Quarterly Review, June 2008
9 June 2008
The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial activity. The second part presents four special feature articles: the first on international banking activity amidst the recent financial market turmoil, the second on the benefits of diversification in the management of international reserves, the third on credit derivatives and structured credit in Asian markets, and the fourth on Asian banks and the international interbank market.
Following deepening turmoil and rising concerns about systemic risk in the first two weeks of March, financial markets witnessed a cautious return of investor risk tolerance over the remainder of the period up to end-May 2008. The process of disorderly deleveraging which had started in 2007 intensified from end-February, with asset markets becoming increasingly illiquid and valuations plunging to levels implying severe stress. However, markets subsequently rebounded in the wake of repeated central bank action and the Federal Reserve-facilitated takeover of a large US investment bank. In sharp contrast to these favourable developments, interbank money markets failed to recover, as liquidity demand remained elevated.
Mid-March was a turning point for many asset classes. Amid signs of short covering, credit spreads rallied back to their mid-January values before fluctuating around these levels throughout May. Market liquidity improved, allowing for better price differentiation across instruments. The stabilisation of financial markets and the emergence of a somewhat less pessimistic economic outlook also contributed to a turnaround in equity markets. In this environment, government bond yields bottomed out and subsequently rose considerably. A reduction in the demand for safe government securities contributed to this, as did growing perceptions among investors that the impact from the financial turmoil on real economic activity might turn out to be less severe than had been anticipated. Emerging market assets, in turn, performed broadly in line with assets in the industrialised economies, as the balance of risk shifted from concerns about economic growth to those about inflation.
In the international debt securities markets, net issuance remained broadly stagnant in the first quarter of 2008, declining to $360 billion, below even the level recorded in the third quarter of 2007, when the recent turmoil first hit global financial markets. The fall in net issuance of bonds and notes came chiefly from the euro-denominated segment, and in those countries with significant eurodenominated issuance, ie Spain, Ireland and France. Net issuance of bonds and notes by private financial institutions in developed countries continued to fall markedly, probably indicative of the ongoing capital restructuring among financial institutions since the onset of the financial turmoil in mid-2007. Meanwhile, the issuance of mortgage-backed bonds also remained on a significant downtrend.
Trading on the international derivatives exchanges rebounded in the first quarter of 2008. The total turnover based on notional amounts increased from the previous quarter’s $539 trillion to $692 trillion in the latest quarter, resulting in year-on-year growth of 30%. Most of the increase was observed in derivatives on short-term interest rates. Gains in turnover were also seen in derivatives on long-term interest rates and foreign exchange. In contrast, turnover in derivatives on stock indices showed a slight decline, possibly reflecting overall weakness in stock markets in the first quarter. Furthermore, turnover in derivatives on commodities – which are not included in the above total given that only the numbers of contracts are available – increased substantially, recording a year-on-year growth rate of 52%. This continued sharp upward trend dates back to 2005.
The over-the-counter (OTC) derivatives market showed relatively steady growth in the second half of 2007, despite the continued turmoil in global financial markets. Growth was particularly strong in the credit segment, due possibly to heightened demand for hedging credit exposure. Notional amounts of all categories of OTC contracts increased by 15% to $596 trillion at the end of December, following a 24% increase in the first half of the year. Other segments, including markets for foreign exchange, interest rates and commodity derivatives, were also robust, each recording double digit growth. By contrast, the equity segment posted a negative growth rate.
In the international banking market, activity continued to expand in the fourth quarter of 2007, despite the ongoing tensions in the interbank market. A significant portion of this increase was accounted for by new credit to emerging markets, with claims on Asia-Pacific and Africa and the Middle East expanding the most. In addition, there were large movements in reporting banks’ liabilities to key emerging markets; while some central banks reduced their holdings of reserves in commercial banks, Middle East oil exporters deposited record amounts in banks abroad, as did the banking sector in China.
The recent period of financial turmoil has had a significant impact on banks’ global balance sheet positions. Using the BIS international banking statistics, Patrick McGuire and Goetz von Peter of the BIS trace the longer-term developments in the interbank market which contributed to the funding difficulties experienced during the turbulence, especially in the dollar segment. In their analysis of banks’ bilateral interbank exposures at the level of national banking systems, the authors find signs that national banking systems were starting to unwind their international exposures in the second half of 2007, especially their exposures to US non-bank entities.
As reserve accumulation has gathered pace in recent years, foreign exchange (FX) reserve holdings have risen far above conventional measures of reserve adequacy for many emerging market countries. Analysts debate whether part of these reserves should be invested in riskier asset classes to reduce their financial costs, ie the costs of financing the reserves minus their return. On the basis of hypothetical reserve portfolios of selected emerging market economies over the period 1999–2007, Srichander Ramaswamy of the BIS derives estimates suggesting that the reduction in financial costs from holding riskier assets would generally have been small for these economies relative to GDP. Mr Ramaswamy also discusses how accounting practices and profit distribution rules are likely to play an influential role in central bank asset allocation decisions.
Nascent markets for credit derivatives and structured credit in Asia and the Pacific were poised for rapid growth when the global financial turmoil hit in mid-2007. In their overview of credit risk markets in the region, Eli Remolona and Ilhyock Shim of the BIS focus on the instruments that involve local names as underlying assets. While there has been no significant deterioration in the quality of the underlying names, credit markets in the region have been swept up in the global widening of spreads and increase in aversion to structured finance. The authors note that active trading in CDS indices has continued, and conclude that markets in the region are likely to resume their growth once global conditions settle down.
During the Asian financial crisis of the late 1990s, Asian banks were vulnerable to changes in the risk perceptions of global bankers because they had borrowed dollars at short term to finance long-term projects in local currency. In their analysis of BIS banking and national data, Robert McCauley of the BIS and Jens Zukunft find that banks in the Asian economies most affected by the Asian financial crisis currently enjoy comfortable liquidity in the international interbank market. While banks located in Korea do show a rapid build-up of international interbank debt well in excess of claims on banks abroad, this position is concentrated in the local offices of foreign banks. The authors conclude that foreign banks’ offshore funding of local currency assets may in places have created a new vulnerability of local markets and banks to global bank liquidity crunches.