Description
Financial markets have recovered substantially but vulnerabilities remain significant. Ample liquidity may lead to new bubbles, particularly in some emerging markets, and uncertainties about government exit strategies and regulatory changes threaten a fledgling upswing.
ISSN 1995-2864
Financial Market Trends
© OECD 2009
Pre-publication version for Vol. 2009/2
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 1
C0B
The Financial Industry and Challenges
Related to Post-Crisis Exit Strategies
Gert Wehinger
?
Financial markets have recovered substantially but vulnerabilities
remain significant. Ample liquidity may lead to new bubbles,
particularly in some emerging markets, and uncertainties about
government exit strategies and regulatory changes threaten a fledgling
upswing. Co-ordination and communication of exit policies will be
important, and exit from policy stimulus should not be precipitated at
the current juncture. While financial institutions have increasingly
obtained market financing and paid back state aid, the sector remains
fragile; thus, such voluntary pay-backs should meet preconditions
aimed at ensuring the soundness and sustainability of the concerned
institutions’ balance sheets. At the same time, expectations of future
writedowns and more stringent capital rules put pressure on bank
lending more generally. Restarting securitisation to support lending
would be important and could be fostered by government initiatives
focussing on standardisation, transparency and due diligence to restore
investor confidence. Regulatory reforms currently being proposed
concern accounting rules, capital requirements and compensation
issues. However, further reforms are required to address such systemic
issues as moral hazard created by public support. Measures would
include resolution mechanisms for large and systemically important
banks as well as appropriately fire-walled business structures for the
financial sector. Peer pressure via co-operation in international
standard-setting and relevant bodies should help to keep the reform
momentum, overcome political impediments to reform and maintain a
level playing field.
?
Gert Wehinger is Economist in the Financial Affairs Division of the OECD Directorate for Financial and Enterprise Affairs. The present
article is based on a background note prepared for the OECD Financial Roundtable held with participants of the private
financial sector and members of the OECD Committee on Financial Markets on 8 October 2009. The present version takes
into account the discussions and comments made at that meeting and selected developments that have taken place since.
The author is grateful for additional comments from Adrian Blundell-Wignall, André Laboul and Stephen Lumpkin, and
editorial assistance from Laura McMahon and Edward Smiley. The author is solely responsible for any remaining errors. This
work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments
employed herein do not necessarily reflect the official views of the Organisation or the governments of its member
countries.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
2 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
I. Current outlook and vulnerabilities
Financial markets have
recovered substantially
Financial markets have recovered substantially since March 2009 when the
financial stress began to ease and market conditions started to improve.
With easy monetary policy and large fiscal support to avert larger financial
and economic shocks, liquidity and credit risk premiums have narrowed
significantly (Figure 1). Market value gains have now, globally, neutralised
about 60% of the losses incurred since the onset of the downturn (Figure 2).
...but vulnerabilities
remain significant
While financial markets have entered a period of relative tranquillity and
the outlook for economies has improved,
1
the effects of the financial crisis
linger and vulnerabilities remain, as some of the negative feedback loops
are working their way back from the real sector (which was affected by a
delay bby the first wave of the financial crisis). Should the various risks for
the financial sector materialise in the current conjuncture, their impact
could be relatively more significant than under more stable circumstances.
Figure 1. Risk spreads have narrowed
High-yield and emerging market bond spreads
0
200
400
600
800
1000
1200
1400
0
100
200
300
400
500
600
700
B
a
s
i
s
p
o
i
n
t
s
B
a
s
i
s
p
o
i
n
t
s
Investment grade ? US (Barclays)
Investment grade ? Europe (JPM)
High yield ? US (BOFAML) (r.h.s.)
High yield ? Europe (JPM) (r.h.s.)
EMBI global (JPM) (r.h.s.)
Note: Daily data until 1 February 2010.
Source: Thomson Reuters Datastream.
New bubbles may be
forming
While easy monetary and fiscal policies have been providing relief from the most
severe effects of the crisis, they maintain global liquidity at a high level (Figure 3).
As investors’ uncertainties and fears subside, this liquidity is searching for new,
higher-yielding investments (Figure 4). Upward price pressures on certain asset
classes are emerging, and some signs of new bubbles are becoming apparent.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 3
Figure 2. Equity valuations are recovering
Datastream World indices, market valuations in USD billion
?
10 000
20 000
30 000
40 000
50 000
60 000
U
S
D
b
i
l
l
i
o
n
WORLD?DS Market ? MARKET VALUE (USD)
WORLD?DS Financials ? MARKET VALUE (USD)
WORLD?DS Banks ? MARKET VALUE (USD)
max: 51 137
29/10/07
min: 20 663
09/03/09
latest:
36 160
01/02/10
Note: Based on equity valuations of constituents contained in the respective Datastream World indices as shown.
Source: Thomson Reuters Datastream.
Figure 3. Global liquidity remains ample
?10%
?5%
0%
5%
10%
15%
20%
25%
30%
35%
?10%
?5%
0%
5%
10%
15%
20%
25%
30%
35%
Y
e
a
r
?
o
n
?
y
e
a
r
p
e
r
c
e
n
t
a
g
e
c
h
a
n
g
e
Y
e
a
r
?
o
n
?
y
e
a
r
p
e
r
c
e
n
t
a
g
e
c
h
a
n
g
e
(
a
c
c
u
m
.
)
growth contribution by China growth contribution by Japan
growth contribution by EU growth contribution by US base money
Global liquidity (a) (r.h.s.)
Weak USD:
Louvre intervention
Weak USD:
BoJ intervention
Weak USD:
BoJ & Chinese
intervention
Financial crisis,
policy actions
a) Annual growth of non-US international reserves and US monetary base.
Note: Contributions to growth measured by the respective reserve or monetary components in the liquidity measure.
Sources: Thomson Reuters Datastream, and OECD.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
4 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
Figure 4. Returns have improved across a broad spectrum of asset classes
Selected investment alternatives, percentage changes over period, annualised, in US dollar terms
?64.1%
?49.0%
?55.5%
?53.7%
?46.5%
?40.5%
?50.4%
?44.9%
?38.7%
?38.6%
?38.5%
?48.8%
?43.3%
?33.8%
?28.7%
?28.2%
?1.7%
?10.2%
?10.9%
?6.7%
?11.1%
10.6%
30.0%
21.2%
?47.5%
?42.8%
?19.1%
12.3%
14.0%
12.7%
0.2%
72.9%
66.6%
61.8%
51.6%
45.0%
34.6%
28.4%
27.8%
22.0%
20.7%
19.0%
16.8%
16.2%
14.8%
13.9%
4.1%
38.3%
29.4%
26.4%
25.4%
22.2%
2.2%
0.5%
?7.2%
85.7%
37.9%
19.5%
11.3%
2.3%
?6.1%
?16.2%
?80% ?60% ?40% ?20% 0% 20% 40% 60% 80% 100%
EQUITIES:
INDIA?DS Market
LATIN AMERICA?DS Market
EMERGING MARKETS?DS Market
ASIA EX JAPAN?DS Market
CHINA?DS MARKET $
NASDAQ COMPOSITE
FTSE 100
WORLD?DS Market
DJ US TOTAL STOCK MARKET
US?DS Market
S&P 500 COMPOSITE
EMU?DS Market
DAX 30 PERFORMANCE
DOW JONES INDUSTRIALS
NIKKEI 225 STOCK AVERAGE
TOPIX
BONDS:
JPM EMBI GLOBAL MIDDLE EAST
JPM EMBI GLOBAL AFRICA
JPM EMBI GLOBAL COMPOSITE
JPM EMBI GLOBAL ASIA
JPM EMBI GLOBAL LATIN AMERICA
EMU BENCHMARK 10 YR. DS GOVT. INDEX
JP BENCHMARK 10 YEAR DS GOVT. INDEX
US BENCHMARK 10 YEAR DS GOVT. INDEX
OTHER:
Economist Commodity Inds/All ($)
S&P GSCI Commodity Spot
C.S/TREMONT HEDGE FUND
Carry trade Index ? USD ? AUD (a)
Carry trade Index ? USD ? NZ$ (a)
Carry trade Index ? Yen ? AUD (a)
Carry trade Index ? Yen ? USD (a)
2008 (1?Jan?08 to 1?Jan?09)
From 1?Jan?09 to 01?Feb?10
(annualised)
a) The carry trade return index is calculated based on the assumption of one-month investments in the respective currencies,
borrowing in yen, applying one-month eurodollar interest rates and central exchange rates, without taking into account bid-ask
spreads and transaction costs.
Sources: Thomson Reuters Datastream and OECD.
…in emerging
markets in particular
However, there is some agreement among market observers that despite the rallies
in almost all asset classes, most of them have not reached bubble territory. Perhaps
the high-yield bond segment, which has seen record levels of issuance in recent
months (while declining spreads reflect investors’ increasing risk appetite), bears
watching. But market participants are becoming wary of some early signs of
bubble formation that are beginning to show in Asian and other emerging markets.
On-going adjustmentd to the global saving and investment imbalances are
rendering many of these economies more vulnerable than investors may currently
be aware. While carry trades are becoming profitable against the background of
low US interest rates and some fixed Asian exchange rates, the build-up of trades
could create problems farther down the road. The rallies in these markets may
create the fault lines for future disruptions.
Real estate markets
remain a problem,
and credit quality is
deteriorating across a
broad spectrum of
lending categories
At the same time, house prices (their sharp drop was at the heart of the current
crisis and some analysts believe they still need to undergo further downward
adjustment) are beginning to rise, too early perhaps, in some parts of the world.
2
Commercial property may turn into a severe problem, especially in Europe where
a vast amount of commercial property loans need to be restructured or refinanced,
part of it in commercial mortgage-backed securities (CMBS) for which
restructuring has proved especially difficult. In addition, credit quality across a
broad spectrum of lending categories is further deteriorating, and default rates are
expected to rise.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 5
Recovery in money
markets has been
uneven, favouring
the United States
Market participants have also pointed out that market recovery has not been even,
in part due to unlevel playing fields that risk becoming more unbalanced. In
particular, in security-backed short-term cash markets, divergences between the
United States (and Asia-Pacific) on the one hand and Europe and the United
Kingdom on the other are still significant. In the United States, where markets
have benefitted from the Term Asset-Backed Securities Loan Facility (TALF)
programme and where underlying securities are more homogenous, markets are
more liquid, while in Europe the challenges to access short-term cash are much
greater because collateral securities carry more idiosyncratic risks and maturities
tend to be longer, exposing them to extension risk.
Risks also exist with
respect to policy exit
and sovereign debt
The necessary withdrawal from extraordinary policy support measures constitutes
the basis for another set of risk factors. There is a danger that policy makers exit
either too soon or too late. In the first case, stimulus withdrawals could throw the
economy back into contracting mode, generating an often feared double-dip
recession. In the second case, where withdrawal is too late, fiscal deficits would
rise even more and inflation could surge, also because monetising the rising fiscal
deficits would meet less political resistance than spending cuts or tax increases.
New bubbles would easily build, and these imbalances would unnecessarily
postpone adjustment and, in the end, require tighter stabilisation policies that
might upset financial markets to a larger extent than an earlier adjustment would
have. Some of the risks related to fiscal deficits have been foreshadowed in recent
sovereign rating downgrades in Europe and rising credit default swap (CDS)
spreads for sovereign debt (Figure 5).
Figure 5. Selected credit default swap (CDS) spreads
0 50 100 150 200 250 300 350 400 450
Greece
Hungary
Portugal
Ireland
Spain
Italy
Austria
United Kingdom
Slovenia
Belgium
France
United States
Netherlands
Germany
Norway
Sectors:
EUBANKS
UKBANKS
US BANKS
Basis points
01/02/2008
31/01/2009
01/02/2010
Notes: Senior five-year credit default swap premiums (mid) for sovereign bonds; senior five-year credit default swap premium index
(mid) for banking sector.
Sources: Thomson Reuters Datastream and OECD.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
6 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
Co-ordination and
communication of
exit policies will be
important
While the risks associated with such timing issues may be large, there are also
risks that uncoordinated exit policies may create an uneven playing field across
financial sectors and countries. There are further risks that inappropriate
communication or lack of credibility of proposed exit policies could create
uncertainties which could again destabilise markets. Unexpected policy
withdrawals could render a transition to the new regime more difficult for financial
institutions, and the sector as a whole.
Exit from policy
stimulus should not
be precipitated
There seems to be a broad consensus in the official as well as the private sector
that the recent upswing is not yet fully self-sustained and that policy stimulus is
still necessary in many economies. At the current juncture, it seems better to err on
the side of avoiding the downside risks, which include deflation and a double-dip
recession. In the current cycle, the Reserve Bank of Australia was one of the first
central banks to raise interest rates in October 2009 (with two further increases in
November and December). Similarly, China tightened credit in early J anuary
2010, and others may follow in due course.
The success of exit
strategies will depend
on proper co-
ordination, timing
and policy
communication
Proper co-ordination between fiscal and monetary policies will be important. Also,
given differences in economic stance and exchange rate pressures, the speed of
exit will have to differ across economies and will thus need proper international
co-ordination in order to avoid imbalances and unlevel playing fields. Timely and
clear communication of these policies will be important so as to render policies
predictable and credible, and to facilitate the transition to a new policy regime. As
this crisis has shown, expectations are important and building confidence will be a
prerequisite for a solid recovery.
II. Assessing the resilience of the banking sector
Financial sector soundness
Financial institutions
have increasingly
obtained market
financing
As financial markets recovered, financial institutions have been able to raise
capital on equity markets, especially in the United States. Share prices have
improved; major G-20 banks have on average recovered about two thirds of their
2008 losses (Table 1). These improvements also reflect profit reports, some of
which have become more positive after the heavy 2008 writedowns. Banks are
now buying back securitised credit on the secondary market and are benefiting
from the reduced spreads. These improvements have allowed several banks to
repay state aid, and other financial institutions are considering exiting too.
The effects of
liquidity support are
now visible in the
growing search for
yield and appetite for
risk
Liquidity interventions and terming out of public sector funding replaced private
sector funding where there were shortening maturities, and the expansion of
collateral has allowed banks to refinance in liquid assets. The money market
guarantees in the United States have allowed, both directly and indirectly, about
USD 4 trillion of assets to continue to circulate. However, the effects of this
liquidity increase can now be seen in the increasing search for yield and appetite
for risk. This shows up particularly in the fixed-income market through
contraction of spreads in the secondary securitised credit market and in spreads of
unsecuritised bank credit. Initially this took place at the highest credit quality, but
lower-grade credit soon followed the spread contraction.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 7
Table 1. Banks’ market value losses and gains
Change in market value of largest G20 banks, in USD billion
a)
2009
b)
2008 2007 2006 2005 2004
memo: MV
(latest)
e)
memo:
recovery
f)
United States 250.6 - 332.0 - 290.4 173.7 - 20.0 162.2 765.3 75.5
United Kingdom 173.5 - 256.7 - 72.8 109.0 - 19.1 58.2 374.6 67.6
Italy 27.9 - 177.9 73.2 61.4 47.1 21.4 158.9 15.7
France 86.8 - 157.6 - 31.6 108.6 13.4 26.9 191.3 55.1
China 101.1 - 124.3 60.1 82.3 - - 318.1 81.4
Australia 123.9 - 110.9 43.7 38.9 18.2 19.2 247.1 111.6
Russian Federation 68.3 - 110.1 24.7 47.1 17.9 4.7 97.6 62.1
J apan - 4.0 - 107.7 - 111.8 - 48.6 204.0 96.3 292.7 - 3.7
Canada 93.7 - 97.4 12.2 31.1 37.2 24.7 226.3 96.2
Brazil 126.0 - 86.4 59.6 38.6 29.9 12.5 224.2 145.8
Germany 22.3 - 80.0 - 3.7 34.1 14.8 1.2 62.6 27.9
Turkey 52.1 - 69.1 40.9 - 4.0 26.0 10.0 96.4 75.4
South Korea 33.2 - 63.8 - 0.0 11.9 39.1 8.2 66.8 52.1
India 41.5 - 59.3 56.5 16.7 11.6 7.9 93.9 70.0
South Africa 22.0 - 22.1 - 0.3 6.8 7.7 23.5 61.7 99.5
Indonesia 23.8 - 16.2 7.6 14.1 - 1.4 7.3 47.7 147.3
Mexico 7.0 - 8.9 5.6 6.6 0.8 4.7 24.1 77.9
Argentina 3.7 - 4.5 - 0.4 2.7 0.6 0.6 7.1 81.3
G-20 country total 1 253.4 -1 885.0 - 126.8 730.9 427.7 489.4 3 356.3 66.5
memo item: Euro area total
c)
228.6 - 789.1 81.8 379.2 105.6 143.7 746.0 29.0
memo item: G-7 total
c)
650.8 -1 209.4 - 424.8 469.3 277.4 390.8 2 071.6 53.8
memo item: Global
d)
1 671.5 -2 784.9 - 43.6 1 140.6 505.7 695.1 4 540.1 60.0
Sorted by 2008 losses.
a) Based on banks contained in respective countries' Datastream bank indices.
Note that such data are not available for Saudi Arabia.
b) From 1-J an-09 to 1-Feb-10.
c) Based on banks contained in respective countries' Datastream bank indices.
d) Based on banks in Datastream worldwide bank index.
e) Memo item: Market valuation as of 1-Feb-10.
f) Ratio of change in 2009 (b) over the negative change in 2008, in per cent.
Sources: Thomson Reuters and OECD.
Banks’ balance
sheets are not yet on
a sound footing
But, overall, the situation for the banking sector remains fragile. Writedowns
have continued and have not yet been fully matched by private capital raised.
While the situation seems to look relatively better for European than for US
banks, off-balance-sheet items and contingent liabilities may yet pose serious
problems for European banks. Furthermore, the European group of banks
reporting losses has a much higher leverage ratio than their US counterparts.
3
Future bank losses
are still expected to
be significant
Due to accounting requirements,
4
US banks will need to bring USD 1.3 trillion
in off-balance-sheet vehicles onto their balance sheets over the next year. Future
losses are still expected to be significant. The IMF expects losses of USD 3.4
trillion over 2007-2010, down from the previous USD 4 trillion;
5
J PMorgan has
recently published a smaller loss estimate of USD 2.3 trillion.
Balance sheets are
not comparable
globally due to
A note of caution is required when comparing losses and writedown data
internationally. Differences in accounting rules make for gaps in the range of
perhaps a factor of two. Thus, if such a factor were applied, i.e., assuming
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
8 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
different accounting
rules – a case that
presses for
harmonisation
European banks were to apply the US Generally Accepted Accounting
Principles (GAAP) instead of International Financial Reporting Standards
(IFRS), the recent IMF estimates for losses of European banks could be roughly
halved. Nevertheless, losses would remain huge, but such calculations are a
stark reminder of the importance of harmonising accounting rules, in particular
as international policy co-ordination is of the essence to resolve the crisis.
Further official
support will be
needed for the
banking sector
Further official support will be needed as there is not yet enough capital in the
banking system, and many banks do not yet have access to wholesale funding.
The market is not yet deep enough for the liquidity schemes, put in place in
response to the crisis, to be removed. A sudden withdrawal of these schemes
would seriously impede recovery. Also, the success of various government
programmes to deal with toxic assets (e.g., Public-Private Investment Program
for Legacy Assets (PPIP) in the United States, “bad banks” in the United
Kingdom, Ireland and Germany) and their phasing out will be crucial for the
financial sector to recover.
Banks are exposed to
risks in commercial
real estate and
business loans
One of the major risks going forward is in the commercial real estate segment
where prices are declining and delinquency rates are rising. In the United States,
about 12% of the approximately 8 200 banks have a commercial real estate
exposure of more than five times their tier-one capital, and it is estimated that up
to a thousand banks will face major difficulties. A second area of banking sector
worries is loans to business, in particular large syndicated loans. By end-2009,
118 US banks had failed, and the number is expected to rise substantially.
6
Bank lending has not
yet picked up as
banks are increasing
liquidity buffers
These pending risks and the banking sector’s fragility from previous losses are
the reason that much of the liquidity support is currently resting in deposits by
banks that need to improve their balance sheets. At end-2009, US banks held
more than USD 1 trillion in excess reserves with the Federal Reserve. But these
reserves not only serve as buffers against expected losses but also act as buffers
for the unsecured parts of the interbank market. Banks claim that these reserves
are also serving the function to prepare for potentially tighter regulatory
requirements. In fact, due to such requirements, the industry expects banking to
become less profitable: some observers from within the banking industry expect
that return on equity could drop by one third to one half, based on a five-year
average measured from 2002 to 2007.
…but demand factors
also play a role
But lower lending is also due to demand-side factors. Demand-side effects are
relatively strong in countries with low saving rates. In the United States and
United Kingdom, as well as some other continental European countries where
households have to repair their balance sheets, credit demand has been slowing
significantly.
As part of an exit
strategy, reserves
could eventually be
replaced by
government bonds
While the liquidity “hoarded” by banks fulfils useful buffer functions, going
forward, and as part of an exit strategy, some industry representatives have
proposed that banks could substitute these buffers with government bonds in
synch with the withdrawal of liquidity, and in accordance with the expected
higher liquidity and capital requirements. Given the future financing needs of
governments, there should be no shortage of such bonds.
7
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 9
Measures to re-establish lending and securitisation markets
The key missing link
to restart lending is
securitisation, which
needs to be restored
One of the key missing links to put bank liquidity to use for lending is
securitisation.
8
In the US market, about USD 1.8 trillion (net amount of
residential mortgage-backed securities (RMBS) issued by the banking sector in
2007
9
) of securitised assets need to be replaced. The decline in securitisation has
left a gap that cannot be easily filled by traditional bank balance sheet lending
alone. Securitisation is a way by which private investors fund household and
business loans and is thus an important element in restoring economic growth.
The two publicly distributed asset-backed securities (ABS) deals in Europe in
late summer 2009, the first since J uly 2007, were seen by many market
participants as an indication of the right way forward. It is thus in the interest of
policy makers to help restore this market segment, and the current central bank
lending programmes (widening of eligible collateral) are part of these efforts. It
is noteworthy that the ECB’s collateral framework had allowed the use of ABS
as eligible instruments, even before the sudden appearance of the funding
difficulties, which proved great support during the crisis.
10
As some central banks
have become large securities buyers, policy makers need to think about how to
make these markets sustainable once official demand is withdrawn. More
structural measures will need to be put in place to support the market.
...with policy support
that focuses on
standardisation,
transparency and due
diligence
Policy makers have many possibilities to support securitisation markets and to
restore investor confidence and secondary market liquidity, e.g., by enhancing
standards, transparency (such as allowing access to loan-level data, already
possible in the United States) and overview of investor due diligence.
Institutional investors are currently avoiding these markets because many of
them have lost confidence. And, due to single-name limits, many of the
institutional investors would also not be allowed to invest large volumes directly
in a few large banks (those that were the main RMBS issuers). As many of these
investors were forced to sell the toxic assets, they took the brunt of the price
adjustment, while banks are now buying (back) many of the securities on the
secondary market (while at the same time they are hardly issuing any new ones).
Loan funds could
support lending
Further proposals for official measures to re-establish lending and securitisation
markets could be put forward. One is that government compete with banks
through asset management companies that would extend direct loans to the
industry. Some so-called loan funds engaging in this type of business exist
already.
Measures need to be
initiated by
government
Deriving lessons from the origins of the development of securities and
derivatives markets could help. The securitisation model’s original purpose (in
the late 1980s) was transferring risk to investors who previously had unsecured
(not asset-backed) exposure, and it had evolved into a well-established system
with standards, enhanced infrastructures and built-in checks and balances.
Likewise, swap markets developed through standardisation, netting agreements,
etc. Thus, the securities market would also benefit from standardisation of
products, better information, transparency and due diligence. Policy makers
would need to provide the momentum (as was done in the case of the creation of
swap markets) to develop these measures. For example, the Eurosystem has
taken some steps to simplify the structures of ABS, which it accepts as collateral
in order to create more transparent instruments.
11
Such transparency, with more
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10 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
timely and standardised information on the performance of underlying loans,
would help investors’ due diligence.
Exchange trading
would enhance price
transparency and
attract more investors
Better price transparency is one of the elements needed to make the market more
liquid. This could be achieved by transferring a large part of the business away
from over-the-counter (OTC) trading onto exchanges, where government could
initiate or support market-making activities if needed. Furthermore, the
traditional buyers of securities credit used to be short-term, fixed-income and
cash investors because of the floating-rate nature of these products. Turning
them into more fixed-rate-like products could attract a different buyer base into
the market.
Voluntary exit from government support by financial institutions
Some banks have
started to pay back
public support
So far, a decline in borrowing from the various emergency liquidity facilities
provided by central banks in response to the crisis has been observed, and banks
have made efforts to pay back the government support they received in response
to the crisis. US banks (large money centre banks) had by end-2009 paid back
about USD 164 billion of public support
12
and raised capital beyond that amount.
Similar paybacks have taken place in France (where all banks have reimbursed
official money), the United Kingdom and elsewhere,
13
and many banks are
considering such exit from state support.
…but such exit has to
be carefully managed
But such exits have to be carefully designed and managed. While the
improvements in financial markets have made it relatively easy for banks to
repay state aid, an exit from government support may be premature for many
institutions and not warranted with the still fragile situation. But, again, many
government programmes were designed in such a way as to make state aid
unattractive as market conditions improve. Some of these built-in withdrawal
incentives may have to be reassessed as aid programmes are being rescheduled.
Perhaps governments should also establish conditions under which a recipient
institution would be allowed to repay government support. Such rules would
then need to be communicated in a proper and timely manner.
Market-driven exits
should not create
undue risk
More generally, exit from state support should happen without creating undue
risk. For example, reimbursement of official funds could happen under the
conditions that i) paybacks are replaced by high-quality capital raised; ii) assets,
especially risky assets, on the balance sheets of banks concerned are fairly
valued; and iii) these banks have a viable long-term business strategy. To qualify
for repayment of state aid, institutions should also credibly demonstrate to have
market access and should be able to raise capital by issuing equity, and not by
excessive deleveraging and tightening credit supply. Such conditions could also
specify that capital ratios should remain comfortably above the regulatory
minimum. Quality requirements for private capital that is used to replace public
capital support could specify, e.g., that private capital should be at least of the
same quality as the public capital that is being repaid.
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III. Some issues for further regulatory reform
Governments’ enhanced role and moral hazard problems
Public support
creates moral hazard
Public sector support for the financial sector during this crisis has been
exceptional, ranging from capital injections, asset purchases and various forms of
central bank support to guarantees. Guarantees constitute by far the most
extensive support category, even though in principle no upfront financing is
needed and the contingent liabilities may remain undrawn.
14
While this support
has so far been successful in averting an even bigger financial crisis, there is
broad agreement between policy makers and the private sector that direct
involvement of governments in markets should not be extended over the long
term. Such involvement sustains or even fosters moral hazard, as risky behaviour
is favoured. In particular large, “too-big-to-fail” institutions benefit from large-
scale financial support, and negative consequences of imprudent lending or other
high-risk activities are not properly sanctioned. Risk is underpriced.
...and at times
uncertainty, and it
distorts competition
At the same time, a discretionary element in such support may lead to uncertainty
that affects planning and creates inefficiencies in the financial sector (the financial
market calamities after the Lehman default serve as a telling example of the
effects of such uncertainty). Furthermore, uneven support creates an unlevel
playing field (with smaller institutions at the lower end). The on-going and
selective official intervention in mainly large financial institutions during this
crisis has the potential to distort competition to the detriment of smaller and
perhaps more viable banks, running the risk of “subsidising failure” and creating
moral hazard. Expectations of future bailout in case of failure may also be a
problem for (uninformed retail) investors who have the, perhaps wrong,
perception of a risk-free trade in dealing with such banks.
Withdrawals should
be properly managed
However, it is clear that certain elements of the safety net provided by
governments and central banks will have to remain in place to safeguard financial
stability (e.g., deposit guarantees to avoid bank runs), but other elements need to
be withdrawn in order not to prolong and foster the negative effects mentioned
above (moral hazard, distortion of competition, etc.). The crucial issue to be
addressed is then how to obtain the benefits created by financial system stability
while minimising the downside risks and losses for taxpayers.
Accounting rules and capital standards
Single global
accounting standards
help minimise
distortions and
regulatory arbitrage
With regard to accounting rules, where different rules and standards can create
significant distortions, co-ordination is particularly relevant. For example,
leverage ratios are defined differently under US GAAP and the International
Accounting Standards (IAS) as applied in Europe and elsewhere. Some
observers also see problems arising from recent regulatory initiatives regarding
trading book rules. There are proposals that capital requirements should be
increased for any illiquid asset in the trading book. But illiquid assets should
not be in the trading book at all. That is due only to accounting rules that allow
classifying even illiquid assets as available for sale, without regard to the actual
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12 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
time it would take to sell the asset in question. If accounting rules allow
defining the holding period of assets over almost any time span, they create
distortions between liquid and illiquid assets. Thus, treatment of these assets is
another area that needs global standards.
Trading book rules
need to be well
balanced
However, the banking industry has pointed out that, given the importance of
trading activities for secondary market liquidity and capital market
intermediation more generally, trading book rules should be addressed by
regulators in a balanced way – as is the case for banking book rules that balance
the need for prudential requirements and the need to extend credit to the
economy. Some of the current proposals are seen as imposing “onerous”
liquidity and capital requirements on trading books.
Capital requirements
also need common
global standards;
leverage ratios need a
risk-based
complement
Capital requirements are another area where common standards are needed, as
there is a danger that in implementing standards, countries move at a different
pace and towards different definitions, which could create major distortions.
Regulators and industry representatives agree that capital requirements should
move towards higher quality and more self-sufficiency. Many see the currently
discussed leverage ratio requirements as useful, but there are some fears that if
introduced without risk-based capital requirements they would create
distortions with respect to firms’ financial buffers. Because of its simplicity,
Basel I is often seen as having driven much bank lending activity off their
balance sheets and as having created a lot of regulatory arbitrage. Given the
complexity of the banking business, many see simple capital rules as
insufficient.
Higher liquidity and
capital provisions will
make the industry less
profitable
As higher liquidity and capital provisions will make the industry less profitable,
the question is also what rate of return do institutional investors expect from
bank equity. If investors continue to expect high returns, this could put banks
under pressure to engage in more risky business.
Compensation issues
Remuneration
schemes need to be
risk compatible
There is broad agreement between the industry and policy makers that there is
a need for better, risk-compatible remuneration schemes in order to avoid
excessive risk-taking. This is particularly relevant for big banks and financial
conglomerates where risk-reward schemes are largely distorted by cheap
funding paired with moral hazard.
Recommended
remuneration
standards are being
implemented, but
performance targets
need to be lowered
Remuneration systems at many banks are being brought in line with
recommended standards,
15
taking into account risk-compatibility and longer-
term goals. But these measures will become truly effective only if they are
implemented uniformly (given the mobility of the financial labour force) and if
performance targets, which are still too high in many cases, are lowered
accordingly. Perhaps bonus payments should not be linked to beta (the general
market) but to the alpha effect (manager-specific performance). In banks, the
risk-return relationship in remuneration tends to be distorted, as traders are
risking “other people’s money” with little personal downside risk (unlike, for
example, hedge fund managers who often have personal money at stake).
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Risk management has
improved
In response to the crisis and in line with recommendations, risk management in
most institutions has been improved by instilling a better risk culture in banks
and their boards. For example, in many banks the role of the chief risk officer
is being enhanced, as is the risk function performed by the CEO in defining
and examining the risk profile of the institution.
But even risk-
compatible
remuneration policies
cannot spare firms
difficulties
It should be also be noted, however, that compensation policies are not a
panacea. Remuneration policies of some institutions had already been aligned
with the long-term interests of the firm, yet this did not help them much in
avoiding a crisis. Notably Bear Stearns had paid its bonuses in shares with a
vesting period of five years, one of the longest terms in the industry.
Moreover, at the time the firm went bankrupt, Bear Sterns employees owned
about one third of the firm, with senior executives – whose decisions were
crucial for the performance and survival of the firm – having the largest share.
Many financial sector employees lost out in the current crisis. Going forward,
many banks will probably reduce the bonus part of employee compensation,
thereby reducing risk-taking.
Officials in regulatory
and supervisory
authorities may need
to be better paid and
closer to the market
The current crisis has revealed failures not only in the financial industry but
also in the regulatory and supervisory system. To attract a capable – and,
moreover, globally mobile – workforce required to deal with ever more
complex issues and to increase the quality of supervision, it has been
suggested that the compensation of officials in regulatory and supervisory
authorities needs to increase. Furthermore, market experience should be
required of these officials, which should give them the insight and working
knowledge required for due diligence exercises.
Systemic considerations, bank structure and resolution mechanisms
Systemic relevance
needs to be defined in
a dynamic way
Systemic relevance is defined by the size and/or interconnectedness of an
institution, but clear measures and definitions are lacking. The Financial
Stability Board (FSB), in which the OECD participates, is currently looking
into these issues, including definitions of systemic importance.
16
But again,
defining and then permitting the existence of “systemic” banks may create more
moral hazard and competitive distortions if not counterbalanced by, for
example, greater capital requirements. Perhaps a combination of effective
micro- and macro-prudential supervision allowing a dynamic identification of
the problem is needed.
Structural firewalls
within financial firms
could reduce systemic
risk
An additional approach is to devise principles and structures that would avoid
financial institutions becoming too large and systemically important, i.e., avoid
maintaining or creating too-big-to-fail institutions. The recent US initiative to
separate banking business tries to address such problems.
17
Another proposal
would envisage putting firewalls in large financial conglomerates, via a non-
operating holding company (NOHC) structure.
18
Such a structure would
enhance transparency (financial reporting for each entity), improve governance,
level the playing field (group affiliates compete with stand-alone companies),
allow separate resolution of affiliates and ease regulatory intervention. Such
reforms would be essential to deal with the contagion and counterparty failure
that have been the main hallmarks of the current crisis. This approach would
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14 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
also be somewhat more flexible than a stricter separation of banking business
like the one under the Glass-Steagall Act.
19
…and could make
resolutions of large
banks that are very
complex easier
As past developments in the financial industry have shown, imposing one
single business model would not be helpful, given the growing complexity and
interconnectedness of financial markets and products. A firewalled NOHC
structure could help to solve the complex issues that arise related to the
resolution of large banks. Various advances with regard to resolution
procedures have been made, and additional reforms are underway, like the
Special Resolution Regime (SRR) in the United Kingdom (UK Banking Act
2009). But resolution issues also involve, for example, differences in the data
architecture, and arise from the fact that legal and business forms do not
overlap, but are intertwined in a complex matrix that makes resolutions, even
of only single entities of the whole structure, complicated.
“Living wills” for
systemic firms may be
very costly
A so-called “living will” approach has been proposed under which
(systemically important) financial companies (banks in the current UK
proposal) would have to devise detailed plans that would enable them to
stipulate in advance how they would raise funds in a crisis and how their
operations could be dismantled after a collapse. Such plans could also improve
cross-border litigation and help to mitigate uncertainties and avoid panic
reactions to the failure of a major, globally active financial institution. But
implementing such living wills may involve heavy reporting requirements with
the need to provide constantly updated information, in line with an evolving
business structure, and may thus prove to be unduly costly. The current
complexity of the banking industry would make such an exercise very difficult.
Some current regulatory reform proposals
OECD proposes a
Policy Framework
for Effective and
Efficient Financial
Regulation
The OECD has recently proposed a Policy Framework for Effective and Efficient
Financial Regulation.
20
The Framework is a tool that can support ongoing efforts
by policymakers, regulators and supervisors to achieve a stronger, more resilient
financial system. As it is general in nature, it cannot be a substitute for more
focused, micro-prudential principles and guidelines of international standard-
setting bodies. But it can guide strategic thinking and promote governmental
leadership and action so that the financial system can play its vital role in the
functioning of the economy, both domestically and globally. While future crises
can hardly be avoided, regulation and supervision in a “new financial landscape”
should be based on guiding principles that allow striking the right balance between
stability and growth, in supporting and maintaining financial sector resilience
without stifling financial innovation.
G-20 as a platform
for regulatory reform
discussion
Recently, the G-20 has become a platform to discuss and help co-ordinate not only
current financial sector support but also further regulatory reform in the financial
sector. In their September 2009 Statement, G-20 finance ministers and central
bank governors emphasised, among many other necessary reforms, the need for
revised accounting standards, new liquidity and capital requirements, as well as
stronger oversight and better resolution procedures.
21
Most of the technical work is
currently being undertaken by the FSB and its related bodies. Comprehensive
consultative proposals to strengthen the resilience of the banking sector and to
create an international framework for liquidity risk measurement, standards and
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 15
monitoring have recently been put forward by the Basel Committee on Banking
Supervision.
22
The financial
industry proposes
reforms and seeks co-
operation
The financial industry responded to the crisis early on with its own initiatives for
self-regulation.
23
Co-ordination and communication efforts have been stepped up
not only between policy makers, but also between the government and the private
sectors. As the shape of a future financial landscape is not yet well defined, and
with different and often country-specific support measures in place, there is a risk
that new regulations are being introduced in an uncoordinated fashion. Regulatory
impact studies involving all stakeholders would be an important complement to
new regulatory measures.
Peer pressure is
important as political
momentum for
reform may wane
Co-ordination in the design of a new financial landscape remains important. There
is a danger that the political momentum for financial reform may soon lose steam
as an improving economic situation appears to obviate the need for more
substantive reforms. If political pressures leading to impediments in reform efforts
are building up unevenly across countries, regulatory arbitrage may become a
problem. International co-ordination, including peer pressure exerted through
international (standard-setting and other) bodies, should help to keep the
momentum for reforms.
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16 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
3BNOTES
1
OECD (2009b).
2
In the United States, the Case-Shiller house price index changed direction in May 2009, growing 3% in the second
quarter, the first quarterly increase since 2006q2. However, official statistics (from the Federal Housing
Finance Agency - FHFA) still show a decline (in their latest values as of 2009q3).
3
Blundell-Wignall et al. (2009a, b).
4
FASB’s new rules FAS 166 and 167, which concern the accounting of securitisations and special-purpose entities,
are scheduled to become effective at the start of a company’s first fiscal year beginning 15 November
2009, or 1 J anuary 2010 for companies reporting earnings on a calendar-year basis.
5
IMF (2009).
6
Research from CreditSights suggests that 600 to 1 100 of America’s 8 200 banks may need help from, or winding
down by, the Federal Deposit Insurance Corporation during this cycle.
7
Government borrowing needs are expected to surge: gross borrowing needs of OECD governments are expected to
reach almost USD 16 trillion in 2009, up from an earlier estimate of around USD 12 trillion, and again
around USD 16 trillion in 2010; see Blommestein and Gok (2009) in this issue of Financial Market
Trends.
8
In this context, see also Lumpkin (2009) in this issue of Financial Market Trends for a more general discussion of
financial innovation.
9
Fed data (gross figures) show that home mortgage debt in RMBS pools amounted to USD 2 168.61 billion at the end
of 2007 and USD 1 848.02 billion end-2008.
10
González-Páramo (2009).
11
González-Páramo (2009).
12
U.S. Treasury Department press release of 23 December 2009: “Treasury receives $45 billion in repayments from
Wells Fargo and Citigroup – TARP repayments now total $164 billion”. See also SIGTARP’s reports to
Congress, available at www.sigtarp.gov/reports.shtml.
13
Even the troubled, state-owned German Hypo Real Estate bank reimbursed, in December 2009, EUR 7 billion of
the initial EUR 50 billion rescue package provided in 2008 by a consortium that included the federal
government, the central bank and private institutions. The total amount of guarantees still at HRE's
disposition fell from EUR 102 billion to EUR 95 billion.
14
Schich (2009b) in this issue of Financial Market Trends.
15
The industry itself has made proposals that are largely in line with official proposals by the FSB and other bodies.
Generally, these recommendations suggest that employee remuneration should be in line with the
employing institution’s long-term goals and should not induce excessive risk-taking. Thus, upfront multi-
year bonuses, for example, would not be in line with these recommendations. See IIF (2008).
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 17
16
See IMF-BIS-FSB (2009).
17
See also the OECD statement “US: Obama plan for banks can help to avoid a new financial crisis” at
www.oecd.org/document/55/0,3343,en_2649_34487_44475383_1_1_1_1,00.html.
18
For more details, see Blundell-Wignall et al. (2009b), in this issue of Financial Market Trends, and OECD (2009a).
19
The Glass-Steagall Act, devised during the Great Depression, separated investment banking from commercial
banking, prohibiting a bank holding company from owning other financial companies and prohibiting a
bank from offering investment banking and insurance services. This separation had already been
abandoned, and the “pure” investment banking model softened in 1999 when the Glass-Steagall Act was
repealed by the Gramm-Leach-Bliley Act, which allowed commercial and investment banks to consolidate.
This made permanent a temporary waiver that was issued for Citibank’s merger with the insurance
company Travelers Group in 1993 (finalised in 1994; in 1998 they formed the financial conglomerate
Citigroup).
20
See OECD (2009c) in this issue of Financial Market Trends.
21
See www.g20.org and Box 1 in Blundell-Wignall et al. (2009b), in this issue of Financial Market Trends.
22
See Basel Committee (2009a, b), announced on 17 December 2009 at www.bis.org/press/p091217.htm. The reform
programme has been endorsed by the Financial Stability Board and by the G-20 leaders at their Pittsburgh
Summit, and comments on the consultative documents are invited by 16 April 2010.
23
For example, IIF (2009).
REFERENCES
Basel Committee on Banking Supervision (2009a), Strengthening the Resilience of the Banking Sector,
consultative document, December, available at www.bis.org/publ/bcbs164.htm.
Basel Committee on Banking Supervision (2009b), International framework for liquidity risk
measurement, standards and monitoring, consultative document, December, available at
www.bis.org/publ/bcbs165.htm.
IMF (2009), Global Financial Stability Report, October.
IMF-BIS-FSB (2009), Guidance to Assess the Systemic Importance of Financial Institutions, Markets and
Instruments: Initial Considerations, report and background paper, available at
www.financialstabilityboard.org.
Blommestein, Hans J . and Arzu Gok (2009), “The Surge in Borrowing Needs of OECD Governments:
Revised Estimates for 2009 and 2010 Outlook”, OECD J ournal: Financial Market Trends, vol.
2009/2.
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18 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
Blundell-Wignall, Adrian, Paul Atkinson, and Se Hoon Lee (2008), “The Current Financial Crisis: Causes
and Policy Issues”, OECD J ournal: Financial Market Trends, vol. 2008/2.
Blundell-Wignall, Adrian, Paul Atkinson and Se Hoon Lee (2009a), “Dealing with the Financial Crisis and
Thinking about the Exit Strategy”, OECD J ournal: Financial Market Trends, vol. 2009/1.
Blundell-Wignall, Adrian, Gert Wehinger and Patrick Slovik (2009b), “The Elephant in the Room: The
Need to Deal with What Banks Do”, OECD J ournal: Financial Market Trends, vol. 2009/2.
González-Páramo, J osé Manuel (2009), “Our gameplan for rejuvenating the asset-backed securities
sector”, Financial Times, 23 November.
Institute of International Finance (IIF) (2008), Final Report of the IIF Committee on Market Best
Practices: Principles of Conduct and Best Practice Recommendations – Financial Services Industry
Response to the Market Turmoil of 2007-2008, J uly, available at www.iif.com/regulatory.
Institute of International Finance (IIF) (2009), Restoring Confidence, Creating Resilience: An Industry
Perspective on the Future of International Financial Regulation and the Search for Stability, J uly,
available at www.iif.com/regulatory.
Lumpkin, Stephen (2009), “Regulatory Issues related to Financial Innovation”, OECD J ournal: Financial
Market Trends, vol. 2009/2.
Schich, Sebastian (2008), “Challenges related to Financial Guarantee Insurance”, OECD J ournal:
Financial Market Trends ,vol. 2008/1.
Schich, Sebastian (2009), “Expanded Guarantees for Banks: Benefits, Costs and Exit Issues”, OECD
J ournal: Financial Market Trends, vol. 2009/2.
OECD (2009a), The Financial Crisis: Reform and Exit Strategies, OECD, September, Paris, available at
www.oecd.org/dataoecd/55/47/43091457.pdf.
OECD (2009b), Economic Outlook, vol. 2009/2, no. 86, November.
OECD (2009c), “Policy Framework for Effective and Efficient Financial Regulation: General Guidance
and High-Level Checklist”, OECD J ournal: Financial Market Trends, vol. 2009/2.
doc_544642913.pdf
Financial markets have recovered substantially but vulnerabilities remain significant. Ample liquidity may lead to new bubbles, particularly in some emerging markets, and uncertainties about government exit strategies and regulatory changes threaten a fledgling upswing.
ISSN 1995-2864
Financial Market Trends
© OECD 2009
Pre-publication version for Vol. 2009/2
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 1
C0B
The Financial Industry and Challenges
Related to Post-Crisis Exit Strategies
Gert Wehinger
?
Financial markets have recovered substantially but vulnerabilities
remain significant. Ample liquidity may lead to new bubbles,
particularly in some emerging markets, and uncertainties about
government exit strategies and regulatory changes threaten a fledgling
upswing. Co-ordination and communication of exit policies will be
important, and exit from policy stimulus should not be precipitated at
the current juncture. While financial institutions have increasingly
obtained market financing and paid back state aid, the sector remains
fragile; thus, such voluntary pay-backs should meet preconditions
aimed at ensuring the soundness and sustainability of the concerned
institutions’ balance sheets. At the same time, expectations of future
writedowns and more stringent capital rules put pressure on bank
lending more generally. Restarting securitisation to support lending
would be important and could be fostered by government initiatives
focussing on standardisation, transparency and due diligence to restore
investor confidence. Regulatory reforms currently being proposed
concern accounting rules, capital requirements and compensation
issues. However, further reforms are required to address such systemic
issues as moral hazard created by public support. Measures would
include resolution mechanisms for large and systemically important
banks as well as appropriately fire-walled business structures for the
financial sector. Peer pressure via co-operation in international
standard-setting and relevant bodies should help to keep the reform
momentum, overcome political impediments to reform and maintain a
level playing field.
?
Gert Wehinger is Economist in the Financial Affairs Division of the OECD Directorate for Financial and Enterprise Affairs. The present
article is based on a background note prepared for the OECD Financial Roundtable held with participants of the private
financial sector and members of the OECD Committee on Financial Markets on 8 October 2009. The present version takes
into account the discussions and comments made at that meeting and selected developments that have taken place since.
The author is grateful for additional comments from Adrian Blundell-Wignall, André Laboul and Stephen Lumpkin, and
editorial assistance from Laura McMahon and Edward Smiley. The author is solely responsible for any remaining errors. This
work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments
employed herein do not necessarily reflect the official views of the Organisation or the governments of its member
countries.
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2 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
I. Current outlook and vulnerabilities
Financial markets have
recovered substantially
Financial markets have recovered substantially since March 2009 when the
financial stress began to ease and market conditions started to improve.
With easy monetary policy and large fiscal support to avert larger financial
and economic shocks, liquidity and credit risk premiums have narrowed
significantly (Figure 1). Market value gains have now, globally, neutralised
about 60% of the losses incurred since the onset of the downturn (Figure 2).
...but vulnerabilities
remain significant
While financial markets have entered a period of relative tranquillity and
the outlook for economies has improved,
1
the effects of the financial crisis
linger and vulnerabilities remain, as some of the negative feedback loops
are working their way back from the real sector (which was affected by a
delay bby the first wave of the financial crisis). Should the various risks for
the financial sector materialise in the current conjuncture, their impact
could be relatively more significant than under more stable circumstances.
Figure 1. Risk spreads have narrowed
High-yield and emerging market bond spreads
0
200
400
600
800
1000
1200
1400
0
100
200
300
400
500
600
700
B
a
s
i
s
p
o
i
n
t
s
B
a
s
i
s
p
o
i
n
t
s
Investment grade ? US (Barclays)
Investment grade ? Europe (JPM)
High yield ? US (BOFAML) (r.h.s.)
High yield ? Europe (JPM) (r.h.s.)
EMBI global (JPM) (r.h.s.)
Note: Daily data until 1 February 2010.
Source: Thomson Reuters Datastream.
New bubbles may be
forming
While easy monetary and fiscal policies have been providing relief from the most
severe effects of the crisis, they maintain global liquidity at a high level (Figure 3).
As investors’ uncertainties and fears subside, this liquidity is searching for new,
higher-yielding investments (Figure 4). Upward price pressures on certain asset
classes are emerging, and some signs of new bubbles are becoming apparent.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 3
Figure 2. Equity valuations are recovering
Datastream World indices, market valuations in USD billion
?
10 000
20 000
30 000
40 000
50 000
60 000
U
S
D
b
i
l
l
i
o
n
WORLD?DS Market ? MARKET VALUE (USD)
WORLD?DS Financials ? MARKET VALUE (USD)
WORLD?DS Banks ? MARKET VALUE (USD)
max: 51 137
29/10/07
min: 20 663
09/03/09
latest:
36 160
01/02/10
Note: Based on equity valuations of constituents contained in the respective Datastream World indices as shown.
Source: Thomson Reuters Datastream.
Figure 3. Global liquidity remains ample
?10%
?5%
0%
5%
10%
15%
20%
25%
30%
35%
?10%
?5%
0%
5%
10%
15%
20%
25%
30%
35%
Y
e
a
r
?
o
n
?
y
e
a
r
p
e
r
c
e
n
t
a
g
e
c
h
a
n
g
e
Y
e
a
r
?
o
n
?
y
e
a
r
p
e
r
c
e
n
t
a
g
e
c
h
a
n
g
e
(
a
c
c
u
m
.
)
growth contribution by China growth contribution by Japan
growth contribution by EU growth contribution by US base money
Global liquidity (a) (r.h.s.)
Weak USD:
Louvre intervention
Weak USD:
BoJ intervention
Weak USD:
BoJ & Chinese
intervention
Financial crisis,
policy actions
a) Annual growth of non-US international reserves and US monetary base.
Note: Contributions to growth measured by the respective reserve or monetary components in the liquidity measure.
Sources: Thomson Reuters Datastream, and OECD.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
4 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
Figure 4. Returns have improved across a broad spectrum of asset classes
Selected investment alternatives, percentage changes over period, annualised, in US dollar terms
?64.1%
?49.0%
?55.5%
?53.7%
?46.5%
?40.5%
?50.4%
?44.9%
?38.7%
?38.6%
?38.5%
?48.8%
?43.3%
?33.8%
?28.7%
?28.2%
?1.7%
?10.2%
?10.9%
?6.7%
?11.1%
10.6%
30.0%
21.2%
?47.5%
?42.8%
?19.1%
12.3%
14.0%
12.7%
0.2%
72.9%
66.6%
61.8%
51.6%
45.0%
34.6%
28.4%
27.8%
22.0%
20.7%
19.0%
16.8%
16.2%
14.8%
13.9%
4.1%
38.3%
29.4%
26.4%
25.4%
22.2%
2.2%
0.5%
?7.2%
85.7%
37.9%
19.5%
11.3%
2.3%
?6.1%
?16.2%
?80% ?60% ?40% ?20% 0% 20% 40% 60% 80% 100%
EQUITIES:
INDIA?DS Market
LATIN AMERICA?DS Market
EMERGING MARKETS?DS Market
ASIA EX JAPAN?DS Market
CHINA?DS MARKET $
NASDAQ COMPOSITE
FTSE 100
WORLD?DS Market
DJ US TOTAL STOCK MARKET
US?DS Market
S&P 500 COMPOSITE
EMU?DS Market
DAX 30 PERFORMANCE
DOW JONES INDUSTRIALS
NIKKEI 225 STOCK AVERAGE
TOPIX
BONDS:
JPM EMBI GLOBAL MIDDLE EAST
JPM EMBI GLOBAL AFRICA
JPM EMBI GLOBAL COMPOSITE
JPM EMBI GLOBAL ASIA
JPM EMBI GLOBAL LATIN AMERICA
EMU BENCHMARK 10 YR. DS GOVT. INDEX
JP BENCHMARK 10 YEAR DS GOVT. INDEX
US BENCHMARK 10 YEAR DS GOVT. INDEX
OTHER:
Economist Commodity Inds/All ($)
S&P GSCI Commodity Spot
C.S/TREMONT HEDGE FUND
Carry trade Index ? USD ? AUD (a)
Carry trade Index ? USD ? NZ$ (a)
Carry trade Index ? Yen ? AUD (a)
Carry trade Index ? Yen ? USD (a)
2008 (1?Jan?08 to 1?Jan?09)
From 1?Jan?09 to 01?Feb?10
(annualised)
a) The carry trade return index is calculated based on the assumption of one-month investments in the respective currencies,
borrowing in yen, applying one-month eurodollar interest rates and central exchange rates, without taking into account bid-ask
spreads and transaction costs.
Sources: Thomson Reuters Datastream and OECD.
…in emerging
markets in particular
However, there is some agreement among market observers that despite the rallies
in almost all asset classes, most of them have not reached bubble territory. Perhaps
the high-yield bond segment, which has seen record levels of issuance in recent
months (while declining spreads reflect investors’ increasing risk appetite), bears
watching. But market participants are becoming wary of some early signs of
bubble formation that are beginning to show in Asian and other emerging markets.
On-going adjustmentd to the global saving and investment imbalances are
rendering many of these economies more vulnerable than investors may currently
be aware. While carry trades are becoming profitable against the background of
low US interest rates and some fixed Asian exchange rates, the build-up of trades
could create problems farther down the road. The rallies in these markets may
create the fault lines for future disruptions.
Real estate markets
remain a problem,
and credit quality is
deteriorating across a
broad spectrum of
lending categories
At the same time, house prices (their sharp drop was at the heart of the current
crisis and some analysts believe they still need to undergo further downward
adjustment) are beginning to rise, too early perhaps, in some parts of the world.
2
Commercial property may turn into a severe problem, especially in Europe where
a vast amount of commercial property loans need to be restructured or refinanced,
part of it in commercial mortgage-backed securities (CMBS) for which
restructuring has proved especially difficult. In addition, credit quality across a
broad spectrum of lending categories is further deteriorating, and default rates are
expected to rise.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 5
Recovery in money
markets has been
uneven, favouring
the United States
Market participants have also pointed out that market recovery has not been even,
in part due to unlevel playing fields that risk becoming more unbalanced. In
particular, in security-backed short-term cash markets, divergences between the
United States (and Asia-Pacific) on the one hand and Europe and the United
Kingdom on the other are still significant. In the United States, where markets
have benefitted from the Term Asset-Backed Securities Loan Facility (TALF)
programme and where underlying securities are more homogenous, markets are
more liquid, while in Europe the challenges to access short-term cash are much
greater because collateral securities carry more idiosyncratic risks and maturities
tend to be longer, exposing them to extension risk.
Risks also exist with
respect to policy exit
and sovereign debt
The necessary withdrawal from extraordinary policy support measures constitutes
the basis for another set of risk factors. There is a danger that policy makers exit
either too soon or too late. In the first case, stimulus withdrawals could throw the
economy back into contracting mode, generating an often feared double-dip
recession. In the second case, where withdrawal is too late, fiscal deficits would
rise even more and inflation could surge, also because monetising the rising fiscal
deficits would meet less political resistance than spending cuts or tax increases.
New bubbles would easily build, and these imbalances would unnecessarily
postpone adjustment and, in the end, require tighter stabilisation policies that
might upset financial markets to a larger extent than an earlier adjustment would
have. Some of the risks related to fiscal deficits have been foreshadowed in recent
sovereign rating downgrades in Europe and rising credit default swap (CDS)
spreads for sovereign debt (Figure 5).
Figure 5. Selected credit default swap (CDS) spreads
0 50 100 150 200 250 300 350 400 450
Greece
Hungary
Portugal
Ireland
Spain
Italy
Austria
United Kingdom
Slovenia
Belgium
France
United States
Netherlands
Germany
Norway
Sectors:
EUBANKS
UKBANKS
US BANKS
Basis points
01/02/2008
31/01/2009
01/02/2010
Notes: Senior five-year credit default swap premiums (mid) for sovereign bonds; senior five-year credit default swap premium index
(mid) for banking sector.
Sources: Thomson Reuters Datastream and OECD.
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6 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
Co-ordination and
communication of
exit policies will be
important
While the risks associated with such timing issues may be large, there are also
risks that uncoordinated exit policies may create an uneven playing field across
financial sectors and countries. There are further risks that inappropriate
communication or lack of credibility of proposed exit policies could create
uncertainties which could again destabilise markets. Unexpected policy
withdrawals could render a transition to the new regime more difficult for financial
institutions, and the sector as a whole.
Exit from policy
stimulus should not
be precipitated
There seems to be a broad consensus in the official as well as the private sector
that the recent upswing is not yet fully self-sustained and that policy stimulus is
still necessary in many economies. At the current juncture, it seems better to err on
the side of avoiding the downside risks, which include deflation and a double-dip
recession. In the current cycle, the Reserve Bank of Australia was one of the first
central banks to raise interest rates in October 2009 (with two further increases in
November and December). Similarly, China tightened credit in early J anuary
2010, and others may follow in due course.
The success of exit
strategies will depend
on proper co-
ordination, timing
and policy
communication
Proper co-ordination between fiscal and monetary policies will be important. Also,
given differences in economic stance and exchange rate pressures, the speed of
exit will have to differ across economies and will thus need proper international
co-ordination in order to avoid imbalances and unlevel playing fields. Timely and
clear communication of these policies will be important so as to render policies
predictable and credible, and to facilitate the transition to a new policy regime. As
this crisis has shown, expectations are important and building confidence will be a
prerequisite for a solid recovery.
II. Assessing the resilience of the banking sector
Financial sector soundness
Financial institutions
have increasingly
obtained market
financing
As financial markets recovered, financial institutions have been able to raise
capital on equity markets, especially in the United States. Share prices have
improved; major G-20 banks have on average recovered about two thirds of their
2008 losses (Table 1). These improvements also reflect profit reports, some of
which have become more positive after the heavy 2008 writedowns. Banks are
now buying back securitised credit on the secondary market and are benefiting
from the reduced spreads. These improvements have allowed several banks to
repay state aid, and other financial institutions are considering exiting too.
The effects of
liquidity support are
now visible in the
growing search for
yield and appetite for
risk
Liquidity interventions and terming out of public sector funding replaced private
sector funding where there were shortening maturities, and the expansion of
collateral has allowed banks to refinance in liquid assets. The money market
guarantees in the United States have allowed, both directly and indirectly, about
USD 4 trillion of assets to continue to circulate. However, the effects of this
liquidity increase can now be seen in the increasing search for yield and appetite
for risk. This shows up particularly in the fixed-income market through
contraction of spreads in the secondary securitised credit market and in spreads of
unsecuritised bank credit. Initially this took place at the highest credit quality, but
lower-grade credit soon followed the spread contraction.
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 7
Table 1. Banks’ market value losses and gains
Change in market value of largest G20 banks, in USD billion
a)
2009
b)
2008 2007 2006 2005 2004
memo: MV
(latest)
e)
memo:
recovery
f)
United States 250.6 - 332.0 - 290.4 173.7 - 20.0 162.2 765.3 75.5
United Kingdom 173.5 - 256.7 - 72.8 109.0 - 19.1 58.2 374.6 67.6
Italy 27.9 - 177.9 73.2 61.4 47.1 21.4 158.9 15.7
France 86.8 - 157.6 - 31.6 108.6 13.4 26.9 191.3 55.1
China 101.1 - 124.3 60.1 82.3 - - 318.1 81.4
Australia 123.9 - 110.9 43.7 38.9 18.2 19.2 247.1 111.6
Russian Federation 68.3 - 110.1 24.7 47.1 17.9 4.7 97.6 62.1
J apan - 4.0 - 107.7 - 111.8 - 48.6 204.0 96.3 292.7 - 3.7
Canada 93.7 - 97.4 12.2 31.1 37.2 24.7 226.3 96.2
Brazil 126.0 - 86.4 59.6 38.6 29.9 12.5 224.2 145.8
Germany 22.3 - 80.0 - 3.7 34.1 14.8 1.2 62.6 27.9
Turkey 52.1 - 69.1 40.9 - 4.0 26.0 10.0 96.4 75.4
South Korea 33.2 - 63.8 - 0.0 11.9 39.1 8.2 66.8 52.1
India 41.5 - 59.3 56.5 16.7 11.6 7.9 93.9 70.0
South Africa 22.0 - 22.1 - 0.3 6.8 7.7 23.5 61.7 99.5
Indonesia 23.8 - 16.2 7.6 14.1 - 1.4 7.3 47.7 147.3
Mexico 7.0 - 8.9 5.6 6.6 0.8 4.7 24.1 77.9
Argentina 3.7 - 4.5 - 0.4 2.7 0.6 0.6 7.1 81.3
G-20 country total 1 253.4 -1 885.0 - 126.8 730.9 427.7 489.4 3 356.3 66.5
memo item: Euro area total
c)
228.6 - 789.1 81.8 379.2 105.6 143.7 746.0 29.0
memo item: G-7 total
c)
650.8 -1 209.4 - 424.8 469.3 277.4 390.8 2 071.6 53.8
memo item: Global
d)
1 671.5 -2 784.9 - 43.6 1 140.6 505.7 695.1 4 540.1 60.0
Sorted by 2008 losses.
a) Based on banks contained in respective countries' Datastream bank indices.
Note that such data are not available for Saudi Arabia.
b) From 1-J an-09 to 1-Feb-10.
c) Based on banks contained in respective countries' Datastream bank indices.
d) Based on banks in Datastream worldwide bank index.
e) Memo item: Market valuation as of 1-Feb-10.
f) Ratio of change in 2009 (b) over the negative change in 2008, in per cent.
Sources: Thomson Reuters and OECD.
Banks’ balance
sheets are not yet on
a sound footing
But, overall, the situation for the banking sector remains fragile. Writedowns
have continued and have not yet been fully matched by private capital raised.
While the situation seems to look relatively better for European than for US
banks, off-balance-sheet items and contingent liabilities may yet pose serious
problems for European banks. Furthermore, the European group of banks
reporting losses has a much higher leverage ratio than their US counterparts.
3
Future bank losses
are still expected to
be significant
Due to accounting requirements,
4
US banks will need to bring USD 1.3 trillion
in off-balance-sheet vehicles onto their balance sheets over the next year. Future
losses are still expected to be significant. The IMF expects losses of USD 3.4
trillion over 2007-2010, down from the previous USD 4 trillion;
5
J PMorgan has
recently published a smaller loss estimate of USD 2.3 trillion.
Balance sheets are
not comparable
globally due to
A note of caution is required when comparing losses and writedown data
internationally. Differences in accounting rules make for gaps in the range of
perhaps a factor of two. Thus, if such a factor were applied, i.e., assuming
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
8 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
different accounting
rules – a case that
presses for
harmonisation
European banks were to apply the US Generally Accepted Accounting
Principles (GAAP) instead of International Financial Reporting Standards
(IFRS), the recent IMF estimates for losses of European banks could be roughly
halved. Nevertheless, losses would remain huge, but such calculations are a
stark reminder of the importance of harmonising accounting rules, in particular
as international policy co-ordination is of the essence to resolve the crisis.
Further official
support will be
needed for the
banking sector
Further official support will be needed as there is not yet enough capital in the
banking system, and many banks do not yet have access to wholesale funding.
The market is not yet deep enough for the liquidity schemes, put in place in
response to the crisis, to be removed. A sudden withdrawal of these schemes
would seriously impede recovery. Also, the success of various government
programmes to deal with toxic assets (e.g., Public-Private Investment Program
for Legacy Assets (PPIP) in the United States, “bad banks” in the United
Kingdom, Ireland and Germany) and their phasing out will be crucial for the
financial sector to recover.
Banks are exposed to
risks in commercial
real estate and
business loans
One of the major risks going forward is in the commercial real estate segment
where prices are declining and delinquency rates are rising. In the United States,
about 12% of the approximately 8 200 banks have a commercial real estate
exposure of more than five times their tier-one capital, and it is estimated that up
to a thousand banks will face major difficulties. A second area of banking sector
worries is loans to business, in particular large syndicated loans. By end-2009,
118 US banks had failed, and the number is expected to rise substantially.
6
Bank lending has not
yet picked up as
banks are increasing
liquidity buffers
These pending risks and the banking sector’s fragility from previous losses are
the reason that much of the liquidity support is currently resting in deposits by
banks that need to improve their balance sheets. At end-2009, US banks held
more than USD 1 trillion in excess reserves with the Federal Reserve. But these
reserves not only serve as buffers against expected losses but also act as buffers
for the unsecured parts of the interbank market. Banks claim that these reserves
are also serving the function to prepare for potentially tighter regulatory
requirements. In fact, due to such requirements, the industry expects banking to
become less profitable: some observers from within the banking industry expect
that return on equity could drop by one third to one half, based on a five-year
average measured from 2002 to 2007.
…but demand factors
also play a role
But lower lending is also due to demand-side factors. Demand-side effects are
relatively strong in countries with low saving rates. In the United States and
United Kingdom, as well as some other continental European countries where
households have to repair their balance sheets, credit demand has been slowing
significantly.
As part of an exit
strategy, reserves
could eventually be
replaced by
government bonds
While the liquidity “hoarded” by banks fulfils useful buffer functions, going
forward, and as part of an exit strategy, some industry representatives have
proposed that banks could substitute these buffers with government bonds in
synch with the withdrawal of liquidity, and in accordance with the expected
higher liquidity and capital requirements. Given the future financing needs of
governments, there should be no shortage of such bonds.
7
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 9
Measures to re-establish lending and securitisation markets
The key missing link
to restart lending is
securitisation, which
needs to be restored
One of the key missing links to put bank liquidity to use for lending is
securitisation.
8
In the US market, about USD 1.8 trillion (net amount of
residential mortgage-backed securities (RMBS) issued by the banking sector in
2007
9
) of securitised assets need to be replaced. The decline in securitisation has
left a gap that cannot be easily filled by traditional bank balance sheet lending
alone. Securitisation is a way by which private investors fund household and
business loans and is thus an important element in restoring economic growth.
The two publicly distributed asset-backed securities (ABS) deals in Europe in
late summer 2009, the first since J uly 2007, were seen by many market
participants as an indication of the right way forward. It is thus in the interest of
policy makers to help restore this market segment, and the current central bank
lending programmes (widening of eligible collateral) are part of these efforts. It
is noteworthy that the ECB’s collateral framework had allowed the use of ABS
as eligible instruments, even before the sudden appearance of the funding
difficulties, which proved great support during the crisis.
10
As some central banks
have become large securities buyers, policy makers need to think about how to
make these markets sustainable once official demand is withdrawn. More
structural measures will need to be put in place to support the market.
...with policy support
that focuses on
standardisation,
transparency and due
diligence
Policy makers have many possibilities to support securitisation markets and to
restore investor confidence and secondary market liquidity, e.g., by enhancing
standards, transparency (such as allowing access to loan-level data, already
possible in the United States) and overview of investor due diligence.
Institutional investors are currently avoiding these markets because many of
them have lost confidence. And, due to single-name limits, many of the
institutional investors would also not be allowed to invest large volumes directly
in a few large banks (those that were the main RMBS issuers). As many of these
investors were forced to sell the toxic assets, they took the brunt of the price
adjustment, while banks are now buying (back) many of the securities on the
secondary market (while at the same time they are hardly issuing any new ones).
Loan funds could
support lending
Further proposals for official measures to re-establish lending and securitisation
markets could be put forward. One is that government compete with banks
through asset management companies that would extend direct loans to the
industry. Some so-called loan funds engaging in this type of business exist
already.
Measures need to be
initiated by
government
Deriving lessons from the origins of the development of securities and
derivatives markets could help. The securitisation model’s original purpose (in
the late 1980s) was transferring risk to investors who previously had unsecured
(not asset-backed) exposure, and it had evolved into a well-established system
with standards, enhanced infrastructures and built-in checks and balances.
Likewise, swap markets developed through standardisation, netting agreements,
etc. Thus, the securities market would also benefit from standardisation of
products, better information, transparency and due diligence. Policy makers
would need to provide the momentum (as was done in the case of the creation of
swap markets) to develop these measures. For example, the Eurosystem has
taken some steps to simplify the structures of ABS, which it accepts as collateral
in order to create more transparent instruments.
11
Such transparency, with more
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10 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009
timely and standardised information on the performance of underlying loans,
would help investors’ due diligence.
Exchange trading
would enhance price
transparency and
attract more investors
Better price transparency is one of the elements needed to make the market more
liquid. This could be achieved by transferring a large part of the business away
from over-the-counter (OTC) trading onto exchanges, where government could
initiate or support market-making activities if needed. Furthermore, the
traditional buyers of securities credit used to be short-term, fixed-income and
cash investors because of the floating-rate nature of these products. Turning
them into more fixed-rate-like products could attract a different buyer base into
the market.
Voluntary exit from government support by financial institutions
Some banks have
started to pay back
public support
So far, a decline in borrowing from the various emergency liquidity facilities
provided by central banks in response to the crisis has been observed, and banks
have made efforts to pay back the government support they received in response
to the crisis. US banks (large money centre banks) had by end-2009 paid back
about USD 164 billion of public support
12
and raised capital beyond that amount.
Similar paybacks have taken place in France (where all banks have reimbursed
official money), the United Kingdom and elsewhere,
13
and many banks are
considering such exit from state support.
…but such exit has to
be carefully managed
But such exits have to be carefully designed and managed. While the
improvements in financial markets have made it relatively easy for banks to
repay state aid, an exit from government support may be premature for many
institutions and not warranted with the still fragile situation. But, again, many
government programmes were designed in such a way as to make state aid
unattractive as market conditions improve. Some of these built-in withdrawal
incentives may have to be reassessed as aid programmes are being rescheduled.
Perhaps governments should also establish conditions under which a recipient
institution would be allowed to repay government support. Such rules would
then need to be communicated in a proper and timely manner.
Market-driven exits
should not create
undue risk
More generally, exit from state support should happen without creating undue
risk. For example, reimbursement of official funds could happen under the
conditions that i) paybacks are replaced by high-quality capital raised; ii) assets,
especially risky assets, on the balance sheets of banks concerned are fairly
valued; and iii) these banks have a viable long-term business strategy. To qualify
for repayment of state aid, institutions should also credibly demonstrate to have
market access and should be able to raise capital by issuing equity, and not by
excessive deleveraging and tightening credit supply. Such conditions could also
specify that capital ratios should remain comfortably above the regulatory
minimum. Quality requirements for private capital that is used to replace public
capital support could specify, e.g., that private capital should be at least of the
same quality as the public capital that is being repaid.
THE FINANCIAL INDUSTRY AND CHALLENGES RELATED TO POST-CRISES EXIT STRATEGIES
OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2009 – ISSUE 2 - ISSN 1995-2864 - © OECD 2009 11
III. Some issues for further regulatory reform
Governments’ enhanced role and moral hazard problems
Public support
creates moral hazard
Public sector support for the financial sector during this crisis has been
exceptional, ranging from capital injections, asset purchases and various forms of
central bank support to guarantees. Guarantees constitute by far the most
extensive support category, even though in principle no upfront financing is
needed and the contingent liabilities may remain undrawn.
14
While this support
has so far been successful in averting an even bigger financial crisis, there is
broad agreement between policy makers and the private sector that direct
involvement of governments in markets should not be extended over the long
term. Such involvement sustains or even fosters moral hazard, as risky behaviour
is favoured. In particular large, “too-big-to-fail” institutions benefit from large-
scale financial support, and negative consequences of imprudent lending or other
high-risk activities are not properly sanctioned. Risk is underpriced.
...and at times
uncertainty, and it
distorts competition
At the same time, a discretionary element in such support may lead to uncertainty
that affects planning and creates inefficiencies in the financial sector (the financial
market calamities after the Lehman default serve as a telling example of the
effects of such uncertainty). Furthermore, uneven support creates an unlevel
playing field (with smaller institutions at the lower end). The on-going and
selective official intervention in mainly large financial institutions during this
crisis has the potential to distort competition to the detriment of smaller and
perhaps more viable banks, running the risk of “subsidising failure” and creating
moral hazard. Expectations of future bailout in case of failure may also be a
problem for (uninformed retail) investors who have the, perhaps wrong,
perception of a risk-free trade in dealing with such banks.
Withdrawals should
be properly managed
However, it is clear that certain elements of the safety net provided by
governments and central banks will have to remain in place to safeguard financial
stability (e.g., deposit guarantees to avoid bank runs), but other elements need to
be withdrawn in order not to prolong and foster the negative effects mentioned
above (moral hazard, distortion of competition, etc.). The crucial issue to be
addressed is then how to obtain the benefits created by financial system stability
while minimising the downside risks and losses for taxpayers.
Accounting rules and capital standards
Single global
accounting standards
help minimise
distortions and
regulatory arbitrage
With regard to accounting rules, where different rules and standards can create
significant distortions, co-ordination is particularly relevant. For example,
leverage ratios are defined differently under US GAAP and the International
Accounting Standards (IAS) as applied in Europe and elsewhere. Some
observers also see problems arising from recent regulatory initiatives regarding
trading book rules. There are proposals that capital requirements should be
increased for any illiquid asset in the trading book. But illiquid assets should
not be in the trading book at all. That is due only to accounting rules that allow
classifying even illiquid assets as available for sale, without regard to the actual
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time it would take to sell the asset in question. If accounting rules allow
defining the holding period of assets over almost any time span, they create
distortions between liquid and illiquid assets. Thus, treatment of these assets is
another area that needs global standards.
Trading book rules
need to be well
balanced
However, the banking industry has pointed out that, given the importance of
trading activities for secondary market liquidity and capital market
intermediation more generally, trading book rules should be addressed by
regulators in a balanced way – as is the case for banking book rules that balance
the need for prudential requirements and the need to extend credit to the
economy. Some of the current proposals are seen as imposing “onerous”
liquidity and capital requirements on trading books.
Capital requirements
also need common
global standards;
leverage ratios need a
risk-based
complement
Capital requirements are another area where common standards are needed, as
there is a danger that in implementing standards, countries move at a different
pace and towards different definitions, which could create major distortions.
Regulators and industry representatives agree that capital requirements should
move towards higher quality and more self-sufficiency. Many see the currently
discussed leverage ratio requirements as useful, but there are some fears that if
introduced without risk-based capital requirements they would create
distortions with respect to firms’ financial buffers. Because of its simplicity,
Basel I is often seen as having driven much bank lending activity off their
balance sheets and as having created a lot of regulatory arbitrage. Given the
complexity of the banking business, many see simple capital rules as
insufficient.
Higher liquidity and
capital provisions will
make the industry less
profitable
As higher liquidity and capital provisions will make the industry less profitable,
the question is also what rate of return do institutional investors expect from
bank equity. If investors continue to expect high returns, this could put banks
under pressure to engage in more risky business.
Compensation issues
Remuneration
schemes need to be
risk compatible
There is broad agreement between the industry and policy makers that there is
a need for better, risk-compatible remuneration schemes in order to avoid
excessive risk-taking. This is particularly relevant for big banks and financial
conglomerates where risk-reward schemes are largely distorted by cheap
funding paired with moral hazard.
Recommended
remuneration
standards are being
implemented, but
performance targets
need to be lowered
Remuneration systems at many banks are being brought in line with
recommended standards,
15
taking into account risk-compatibility and longer-
term goals. But these measures will become truly effective only if they are
implemented uniformly (given the mobility of the financial labour force) and if
performance targets, which are still too high in many cases, are lowered
accordingly. Perhaps bonus payments should not be linked to beta (the general
market) but to the alpha effect (manager-specific performance). In banks, the
risk-return relationship in remuneration tends to be distorted, as traders are
risking “other people’s money” with little personal downside risk (unlike, for
example, hedge fund managers who often have personal money at stake).
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Risk management has
improved
In response to the crisis and in line with recommendations, risk management in
most institutions has been improved by instilling a better risk culture in banks
and their boards. For example, in many banks the role of the chief risk officer
is being enhanced, as is the risk function performed by the CEO in defining
and examining the risk profile of the institution.
But even risk-
compatible
remuneration policies
cannot spare firms
difficulties
It should be also be noted, however, that compensation policies are not a
panacea. Remuneration policies of some institutions had already been aligned
with the long-term interests of the firm, yet this did not help them much in
avoiding a crisis. Notably Bear Stearns had paid its bonuses in shares with a
vesting period of five years, one of the longest terms in the industry.
Moreover, at the time the firm went bankrupt, Bear Sterns employees owned
about one third of the firm, with senior executives – whose decisions were
crucial for the performance and survival of the firm – having the largest share.
Many financial sector employees lost out in the current crisis. Going forward,
many banks will probably reduce the bonus part of employee compensation,
thereby reducing risk-taking.
Officials in regulatory
and supervisory
authorities may need
to be better paid and
closer to the market
The current crisis has revealed failures not only in the financial industry but
also in the regulatory and supervisory system. To attract a capable – and,
moreover, globally mobile – workforce required to deal with ever more
complex issues and to increase the quality of supervision, it has been
suggested that the compensation of officials in regulatory and supervisory
authorities needs to increase. Furthermore, market experience should be
required of these officials, which should give them the insight and working
knowledge required for due diligence exercises.
Systemic considerations, bank structure and resolution mechanisms
Systemic relevance
needs to be defined in
a dynamic way
Systemic relevance is defined by the size and/or interconnectedness of an
institution, but clear measures and definitions are lacking. The Financial
Stability Board (FSB), in which the OECD participates, is currently looking
into these issues, including definitions of systemic importance.
16
But again,
defining and then permitting the existence of “systemic” banks may create more
moral hazard and competitive distortions if not counterbalanced by, for
example, greater capital requirements. Perhaps a combination of effective
micro- and macro-prudential supervision allowing a dynamic identification of
the problem is needed.
Structural firewalls
within financial firms
could reduce systemic
risk
An additional approach is to devise principles and structures that would avoid
financial institutions becoming too large and systemically important, i.e., avoid
maintaining or creating too-big-to-fail institutions. The recent US initiative to
separate banking business tries to address such problems.
17
Another proposal
would envisage putting firewalls in large financial conglomerates, via a non-
operating holding company (NOHC) structure.
18
Such a structure would
enhance transparency (financial reporting for each entity), improve governance,
level the playing field (group affiliates compete with stand-alone companies),
allow separate resolution of affiliates and ease regulatory intervention. Such
reforms would be essential to deal with the contagion and counterparty failure
that have been the main hallmarks of the current crisis. This approach would
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also be somewhat more flexible than a stricter separation of banking business
like the one under the Glass-Steagall Act.
19
…and could make
resolutions of large
banks that are very
complex easier
As past developments in the financial industry have shown, imposing one
single business model would not be helpful, given the growing complexity and
interconnectedness of financial markets and products. A firewalled NOHC
structure could help to solve the complex issues that arise related to the
resolution of large banks. Various advances with regard to resolution
procedures have been made, and additional reforms are underway, like the
Special Resolution Regime (SRR) in the United Kingdom (UK Banking Act
2009). But resolution issues also involve, for example, differences in the data
architecture, and arise from the fact that legal and business forms do not
overlap, but are intertwined in a complex matrix that makes resolutions, even
of only single entities of the whole structure, complicated.
“Living wills” for
systemic firms may be
very costly
A so-called “living will” approach has been proposed under which
(systemically important) financial companies (banks in the current UK
proposal) would have to devise detailed plans that would enable them to
stipulate in advance how they would raise funds in a crisis and how their
operations could be dismantled after a collapse. Such plans could also improve
cross-border litigation and help to mitigate uncertainties and avoid panic
reactions to the failure of a major, globally active financial institution. But
implementing such living wills may involve heavy reporting requirements with
the need to provide constantly updated information, in line with an evolving
business structure, and may thus prove to be unduly costly. The current
complexity of the banking industry would make such an exercise very difficult.
Some current regulatory reform proposals
OECD proposes a
Policy Framework
for Effective and
Efficient Financial
Regulation
The OECD has recently proposed a Policy Framework for Effective and Efficient
Financial Regulation.
20
The Framework is a tool that can support ongoing efforts
by policymakers, regulators and supervisors to achieve a stronger, more resilient
financial system. As it is general in nature, it cannot be a substitute for more
focused, micro-prudential principles and guidelines of international standard-
setting bodies. But it can guide strategic thinking and promote governmental
leadership and action so that the financial system can play its vital role in the
functioning of the economy, both domestically and globally. While future crises
can hardly be avoided, regulation and supervision in a “new financial landscape”
should be based on guiding principles that allow striking the right balance between
stability and growth, in supporting and maintaining financial sector resilience
without stifling financial innovation.
G-20 as a platform
for regulatory reform
discussion
Recently, the G-20 has become a platform to discuss and help co-ordinate not only
current financial sector support but also further regulatory reform in the financial
sector. In their September 2009 Statement, G-20 finance ministers and central
bank governors emphasised, among many other necessary reforms, the need for
revised accounting standards, new liquidity and capital requirements, as well as
stronger oversight and better resolution procedures.
21
Most of the technical work is
currently being undertaken by the FSB and its related bodies. Comprehensive
consultative proposals to strengthen the resilience of the banking sector and to
create an international framework for liquidity risk measurement, standards and
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monitoring have recently been put forward by the Basel Committee on Banking
Supervision.
22
The financial
industry proposes
reforms and seeks co-
operation
The financial industry responded to the crisis early on with its own initiatives for
self-regulation.
23
Co-ordination and communication efforts have been stepped up
not only between policy makers, but also between the government and the private
sectors. As the shape of a future financial landscape is not yet well defined, and
with different and often country-specific support measures in place, there is a risk
that new regulations are being introduced in an uncoordinated fashion. Regulatory
impact studies involving all stakeholders would be an important complement to
new regulatory measures.
Peer pressure is
important as political
momentum for
reform may wane
Co-ordination in the design of a new financial landscape remains important. There
is a danger that the political momentum for financial reform may soon lose steam
as an improving economic situation appears to obviate the need for more
substantive reforms. If political pressures leading to impediments in reform efforts
are building up unevenly across countries, regulatory arbitrage may become a
problem. International co-ordination, including peer pressure exerted through
international (standard-setting and other) bodies, should help to keep the
momentum for reforms.
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3BNOTES
1
OECD (2009b).
2
In the United States, the Case-Shiller house price index changed direction in May 2009, growing 3% in the second
quarter, the first quarterly increase since 2006q2. However, official statistics (from the Federal Housing
Finance Agency - FHFA) still show a decline (in their latest values as of 2009q3).
3
Blundell-Wignall et al. (2009a, b).
4
FASB’s new rules FAS 166 and 167, which concern the accounting of securitisations and special-purpose entities,
are scheduled to become effective at the start of a company’s first fiscal year beginning 15 November
2009, or 1 J anuary 2010 for companies reporting earnings on a calendar-year basis.
5
IMF (2009).
6
Research from CreditSights suggests that 600 to 1 100 of America’s 8 200 banks may need help from, or winding
down by, the Federal Deposit Insurance Corporation during this cycle.
7
Government borrowing needs are expected to surge: gross borrowing needs of OECD governments are expected to
reach almost USD 16 trillion in 2009, up from an earlier estimate of around USD 12 trillion, and again
around USD 16 trillion in 2010; see Blommestein and Gok (2009) in this issue of Financial Market
Trends.
8
In this context, see also Lumpkin (2009) in this issue of Financial Market Trends for a more general discussion of
financial innovation.
9
Fed data (gross figures) show that home mortgage debt in RMBS pools amounted to USD 2 168.61 billion at the end
of 2007 and USD 1 848.02 billion end-2008.
10
González-Páramo (2009).
11
González-Páramo (2009).
12
U.S. Treasury Department press release of 23 December 2009: “Treasury receives $45 billion in repayments from
Wells Fargo and Citigroup – TARP repayments now total $164 billion”. See also SIGTARP’s reports to
Congress, available at www.sigtarp.gov/reports.shtml.
13
Even the troubled, state-owned German Hypo Real Estate bank reimbursed, in December 2009, EUR 7 billion of
the initial EUR 50 billion rescue package provided in 2008 by a consortium that included the federal
government, the central bank and private institutions. The total amount of guarantees still at HRE's
disposition fell from EUR 102 billion to EUR 95 billion.
14
Schich (2009b) in this issue of Financial Market Trends.
15
The industry itself has made proposals that are largely in line with official proposals by the FSB and other bodies.
Generally, these recommendations suggest that employee remuneration should be in line with the
employing institution’s long-term goals and should not induce excessive risk-taking. Thus, upfront multi-
year bonuses, for example, would not be in line with these recommendations. See IIF (2008).
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16
See IMF-BIS-FSB (2009).
17
See also the OECD statement “US: Obama plan for banks can help to avoid a new financial crisis” at
www.oecd.org/document/55/0,3343,en_2649_34487_44475383_1_1_1_1,00.html.
18
For more details, see Blundell-Wignall et al. (2009b), in this issue of Financial Market Trends, and OECD (2009a).
19
The Glass-Steagall Act, devised during the Great Depression, separated investment banking from commercial
banking, prohibiting a bank holding company from owning other financial companies and prohibiting a
bank from offering investment banking and insurance services. This separation had already been
abandoned, and the “pure” investment banking model softened in 1999 when the Glass-Steagall Act was
repealed by the Gramm-Leach-Bliley Act, which allowed commercial and investment banks to consolidate.
This made permanent a temporary waiver that was issued for Citibank’s merger with the insurance
company Travelers Group in 1993 (finalised in 1994; in 1998 they formed the financial conglomerate
Citigroup).
20
See OECD (2009c) in this issue of Financial Market Trends.
21
See www.g20.org and Box 1 in Blundell-Wignall et al. (2009b), in this issue of Financial Market Trends.
22
See Basel Committee (2009a, b), announced on 17 December 2009 at www.bis.org/press/p091217.htm. The reform
programme has been endorsed by the Financial Stability Board and by the G-20 leaders at their Pittsburgh
Summit, and comments on the consultative documents are invited by 16 April 2010.
23
For example, IIF (2009).
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