Quarterly Review, September 2009
14 September 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 the future of securitisation; the second on central counterparties for over-thecounter derivatives; the third on the cost of equity for global banks from 1990 to 2009; and the fourth on the systemic importance of financial institutions.
Despite uncertainty about the pace of economic recovery, investors remained cautiously optimistic in the period between end-May and early September 2009. Positive macroeconomic news as well as strong earnings announcements gave market participants hope of a turnaround. Consequently, equity prices rose and credit spreads narrowed. Nevertheless, disappointing data releases at times led investors to doubt their regained optimism, resulting in bouts of volatility. Moreover, bond investors generally appeared somewhat less convinced about the pace of the recovery.
The financial sector continued to report surprisingly strong earnings for the second quarter. Although questions remain about the quality and sustainability of bank profits, the sector outperformed others in both credit and equity markets. Bank credit spreads rallied markedly, nearly reaching the levels prevailing before the Lehman failure, while financial sector equity prices surged by 15-20% in the period.
Generally, markets continued to show signs of normalising, as risk tolerance edged further upwards and risk premia receded. In interbank money markets, key spreads narrowed to levels not seen since the beginning of 2008, and in some cases even further. Improvements were also visible in credit markets, although important segments continued to rely on central bank support.
In this environment, government bond yields were volatile. This reflected the markets' evolving perceptions about both the economic outlook and the future path of monetary policy. Over time, bond investors seemed to increasingly take the view that the worst of the economic downturn was over, but that recovery was likely to be gradual and vulnerable to setbacks. This, in combination with low expected inflation, led them to scale back expectations that monetary polices would return to normal anytime soon.
Among emerging markets, the strong growth in some parts of Asia attracted attention. However, concerns over the extent of the credit expansion in China prompted expectations of imminent policy tightening and a reassessment of the country's growth prospects. The ensuing sharp correction in the Chinese equity markets in August exerted a drag on other stock exchanges in the region and at times even on major equity markets.
As tensions in financial markets began to subside in the first quarter of 2009, the contraction of banks' international balance sheets slowed. Banks still registered an $812 billion fall in their interbank positions comparable to that experienced in the fourth quarter of 2008, reflecting protracted funding pressures. However, the decrease in international credit to non-banks, at $258 billion, was only one fourth that seen in the previous quarter. Banks also trimmed their international credit to emerging markets, but their local lending from offices in emerging market host countries remained stable. For most major banking systems, local lending in local currency is at least as large as their international claims.
Continued government support of financial markets led to an increase in the issuance of international debt securities in the second quarter of 2009. Net issuance rose by 25% to $837 billion, but remained short of its level in the second quarter of 2007. The increase was mostly accounted for by bonds and notes issued by financial institutions, particularly in the euro area, and public sector borrowers. By contrast, money market borrowing stagnated further.
Activity on the international derivatives exchanges rebounded in the second quarter, but remained well below previous peaks. Total turnover based on notional amounts increased by 16% to $426 trillion, mainly reflecting higher activity in futures and options on short-term interest rates. Higher stock prices also drove up turnover of equity index derivatives measured by notional amounts, although the number of contracts traded went up only slightly.
This special feature by Ingo Fender (BIS) and Janet Mitchell (National Bank of Belgium) reviews the recent collapse of global securitisation markets and sets out measures that could be taken to revive issuance. Fender and Mitchell argue that measures aimed at eliminating the overhang of so-called legacy assets are showing some signs of success, but that ultimately changes in the structure of the securitisation process are required to attract new investors. They review initiatives currently being implemented in a number of areas and then discuss mechanisms aimed at aligning incentives between originators and investors through forced retention by originators of a portion of their securitisations. The authors conclude that overly prescriptive "one size fits all" requirements are not likely to achieve the desired objective. Instead, they propose keeping retention requirements flexible but making sure that investors are aware of all necessary details concerning retention both at issuance and over the lifetime of a transaction.
Wider use of central counterparties (CCPs) for over-the-counter derivatives has the potential to improve market resilience, argue Stephen G Cecchetti, Jacob Gyntelberg and Marc Hollanders (BIS). First, concentrating outstanding derivatives positions in a limited number of CCPs is likely to reduce counterparty risk, making the entire financial system safer. Second, CCPs can help bring about significant gains in operational efficiency through the standardisation of risk management and improved management of collateral. Third, CCPs can help make markets more transparent by providing timely data. Fourth, assuming high-quality risk management, CCPs will increase the amount of collateral and capital available to absorb potential losses. And finally, CCPs can help reduce the contribution of derivatives to the procyclicality of the financial system. The introduction of CCPs alone, however, is not sufficient to ensure that OTC derivatives markets operate efficiently and remain resilient. It is important to complement their introduction with improvements in both trading and settlement infrastructure and capital regulation.
Estimates by Michael King (BIS) indicate that the inflation-adjusted cost of equity or banks in six countries declined steadily from 1990 to 2005 but then rose from 2006 onwards. King calculates the cost using the single-factor capital asset pricing model (CAPM), in which expected stock returns are a function of risk-free rates and a bank-specific risk premium. The fall in the cost of equity reflects (i) the decrease in risk-free rates over the period examined, and (ii) a decline in the sensitivity of bank stock returns to market risk (a fall in the CAPM beta) in all the countries except Japan. The estimates show wide variation across banks, highlighting the difficulty of estimating expected returns using the CAPM.
Prudential tools that target financial stability need to be calibrated at the level of the financial system but implemented at the level of each regulated institution. Regulators require tools to allocate system-wide risk to the individual institutions that cause it. In this article, Nikola Tarashev, Claudio Borio and Kostas Tsatsaronis (BIS) propose a general and flexible methodology to achieve this. Their research shows that the systemic importance of an institution increases more than proportionally with its size. However, none of the various drivers of the systemic importance of an institution (size, probability of default and exposure to common risk factors), taken on its own, gives an adequate picture of how that institution contributes to the overall risk of the financial system. Instead, the drivers must be viewed together. In the final part of their feature, using a group of large internationally active institutions as their sample, the authors illustrate how the methodology could be employed in practice.