Quarterly Review, March 2008
3 March 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 five special feature articles, all related to the recent financial turmoil: the first on central bank operations designed to implement monetary policy; another on the drivers of international interbank rates; a third on interbank rate fixings; a fourth on the spillover of money market turbulence to FX swap and cross-currency swap markets; and the last on the linkages between credit fundamentals, ratings and value-at-risk measures for collateralised debt obligations (CDOs) and more traditional corporate bond exposures.
After a relatively calm December that saw markets broadly unchanged, accumulating evidence of a real-side slowdown prompted a broad-based repricing of growth risk and associated shifts in policy expectations in January. While tensions in money markets eased somewhat during the period under review, weak US macroeconomic data releases, combined with further large-scale bank writedowns and concerns about financial guarantors, increased the perceived chances of global financial stress spilling over into the real economy.
When investors realised that the economic fallout from the credit crisis might not be confined to the United States, asset markets sold off across the board. Credit spreads, which had in fact reflected concerns about broader economic weakness for some time, reached new peaks against the background of growing financial sector strains. Global equity markets saw sharp declines in January as well, as investors revised downwards their expectations of future profitability. However, equities rebounded in February, outperforming credit markets, supported by repeated US monetary policy action. Investors, in turn, were quick to price in additional easing by the US Federal Reserve and by other central banks, anticipating further evidence of slowing growth. Long-term inflation-linked government bond yields declined, and more so than nominal yields, pushing up break-even inflation rates in the United States.
While price reactions to credit market stress had previously been more pronounced among industrialised economies, concerns over a more widespread growth slowdown clearly began to weigh on many emerging financial markets over the period. Equity markets, including those that had shown previous resilience, recorded the most pronounced weakness.
In the international debt securities market, issuance remained sluggish in the fourth quarter of 2007, amid the turmoil in financial markets. While the net issuance of bonds and notes increased to $487 billion from $399 billion the previous quarter, the year-on-year growth rate plunged to –45%, down even further from the –23% recorded in the third quarter. Net issuance of bonds and notes by financial institutions in developed countries was particularly weak at $351 billion, down from the previous quarter’s $363 billion, and about half the level of a year earlier. By contrast, net issuance by non-financial corporate issuers was relatively robust at $30 billion, which corresponded to a positive year-on-year growth rate of 21%.
The latest BIS statistics on trading in exchange-traded derivatives markets, for the fourth quarter of 2007, also indicate a substantial decline in activity. However, this marked a reversal from the third quarter, in which the turmoil in financial markets had resulted in the highest turnover on record. The largest fall was in derivatives on short-term interest rates, where turnover based on notional amounts decreased from the previous quarter’s $535 trillion to $405 trillion in the fourth. Declines were also evident for derivatives on long-term interest rates and stock indices and foreign exchange derivatives. Total turnover in listed futures and options on all financial instruments fell from $681 trillion to $539 trillion in the fourth quarter, although the year-on-year growth rate remained at a high level of 25%.
Activity in the international banking market continued to expand in the third quarter of 2007, amid growing tensions in the interbank market in various segments. The cross-border claims of reporting banks expanded to $32 trillion, contributing to a year-on-year growth rate exceeding 20%. The evolution of international banks’ US dollar funding needs suggests that European banks have increasingly borrowed from other banks to finance their growing net long positions vis-à-vis non-banks, a situation which may have contributed to tensions in the interbank market as refinancing became more difficult. An examination of bilateral interbank exposures of various banking systems indicates that international interbank exposures (relative to Tier 1 capital) differ significantly across systems, with European banks generally exhibiting higher ratios than US banks. In terms of foreign claims on an ultimate risk basis, there were tentative signs of a credit contraction in interbank exposures during the third quarter of 2007.
The serious disruptions in interbank markets since August 2007 have firmly put the spotlight on central bank operations designed to implement monetary policy. Not only are the operating frameworks the least understood aspect of monetary policy, they also differ considerably across countries. After providing a conceptual roadmap to allow better understanding of the challenges central banks face in implementing monetary policy in times of stress, Claudio Borio and William Nelson of the BIS discuss how central bank responses to the recent financial turmoil have been influenced by the operating frameworks in place. The authors show that the frameworks can have a first-order influence on the size and type of liquidity injections employed and on the need for exceptional measures.
The risk premium contained in the interest rates on three-month interbank deposits at large, internationally active banks increased sharply in August 2007 and risk premia have remained at an elevated level since. In their analysis of the interest rates on interbank deposits reported by the Libor panel of banks, François-Louis Michaud and Christian Upper of the BIS aim to identify the drivers of this increase, in particular the role of credit and liquidity factors. The authors find evidence of a role played by credit risk, at least at lower frequencies. At the same time, the absence of a close relationship between the risk of default and risk premia in the money market, as well as the reaction of the interbank markets to central bank liquidity provisions, point to the importance of liquidity factors for banks’ day-to-day quoting behaviour.
The evaporation of liquidity in the term segment of major interbank markets in the second half of 2007 raises questions about the reliability of rate fixings purported to represent conditions in these markets. In their comparison of different fixings in the same currency, Jacob Gyntelberg and Philip Wooldridge of the BIS find that interbank rates diverged to an unusual extent in the second half of 2007. The authors conclude that this divergence reflected dislocation in the underlying interbank markets more than shortcomings in the design of the fixing mechanisms. In fact, the design worked as intended to moderate the influence of strategic behaviour and changing perceptions of credit quality.
In the late 1990s, problems for Japanese banks in securing US dollar funding in major interbank markets led to dislocations in yen/dollar FX and cross-currency swap markets. In their special feature covering the financial turmoil of the second half of 2007, Naohiko Baba and Frank Packer of the BIS and Teppei Nagano of the Bank of Japan document that interbank funding problems once again led to significant spillover to FX and cross-currency swap markets. The evidence suggests that the use of swap markets to overcome the US dollar funding shortages of financial institutions resulted in significant deviations from covered interest parity conditions and the impairment of liquidity in these markets. Although the movement in the euro/dollar basis swap price was unprecedented, the authors conclude that the degree of the distortion did not reach that seen for the yen/dollar pair in the late 1990s.
Recent, large-scale downgrades of structured finance CDOs are a reminder that rating transitions for structured finance products can be much more pronounced than those for more traditional credit instruments. In their analysis of the linkages between credit fundamentals, ratings and value-at-risk measures both for CDO tranches and for corporate bond exposures, Ingo Fender, Nikola Tarashev and Haibin Zhu of the BIS suggest at least two reasons for the above pattern. First, the tranching process results in a non-linear relationship between the credit quality of the underlying assets and that of the tranched products. Second, ratings of tranched products are more sensitive to systematic risk. The authors conclude that undue reliance on ratings can lead to mispriced and mismanaged risk exposures as well as unfavourable market dynamics if these exposures have to be unwound.