Quarterly Review, December 2009
7 December 2009
The BIS Quarterly Review released today is divided into two parts. We begin with 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. This is followed by five special feature articles: the first discusses the use and limitations of macro stress tests; the second analyses the relationship between monetary policy and risk-taking by banks; the third provides estimates of the link between government size and macroeconomic stability; the fourth draws lessons from loan provisioning regimes set up in Asia after the crisis of the late 1990s; and the fifth looks at factors driving the appreciation of the US dollar in late 2008.
From early September to late November, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around, but investor confidence remained fragile. This was clearly illustrated towards the end of the period under review, when prices of risky assets dropped sharply as investors reacted nervously to news that government-owned Dubai World had asked for a delay in some payments on its debt.
Market participants expected the recovery to continue, but at times grew wary about its pace and shape due to uncertainty about the timing and speed of withdrawal of monetary and fiscal stimulus as well as the associated risks to economic activity. The unease was compounded by the unevenness of the recovery among different regions of the world, which in turn was seen as increasing the risk that harmful imbalances could build, thereby adding to challenges for policymakers.
In this environment, market developments continued to be driven to a significant degree by ongoing and expected policy stimulus, in particular expansionary monetary policy. As investorsd priced in expectations that interest rates in major advanced economies would remain low, prices of risky assets continued to increase. Equity prices generally rose, in particular in emerging markets. Investment grade credit spreads were little changed, while sub-investment grade spreads narrowed further. Expectations of a prolonged period of low policy rates kept long-term government bond yields down, as did low term premia. Some market commentary pointed to the risk of higher inflation going forward, but both market- and survey-based indicators continued to suggest that price pressures in the largest advanced economies were expected to remain well contained.
The low interest rates in the advanced economies, together with the earlier and stronger recovery in a number of emerging economies, continued to drive significant capital inflows into emerging markets, particularly in Asia and the Pacific. Although difficult to quantify, a related development was increasing FX carry trade activity funded in US dollars and other low interest rate currencies. This resulted in rapid asset price increases in several emerging economies as well as substantial exchange rate appreciation with respect to the US dollar.
Banks’ international balance sheets continued to contract during the second quarter of 2009, albeit at a much slower pace than in the preceding six months. The $477 billion decline in the total gross international claims of BIS reporting banks was considerably smaller than the reductions registered in the prior two quarters, but was still the fourth largest in the last decade. The shrinkage in international balance sheets was entirely driven by a contraction in interbank claims, which fell by $481 billion. By contrast, international claims on non-banks increased slightly (by $4 billion). Reporting banks’ cross-border claims on emerging market borrowers also showed signs of stabilising. Conversely, their local positions in local currencies in many countries contracted modestly for the first time since the onset of the crisis.
In the first half of 2009, notional amounts of all types of over-the-counter (OTC) derivatives contracts rebounded somewhat to stand at $605 trillion at the end of June, 10% higher than six months before. In contrast, gross credit exposures fell by 18% from an end-2008 peak to $3.7 trillion. Gross credit exposures take into account bilateral netting agreements but not collateral, so they provide a measure of counterparty exposures. The increase in outstanding amounts was due in large part to interest rate derivatives. By contrast, continuing a trend that began in the first half of 2008, outstanding notional amounts of CDS contracts fell to $36 trillion at the end of June 2009.
Activity on the international derivatives exchanges stabilised at around 60% of the pre-crisis level in the third quarter of 2009. Total turnover based on notional amounts was unchanged from the previous quarter, at $425 trillion.
Seasonal factors weighed on activity in the primary market for international debt securities in the third quarter of 2009. Net issuance almost halved to $475 billion, the lowest level since the third quarter of 2008. Depending on the method used, seasonally adjusted issuance either remained stable at a high level or went up slightly. The decline in activity was mainly driven by lower net issuance by borrowers resident in developed economies (–45%), which account for the bulk of borrowing on the international debt securities market. Residents in emerging market economies took advantage of the improved financing conditions and issued $34 billion of international debt securities. This was 52% more than in the second quarter and well above the quarterly average for 2006 and early 2007, prior to the crisis.
Few, if any, of the macro stress tests undertaken before the current crisis uncovered significant vulnerabilities. Rodrigo Alfaro (Central Bank of Chile) and Mathias Drehmann (BIS) examine the reasons for this poor performance by comparing the outcomes of simple stress tests with actual events for a large sample of historical banking crises. Their results highlight the fact that structural assumptions underlying stress testing models do not match output patterns in many of the past crises. Furthermore, unless macro conditions are already weak prior to the eruption of the crisis, the vast majority of stress scenarios based on historical data are not severe enough. Last, the authors go on to emphasise that stress testing models are not robust, as statistical relationships tend to break down during crises. These insights have important implications for the design and conduct of stress tests in the future.
In this feature, Leonardo Gambacorta (BIS) argues that low interest rates can encourage banks to take on more risks. He notes that monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) through the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure and price risk. Using a comprehensive dataset of listed banks, Gambacorta goes on to show that low interest rates over an extended period cause an increase in banks’ risk-taking.
M S Mohanty and Fabrizio Zampolli (BIS) examine the potential role of government size in stabilising the economy. They find that larger government size, as measured by the share of expenditure in GDP, had been associated with a modest reduction in output volatility in OECD economies since 1970, but that this link, which was small to begin with, seems to have weakened even further since the mid-1980s. Instead, output volatility is driven by factors such as trade openness and exposure to terms-of-trade shocks as well as the volatility of inflation. Interestingly, the same set of factors help to explain the severity of recessions.
In the aftermath of the Asian financial crisis of the late 1990s, many jurisdictions in Asia strengthened their approaches to loan loss provisioning, including the adoption of discretionary measures. In this feature, Sarawan Angklomkliew (Bank of Thailand), Jason George and Frank Packer (BIS) discuss how authorities in Asia changed the provisioning regimes in their jurisdictions, and how these changes have strengthened banking systems in the region.
Many observers were surprised by the US dollar’s appreciation in late 2008, the sharpest in the period since generalised floating began in 1973. In their feature, Robert McCauley and Patrick McGuire (BIS) argue that a combination of factors contributed to this development. First, the US dollar benefited from the global flight to safety into US Treasury bills. Second, the dollar profited from the reversal of carry trades. Third, a dollar shortage in the international banking market resulted in high dollar interest rates in private markets, which supported the currency. Finally, writedowns of dollar assets left European banks and institutional investors outside the United States overhedged. The resultant squaring of their positions in turn may also have boosted the dollar.