Global Financial Market Risk-Who is Responsible for What? Keynote Address by Jaime Caruana, Director, Monetary and Capital Markets Department, IMF
IMF News, May 30, 2007
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- Published: May 30, 2007
Globalization: Description of trends
- Cross-border capital flows and financial assets have grown rapidly:
- In 2005, global cross border flows are estimated to have reached around $9 trillion or almost a fifth of world GDP.
- Between 1990 and 2005, the sum of equity market capitalization, outstanding bond issues, and bank assets rose from 81 percent of world GDP to 137 percent.
- Three drivers of the capital flows revolution identified:
- Rapid growth of assets under management of institutional investors.
- Changes in asset allocation behavior as `home bias' declines.
- Broadening of the global investor base, including an increasingly important role for the emerging market official sector, central banks, sovereign wealth funds, and increased activity of hedge funds.
- Institutional and market structural shifts:
- Cross-border financial M&A: cross-border financial M&A accounted for only 1% of the total a decade ago and had risen to 40% of the value of deals last year.
- Hedge funds are now estimated to have approximately $1.4 trillion of assets under management—a figure that has at least tripled since the turn of the century.
- There are an estimated 9000 hedge funds now active, concentrating transactions through a narrow band of investment banks and a shrinking number of exchanges and infrastructure systems.
- European integration observations:
- European money markets have become fully integrated; government and corporate bond markets also achieving high degrees of integration.
- The share of cross-border holdings of long-term debt securities has more than doubled since 1999.
- The use of cross-border collateral has doubled.
- The share of cross-border holdings of equity has almost doubled.
- Banking system integration indicators show much slower progress in Europe, particularly for retail banking.
Globalization: Assessment of impact
- Net assessment:
- Overall view: “the revolution in cross-border capital flows ... will ultimately prove beneficial for the global economy,” by widening investor choices and promoting diversification.
- Risks and vulnerabilities from increased capital flows:
- Acceleration of flows to some emerging market countries has been challenging.
- Observed "pockets of vulnerability" in countries where capital flows finance large current account deficits and rapid credit growth.
- Household credit expanding at "breakneck speed" in some emerging markets, raising concerns about banks' screening and risk assessment.
- Heavy issuance of foreign exchange-denominated debt at increasingly lower credit ratings by emerging market banks and corporations.
- Capital flows into previously little-invested countries, including some in sub-Saharan Africa.
- Historical precedent: past episodes of rapid international capital flow growth have led to abrupt reversals.
- Declining home bias and improved fundamentals may make current flows less volatile, but it may be premature to conclude this.
- Globalization of financial institutions:
- Positive relationship between increasing cross-border activity (primarily by banks) and their performance; measures of financial soundness generally improve with cross-border diversification.
- However, large international banks show signs of becoming more correlated over time as they internationalize, increasing vulnerability to common shocks and spillovers.
- Globalization of markets:
- Increasing co-movement: bond and equity markets of Europe, Japan, and the U.S. move much more closely together than a decade ago; co-movements sometimes occur between markets with little direct economic connection.
- Concentration risk: increased transaction volumes concentrated through a small set of investment banks and infrastructure providers reduces settlement risk but raises reliance on a few institutions.
- Innovation and risk transfer: growth of credit derivatives and securitization allows banks to originate and distribute risks, increasing dependence on market liquidity and packaging/transfer mechanisms.
- Incentive concern: as originators become less likely to hold assets, lending conditions may relax—“bad loans are made in liquid times.”
Roles and responsibilities (policy recommendations and obligations)
- Households:
- Households are bearing more market risk directly due to shifts from earnings-related pensions and responsibilities for education, health care, and long-term care.
- Survey evidence indicates a lack of basic financial knowledge and skills internationally.
- Recommended actions:
- Increase financial literacy through education to equip households to make prudent choices.
- Combine efforts across:
- Governments: provision of financial literacy in schools and counseling for low-income groups.
- Private sector: provide simple products with transparent fee structures and good-value savings schemes as employers.
- Regulatory authorities: promote simple, easily understood investment products; coordinate efforts and publicize neutral sources of financial advice.
- Consider pension savings schemes with `soft compulsion' to improve retirement provision.
- Financial institutions:
- Strengthen risk management systems to match growing market complexity and avoid negative spillovers.
- Market participants should impose market discipline by rewarding strong risk management and disclosure and penalizing weak practices.
- Balance disclosure requirements against the risk of driving activity to less regulated, less transparent entities.
- Encourage voluntary measures by hedge funds (codes of conduct, benchmarks for disclosure and risk management) while recognizing the role of counterparties’ market discipline.
- National authorities and regulators:
- Responsibilities include:
- Ensuring regulatory and supervisory frameworks produce well-managed institutions with adequate capital buffers and risk management.
- Requiring and providing sufficient information to enable effective market discipline.
- Ensuring crisis management and resolution procedures are adequate.
- Considering international spillovers of domestic policies and fostering international cooperation.
- International cooperation architecture cited: Gs (G7, G8, G20, G30 etc); the BIS and the FSF; standard setters (Basel Committee, IOSCO, IAIS, CPSS); and international institutions (IMF, World Bank, OECD).
- Banking example: significant efforts devoted to home-host issues and consistency among supervisors to minimize burden on international banks and ensure a level playing field.
- European-specific recommendations:
- Strengthen supervisory cooperation to minimize regulatory gaps and ensure a level playing field while minimizing supervisory burdens.
- Further strengthen the Lamfalussy process and broaden national supervisors' mandates to consider pan-European implications.
- Move to a more predictable and rule-based system for early remedial action to facilitate effective, low-cost cross-border crisis management.
- Greater harmonization of deposit insurance schemes to avoid hindering cross-border problem resolution.
- International Financial Institutions (IFIs), including the IMF:
- Monitor global financial stability and potential threats.
- Advise member countries on policies to minimize globalization-related risks.
- Provide technical assistance to help countries develop markets and infrastructure.
- Lending facilities available to provide resources to member countries facing balance of payments difficulties.
- Surveillance activities described:
- Bilateral surveillance via Article IV consultation and Financial Sector Assessment Program.
- Regional analysis to identify common trends, challenges, and policy responses.
- Global surveillance, including Global Financial Stability Reports, to focus on global market developments and inform bilateral/regional work.
- Significant resources devoted to technical advice and cooperation to build domestic capacity.
Key statistics and exact figures cited
- $9 trillion (global cross border flows in 2005).
- Almost a fifth of world GDP (share of global cross border flows in 2005).
- 81 percent of world GDP to 137 percent of world GDP (sum of equity market capitalization, outstanding bond issues, and bank assets between 1990 and 2005).
- Cross-border financial M&A: 1% (a decade ago) versus 40% (last year) of deal value.
- $1.4 trillion (approximate hedge fund assets under management).
- 9000 (estimated number of hedge funds).
- Share of cross-border holdings of long-term debt securities has more than doubled since 1999.
- Use of cross-border collateral has doubled.
- Share of cross-border holdings of equity has almost doubled.
Conclusion
- Fundamental view reiterated: forces of financial globalization are ultimately beneficial to global financial stability and economic welfare, but risks must be closely monitored and managed.
- Emphasis on shared responsibilities across households, financial institutions, national regulators, supranational authorities, and international financial institutions.
- IMF stands ready to engage in dialogue, collaboration, cooperation, monitoring, technical assistance, and lending to help manage globalization’s risks and maximize benefits.
Keynote Address by Jaime Caruana, Director, Monetary and Capital Markets Department, IMF, May 30, 2007.