Quarterly Review, March 2009
2 March 2009
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 is on assessing the risk of banking crises; the second on the US dollar shortage in global banking; the third on US dollar money market funds and non-US banks; and the fourth on execution methods in foreign exchange markets.
Uncertainty about the depth and duration of the economic contraction continued to roil financial markets over the period between end-November 2008 and 20 February 2009. Credit markets generally remained under pressure from weak economic data and earnings reports and the resulting expectations of rising defaults. Pressures were particularly evident in the renewed widening of non-investment grade spreads. Cyclical deterioration also drove the worsening of equity prices, particularly in Japan.
At the same time, policy measures aimed at stabilising markets appeared to gain traction over the period. In money markets, central bank actions and government guarantees helped to calm interbank markets and spreads between Libor and overnight index swaps continued to decline gradually. Facilities that included outright purchases of agency mortgage- and other asset-backed securities contributed to signs of normalisation in mortgage markets, while funding facilities and government guarantees of financial sector issues provided a helping hand to primary debt markets, where activity surged to record levels in January.
To be sure, policy measures backstopping debt claims on banks were generally not perceived as positive for financial shares, and financial sector concerns continued to lead overall equity market losses in the United States and Europe. Meanwhile, the lack of detail on key support packages, among other factors, contributed to elevated levels of implied volatility as well as to price/earnings ratios which were extremely low by the standards of the past two decades.
Uncertainties about the severity of the financial crisis and the economic downturn exerted further downward pressure on government bond yields, though mounting concerns over increased issuance limited overall declines in yield during the period under review. At the same time, segments of the bond market were still showing clear signs of being affected by factors other than expectations about economic fundamentals and policy actions.
Although emerging markets generally had little direct exposure to the distressed asset problem plaguing major industrial economies and managed to weather the most acute phase of the financial crisis in late 2008 relatively well, they were much less immune to the deepening recession in the advanced industrial world. Plunging exports and GDP growth bore clear evidence of the severity and synchronicity of the global economic downturn, which was reflected in declining asset prices, particularly in emerging Europe.
The latest BIS international banking statistics indicate that international banking activity continued to reflect the tensions on bank balance sheets in the third quarter of 2008. BIS reporting banks' total gross international claims actually grew, by $248 billion to $37.5 trillion, driven largely by greater inter-office activity. Lending to other (unaffiliated) banks fell, however, reflecting the severe market strains following the failure of Lehman Brothers on 15 September. With interbank markets effectively shut down by end-September, banks sought dollar financing elsewhere: their liabilities to official monetary authorities soared in the third quarter, reflecting in part their use of central bank swap lines. Banks also curtailed their lending to emerging markets.
The latest BIS international debt securities statistics show that borrowing in the international debt securities market rebounded in the fourth quarter of 2008 as the turmoil in financial markets subsided. Net issuance of international bonds and notes increased to $624.3 billion, up substantially from $253.3 billion in the third quarter. Financial institutions recorded the largest increase, as their borrowing was supported by government guarantee schemes for bank bonds in Europe as well as in the United States. Even more important was much greater issuance of mortgage-backed bonds in the United Kingdom as well as in Belgium, Germany, Italy and Spain. The notable increase in issuance coincided with the introduction of government-led policy initiatives which included asset purchase programmes and swap facilities.
The latest BIS derivatives statistics indicate that activity on the international derivatives exchanges continued to decline in the fourth quarter of 2008 to the lowest levels in more than two years. Turnover fell sharply in the interest rate, equity index and foreign exchange contract segments alike. Total turnover based on notional amounts decreased to $408 trillion from $543 trillion in the previous quarter. The decline in trading activity reflects a combination of significantly reduced risk appetite, expectations of stable low interest rates in major markets and lower hedge fund activity.
Historically, unusually strong increases in credit and asset prices have tended to precede banking crises. Could the current crisis have been anticipated by exploiting this relationship? Claudio Borio and Mathias Drehmann of the BIS explore this question by assessing the out-of-sample performance of leading indicators of banking system distress developed in previous work, also extended to incorporate explicitly property prices. The authors find that the indicators are fairly successful in providing a signal for several banking systems currently in distress, including that of the United States. They also consider the complications that arise in calibrating the indicators as a result of cross-border exposures, so prominent in the current episode.
Understanding the global financial crisis and the stresses on bank balance sheets requires a perspective on banks' international investment positions and how these positions have been funded across currencies and counterparties. Using the BIS international banking statistics to identify the cross-currency and counterparty funding patterns for the largest banking systems, Patrick McGuire and Goetz von Peter of the BIS assess the causes of the US dollar shortage during the critical phases of the crisis. The authors' analysis documents the way many European banks built up long US dollar positions vis-à-vis non-banks and funded the positions by interbank borrowing and FX swaps, exposing the banks to funding risk. When heightened credit risk concerns crippled these sources of short-term funding, the chronic US dollar funding needs became acute.
The Lehman Brothers failure stressed global interbank and foreign exchange markets because it led to a run on money funds, the largest suppliers of dollar funding to non-US banks. After quantifying the role of dollar money market funds as dollar providers to European banks, Naohiko Baba, Robert McCauley and Srichander Ramaswamy of the BIS trace how the Lehman failure undid this role. The authors document how policies succeeded in stopping the run, thereby stabilising money market funds' assets and their holdings of non-US banks' paper. Policies also more than replaced the funding to non-US banks previously provided by money market funds.
Over the past decade or so, the spread of electronic trading has brought about significant changes in the structure of the interbank foreign exchange markets and the relationship between foreign exchange dealers and their clients. Paola Gallardo of the BIS and Alexandra Heath of the Reserve Bank of Australia look at the way foreign exchange transactions are executed based on the BIS triennial survey data, and provide some quantitative estimates of the importance of electronic trading across transaction types, counterparties and economies. The authors find that the spread of electronic trading has been most pronounced among simpler transaction types, and document considerable diversity in the diffusion of electronic trading methods across economies.