Speech

Global Financial Market Risk-Who is Responsible for What? Keynote Address by Jaime Caruana, Director, Monetary and Capital Markets Department, IMF

May 30, 2007

Thank you for those kind introductory remarks—it is a pleasure to be here today and to be a part of this conference. My remarks today will touch on many of the important themes and issues that have been raised in the conference, and will hopefully offer a global perspective on how the IMF sees these developments.

I would like to focus my remarks today on the benefits and risks from the globalization of financial markets, and the shared roles and responsibilities that globalization brings. Globalization is introducing profound changes in the way that financial systems operate. Households, financial institutions, policy makers, supranational bodies, and international financial institutions like the IMF each have our own role to play in protecting the public good of financial stability.

Globalization: Description of trends

Let me begin by discussing some of the broad trends towards the globalization of financial markets in recent years. At the outset, it is important to highlight three longer-term trends in global markets that the IMF has recently addressed in the latest edition of our Global Financial Stability Report. These are the dramatic increase in cross-border capital flows, including the new role of emerging markets, the globalization of financial institutions, and the globalization of financial markets.

Globalization of capital flows: With regard to capital flows, we are living through a revolution in the degree to which capital is moving across-borders. In 2005, global cross border flows are estimated to have reached around $9 trillion or almost a fifth of world GDP. Just a decade ago, these figures were around a quarter of the levels they now are. In addition, financial development has taken place much more rapidly than that of the real economy. 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. And so, while the world is in the midst of a period of historically high and stable growth, cross-border capital flows and financial assets are expanding even faster, as countries invest in each other's economies to an ever greater degree than before.

This trend is being driven by three dramatic changes: the rapid growth of assets under management of institutional investors; changes in asset allocation behavior as `home bias' declines; and the broadening of the global investor base, with an increasingly important role for the emerging market official sector, central banks, and sovereign wealth funds, and on the other side the increasing activity of hedge funds. The reasons behind such developments are not difficult to recall, with demographics, longevity, and commodity price developments all playing a role. Countries have largely abolished or relaxed the most significant restrictions on investors buying assets abroad, and most have relaxed the controls on capital inflow. There is increased demand for assets that can provide the returns required to prepare for increasing numbers of retirees. As up-to-date information about countries, markets, and firms becomes far more widely available around the globe at lower cost, investors are more confident about venturing into new territory. Investors and their advisors are increasingly realizing the profit opportunities and diversification benefits that cross-border investments can offer.

The role of emerging globalization of financial institutions: The next major development in global financial affairs that I would like to mention is the globalization of financial institutions, which is happening to a large extent through mergers and acquisitions of banks and life insurance companies in high income countries as well as Eastern Europe and Latin America. Indeed, whereas cross-border financial M&A accounted for only 1% of the total a decade ago, it had risen to 40% of the value of deals last year, and looks to be much higher this year.

Globalization and transformation of financial markets: The globalization of financial markets has gone hand-in-hand with the globalization of institutions. As I have already mentioned, traditional investors, such as pension and mutual funds, asset managers and retail investors, are all increasingly diversifying their assets into foreign markets. The innovation and progress in the area of risk management is another feature of the transformation of the financial market landscape. But perhaps even more influential is the growth of hedge funds and their focus on absolute returns, which is bringing international investor interest to a number of domestic financial markets that previously had received little attention.

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. Perhaps even more important to note, however, is that they account for a disproportionately large percentage of the trading in a number of markets. This is important in the context of the globalization of markets because hedge funds' investment strategies do not start from the premise of operating in a designated `home' market and then diversifying out. Rather, investment and arbitrage opportunities are taken wherever the manager believes assets are mis-priced and markets offer high absolute returns for the risk involved. As a result, hedge funds—and the investment bank operations that emulate them—are actively trading and arbitraging across markets in different countries with far less reluctance to cross traditional geographical borders than before. Hedge funds have also been very active in the rapid development of some segments of the market, such as derivatives and structured products, helping to make more complete asset markets in the process.

European perspective on integration

From a European perspective, the increase in cross-border activities has been equally impressive, as Europe decided that integration was the right answer to globalization, and that integration could bring efficiency and stability. There has been a pronounced increase in cross-border financial flows in Europe. The ECB's report¹ on financial integration shows that the European money markets have become fully integrated, with 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. These impressive figures stand in contrast to those of the banking system, where available indicators show much slower progress in Europe, particularly for retail banking.

Globalization: Assessment of Impact

Having described the dramatic changes occurring in the global financial landscape, I would like to give our view on the impact these changes are likely to have on financial stability. Let me start by noting that the impact of these trends towards greater global financial integration are numerous and multi-faceted, so any broad-brush assessment is obviously an oversimplification of the subtle complexities involved. But with that caveat in mind, our overall assessment is that the revolution in cross-border capital flows that we are witnessing will ultimately prove beneficial for the global economy. Investors and savers are increasingly offered a wider menu of options that permit them to match their risk preferences and put their resources to greatest use. This is likely to have a positive impact on global financial stability. The increasing diversity of cross-border investors with differing investment behaviors and time horizons should contribute to a wider distribution of risk holdings and tolerance for volatility over the longer term.

Impact of increased capital flows

However, these changes are not without risks and pitfalls. The recent acceleration of flows to some emerging market countries has been challenging for the authorities there. While emerging market economic fundamentals have improved overall, we continue to observe "pockets of vulnerability," particularly in countries where capital flows are financing large current account deficits and credit growth is rapid. Household credit is expanding at breakneck speed in some emerging market economies, and this naturally raises concerns about banks' ability to screen borrowers and assess risks adequately. In addition, I would like to point to the heavy issuance of foreign exchange-denominated debt at increasingly lower credit ratings by emerging market banks and corporations, encouraged by increasing investor risk appetite. Also noteworthy have been capital flows into a number of countries that have previously received very little interest from foreign investors, particularly some countries in sub-Saharan Africa.

In the past, some episodes of rapid growth of international capital flows have led to abrupt reversals. The favorable economic circumstances in which this round of globalization has taken place also offers little guidance about the robustness of the global system under significant or sustained stress. However, the declining home bias of longer-term investors and improved fundamentals hopefully means that these increased capital flows may be less volatile than in previous cycles, but it may be premature to make this assessment.

Impact of globalization of financial institutions

Turning to at the impact of the globalization of financial institutions, our studies show a positive relationship between increasing cross-border activity, primarily by banks, and their performance. We find that measures of financial soundness generally improve with the diversification of banks cross-border. However, the stability benefits of cross-border mergers are less clear cut when looked at from the global perspective—indeed, large international banks as a group show signs of becoming more correlated over time as they internationalize. The intuition behind this finding is that when banks diversify abroad, their incomes become more correlated with each other, and in that sense it can be argued that financial systems may become more vulnerable to large common shocks and spillover effects, and severe crises become more complicated to deal with.

Impact of globalization of markets

The impact of greater cross-border flows on financial markets has also been profound. First, markets across the world move more closely together than they did in the past. For instance, the bond and equity markets of Europe, Japan, and the U.S. move much more closely together than they did a decade ago. One would expect that as the world's economies become more inter-related through trade and investment, their financial markets would react in similar ways to common developments and shocks. But the increase in co-movements between markets that have very little direct economic connection suggests that something more fundamental in the structure of financial markets is going on, as the marginal investors in a market across the globe react in similar ways.

Second, the increasing volume of financial transactions in some segments of the market is being more and more concentrated on a narrow band of investment banks and consolidating payment and settlement infrastructure providers. In contrast to the proliferation of the 9000 hedge funds now estimated to exist, they concentrate their transactions through a tight group of investment banks, who in turn, trade and hedge their positions heavily with one another, and settle their transactions on a shrinking number of exchanges and infrastructure systems. The latter consolidation can, in many ways, be a healthy development as it can result in a dramatic reduction in settlement and payment risk. However, this does mean that the global financial system is becoming evermore reliant on the resilience of a few institutions and infrastructure providers.

Third, the innovation and progress in the area of risk management has been enormous, and has changed the nature of banking in fundamental ways. The growth of credit derivatives and securitization has brought new possibilities to banks to manage their risks actively. Banks can decide what risks they want to hold on their balance sheets, and those they need to transfer. This is transforming the business of banking and the risk profile of banks towards a model of originating and distributing risks. At the same time, this new model is more dependent on market liquidity and the ability to package and transfer these risks, increasing the dependence on the smooth functioning of markets. This model also requires us to pay more attention to the incentive structures surrounding loan origination. As originators becomes less likely to hold the asset, this may cause a relaxation of lending conditions. We need to remain vigilant to ensure that the old adage that "bad loans are made in good times" doesn't become "bad loans are made in liquid times."

So, to summarize my speech so far, I would say that globalization has brought enormous changes in cross-border flows, in financial institutions, and in markets. Most of these changes have been for the better, but they are not without risks.

Roles and responsibilities

So what can we do to ensure that the risks are properly managed so that any threats to financial stability are minimized, and the benefits of financial globalization are widely shared? To answer this question, I would like to consider the shared roles and responsibilities that households, financial institutions, national authorities and regulators, supranational authorities, and international financial institutions like the IMF all share.

Role and responsibilities of households

Let's begin with households. Many households have clearly benefited from the widespread changes in global financial markets and institutions, either through increased access to credit at lower cost, or through a wider range of investment options. However, what is different now is that risks are being borne directly by households with far fewer layers and intermediaries to smooth the impact of changes in market values on their purchasing power and retirement savings. In the past, adverse shocks were partly absorbed by companies and financial institutions, and so were predominantly felt by shareholders instead of households, but now risks are more widely dispersed and potentially felt by all savers. Many countries with still generous earnings-related pension schemes provided by the government are scaling back such schemes and are shifting market risk directly to the household saver. Also, responsibility to finance higher education, health care costs and the cost of long-term old age care is being transferred back to households in many countries. At the same time, households are being expected and required to take greater financial responsibility for their future living standards.

But are households equipped and sufficiently informed to assume the greater financial risks that are being transferred to them? Around the world, survey evidence frequently confirms a lack of basic knowledge and skills about financial matters, suggesting that many households are not well equipped to deal with the brave new world of global capital flows. The obvious solution to this situation is to increase financial literacy through education, to equip households with the tools, information, and confidence to make prudent choices themselves. A more financially-literate population should also enhance competitive pressures on the financial industry, as people are more able to spot poor value products and are more willing to switch their business to better providers.

But who should provide this education?. The obvious solution is that all three parties—government, regulators, and the private sector—have complementary and essential roles to play:

- Governments, in focusing on the provision of financial literacy in schools and ensuring the availability of counseling for low-income groups;

- The private sector, through providing simple products with transparent fee structures as providers and simple, good value savings schemes as employers; and

- Regulatory authorities, can help to promote simple, easily understood investment products and menus as being most appropriate for less sophisticated investors. Also, as neutral—and hopefully trusted—sources of advice on financial matters, regulators can coordinate the wider efforts of other parties and can publicize the best sources of neutral counsel on financial planning.

A further step is that, if households are making insufficient provision for retirement, governments can develop pension savings schemes that depend on `soft compulsion' (i.e., that require savers actively to exercise choices to opt-out if they wish to avoid being signed-up for a pension scheme, and having their savings placed in an investment plan designed for their stage in life). Thus households, governments, and private financial institutions all have responsibilities to ensure that households are adequately informed of the risks that this new global financial architecture brings, and have the tools necessary to assess and manage these risks.

Role and responsibilities of financial institutions

Turning now to financial institutions, it is clear that they can contribute to financial stability by increasing the sophistication of their risk management systems to match the growing complexity of domestic and international financial markets, to help ensure that their actions do not have a negative impact on other participants in global financial markets. Financial market participants, in turn, have a responsibility to impose greater market discipline on financial institutions by rewarding those that have better risk management systems and disclosure practices, and punishing those where such systems are weak. Achieving both of these objectives will inevitably require meaningful disclosure of activities and systems, but we must be careful to balance the costs and benefits of this disclosure. Overburdening banks and other institutions with costly new disclosure requirements can be self-defeating if it causes transactions to move to less heavily regulated entities that may be even less transparent. In this regard, the discussion of hedge funds that was held earlier today provides an interesting example of this approach. It is our view that market discipline by hedge fund counterparties remains a necessary and key component of the response to the challenges posed by their presence in any market. Greater disclosure by hedge funds themselves may be helpful in this regard, for example through voluntary codes of conduct or benchmarks for disclosure and risk management practices.

Role and responsibilities of regulators

Turning now to national authorities and regulators, we see their responsibilities as being two-fold. First, they need to have in place a regulatory and supervisory framework that ensures the key financial institutions in their jurisdiction are well managed, with adequate capital buffers and risk management systems in place. Second, supervisors have a responsibility to ensure that the information they provide and the information they require regulated entities to disclose is sufficient for market discipline to be effective. Supervisors must also ensure that crisis management and resolution procedures are adequate and well thought through. And third, national authorities have a responsibility to consider the international implications of their actions and the spillovers that can arise from institutions within their jurisdiction. These cross-border spillovers of national policies are becoming more relevant as the globalization of flows, institutions, and markets continues. This requires all parties to pay more attention to international cooperation, and as you know there is a complex architecture of fora and institutions developed to foster cooperation: including the Gs (G7, G8, G20, G30 etc); the BIS and the FSF; standard setters like the Basel Committee, IOSCO, IAIS, CPSS; and international institutions like the IMF, the World Bank, and the OECD, just to name a few. In the area of banking, to take one example of successful international cooperation, significant efforts have been devoted to the home-host issue and consistency among supervisors, minimizing the burden on international banks, and ensuring a level playing field.

Role and responsibilities in the European context

In the European context, the responsibility of supervisors to consider the international implications of their actions is particularly relevant. The increasing integration of financial markets in Europe and the growing complexity of cross-border banking means that supervisory cooperation, crisis management, and resolution procedures in Europe need to be strengthened further. At the same time, the European Union has more instruments and tools at its disposal, including directives, committees, and coordinating mechanisms. Therefore, Europe can be more ambitious in its agenda, and set the example of good practices for coordination and cooperation for other countries and regions in the world.

On this topic I can see three key areas where the European supervisory framework can be strengthened further to help mitigate the risks posed by greater integration of financial markets in the EU. First is the need to exploit the maximum potential for cooperation amongst different national supervisors, to minimize regulatory gaps, and to help ensure a level playing field for financial institutions across countries, while minimizing the supervisory burden on financial institutions. This can be done most effectively by further strengthening the Lamfalussy process, and by broadening the mandates of national supervisors to consider the pan-European implications of their actions. The second key area of reform of the European framework is the need to move to a more predictable and rule-based system for early remedial action. This will help to build confidence among member countries that cross-border crisis management operations are carried out in the most effective and least cost manner. And finally, there is a need to achieve greater harmonization of deposit insurance schemes, to ensure a more level playing field and to avoid the situation that differences in deposit insurance systems hinder cross-border problem resolution. These are all areas that will require much effort and debate to make any progress, but progress is essential to avoid getting further behind the developments that are taking place in the markets.

Role and responsibilities of IFIs

Finally, I would like to talk about the responsibilities of the IMF and other international financial institutions in mitigating the risks of globalization. As an international organization with near universal membership, we have a responsibility to monitor global financial stability and any potential threats to it, as well as a duty to advise our member countries on policies to minimize the risks to their financial systems and economies posed by the forces of globalization. We also have a responsibility to provide technical assistance to our members to help them develop the necessary markets and infrastructure to cope with these challenges, and to help ensure they obtain the maximum benefit from financial globalization. Finally, our lending facilities stand ready to provide resources to member countries facing difficulties in their balance of payments. Our activities are thus focused on meeting these responsibilities.

In our bilateral surveillance activities, we monitor financial systems through the regular Article IV consultation process, with in depth analysis from our Financial Sector Assessment Program. At a regional level we provide analysis of financial conditions facing various groups or regions of countries, looking at things from the perspective of common trends, challenges, and policy responses beyond a strictly national focus. For example, in the Euro area we have a separate consultation process that looks specifically at European financial and economic issues from the perspective of the entire area. Finally, in our global surveillance activities, which include our Global Financial Stability Reports, we focus on developments in global financial markets, trends affecting the global financial system, and the policy challenges and responses necessary to maintain financial stability. Here we bring the global perspective to financial sector developments, which helps to inform our bilateral and regional surveillance activities as well. Finally, a key area where we devote a significant amount of our resources is in providing technical advice and cooperation for country authorities. The object of this advice and cooperation is to provide countries with the skills and knowledge to develop their own markets, institutions, and policies to meet the challenges posed by globalization, and ensure that they can benefit from these powerful forces.

Conclusion

In closing, I would like to reiterate our fundamental view that we see the forces for financial globalization as ultimately beneficial to global financial stability and to economic welfare, but there are risks that need to be closely monitored and managed. We all have responsibilities for managing this process to ensure that the benefits of these fundamental changes being caused by a revolution in global capital flows, institutions, and markets outweigh the downside risks. We at the IMF stand ready to play our part, and we look forward to continuing dialogue, collaboration, and cooperation with regulators, policymakers, and the public to make this happen.

¹ http://www.ecb.int/pub/pdf/other/financialintegrationineurope200703en.pdf