the larger futures markets, and payments and settlement systems once again coped satisfactorily with the increased volumes. The disturbances in bond markets also did not spread out widely to currency markets. Some hedge funds, along with a variety of other aggressive position-takers, suffered large losses—and a few even failed. Such losses are part and parcel of the business of taking risks, and their occasional occurrence is what presumably keeps the “smart money” from getting too smart or too large. The important thing was that difficulties at individual firms did not have systemic effects. Mark-to-market accounting methods, explicit loss limits, and the taking of both marketable collateral and margin payments by banks and securities houses in their lending to the heavy position-takers, all played a helpful role in limiting systemic risk.

On the basis of developments in bond and foreign exchange markets over the past few years, it seems ill-advised to single out hedge funds for special new regulatory requirements. Where there has been turbulence, it is doubtful that it would have been avoided or significantly lessened by restricting the activities of hedge funds. There are just too many other large players in the markets who have taken a similar view of market opportunities, and who have acted on those views, to hold any single class of players responsible for what happened. Also, there will be times when hedge funds’ flexibility in seeking high returns will permit them to act as a stabilizing force in markets when others—because of their external guidelines or more conservative attitudes toward risk—either cannot or choose not to do so.

But all of this does not mean that regulatory and supervisory authorities have cause to become complacent about the resiliency of the financial system. Quite the contrary. With pools of high-yield seeking capital growing rapidly, with the technology of international capital markets making it cheaper and easier to alter the asset and currency composition of portfolios at short notice, and with institutional fund managers under continuing pressure to deliver high performance, it is all the more important that systemic risk control mechanisms be up to the task of dealing with surges in transactions volumes, with occasional periods of high volatility in asset prices, and with the inevitable, sizable losses that will occur from time to time in parts of the financial services industry. The aim of these systemic risk control mechanisms is not to discourage risk-taking activity, for that activity is much needed; it is instead to ensure that risks are undertaken by those who are aware of those risks and who are able to bear the losses—without having those losses spill over broadly onto others, thereby resulting in costly disruptions of the payments and settlement system, or in a large public sector liability, or in a weakened performance of the macroeconomy.

Toward this end, maintenance of sound risk management and exercise of vigilant supervision remain key priorities. To begin with, banks and their supervisors need to ensure that banks are setting appropriate collateral and margin requirements on their lending to hedge funds and other aggressive position-takers. Indeed, margin requirements have to reflect the fact that the collateral will decline in value whenever the borrower loses on his long position, since that position itself serves as the collateral. The large losses sustained by banks in their collateralized real estate lending over the past few years indicate that holding collateral by itself is no guarantee of repayment: the collateral must be highly marketable and its liquidation value correctly appraised. Margins too have to be set at the appropriate level and adjusted promptly when market conditions change markedly—even when the borrower is a large and important customer of the lender.

Up-to-date knowledge of the consolidated position of the borrower would be helpful in assessing the borrower’s capacity to meet many margin calls simultaneously under adverse market conditions. Further protection is afforded by more general concentration and large exposure guidelines that seek to ensure that lenders do not put too many of their eggs in one basket. In terms of safeguarding the integrity of government bond markets, there is also merit in giving consideration to the passage and implementation of large position reporting and information systems throughout the industrial countries. As noted earlier, enabling legislation is now in place for such a system to be implemented in the U.S. Government securities market, but other government bond markets—particularly the smaller ones—would also benefit from the information that such a system can provide about all large trades and traders (not just those carried out by hedge funds). Finally, the impressive progress that has already been made in improving the design and functioning of payments and settlement systems needs to continue, including the introduction of real time gross settlement systems and fees for daylight overdrafts, as well as efforts to improve liquidity in the underlying bond markets themselves. When the surges in transaction volumes come, the liquidity and infrastructure of financial markets have a great deal to do with how well markets cope with it.

2. The proposals put forth by the Basle Committee on Banking Supervision for extending the 1988 Basle Capital Accord to cover market risk and to permit netting of positions are a welcome step forward in reducing potential systemic risks associated with the growing volume of off-balance sheet banking activities. So long as supervisors develop explicit criteria—preferably harmonized across the major countries—to determine whether the key assumptions embedded in banks’ own risk-management models are reasonable, and so long as the burden of proof for compliance rests with the banks, there is no problem in allowing those banks who wish to do so to use their models for the purpose of figuring capital charges for market risk.47 Other banks may decide that the Basle Committee’s standardized methodology is perfectly adequate. The important thing is to put in place one method or the other so that market risk is appropriately priced in banks’ portfolio decisions.

Ongoing efforts to improve accounting and disclosure standards for derivatives deserve strong support. For market discipline to operate effectively, market participants need to have adequate information on the risks they are assuming in dealing with counterparties. Derivative positions and activities are increasingly an important component of the activities of banks, securities houses, and other large players. Accurate risk assessment has up to now been hampered by a lack of transparency about these exposures. The better the quality of information available, the lower the probability of market “runs” based on false information.

Even, however, with improved measures of regulatory capital and with better accounting and disclosure standards for derivatives, the key line of defense against systemic risk in derivatives lies with firms’ own risk management. A bank’s trading exposure can change too fast to be protected by last quarter’s balance sheet, and even a well-capitalized firm may not have sufficient capital to cover a very large trading loss after it has already occurred. The firm’s risk management needs to catch an ill-conceived trading strategy or a faulty hedge before it takes place, or failing that, to at least ensure that when losses reach a prespecified limit, operations are cut back to prevent even larger losses from being sustained. Continuing efforts to improve the quality of risk management must therefore be strongly encouraged.

3. By now, it is increasingly accepted that there is not one exchange arrangement that is “best” for all countries; instead, the choice of exchange rate regime depends on the country’s particular characteristics and circumstances. Much the same is true for the role of the central bank in banking supervision. In those financial centers where liquidity-intensive financial activities are most pervasive and where liquidity shocks—if not reacted to in a timely fashion—could raise systemic risks, there is a comparative advantage in the central bank assuming a hands-on role in banking supervision. It is not that the central bank could not be effective in resolving financial crises without it—indeed, there have been cases in such economies where the central bank has been deeply involved in resolving a crisis in a sector outside its supervisory jurisdiction (e.g., insurance and nonfinancial corporations); it is instead that the central bank will likely be more effective in such situations when it has close knowledge of the links between banks and other financial institutions, when it is well acquainted (before the crisis occurs) with the exposure of individual institutions and the quality of their balance sheets, and when it knows who to contact to do what in a particular bank in a time of emergency. In those same circumstances, it is also doubtful that some other institution would do the job better.

In other economies, where the need for short-term liquidity management is somewhat less, or where a large share of banking activities are concentrated in a handful of large banks, or where financial innovation does not occur at as quite a rapid pace, there may be advantages in having some other agency act as the banking supervisor—so long as the central bank can both get the information on banks it needs at short notice and make its views on banking regulation known and listened to.48 In those circumstances, having the central bank’s money desk located close to the market and having close working relationships with banks, dealers, and other key players, may well be sufficient to absorb the information and knowledge that is useful for crisis intervention and for monetary policy implementation—without having any formal responsibility for banking supervision. This also of course frees the central bank to spend more time on its task of designing and implementing monetary policy. There can even be country circumstances (say, where there are a limited number of large banks headquartered abroad) where much of the load of banking supervision can be taken up by market forces (together with strict disclosure requirements, mandatory credit ratings, and the like). The same suit of clothes need not fit everyone. That being said, the staff is somewhat skeptical of the argument that a less hands-on role for the central bank in banking supervision will make it easier for it to resist calls for a “bailout” when a bank gets into trouble. The key consideration is size. Letting a small bank fail is one thing. But if the bank is “too large to fail,” it will be difficult to resist such calls, no matter what the central bank’s role, or lack of it, in supervision.

4. There is no doubt that the lines of demarcation between the activities of banks and nonbanks have become blurred over the past decade. It is also apparent in some industrial countries that the muscle in financial markets has been shifting away from banks and toward institutional investors and securities houses. And indisputably, the activities of large financial institutions—banks and nonbanks alike-are becoming more international in character. The question is what do these trends imply about the appropriate way to orient supervision toward banks and nonbanks? There are two related but distinct issues here. One concerns the efficient delivery of financial services, the maintenance of a level playing field for different providers of those services, and the pressure to engage in excessive risk-taking. The second one concerns the systemic risk associated with winding down a troubled bank versus that for a troubled nonbank.

It is easy to concede that the delivery of financial services to the user would be more efficient in some industrial countries if providers of those services were free—subject to codes of conduct and overall market surveillance—to furnish whatever mix of financial services was consistent with their perceived comparative advantage—more in line with the practice in countries that have universal banking systems. It is also the case that differences in regulatory treatment (along with implicit and explicit guarantees) between banks and nonbanks—in tandem with growing similarities in the products of banks and nonbanks—has led to some significant shifts in market shares—both between banks and nonbanks within certain countries and between banks in countries with different regulatory regimes. There is a lot of empirical support for the proposition that it is precisely when banks and other depository institutions have lost market share that they are most likely to leverage off their deposit insurance (and other guarantees) to engage in excessive risk-taking (so as to increase their profitability and avoid downsizing). This is just a long way of saying that if one were starting from scratch in designing a regulatory framework for certain industrial countries, there would be a lot of merit in considering a more “functional” approach to regulation, where regulation was organized around the financial service provided, not around the provider of the services—for example, all providers of risk-hedging services would be subject to the same regulations. The difficulty of course is that we are not starting from scratch, and the existing organization of the financial services industry has not yet evolved far enough along functional lines on its own account to make such a radical change in the regulatory structure likely any time soon.

A similar argument to that outlined above might also be employed to suggest that an approach to regulation of nonbanks that focuses almost exclusively on investor protection is outmoded. As banks and nonbanks become more alike, and as nonbanks become more important, is it not true that a systemic threat is just as likely to arise in capital markets as in the banking sector? That argument ignores one powerful empirical regularity. Over the past few decades, when banks and other depository institutions (e.g., U.S. thrift institutions) have been in trouble, the systemic consequences have been substantial. Recall the huge public sector liability associated with resolving the recent banking crises in three Scandinavian countries or the cost to U.S. taxpayers of cleaning up the savings and loan problem; or recall the effects that a weakened banking sector has had on the pace of recovery from the recent recession in some industrial countries. In contrast, at least to this point, troubles at nonbanks have had much less serious systemic effects; there, it has proved easier to confine losses to those who took the risks, and those who have borne the losses have been diversified enough in their portfolios to prevent any significant feedback effects on the real economy. This difference is at the heart of the argument for why supervision of nonbanks can legitimately focus on investor protection and downplay the safety and soundness of the individual institutions themselves.

The relevant question is whether this difference in systemic risk between banks and nonbanks will persist in the future—now that there is greater similarity between bank and nonbank liabilities and assets (e.g., would runs on nonbank money market mutual funds carry the same consequences as runs on bank deposits, or would the failure of a large nonbank to settle a derivative contract carry the same consequences as the failure of a bank to settle).49 There is no clear answer to that question-but prudence would suggest that nonbank supervisors may want to give somewhat more attention to market developments, to identifying potential systemic threats, and to international sharing and coordination of information. Some of this is already going on, as evidenced by the increase in memoranda of understanding between securities regulators in important financial centers. But perhaps it is worth considering whether nonbank supervisors from the industrial countries would profit from meeting more frequently on a regular basis to review developments in markets and to discuss problems of mutual concern. Similarly, and as noted earlier, implementation of large position reporting and information systems would help fill some of the gaps in understanding about the activities of large nonbanks. If an inducement were needed to get certain types of nonbanks to agree to additional reporting or supervisory requirements, granting them access to the wholesale payments system could be a possibility.

5. Private financing to developing countries has continued to mature. The volume of flows, the terms of borrowing, the width of the investor base, and the choice of financing instruments, have all improved markedly over recent years. Moreover, there are some good reasons for optimism over the longer term: many more performance-oriented investors now have direct experience with the high returns to capital available in those emerging markets that can sustain high growth rates; some more conservative investors are being induced to give emerging-market securities a closer look now that many more developing countries have a strong policy track record and now that there is more investment-grade developing country paper available; the share of institutional-investor portfolios in the largest creditor countries now devoted to emerging markets is now so small (1–2 percent) that even a moderate increase would translate into a large increase in the pool of resources going to developing countries; and larger inflows should act as an impetus for improvements in disclosure standards and in the legal and regulatory framework that, in turn, should further increase the attractiveness of these markets. So much for the good news. The bad news is that there is not yet any firm indication that the volatility that has often characterized private financial flows to developing countries is on the wane. This volatility stems from a variety of sources, including changes in the pace or scope of economic policy reform in the host countries, terms-of-trade shocks, and variations in industrial country growth, interest rates, exchange rates, and trade policies. The push that low interest rates in the industrial countries have given to these financial flows to emerging markets is a case in point: the flows have been huge, but it is difficult to know how much of it will be sustained once the recovery gains momentum in the industrial world and interest rates there return to normal levels. The fact that the investment portfolios of institutional investors are large relative to the capitalization of most stock markets in developing countries also means that sharp, one-sided shifts in foreign investor sentiment can induce large swings in local equity prices. In the end, the most effective action that host countries can take to minimize this volatility is to strive for consistency in the implementation of strong macro-economic and structural policies and to make every effort to see that borrowed resources are wisely invested.

6. One of the more important structural changes to have taken place in international capital markets over the past decade is the trend toward increasing nonresident ownership of government debt. In effect, the largest economic entities in the industrial world have decided that participation in world capital markets confers significant enough advantages to make it worthwhile to subject themselves to the unwritten rules of the marketplace. This surveillance by global capital markets is of two types: first, the market’s evaluation of national economic policies; and second, the market’s evaluation of the structural characteristics of national financial markets. The more favorable is the market’s evaluation on both counts, the lower will be the home country’s cost of placing and servicing government debt.

While the sequencing and precise nature of reform in the government securities market inevitably differs across the industrial countries, there is a consistent enough pattern to talk of a broad consensus on what a country needs to do (macro-economic fundamentals aside) to be attractive to international, institutional investors.

In brief, the ten commandments are (i) establish a primary dealer system to underpin liquidity, especially in the secondary market; (ii) create fungible benchmark issues in a few key maturities, as larger issues tend to be more liquid than smaller ones; (iii) have a firm issue calendar, so professionals can operate under conditions of greater predictability; (iv) opt for open auctions instead of syndications—the choice of a particular auction pricing method is less important; (v) create a safe and efficient repurchase market to facilitate the funding of positions; (vi) encourage trading in a few futures contracts on the benchmark issues, so that the market can hedge trading portfolios; (vii) establish an efficient securities settlement and clearance system, preferably in book-entry form; (viii) eliminate withholding and turnover taxes—and if that is not possible, at least reimburse these taxes to nonresidents quickly and smoothly; (ix) know the investor base, since different investors have different needs; and (x) for very large issues, consider global bonds.

The impact of this increased foreign ownership of government debt goes beyond just the potential reduction in debt-servicing costs for the borrower. Two externalities merit explicit mention. First, it seems clear that increased foreign ownership of government debt has acted as a force to dissuade countries from imposing capital controls at times of market turbulence. Any short-term gains in the room for maneuver for macroeconomic policy would have to be weighed against the long-term cost of alienating the very investors whom one wants to attract and to hold. Even when capital controls have been imposed recently during exchange market crises, they have been short-lived. Second, a common feature of many of the reforms outlined above is that they increase the liquidity of government bond markets. As noted earlier in the discussion of recent bond market turbulence, strains are more likely to occur in markets and for financial instruments that are relatively illiquid. Even the best risk management system in the world cannot get a firm out of a position without a significant loss if the market does not have the requisite liquidity. To the extent that the liquidity of government bond markets is higher today than it was ten years ago, so too is the resiliency of the system to large and sudden portfolio shifts.

7. The development of capital markets in China has to be seen in a broader context than simply as an additional source of finance; instead, it is best viewed as part of the cutting edge of the reform process itself. The development of securities markets creates a window through which international financial techniques and practices can be absorbed in China. The listing on an exchange, as well as market evaluation of an enterprise’s stock, may over time provide an additional source of discipline on enterprise governance. The development of securities markets can also increase pressure for decontrolling other financial markets. Once there is a fully market-determined rate of return available to savers on some assets (such as equities), there will be pressure to liberalize the rate of return on other assets so as to limit the size of financial flows into the initially liberalized ones. These changes in capital markets need to be carefully managed so that they do not run ahead of themselves and cause problems for ongoing efforts at macroeconomic stabilization. But over the longer term, their impact is likely to be highly beneficial.

8. To sum up, international capital markets have continued to grow in size, in sophistication, and in the degree of integration. In addition to their traditional functions of channeling resources from units that are net savers to those that are net dissavers, of providing liquidity, and of allocating, pricing, and diversifying risk, international capital markets have acquired increased clout as an indicator of the credibility of the government’s actual or prospective policies, as a disciplining mechanism for errant or inconsistent government policies, and as an impetus for reform of financial markets and practices in industrial and developing countries alike. But if international capital markets are to perform all these functions well—and to avoid the potential systemic risks that go along with increased size and integration—it is important that the supervisory and regulatory framework itself be sensitive and responsive to the changing structure of those markets, including their increasingly “international” dimension. Mark Twain put it succinctly: “Even if you’re on the right track, you’ll get run over if you just sit there.”

Criteria need to be explicitly formulated to allow an objective, consistent, and cost-efficient evaluation of risk-management models.

Some would argue that the central bank, as the primary guardian of overall financial stability, should receive information on all types of financial institutions—not just on banks.

Since money market mutual funds mark assets to market continuously, a run on such a fund would not produce insolvencies, but it might nevertheless generate pressure for public support, if losses were large and if shares in these funds were viewed as being implicitly insured.

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