Transcript of a Press Conference on the Analytic Chapters of the Global Financial Stability Report

September 13, 2011

With Laura Kodres, chief of the Global Financial Stability Division of the Monetary and Capital Markets Department
Srobona Mitra, senior economist,
S. Erik Oppers, deputy chief, Global Financial Stability Division
Andreas Adriano, senior press officer, External Relations Department
Tuesday, September 13, 2011
Washington, DC
Webcast of the press conference Webcast

MR. ADRIANO: Good morning, everybody, and thank you for joining us today at this presentation of the analytic chapters of the Global Financial Stability Report (GFSR). My name is Andreas Adriano, and I'm with the IMF External Relations Department. With us today is Laura Kodres, Assistant Director of the Monetary and Capital Markets Department and head of the Global Financial Stability Division, which is the division that is in charge of producing the report; Srobona Mitra, senior economist in the same division, and lead author of chapter 3, "Towards Operationalizing Macroprudential Policies: When to Act;" and Eric Oppers, Deputy Chief of the same division and lead author of chapter 2, "Long term investors and their asset allocations: Where are They Now?"

Laura, Eric and Srobona will have some introductory remarks for you, and we will then be happy to take your questions. We would like to salute people watching us on the online media briefing center as well and invite you to send in your questions. Before we start I would like to remind you that the presentation of chapter one of the GFSR will be held on September 21st, a week from tomorrow, by the Fund's financial counselor, Jose Viñals. Today we will discuss issues pertaining to chapter 2 and three, and issues related to chapter one will have to wait for the presentation of chapter one. Laura?

MS. KODRES: Thank you very much. I'm sure I'm not revealing anything new by noting that economic growth prospects and financial market conditions have deteriorated of late. The two analytical chapters we are introducing today for our fall Global Financial Stability Report attempt to place some of this turmoil in a longer term context. Our analysis of long term institutional investors suggests that, despite pressures to earn more to cover their future commitments, these investors have yet to venture into riskier asset classes, with most waiting to choose for calmer waters before dipping in their toes.

Our other chapter begins the painstaking work of choosing practical and precise indicators to reliably tell policymakers when to act against financial vulnerabilities, when to build up buffers to better weather crisis times, and when to release them during tough times.

Turning first to chapter two, it takes a specific look at long term unleveraged investors, those that invest their own funds and don't borrow to invest. The investors we examine comprise pension funds, insurance companies, central bank reserve managers and sovereign wealth funds.

We ask whether the crisis of the last several years combined with the low interest rate environment has changed their global asset allocations. Generally, we find that yes, indeed, their asset allocation strategies have changed. They've become more risk conscious, including, not surprising, by looking into the risk of government securities.

Since the crisis began, they've moved into more liquid assets, those that can be sold easily without moving the price, and into emerging market assets, now viewed safer than some of those in the advanced economies. It's worth noting that moving into emerging market assets since the crisis is not a new phenomenon but an acceleration of a pre-crisis trend. We found that investors' decisions about where to place their funds are based predominantly on better economic prospects and less so on interest rate differentials with advanced economies. Eric, the team leader, will explain this in a little bit more detail, because it's a seemingly counterintuitive result.

While these movements seem to be based on a better understanding of emerging market risks, we noted in the chapter that many pension funds and insurance companies are first-time investors in these markets and could well reverse their commitments. And while it is still early days for some of these long term unleveraged investors to alter their allocations, we may be seeing some of that reversal now.

Looking forward, we tried to surmise how these long term investors will react to the continuing low interest rate environment, one that hurts them greatly. The private pension plans of Canada, Germany, Japan, the Netherlands, Switzerland, the United Kingdom and the United States are all in actuarial deficit. That is, the current market value of their pension plan assets cannot cover what the plan owes its beneficiaries. One can certainly envision a tendency of some pension funds and insurance companies to try to recover from their underwater positions by taking on riskier investments. So far it appears that they're paralyzed like deer in the headlights of an oncoming car, afraid to move. We did not detect much aggressive risk-taking by these investors in the reported data nor in our first ever comprehensive survey, just timid steps. Nonetheless, the notion that these traditional deep-pocket investors may be unwilling to hold long term risky assets during a market downdraft is gaining traction, not a good sign for financial stability in the longer run.

In chapter 3, we move the topic of macro-prudential policies forward. You may recall from our first piece on the topic released last April, we defined macro-prudential policies as those aimed at reducing systemic risk in the financial sector; that is, the risk of widespread distress in our financial institutions and markets that can potentially derail economic growth. We suggested in that paper that to counter these risks special tools be aimed at individual institutions or markets to either dampen their procyclical effects on business cycles or limit the system-wide risks associated with interconnectedness across financial institutions.

We now move the topic forward by trying to operationalize some of those concepts. Although systemic risk has two elements, which contribute to cyclical excesses and relate to the transmission of difficulties across institutions through their interconnectedness, this chapter mostly makes its mark on the former, the cyclical part. This is not because the other component is less important. It's just harder to analyze with our usual modeling techniques, and we need more time to set up frameworks and gather data to do this properly.

That said, we first tried to better understand, through a model that accounts for the interaction between the financial sector and the economy, which indicators and what types of shocks give rise to systemic risk. We then use these insights to find indicators to help us predict when risks are building up. We spend some time analyzing credit type indicators, since credit problems are the most common cause of banking crises.

We provide some thresholds and some time frames during which various credit indicators can predict crises reasonably well. We also examine a set of systemic risk indicators based on high frequency market prices to see how well they signal impending periods of distress. We call these "near coincident measures." These two components together will help us when to set up buffers in the financial system and then when to release them if systemic risk materializes.

Lastly, we use our model to look at one tool that policymakers can use to mitigate the buildup of systemic risks: countercyclical capital buffers. This tool would effectively increase capital buffers in upturns and allow them to be drawn down during a downturn, thereby keeping credit flowing and helping to dampen economic cycles.

Indeed, we find this tool works fairly well. In general, for this tool and others to be effective, policymakers should try to reach a common understanding of the sources of shocks that give rise to systemic risk. Their coordination on this front is important so that the chosen policy tools do not suppress economic growth unnecessarily, especially if it is caused by healthy developments like productivity growth.

Overall, the chapter makes a good start at finding indicators of systemic risk that work well and in evaluating macro-prudential tools. We will be doing more of this work going forward, and we hope to release some of it in mid-October. Let me now turn over to the team leaders Eric and Srobona to give you some of the main points of the chapters. Thanks.

MR. OPPERS: Thank you, Laura. Our chapter 2 takes an in-depth look at what drives the investment decisions of institutional investors such as pension funds and insurance companies. These are really money investors that invest their own cash, that is, they don't borrow to invest, and generally have a long investment horizon.

A unique feature of the chapter is that we look at the issue using detailed data on mutual fund investments rather than the more aggregate macroeconomic data that others have used. The data we use actually shows us flows in and out of stock and bond investments in particular countries and therefore allows us to analyze directly what drives these flows.

As Laura mentioned, we find that these long term investors are driven mostly by good growth prospects in the countries where they invest. They also look at low country risk, meaning stable politics and good macroeconomic policies. They like stable inflation and stable exchange rates. What they do not seem to respond to is interest rate differentials between countries, whether they be short term, long term, or adjusted for inflation. This may seem surprising since it appears to go against common financial wisdom. Don't interest rates matter for investors? Well, the point to keep in mind for our analysis is that we look only at the investment decisions of long-term investors. It makes good sense for the long term determinants of investment returns such as economic growth and stable policies to matter for them.

But there's a diversity of investors in the marketplace. In particular, there are those investors that are leveraged, meaning that they borrow to invest. For these investors, the interest rate is a direct cost component, and they are likely to be much more sensitive to interest rate differentials. Indeed, interest rate differentials are in fact the main driver for the carry trade, which is when investors borrow in a low interest rate currency and lend in a high interest rate currency, taking advantage of the interest rate differential. These leveraged investors have fewer funds to invest, perhaps one-tenth or so of the 70 trillion dollars that institutional investors have, but they tend to trade much more frequently and could therefore have a large impact on markets.

There are also reasons to think that some of the longer term real money investors may become more sensitive to interest rate differentials going forward. As Laura mentioned, pension funds and insurance companies that have promised payments based on much higher rates of return on their portfolios -- some are still counting on 8 percent expected returns -- are being badly hurt by the low interest rate environment. For now, they're mostly biding their time, accepting the lower returns for the time being.

But the longer interest rates remain low, and they're expected to remain low for the foreseeable future, the more pressure they will be under to seek out higher returns, and one way of doing so is to move funds to countries with higher interest rates, taking advantage of interest rate differentials.

In addition to private investors, the chapter also looks at the growing importance of sovereign investors. These are the entities that invest a country's national wealth such as international reserves, pension reserves, and receipts from mineral or oil sources. These investable funds have grown very rapidly over the last decade and they have become important players in international financial markets, and their role may grow as their assets are expected to continue to grow both in existing sovereign wealth funds and as more countries establish such funds.

In addition, as international reserves grow beyond the level needed for balance of payments and monetary purposes, some of these funds could be invested in longer term less liquid assets. Indeed, some reserve managers have already established investment tranches for their reserves that have different asset allocation frameworks than regular reserves.

As investable sovereign wealth grows there may be an opportunity for sovereign wealth managers to take advantage of changing private investor behavior. The crisis has made private investors more conscious of risks, including liquidity and credit risk, and including also the risk of sovereign bonds, government bonds; and many institutional investors are being pushed additionally by regulation, including, for example, the European Solvency II Directive for insurance companies to become safer institutions.

Both these developments are pushing these traditional long term investors, the deep pockets of financial markets, if you will, towards more liquid and less risky investments. As private investors exit these market segments, the demand for long term risk assets declines, and their returns would be expected to rise. Sovereign investors could take advantage of these demand shifts and profit from taking on the longer term less liquid investments such as equities, commodities and infrastructure that private investors now avoid. We don't necessarily advocate this, but with their assets growing and the ability to act in the long-term interest of their government sponsors, we think it would be a natural stabilizing extension of their current mandates.

MS. MITRA: As Laura partly explained, the new term "macro-prudential policies" refers to policies that seek to reduce system-wide financial risk. Most people are familiar with the term "micro-prudential tools," like the ones applied by banking supervisors to ensure the safety and soundness of individual banks. These new tools, that is, the macro-prudential tools, by contrast are aimed at ensuring that risk taking in the overall financial system is not excessive in the sense of pushing the economy to the brink of a financial crisis.

For any tool policymakers would need to know when to act. This chapter provides a framework for thinking about indicators that would be useful to tell decision-takers in advance that systemic risk is on the rise. For effective monitoring of systemic risk, we found that understanding the sources of shocks that start the process is key. An example is irrational forces that push house prices away from fundamentals, resulting in house price booms. Financial institutions may ride this boom by giving out more and more loans on the basis of the inflated housing values. The quality of such lending is inherently shaky, and this becomes clear very quickly when the bubble bursts and the economy is faced with a financial crisis.

On the other hand, there could be a good shock that hits the economy. For example, technological progress in the export sector may increase people's incomes permanently. Such shocks do not usually result in systemic risk. A clear understanding of the source of shocks would prevent policymakers from squashing healthy developments prematurely. So policymakers would be well advised to devote resources and coordinate with each other to better understand the sources of shocks.

Among slow moving indicators that signal a buildup in systemic risk, credit aggregates are central but not the only ones. We find that simple indicators of credit growth that are relatively easy to track and measure across countries work pretty well. A threshold where the annual change in the credit-to-GDP ratio is about five percentage points historically misses only a few crises.

We should bear in mind that credit aggregates by themselves may not allow policymakers to distinguish between good shocks and bad shocks. In order to tell shocks apart, policymakers would need to rely on other indicators together with credit, such as foreign borrowing by the financial sector, overdependence of banks on wholesale funding, exchange rate movements and equity and house price movements.

In fact, asset prices and credit growth together form powerful signals. Using data on 36 countries over time, our analysis shows that when credit-to-GDP ratio is growing by more than five percentage points together with equity prices growing by more than 15 percent, the probability of a financial crisis on average is above 20 percent in the next two years. Note that this gives policymakers ample time to try to avoid a crisis.

Once risks build up, however, systemic events tend to materialize very fast; for instance, following the bursting of a house price bubble. Policymakers could look at high frequency market price based indicators, what we term as "near coincidental indicators" in the chapter. These indicators usually are good at informing policymakers that a crisis is imminent or has arrived.

Among the number of indicators we analyzed in the study, the one that incorporated the LIBOR- OIS spread and the yield curve performed best in predicting financial stress in the United States. These two simple variables could potentially be combined in some way to predict financial stress in other countries for which they are available.

We could not find a reliable indicator based on market prices which would alert policymakers to growing interconnectedness among institutions. This information would be useful for understanding the potential for domino effects in the event of a crisis. But at this point policymakers will have to rely on actual information on cross-institutional financial exposures to assess the potential for domino effects.

Our analysis shows that many macro-prudential policy tools could be universal in use but country-specific in design. Tracking the historical use of ten such tools shows that many of them, such as caps on LTV, loan-to-value ratios or debt service to income ratios have been effective in reducing the knock-on effects of financial vulnerabilities in the economy. This was true across countries at different developmental stages and regardless of whether they had a fixed or a floating exchange rate.

We also show that one other tool such as countercyclical capital buffers, capital requirements that increase when systemic risk goes up and decline when systemic risk materializes, could also effectively be used in both countries with fixed as well as flexible exchange rates. These time varying capital requirements work by reducing risk taking during the upturn and put buffers in place to cushion the downturn. However, we find they should be designed more conservatively in fixed exchange rate regimes with widespread foreign currency lending. This is because shocks tend to amplify movements in these situations.

In closing, this chapter moves the discussion on operationalizing macro-prudential policies forward by providing some workable ways to monitor and mitigate systemic risk. Thank you.

MR. ADRIANO: Thank you very much. We'll now take your questions. I encourage people watching on line to send your questions soon so we can receive them. Ian?

QUESTION: On page 30, there seems to be a contradiction in terms of investors being more risk-conscious and taking greater care in the risk management of their portfolio, and yet at the same time you're saying that the low interest rate environments are building pressure for riskier investments. How do you square that?

MS. KODRES: Let me take a first stab at that and then I'll let Eric chime in. I think what you're observing is in fact a conundrum in a way, that the crisis has involved a number of reassessments of risk taking, particularly in the areas of liquidity risk and credit risk. Certainly some investors were surprised to find out that sovereign entities were more risky than they first appeared.

At the same time, this low interest rate environment particularly for those types of investors that have fixed liabilities in the future becomes very painful because they need to earn enough money to pay out these liabilities, and so they're under pressure to increase risk in the sense of trying to increase return simultaneously.

At this point they're reluctant to do so only because they're still reeling from the losses that they experienced in the depth of the crisis. So at this point what we're observing is this sort of middle ground where they're still more risk-conscious. We see the pressures building for them to try to attempt to take more risk in order to earn enough return to offset these losses, but they haven't yet really done so effectively in terms of the data that we've seen and in terms of our survey.

I think it would be useful for those listening to look at the survey which is summarized in Annex 2.2. There are a number of qualitative questions that we asked in the survey about how they are approaching risk that might be useful to examine. One in particular is that they're expecting that this risk environment will continue, and they're expecting the low interest rate environment to continue, and so they are still sitting on the sidelines hoping that some of this uncertainty will pass and then they will be able to invest more efficiently. Eric, perhaps you want to add something.

MR. OPPERS: Just to add, I think one of the strengths of the chapter is that we have very detailed data on investment flows in and out of bonds and equities in individual countries. What we found in that analysis is there was a clear change in behavior at the time of the crisis, and that has to do, we think, with that increased risk consciousness of investors. And as we go forward in time from the time of the crisis in the data we don't see that effect fading. In fact, we think that that change in investment behavior is continuing and may be a more or less permanent feature of a change in investment behavior. And with that comes that pressure of the low interest rate environment; but as Laura mentioned, that changed behavior, greater risk consciousness, for now is prevailing.

QUESTION: May I just follow up on the points that you raised? So if there has been a reassessment of sovereign debt in terms its risk and there is this long term investment sitting on the sidelines, does this not have implications for the enormous debt overhang in Europe, particularly for Spain and Italy? And then just separately, and I think you may have addressed this, the euro has maintained its strength. Is that because of the short term liquidity from the leveraged investors?

MS. KODRES: Let me just note that in terms of the consciousness of risk and in terms of their consciousness of various sovereign risks, these investors are now pickier about the types of sovereign risks that they're willing to undertake. One of the features that we found in our face-to-face interviews was a much greater willingness to look at emerging market sovereign debt and that some of that debt now looks safer than some of the advanced country debt.

So we are seeing flows into emerging market debt, and those debt markets are actually holding up very well and are far more liquid than they used to be, and so that's a feature where we will see some flows into some different types of investments than perhaps we've seen before. In terms of the implications for the euro, I don't think we can comment on exactly why or why not the euro has strengthened. We do not have any implications from our particular study on that.

QUESTION: Please forgive me if I may just press that point a little. You address the issue implicitly in terms of the low interest rate environment, and one of the current wisdoms is that the euro has maintained its strength because of the interest rate differential. I guess if you could address the interest rate differential question in terms of Europe and the U.S., perhaps you could address it in that way.

MS. KODRES: Well, let me comment on what we did study in the chapter. We looked at the differential between the G-4 interest rates and those of the emerging market countries in which we executed our cross-country work, and those differentials don't matter, in the statistical sense, for the types of investor flows that we were analyzing. That doesn't mean, as Eric pointed out, that they don't matter at all, but they don't matter for this set of investors which tend to be unleveraged. I think that's an important counterweight, if you will, to the types of investment that are taken on by leveraged investors where that leveraged differential matters more. So we don't have an implication, if you will, for interest rate differentials vis-à-vis advanced versus emerging that comes out of our study.

MR. ADRIANO: We have a question on line from Lesley Wroughton from Reuters. She asks: Where are these riskier assets? Are you talking about investors looking further afield to Africa and Latin America? What does this movement to riskier assets mean for developing countries?

MS. KODRES: That's a very good question. What we sort of envision in terms of these riskier assets are assets that are more equity-like. We did see in our travels and you'll find in our survey an interest in what we call alternative investments. That asset class encompasses a number of types of investments, including commodities, private equity, infrastructure investments and these sorts of investments.

One of the characteristics of these sorts of investments is they tend to be a little bit less liquid, they tend to have a longer gestation period or a longer implicit maturity for them to earn their returns, and these are the kinds of investments in which those investors with so-called deep pockets that can withstand the ups and downs of the market are more apt to invest. These assets are riskier in and of them themselves in the sense that if you invested in them in a sort of solo type of investment they would show more volatility. But in the context of a portfolio, they actually lower the portfolio risk because they tend to be uncorrelated with the normal types of investments you would put in your portfolio such as debt and publicly traded equity.

So even though it appears that these are more risky from the outside, once you put them in a portfolio context they can actually lower the risk of the portfolio, which is one reason why these sorts of investments are so well suited to the types of long term investors that we were analyzing in our chapter.

MR. ADRIANO: Do you want to make any additional comments, Laura?

MS. KODRES: Let me just add a couple of things to help maybe in terms of how to read the chapters. In terms of chapter 2, I'd like to again sort of plug our survey. It's one of the first surveys that is quite comprehensive. We had a large list of contributors which are also listed in the annex. You'll see a lot of household names in the money management business in that list. We were quite pleased to find that many of these people were willing to share their opinions with us.

The survey goes into things like opinions about what risk will look like going forward. It asks questions about the usage of derivatives, which is not typically collected at any other source. We're hoping that at some point we can return and redo the survey, which I think would be very useful.

In terms of chapter 3, I think a useful chart to look at is Figure 3.3. Srobona mentioned that looking at multiple indicators simultaneously is a good clue as to what type of shock you're dealing with and how to cope with it in terms of mitigating systemic risk. There are a large number of sample charts there of the different kinds of indicators that show up before and after crises. We looked at a number of crises and looked at a number of countries to look at these particular types of data, and so I think that would be a useful starting point.

In terms of the benefits of the countercyclical buffer I would point to Table 3.3 and Figure 3.6. Table 3.3 shows you how that buffer lowers the volatility not just of GDP growth but also consumption and inflation and real credit growth, so that you can see that across the board for a number of types of variables this countercyclical buffer works fairly well to reduce procyclicality.

Figure 3.6 tells you how that works relative to not using any type of mitigating feature or mitigating policy. Again, it shows you very clearly that having a countercyclical buffer can be very helpful in terms of mitigating GDP cycles. I would point to those two areas in particular.

There's a section also of chapter 2 where we also essentially summarize some of the conversations that we had with a number of market participants, and I think there's a lot of nice contextual material in that section of the chapter. It's in the part where we look at the private sector developments.

MR. ADRIANO: Any further questions?

QUESTION: Just to clarify, you say on page 30 that increased variability of returns may make asset allocation more volatile, especially in less liquid markets. Would it be wrong to assume that you were referring largely to emerging markets, or do you have other markets in mind?

MS. KODRES: We were just looking at all markets in which the flows would flow in. If they flow in too rapidly, then that might be an issue in terms of making the market look very liquid in the short term. But if the markets are unable to sustain that sense of liquidity, then they might be more volatile if investors pull out. This is sort of a common feature of many markets that might not be completely liquid at the time that new people enter.

I think this goes to the point of the caller, too, about whether there are new markets say in Africa and in other places. Again, some of those markets are still developing and may be less liquid, and so an investor would need to be careful about their entrances and their exits in terms of not causing excess volatility.

MR. ADRIANO: If we have no further questions, we will wrap up this press conference. Thank you all for watching. I would like just to remind you of the embargo. The content of the chapters and of this press conference are embargoed until 11 o'clock eastern time. That's 11 o'clock Washington time. Thank you very much and have a good day.

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