IMFSurvey Magazine: IMF Research
Global financial stability report
Credit Crisis Is Broadening, IMF Warns
By Laura Kodres
IMF Monetary and Capital Markets Department
April 8, 2008
- Credit crisis spreads to other mortgage, corporate debt markets
- Crisis creating serious macroeconomic feedback effects
- Most emerging markets so far insulated from effects of turmoil
The widening and deepening fallout from the U.S. subprime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF's latest Global Financial Stability Report (GFSR).
At present, the issuance of most structured credit products—instruments that pool and tranche credit risk exposures in various ways—is at a standstill and many banks are coping with losses and involuntary balance expansions, the April 2008 report said. The report examines this and other forces that could push the current credit crisis into a full credit crunch as well as offers policy recommendations to mitigate the impact.
"Financial markets remain under considerable stress because of a combination of three factors," said Jaime Caruana, head of the IMF's Monetary and Capital Markets Department. "First, the balance sheets of financial institutions are weakening; second, the deleveraging process continues and also that asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth," he added.
Growing systemic risks
The crisis has weakened the capital and funding of large systemically important financial institutions, raising systemic risks. Such financial institutions need to raise capital or cut back assets to cope with the strains, the report said. The continued stress increases the downside risks for global financial stability and potentially forces institutions to further curtail credit, it added, noting that the macroeconomic effects could be severe.
Jaime Caruana, (right) Director of the IMF's Monetary and Capital Markets Department, speaking at the April 8 press conference.
But Caruana pointed out that "the recent Fed [U.S. Federal Reserve] actions in solving the Bear Stearns case and also in providing liquidity to a broader range of counterparties have reduced the probability of a tail event, although there are still funding pressures that continue."
Credit deterioration, which was first evident in the U.S. subprime market, is now showing up in higher-quality residential mortgages, U.S. commercial real estate, and the corporate debt markets, according to the GFSR. These concerns are further exacerbated by a drop in valuations of structured credit products and a dramatic drying up of market liquidity.
Uncertainty about the size and distribution of bank losses, reduced capital buffers, and the normal reduction in credit as the cycle turns are also likely to weigh heavily on household borrowing, business investment, and asset prices. This, in turn, would affect employment, output growth, and balance sheets—thereby creating worrying macroeconomic feedback effects.
This feedback dynamic is potentially more severe than in earlier credit cycles, as it was fueled by a proliferation of new credit products that allowed more people to obtain credit, the report said. "Thus, it is now clear that the current turmoil is more than simply a liquidity event, reflecting deep-seated balance sheet fragilities, which means its effects are likely to be broader, deeper, and more protracted," it added.
Even though the United States remains at the "epicenter," financial institutions in other countries have also been affected by the current market crisis—"reflecting the same overly benign global financial conditions, an inattention to appropriate risk management systems, and lapses in prudential supervision."
And there are also signs that house prices in mature markets other than the United States could fall. Therefore, countries in which house prices have been more inflated or corporate or household balance sheets have been more stretched are particularly at risk, the report pointed out.
Emerging markets have so far been relatively insulated from the effects in mature markets, but the earlier benign financial conditions and low interest rate environment have also meant that risk taking was higher in some of these countries. The countries, most notably in emerging Europe, that have experienced rapid credit growth, some of which also have large current account deficits financed by private debt or portfolio flows, may be particularly vulnerable.
The first policy priority is to limit the spread of dislocations to other markets and to repair banks' balance sheets. Systemically important financial institutions need to move quickly to raise equity and medium-term funding, even if it is more costly to do so now, in order to boost confidence and avoid further undermining of credit channels. Although various investors, including sovereign wealth funds, have recently made capital infusions into banks, more such funding will likely be needed to recapitalize institutions.
Further, more rapid and informative disclosure of financial institutions is needed, and national authorities should seek to quell misperceptions by providing timely and accurate aggregate information.
The GFSR proposes that central banks and other relevant regulators issue special financial stability reports that could act to calm markets. Restoring counterparty confidence is a key element to reducing volatility and the knock-on effects to the real economy.
It is now widely acknowledged that public measures are needed in a number of areas. In particular, there may be a need to shore up the prices of various types of securities to prevent fire sales. Plans that use public money, however, should attempt to ensure that shareholders accept the first losses. Also, measures will need to carefully weigh the legitimate issues of consumer protection and the legal rights of contract holders.
The IMF, as a member of the Financial Stability Forum (FSF) working group evaluating the crisis, continues to work closely with the FSF, along with other international fora, to formulate policy recommendations.
Chapter 2 takes an in-depth look at the structured credit markets and their role in the crisis. The chapter focuses on two key factors—first, it examines the valuation and accounting practices for structured finance products and, second, it discusses the business and regulatory incentives that prompted the fast growth of these products, including the role of credit rating agencies.
Chapter 3 examines the liquidity aspects of the crisis, noting how complex linkages between funding and market liquidity produced a downward spiral of illiquidity. The analysis finds that many financial firms became complacent about liquidity risk management, given their dependence on wholesale funding sources, and implicitly relied on central bank intervention to meet emergency liquidity requirements.
Both chapters conclude with a set of longer-term recommendations to improve the resiliency of the global financial system. These recommendations are addressed to the private as well as the public sector.
The hands-on role of major central banks in this crisis suggests that a reexamination of their tools for emergency liquidity support is also warranted. The report notes that central banks could usefully converge to a set of best practices for systemwide liquidity management, which could be drawn from what has worked well so far.
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