## 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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## Bibliographic details
- Published: May 30, 2007

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### 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.*

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## References

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_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp053007_