December 2014 Quarterly Review: Buoyant yet fragile?
- Flip-flopping from "risk-on" to "risk-off" sentiment in financial markets suggests that fragility underlies the current buoyant mood.
- International banking activity expanded in the first half of 2014, regaining some of the ground lost in the previous two years.
- China is now by far the largest emerging market borrower from BIS reporting banks. Outside the EME world, China ranked seventh overall.
- More and more CDS contracts are cleared centrally. This should reduce counterparty risk.
- The risk profile of debt from EME non-financial corporations may vary considerably, depending on whether it is issued through non-financial subsidiaries abroad or via financial affiliates.
- The co-movement of exchange rates is the main factor behind the choice of reserve currencies. Country size alone is less relevant, argue Robert McCauley and Tracy Chan of the BIS.
- Mezzanine tranches may not be easy to assess, even when securitised assets are simple and transparent. This calls for regulatory safeguards against undercapitalisation, conclude Adonis Antoniades and Nikola Tarashev of the BIS.
- Commercial banks performed more stably and were more cost-efficient than capital markets-oriented institutions over the past decade, find Rungporn Roengpitya (Bank of Thailand), Nikola Tarashev and Kostas Tsatsaronis (both BIS).
- The BIS's Stefan Avdjiev, Michael Chui and Hyun Song Shin track EME cross-border capital flows that may signal an increasing transfer of funds raised via offshore affiliates.
Summaries of individual chapters
Markets remain buoyant despite mid-October's spike in the volatility of most asset classes. This sharp retreat in risk appetite reflected growing uncertainty about the global economic outlook and monetary policy stance, as well as increased geopolitical tensions. As selling pressure increased, market liquidity temporarily dried up, amplifying market movements.
Markets rebounded quickly as economic concerns faded and some major central banks further eased monetary policy. In particular, the Bank of Japan and the ECB provided further stimulus, while the Federal Reserve ended its QE3 asset purchases. These opposing moves unsettled exchange rates, with the dollar appreciating against most other currencies.
Reprising the August sell-off and recovery in global financial markets, this rapid flip-flop from "risk-on" to "risk-off" sentiment (and back again) suggests that more than a quantum of fragility underlies the current elevated mood in financial markets.
Highlights of the BIS international statistics
International banking activity expanded for a second consecutive quarter between April and June, regaining some of the ground lost in 2012 and 2013. Thanks to the latest quarterly increase, the annual growth rate of cross-border claims rose to 1.2% in the year to end-June 2014, the first move into positive territory since late 2011.
Banks' cross-border claims on emerging market economies continued to recover from the mid-2013 "taper tantrum". Increases in the second quarter of 2014 were concentrated in Asia, with China again receiving substantial inflows. Cross-border claims on borrowers in emerging Europe fell, especially those on Russia, Hungary and Ukraine.
China has become by far the largest emerging market borrower from BIS reporting banks. Outstanding cross-border claims on China residents totalled $1.1 trillion at end-June 2014, compared with $311 billion on Brazil and slightly more than
$200 billion each on India and Korea. Outside the EME world, China ranked seventh overall, just behind the Netherlands but immediately ahead of Japan.
Positions in OTC derivatives contracted slightly in the first half of 2014. The notional amount of outstanding contracts fell to $691 trillion at end-June 2014, from $711 trillion at end-2013. The gross market value of outstanding OTC derivatives, which measures the market cost of replacing all contracts at the reporting date, declined to $17 trillion at end-June 2014, from $19 trillion at
end-2013.
Central clearing in the CDS market made further progress. At the end of June 2014, 27% of all contracts (measured by notional amounts outstanding) were centrally cleared, up from 23% one year earlier.
The sector classification of foreign affiliates of EME non-financial corporations may shed light on the risk profile of their offshore debt, as non-financial affiliates are presumably more likely than purely financial affiliates to engage in operations other than funding the parent. The split between financial and non-financial subsidiaries varies greatly across countries and industries, with Indian and Chinese non-financial firms issuing mainly through non-financial subsidiaries, and Brazilian and Korean firms mainly through financial subsidiaries. Firms belonging to the oil and gas sector are most likely to use financial affiliates.
Special features
Currency movements drive reserve composition*
Almost two thirds of the world's foreign exchange reserves are denominated in US dollars, a ratio that has been stable for many years. Meanwhile, the US economy's share in global output has fallen to less than one quarter. Why does the dollar's share in global reserves remain so high? Robert McCauley and Tracy Chan of the BIS resolve this puzzle by arguing that it is not the size of the US economy that matters but the share of global output produced in countries with relatively stable dollar exchange rates - the "dollar zone".
This is because reserve managers can stabilise the local currency value of their reserves by holding currencies with a relatively stable exchange rate against their home currency. The evidence for such practice is that countries whose currencies vary less against the dollar than against other reserve currencies hold a substantial part of their reserve portfolio in dollars. McCauley and Chan estimate that the dollar zone has consistently accounted for 50-60% of global output, roughly in line with the dollar's share in reserves.
Looking forward, these findings suggest that changes in the co-movement of currencies could result in more rapid than expected shifts in the composition of reserves, potentially eroding the weight of the dollar. By contrast, country size alone may be less relevant.
Securitisations: tranching concentrates uncertainty*
The past decade witnessed the spectacular rise and fall of the securitisation market, as well as its recent timid revival. Much of this evolution reflected the changing fortunes of securitisations that were split into tranches of different seniority. Initially, such securitisations appealed strongly to investors in search of yield, as well as to banks seeking to reduce regulatory capital through the sale of judiciously selected tranches. Then the financial crisis revealed that the riskiness of some tranches had been greatly underestimated, and how even the soundest of risk assessments can be subject to substantial uncertainty.
In this article, Adonis Antoniades and Nikola Tarashev (BIS) show that the uncertainty inherent in risk assessments is concentrated in tranches of intermediate seniority, ie mezzanine tranches. This is the case even when the underlying assets are simple, transparent and of high quality. The reason for this uncertainty is a cliff effect, which implies that small errors in the estimates of risk parameters can translate into disproportionately large errors in the risk assessment of mezzanine tranches.
Antoniades and Tarashev argue that this calls for particularly large safeguards against the undercapitalisation of such tranches. This means that the regulatory capital for mezzanine tranches should be proportionately much higher than that for the underlying asset pool.
A bank's business model strongly influences its performance and risk. Rungporn Roengpitya from the Bank of Thailand and the BIS's Nikola Tarashev and Kostas Tsatsaronis use a data-driven approach to identify three distinct business models: a retail-funded commercial bank, funded mainly by deposits; a wholesale-funded commercial bank; and a capital markets-oriented bank heavily engaged in trading. They find that the performance of retail-funded commercial banks has been systematically more stable than that of wholesale-funded commercial banks and institutions geared towards capital market activities. That said, wholesale-funded commercial banks have been more cost-efficient.
The authors also find that banks change their profiles over time. Whereas, before the crisis, banks ventured into business models that turned out to be riskier, most of the post-crisis transitions are towards a commercial banking profile.
Non-financial corporations in emerging market economies and capital flows*
Non-financial corporations in EMEs have borrowed heavily through the issuance of debt securities. Much of this debt has been issued through offshore affiliates. In a piece of detective work, Stefan Avdjiev, Michael Chui and Hyun Song Shin of the BIS analyse balance of payments data to track how these funds have been transferred to the home economy.
They identify three main channels: direct lending to headquarters (within-company flows), credit to unrelated companies (between-company flows) and cross-border deposits (corporate deposit flows). Using items buried deep within the broad categories of direct investment and other investment, they show that capital flows associated with all three of the above channels have picked up considerably in recent years, together with the surge in offshore issuance. For some countries, intracompany loans make up a significant share of foreign direct investment. This raises questions about the stability of direct investment flows, especially if the funds reflect financial operations rather than real-economy activities.
* Signed articles reflect the views of the authors and not necessarily those of the BIS.