BIS Quarterly Review, September 2003

The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives exchanges. The second part presents four articles on topics of special interest: changing links between mature and emerging financial markets; the difference between domestic and foreign currency sovereign ratings; issues related to the search for yield by reserve managers; and new developments affecting institutional asset managers.

International banking and financial market developments

A sell-off in global bond markets

In late June and July, global bond markets suffered their largest sell-off since 1994. US dollar, yen and euro yields all increased sharply. The rise in part reflected upward revisions in bond investors' expectations about global growth prospects. An additional factor behind the rise appears to have been a change in bond investors' assessment of the likelihood of unconventional policy measures by the US Federal Reserve.

In the US dollar market, the backup in yields was exacerbated by the hedging activities of holders of mortgage-backed securities (MBSs). As yields rose, the flow of mortgage refinancing started to dry up, and investors found themselves holding MBS portfolios with durations exceeding their targets. To return to their duration targets, many investors turned to the interest rate swap market, where their demand for the fixed payment side of the contracts contributed to a doubling of swap spreads.

Spillovers to credit and equity markets were for the most part limited. Although high-yield and emerging market spreads widened as the search for yield abated, volatility in government bond and swap markets did not trigger a general sell-off in credit markets. The picture was similar in equity markets. In fact, the Tokyo equity market rallied as bond yields rose. Valuations for banks and most other financial institutions kept pace with changes in broad market indices, suggesting that equity investors were not concerned about the impact of higher yields on these institutions' balance sheets.

The international debt securities market

The second quarter of 2003 saw continued strength in fund-raising through the international debt securities market. Aggregate net issuance was $346 billion, essentially unchanged from the previous quarter. This brought net issuance for the first half of the year to $701 billion, an 8% increase over the figure for the first six months of 2002 and a substantial rise over the weak activity of the intervening period. Yield-seeking investors snapped up the new issues. Borrowers also continued to take advantage of historically low long-term interest rates to lengthen the maturity of their debt.

The greater demand for credit products created a favourable environment for lower-rated issues. Emerging market borrowers, in particular, continued to benefit from receptive international capital markets. Their fund-raising through the international debt securities market remained fairly active, as spreads on high-yielding sovereign debt fell to levels last seen in the late 1990s. The quarter also saw a sharp pickup in speculative grade issuance by developed country entities.

Derivatives markets

The aggregate turnover of exchange-traded financial derivatives contracts monitored by the BIS grew further in the second quarter of 2003. The combined value of trading in interest rate, stock index and currency contracts reached $246 trillion, a 24% rise. Trading was buoyant across all major market risk groups, but activity was particularly brisk in interest rate contracts.

Comprising the largest of the broad market risk categories, interest rate contracts continued to grow strongly in the second quarter. The volume of transactions expanded by 25% to $226.2 trillion, compared with an increase of 18% in the first quarter. Much of the increase took place on US exchanges and seemed to result from hedging activity related to future monetary policy actions.

The international banking market

Lending to non-bank borrowers drove claim flows in the international banking market in the first quarter of 2003, largely in the form of repo activity, intragroup lending and lending to governments. Extending the trend evident since mid-2002, and reflecting subdued economic growth, banks in many developed countries shifted their consolidated loan portfolios away from non-bank private sector borrowers. In addition, many banking systems continued to reduce claims on borrowers in lower-rated developing countries.

Emerging markets saw an inflow of funds, although regional differences remained apparent. The net outflow from Latin America continued, reflecting deposit movements and contractions in claims on non-banks in Mexico, Brazil and Argentina. This was more than offset by net inflows to the Asia-Pacific region, mainly the result of increased claims on the Chinese banking sector. Countries in emerging Europe, particularly those in accession negotiations with the European Union, were again recipients of additional bank lending.

Special features

Changing links between mature and emerging markets

Emerging and mature financial markets are more integrated today than at any time since the First World War. Philip Wooldridge, Dietrich Domanski and Anna Cobau, all of the BIS, document three ways in which such integration has been taking place. First, the range of foreigners investing in emerging markets has broadened in recent years. Second, local operations of foreign financial institutions are playing an increasingly important, in some cases even dominant, role in the financial systems of many emerging markets. Finally, emerging market residents are increasingly involved in foreign financial systems, both as issuers and as investors. After discussing these developments, the authors identify several related issues for public policy.

Mind the gap: domestic versus foreign currency sovereign ratings

It has become common practice for rating agencies to assign a domestic currency rating to the debt of sovereign nationals in addition to a foreign currency one. In examining this practice, Frank Packer of the BIS finds that the domestic rating is often higher, reflecting the presumed greater ability and willingness of sovereigns to service debt denominated in their own currency. He then examines the frequency and size of the markup of domestic currency over foreign currency ratings. His investigation reveals not only differences among borrowers, but also surprising differences across the agencies themselves, suggesting greater disagreement among agencies over the risk assessment of domestic currency obligations.

Reaching for yield: tips for reserve managers

In an environment of historically low yields on highly rated government securities, reserve managers have found themselves seeking instruments with higher yields in an effort to enhance returns. Eli Remolona of the BIS and Martijn Schrijvers of the Netherlands Bank focus on three cases for which issues related to higher yields are particularly interesting. These cases consist of a longer-duration portfolio, a corporate bond portfolio and a portfolio of higher-yielding currencies. In the case of longer durations, the authors ask whether the present low-yield environment implies a new trade-off between duration and volatility. Concerning corporate bonds, they focus on the challenge of managing a portfolio in which risk is characterised by low probabilities of heavy losses. Finally, the authors revisit the issue of whether higher yields in certain currencies tend to be offset by movements in exchange rates.

Institutional asset managers: trends, incentives and market efficiency

Institutional asset managers are an increasingly important feature of the world's financial landscape. Ingo Fender of the BIS draws on a recent report by the Committee on the Global Financial System to provide an overview of how the industry structure and asset managers' incentive mechanisms have been changing. He then analyses how these changes might affect the efficiency of financial markets. The size of assets under management in this industry means that