Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
October 16, 2007
Policymakers face a delicate balancing act in the wake of the market turbulence that rocked financial markets in July and August, according to a senior IMF official.
Customers in line to withdraw deposits from U.K. bank stricken by effects of financial turmoil last month (photo: Cate Gillon/Getty)
GLOBAL FINANCIAL STABILITY REPORT
On the one hand, they must make sure that the financial system works better and becomes more transparent. On the other hand, they should not stifle financial market innovation, said Jaime Caruana, a former governor of Spain's central bank who is head of the IMF's Monetary and Capital Markets Department.
"The turmoil has highlighted areas of focus for both policymakers and private financial institutions to help ensure financial stability and to mitigate the costs of adjustment in the period ahead," Caruana told an October 16 press briefing ahead of the IMF-World Bank Annual Meetings being held in Washington D.C. October 20-22.
"Policymakers now face a delicate balancing act. They must reevaluate prudential frameworks so that investors are encouraged to maintain high credit standards and strengthen risk management systems in good times as well as bad," said Caruana, a former Chairman of the Basel Committee on Banking Supervision.
Credit discipline
"At the same time, they must be careful not to discourage financial innovation. Private institutions must do their part to ensure that credit discipline can be better maintained through the credit cycle. In this context, advances in risk management methods for complex instruments will play an important role," he declared.
Central banks in several major economies have poured hundreds of billions of dollars into the financial system since August as credit problems that began with rising defaults in the U.S. subprime mortgage market quickly spread into other forms of debt around the globe and sent stocks sharply lower. Turbulence has since subsided, but the pipeline of buyout debt is still large and is continuing to clog credit channels.
Laura Kodres, a division chief in the Monetary and Capital Markets Department, said one key to recovery was better transparency. Markets where information is deeper have bounced back more quickly.
Discussion at IMFC
The International Monetary and Financial Committee (IMFC), which sets the IMF's political direction and overall policy priorities, will discuss the implications of the recent market turbulence during its meeting in Washington D.C. on October 20.
Rodrigo de Rato, who steps down as IMF Managing Director at the end of October, says he wants the meetings to include discussion about enhanced international cooperation in monitoring global financial markets and in coordinating their regulation. "The Fund, together with other international institutions, has to play a role here, as we did in catalyzing the formulation of plans by major economies to address global imbalances," de Rato told a meeting of the Club of Rome last month.
At a briefing for reporters on October 15, de Rato said that while "we should not try to regulate crises out of existence, it's clear the events we have gone through, and we're still going through, have exposed weakness in the regulatory infrastructure."
Possible setbacks
Caruana said that while the worst of the financial market turbulence may have subsided "the period of adjustment will take some time and setbacks are possible."
"The good news is that these developments are occurring against the backdrop of solid global growth, especially in emerging markets," Caruana stated. "Most systemically important financial institutions had built up substantial capital cushions and this should help absorb the losses. Nevertheless, the coming months are likely to remain challenging for many markets and institutions."
IMF Chief Economist Simon Johnson says that the immediate impact of the market turbulence on the general economy should be modest, but adds that the problems in the U.S. subprime market and elsewhere should serve as "a wake-up call."
"Weaknesses in the global financial and economic system were revealed, some clearly and some less clearly. We need to work hard to understand precisely and to fix these weaknesses now, before it is too late," he told reporters in Washington on October 10 during the release of the analytic chapters of the IMF's World Economic Outlook. The IMF's forecasts for the global economy will be released on October 17.
Stronger market transparency
The IMF published its half-yearly Global Financial Stability Report on September 24. The report highlights five areas that require increased attention:
• Inadequate market transparency. Recent developments have underlined that confidence can easily be shaken when losses are unknown and off-balance sheet commitments are not transparent. One lesson from this episode, therefore, is the need for greater disclosure about the links between systemically important financial institutions and off-balance sheet vehicles.
• Incentives for maintaining credit discipline. Financial innovation has enhanced the ability to transfer credit risk away from banks but it has also altered the incentive structure for borrowers, lenders, ratings agencies, investors, and others in ways that may have contributed to the relaxation of credit standards. Generally, the checks and balances throughout the supply chain of structured products will need to be carefully reviewed.
• Better use of ratings. The rating methodology of complex products will need to be reevaluated. As mentioned in previous reports, differentiated ratings scales for structured products could alert investors to the inherent liquidity and market risks. Likewise, investors' use of ratings should not be seen as a substitute for due diligence and appropriate risk management.
• More realistic valuations. The valuation of complex products in illiquid markets requires more consideration. This period of turbulence has demonstrated that continuous market liquidity is not attainable for all securities. In addition, the way market illiquidity has evolved into funding illiquidity also calls for more robust funding strategies in financial institutions.
• Taking better account of the wider risk perimeter. The relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting and legal perimeters. Some banks have needed to step in to support affiliated entities, such as conduits, special investment vehicles, and asset management subsidiaries.
