BIS Quarterly Review December 2013 - media briefing

On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, 5 December 2013

After a brief pause, the search for yield has continued largely unabated. Financial markets in the advanced economies rallied after the Federal Reserve's decision to postpone the tapering of large-scale asset purchases. True, after falling back to 2.5% in late October, yields on 10-year Treasuries have since retraced part of the decline. But the S&P 500 rose to record highs. Stock and bond markets in other major advanced economies have also rallied. And spreads on corporate bonds have tightened, undoing the brief rise in May and June. In particular, bonds issued by riskier US non-financial firms are paying just over 7% per annum on average. And the non-price terms on which firms get that money are becoming progressively looser. By contrast, in emerging market economies, credit spreads remain elevated and investors continue to retrench.

What is happening in corporate markets is unusual. It is as if the typical relationship with the macroeconomy has taken a holiday. Spreads are low. And so are default rates. Only 2.5% of US and 3.2% of European high-yield debt has defaulted in the past 12 months. This is just slightly higher than what we saw in the years before the financial crisis. But then the economy grew at a much faster pace. And we are just leaving behind one of the worst recessions on record.

So far, investing in risky corporate debt has paid off. But we simply don't know for how long low default rates will prevail. Low defaults drive down spreads; but low spreads can also drive down defaults. This is because lenders are more tolerant; and borrowers face lighter debt-servicing loads. If this process is indeed at work, its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.

Banks headquartered in advanced economies have benefited much less from investors' search for yield than non-financial corporations. Pre-crisis, they could borrow more cheaply than non-financial firms: ostensibly, investors saw them as less risky. This funding-cost advantage, however, reversed during the crisis. And banks have not been able to regain it. To be sure, the gap has narrowed over the past two years and has recently disappeared in the United States. But European banks are still paying considerably more than other firms. As a result, large corporations are turning to the bond market for their external funding. Bond issuance by European corporates, net of repayments, has boomed. Corporates have been paying back bank debt.

Banks can thrive in the long term only if they have a funding-cost advantage. And that funding advantage should not be based on perceptions of public sector support, such as too-big-to-fail subsidies. It is therefore disappointing to see that, once perceptions of such support are stripped out, rating agencies judge banks to be weaker than they were during the crisis. The international policy community has rightly been working hard to end too-big-to-fail. This puts a premium on banks' strengthening their balance sheets further.

The funding disadvantage of banks is not only bad news for the banks. It is bad news for those customers who are too small to access the bond market. And it is bad news for the economy. Fixing the banks is crucial if the recovery is to gain traction. Banks need to recognise fully the losses in their portfolios and raise capital. The ECB's planned asset quality review and stress test are therefore extremely important.

Let me now turn to the special features in this issue. Please note that they reflect the views of the authors and not necessarily those of the BIS. Whenever you refer to these articles, you should attribute the views to the authors.

All features in this issue use data from the Triennial Central Bank Survey to shed light on FX and OTC derivatives markets. These markets are huge. The FX market is the world's largest, with turnover of $5.3 trillion per day in April of this year. The OTC interest rate derivatives market is smaller, but no less important. Despite their size, both markets are quite opaque. Admittedly, there is now more data on activity than only a few years ago, but coverage is still partial. The Triennial Survey is the only source that spans the entire market.

The article by Dagfinn Rime of the Central Bank of Norway and Andreas Schrimpf of the BIS shows how the structure of the FX market has changed over the years. Non-dealer financial institutions, including smaller banks, institutional investors and hedge funds, have become the market's largest counterparty segment. Inter-dealer trading has continued to lose market share, as higher concentration has allowed top-tier dealers to match more trades internally. The once clear-cut divide between inter-dealer and customer-trading segments has faded. That said, top-tier dealers retain a crucial role as prime brokers.

Morten Bech and Jhuvesh Sobrun, both from the BIS, complement this analysis. They combine the Triennial Survey with data from other sources to obtain monthly estimates of FX activity. These suggest that activity actually peaked in April 2013, when the Triennial Survey was taken. Subsequently, it fell back to around $5 trillion per day in October.

Torsten Ehlers and Frank Packer look at FX and derivatives trading in emerging market economies and emerging market currencies. Derivatives turnover in emerging economies has continued to grow since 2010. And so has turnover in contracts in emerging market currencies, which are increasingly traded offshore. In several currencies, more than three quarters of global turnover takes place outside the country.

Finally, the article by Jacob Gyntelberg and Christian Upper looks at the OTC interest rate derivatives part of the Triennial Survey. Low and stable interest rates post-crisis went hand in hand with low but still positive turnover. A small increase in turnover was entirely due to a larger volume of contracts with non-dealer financial institutions. The share of inter-dealer trades shrunk to 35%, the lowest level since the Triennial Survey began. Despite rapid growth in emerging market currencies, trading is still concentrated in major currencies and financial centres.