The financial sector in the advanced industrial economies

30 June 2008

Several years of growth and enhanced profitability for financial firms came to an abrupt halt during the period under review as strains stemming primarily from exposures to residential real estate spread throughout the financial system. What had started as a problem specific to the US subprime mortgage market became a source of outsize losses for financial firms worldwide on their holdings of related securities. Uncertainty about the size and distribution of losses was exacerbated by the complexity of the new structures used in the securitisation process. Retrenchment from risk-taking led to illiquidity, exposing weaknesses in the funding arrangements of many financial firms. Indeed, the situation was punctuated by the near failure of sizeable financial firms, prompting intervention by the public sector to avert potential systemic repercussions from a disorderly collapse.

With many financial institutions nursing weakened balance sheets, even as the macroeconomic environment continues to worsen, a turn in the credit cycle seems likely to imply persistent headwinds for economic activity. How the situation will evolve depends critically on the dynamic interactions between the financial sector and the macroeconomy. Reduced credit availability, due to efforts by the financial sector to preserve its capital base, could prolong the period of weak profitability by affecting aggregate spending, economic activity and asset quality. These effects could also be transmitted across borders if weakened banking systems tend to cut back on their international exposures. Beyond the cyclical implications, this period of intense stress also heralds some structural shifts. Financial firms are revisiting assumptions that supported a move towards a business model focused on origination and distribution of loans through securitisation. At the same time, policymakers are reviewing aspects of the prudential framework that failed to perform as intended.