Transcript of a Press Conference on the October 2007 Global Financial Stability Report, Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department, Laura Kodres and Peter Dattels, Division Chiefs in the Monetary and Capital Markets Department, Washington
September 25, 2007By Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department, Laura Kodres and Peter Dattels, Division Chiefs in the Monetary and Capital Markets Department.
September 24, 2007
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MR. MURRAY: Welcome to the Global Financial Stability Report press conference. Joining us today is First Deputy Managing Director John Lipsky, who will have some brief opening remarks before turning the table over to Jaime Caruana, IMF Counsellor and Director of the Monetary and Capital Markets Department. Joining Jaime Caruana is Laura Kodres, the Chief of the Global Financial Stability Division of the IMF, and Peter Dattels, the Chief of the Global Markets Monitoring and Analysis Division. Thanks to you for joining us. Now let me turn the floor over to Mr. Lipsky.
MR. LIPSKY: Thank you, Bill. It's a pleasure to welcome you to the launch of the latest edition of our Global Financial Stability Report, or GFSR, as we call it. The GFSR, together with the World Economic Outlook document, form our semi-annual flagship publications.
Typically, the Fall editions of these publications are released to the public at the time of our Annual Meetings. The 2007 meetings will take place here in Washington D.C., but beginning on October 20th, about a month later than usual. However, we finalized work on the GFSR already in order to report to our members on the latest financial market developments, and we decided, in turn, to make the report public at this time. It's our hope and intention that the latest edition of our GFSR will provide timely and accurate analysis of the latest events.
Moreover, it is our goal that the report will help to increase understanding of the sources of the recent market turbulence and to aid in the development of remedial action. Recent developments have underscored once again that capital markets have become globally linked. We also have been reminded that financial markets increasingly influence economic developments and that the impact can be felt rapidly.
We understand that financial markets heightened sophistication in global integration has contributed to the unexpected favorable global economic performance of the past five years. At the same time, we understand that market imperfections can impede economic progress.
That dual prospect is one reason why the IMF is bringing financial sector surveillance to the center of its work and why financial sector work is a key aspect of the IMF's bilateral and multilateral surveillance responsibilities.
We're very proud of the work of the Fund's Monetary and Capital Markets Department as exemplified in the GFSR. Previous editions have explained the latest advances in financial market developments. They also have pointed clearly to potential risks and concerns. The latest edition of the GFSR continues in this tradition by providing a forward looking assessment of areas that policy-makers and market participants should consider in order to enhance market efficiency while bolstering financial stability.
I'll end by reminding you that the GFSR represents only one aspect of the work of the Monetary and Capital Markets Department. The staff of this department participate in country missions, in various aspects of multilateral surveillance, in extensive technical assistance, in conducting the IMF's financial sector assessment programs, and in many other ways.
With that said, I'm happy to turn the proceedings over to my friend and colleague, Jamie Caruana, Counsellor and the Director of the Monetary and Capital Markets Department, and his colleagues. Thank you very much for coming and thank you for your work. Thanks.
MR. CARUANA: Thank you, John. Good morning, everybody, thank you for joining us today for the release of our Global Financial Stability Report. I would like to spend a few minutes drawing out our main conclusions.
Following an extended period of exceptionally favorable financial market conditions, the global financial system has undergone an important test, and the test is not over yet. The implications of this period of turbulence will be significant and far reaching. To strengthen the financial system against future strains, it will be important to draw lessons about the market practices that need to change, and the regulatory frameworks that need to be revised.
Our earlier report identified lax credit discipline in several markets as a risk to financial stability. Credit deterioration in the U.S. sub prime mortgage market and the fall in the ratings of associated structured credit products have led to a dramatic repricing and a retrenchment from risk.
Uncertainties about losses on structured credit securities and their location and the difficulty to find reliable valuations and buyers in illiquid markets have led to a pronounced disruption in credit and money markets.
I will not describe in detail all the processes and mechanisms behind this episode, which is covered in the report, but I would like just to highlight the unique combination of three elements in this turmoil. The first is the original source of the turmoil; the second is a new element, and that is the complexity; and the third is an old, perhaps traditional element, which is the maturity mismatch.
The origin of the turmoil was the relaxation of credit discipline in a number of markets, mainly in the subprime mortgage market in the United States. It is worth recalling that this relaxation happened against a backdrop of a period of low interest rates, low volatility, and rapid build-up of leverage in some segments of the financial system. And also, on many occasions concerns were expressed about the mispricing of risks by markets.
The new element has been the complexity of structured products and the securitization process more generally, that is, complexity in the valuation of products such as asset-back securities and collateralized debt obligations, and complexity of their ratings and their use by investors.
The old element is a traditional maturity and liquidity mismatch, which on this occasion has materialized mainly in some conduits and structured investment vehicles. These entities were mainly financed by short term commercial paper, backed in some cases by contingent liquidity lines from banks, and they invested in longer term structured products.
And when the confidence in the quality of these products and their ratings dropped, markets dried up and funding was squeezed. Positions that were supposed to be off the balance sheet of the banks threatened to move "on balance sheet."
The unique combination of these elements transformed a repricing of credit risk and deleveraging into a more widespread liquidity dislocation and funding stress in mature financial markets. Central banks had to inject significant amounts of liquidity to facilitate the orderly functioning of money markets. And also, given the uncertainty and potential impact of these dislocations on the economy, the Federal Reserve reduced policy rates 50 basis points, and the ECB maintained rates.
Thus, compared to five months ago, we now see higher financial stability risks and also that financial conditions have worsened, have tightened. The good news is that all of this is occurring against a backdrop of a long period of solid global growth, especially in emerging markets. And this sustained growth over the past few years has also allowed most systemically important financial institutions to build up sound capital ratios.
Nevertheless, the longer the liquidity and credit problems continue, the larger will be the likely impact on the global economy. The coming months are likely to remain challenging for many markets and institutions. Credit conditions are not likely to normalize soon, and the adjustment process may be protracted, and it may affect not only prices, but also the availability of credit.
From the point of view of financial stability, while it is too early to reach definitive conclusions, we highlight in Chapter 1 several areas that require increased attention.
The first is the important role of information and transparency. Accurate and timely information about underlying risks, the way they are managed, valued, and accounted for are a critical component of market's ability to properly differentiate and price risks. Equally important, greater transparency is needed on the links between systemically important financial institutions and off-balance sheet vehicles.
Second, while financial innovation, such as securitization and structured products, has enhanced risk transfer and broadened the scope for risk sharing, it has also altered the incentive structure in ways that may have contributed to the relaxation of credit standards. Generally, the relaxation between the checks and balances throughout the supply chain of structured products will require study and possible strengthening.
Third, while ratings and rating agencies will continue to be fundamental components in the proper functioning of financial markets, questions have been raised about the rating methodology of complex products.
We have said in previous reports that differentiated rating scales for structured products could alert investors to the inherent liquidity and market risks, and therefore, the scope for more rapid rating changes. Likewise, investors' use of ratings should not be as a substitute for due diligence and appropriate risk management. Fourth, the valuation of complex products in illiquid markets requires more consideration. More work on best practices in liquidity management is necessary. The way market illiquidity has evolved into funding illiquidity also calls for more robust funding strategies in financial institutions.
Fifth, the relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting and legal perimeters. Some banks have needed to step in to support affiliated entities such as conduits, special investment vehicles, and asset management subsidiaries.
So all in all, policy makers now face a delicate balancing act. They must reevaluate prudential frameworks so that investors are encouraged to maintain high credit standards and strengthen risk management systems in good times as well as in bad times. And at the same time, they must be careful not to discourage financial innovation.
Before moving to Chapters 2 and 3, let me say a few words about emerging markets. Emerging markets have weathered this episode of turbulence well so far. Many countries have benefited from improved fundamentals, better policy framework, and larger financial cushions. But, as we have pointed out in previous GFSRs, there are also pockets of vulnerability that need to be monitored, and particularly, again, as we have highlighted in previous editions, in countries where foreign borrowing has supported rapid credit growth.
Let me go now to Chapters 2 and 3. Chapter 2 examines the extent to which market risk management methods may have encouraged more risk-taking during the benign period, perhaps resulting in a more rapid withdrawal from risky assets. This chapter uses a simulation technique to show that when a number of firms use similar risk management techniques mechanistically, their actions can amplify volatility and lead to "fire sales" of risky assets during a period of stress. We are, in fact, currently seeing some behavior along these lines as margin and collateral requirements have been tightened as volatility has increased.
Our analysis suggests that while risk management techniques have improved greatly over the last decade, more stability could be attained with greater diversity of risk management techniques, including stress tests tailored to their specific business model. Even more important to enhance financial stability would be a diversity of types of investors and strategies so that positions are differentiated, making a simultaneous unwinding of risky assets less likely.
Chapter 3 examines the rapid capital inflows experienced by some emerging market countries, a six fold increase in five years, and the role institutions and financial markets can play in coping with such flows. While many take for granted that deep and liquid financial markets help to better intermediate capital flows, Chapter 3 tests this view in some detail.
The results show that over the medium term, greater equity market depth and liquidity and financial openness positively influence the level of capital inflows, while more financial market openness reduces the volatility of inflows over the medium-term. In addition, some indicators of institutional quality, such as rule of law, regulatory quality, and control of corruption, are associated with lower volatility of inflows.
The main message from a specific examination of five emerging market countries in this chapter is that there is no common set of financial policies that help to deal with capital inflows. Each country is at a different stage of development and has different options available to deal effectively with these inflows. Generally, though, policies that encourage financial market development over the medium-term will likely cushion the financial system from potentially destabilizing effects of abrupt capital outflows.
Thank you very much. This is the summary of the present edition of the Global Financial Stability Report, and we are now available for your questions.
MR. MURRAY: Thank you, Mr. Caruana. Let's open the floor to questions.
QUESTIONER: I have two questions. I was wondering how long will it take for the markets to kind of digest the current turmoil, to test how long it's going to last? And, how big it's going to be, according to you, the impact on growth of this turmoil, how many percentage points would you foresee?
MR. CARUANA: You have noticed that we have not mentioned a specific period of time. As you said, it will require some time for the financial system to digest and to be able to value and reprice all these complex products. In some cases it will be necessary for the banking sector to absorb some of these positions in their balance sheets.
So, this is going to take some time. I think it will not be productive to try to calculate how long it will be. As I said at the beginning, we are still in the process, this has not ended, so it's very difficult to say, and I will not risk to do that. In terms of growth, there will be a revision of growth rates. These will be explained extensively when the World Economic Outlook is presented in the next few weeks. It is not really the subject of the Global Financial Stability Report. What we have said is basically that risks have increased, that the reduction of growth will be more important in the United States, because the tightening of financial conditions will join the housing issue in this economy.
In general terms, the tightening of financial conditions will be felt in the global economy through basically two hands: One, the pricing of risk will be higher, therefore, the financial conditions will be a little bit more difficult. But there will be also an effect through quantities: the availability of credit, while this digesting that we were talking about is occurring.
So, the longer that this takes, the higher the possible impact on growth. But again, the IMF is still working on that figure, and these figures will be presented when the World Economic Outlook is presented.
MR. MURRAY: Just for the record, the World Economic Outlook forecast will be published on October 17th, so you can mark that on your calendars. There will be a press conference here at IMF headquarters. We'll take a question from the Media Briefing Center: What role does the recent depreciation of the U.S. dollar play in global financial stability?
MR. CARUANA: The dollar depreciation is, of course, the result of many forces. And part of what we have been seeing is the weakness in the U.S. economy that is behind this movement in the currency.
From the point of view of the Fund, which has been following this issue of the global imbalances, we have said on many occasions that the adjustment on the effective rate of the dollar was part of the necessary adjustment.
At the same time, it would be more efficient if that would happen in relation to the currencies that perhaps have not moved. And a big part of the adjustment in the dollar has been occurring against the euro. There are other currencies that perhaps it would be better if they can adjust more in relation to the dollar.
QUESTIONER: I have a question on this issue of adjustment. I wonder if you can elaborate on that. I mean, what is adjustment? How are the markets going to adjust? And the second question will be on your recommendations for policy makers. What do you want them to do, specifically the Federal Reserve and the European Central Bank? What kind of monetary stance do they follow now?
MR. CARUANA: I hope that you find the description of the process, which has been a complex process and, as I said at the beginning, has involved new elements and old elements, very well explained here.
One of the elements that I was underlying was the complexity of some of these products. This is the new element, and at the same time, it's part of the necessary adjustment. It has been difficult to value these products in a market that has proved to be illiquid. And this valuation of products will require some time. It will require banks in some cases, as I said before, to absorb part of these positions, and they will have to work in terms of what is the proper valuation.
Some of these positions could be sold in the markets. And I don't think it is for us to decide how this adjustment is going to happen. They will have to go through the whole process of what is the best way to move forward. But it would require some time to do this process of adjustment. On policy, first, it is perhaps a little bit too soon to draw the final conclusions on policy. Even, it may be too soon to ask all the right questions.
I think we have made an effort to identify five areas of policy that require more attention. On your question, what is policy in terms of monetary policy of the major central banks, I think we have to analyze what are the implications of this disruption and of this turmoil in the economy. That's the key element, to analyze the potential impact on the economy.
And what this turmoil is bringing is basically two things; one is uncertainty, much more uncertainty on what will be the outlook of the economy, and also the potential impact through the challenge that I described previously, which is the tightening financial conditions in prices and perhaps in the availability of credit.
And the combination of this with other processes that were already in the global economy, like, for example in the case of the United States, the situation of the housing market, will give room for the central banks, in this case the Federal Reserve, to think in terms of monetary policy. So this is, in my view, not going to conflict too much with monetary policy, in the sense that this impact will be, to some extent, deflationary. This will provide with some room. And I guess it's the same for the ECB. But in both cases, they will have to be very attentive to inflation and to data. I think more and more they will have to analyze what is the data that will be coming in the following weeks and months.
As I said, the fact that there will be tightened financial conditions is something that we already know. The impact is difficult to tell at this very moment. But little by little, we will get more additional information, and they will have to act according to this kind of information that will be available in the future. It will be on the basis of the economy, within their frameworks of decision, and it will be very data-dependent in the future.
MR. MURRAY: We received a query from Bangladesh specifically about the state of the Bangladeshi financial system, but it raises the question in general about our current views on the status of financial stability in developing countries and also in emerging economies.
MR. CARUANA: As we said on this occasion, emerging markets, developing markets are not the focus of this turmoil, but they are affected by it. It is obvious that the retrenchment of investors from risk, the repricing of risk, and the less appetite for risk will have an impact in these markets, I would say in lower financial stability. These will be mainly the channels. And, of course, depending on the impact on the global economy, this will be an additional channel that each of the countries must analyze and must work through to develop the aggregate strategies.
So they are not at the center of this turmoil, but they will be affected through these channels. It will be the financial channel, the real channel, and perhaps the confidence channel will be a third channel.
QUESTIONER: When you talk about transparency and information, what is your assessment of the amount of disclosure we've had from some of the global banks so far, and what would you like to hear from them going forward in terms of their exposure to some of these instruments?
MR. CARUANA: First, transparency has been at the center of this turmoil. Second, I would like to see that the information that is in the third pillar of Basel II would be properly implemented. I think there has been a lot of work preparing this kind of information, and I think this would be a very good and positive measure. And it would be good because in this framework, there is a lot of additional information in terms of disclosing the risks that the banks have. So what we need here is risk-based information, and specifically, risks in the process of transferring these positions, risks outside of the balance sheet.
Here accounting issues are very important, and also very important is to disclose quantitatively and qualitatively the way these risks are managed and the way these risks are transferred from balance sheet to other conduits or to other buyers.
Also, the interrelationships of the financial institutions with off-balance vehicles is very important.
I think it will be important today that financial institutions spend a tremendous effort, and we understand that this is not easy, because they are very complex products, to disclose what really are their positions. I think they are doing it. But it will be important to move in that direction.
And what are the relationships with off-balance sheet vehicles that they may have. So, liquidity lines, how they have managed these risks, what are the underlying risks, I think these are the elements that need to be disclosed.
QUESTIONER: Do you think that this turmoil will result in a less complicated financial system? And one more question: I see that you wrote something about soverign wealth funds; do you think they have been a stabilizing force or a destabilizing force in this turmoil?
MR. CARUANA: No, I don't think so, and I hope that these products do not disappear. I think there are many positive elements in the innovation that has happened over the past few years. But we have identified, and this turmoil has shown that there were some flaws and that some practices need to be changed.
We have tried to outline some of these areas that need to be rethought. The incentive area is a clear one, to what extent this "originate and distribute" model has created incentives, not to put enough analysis on the credit worthiness on the underlying positions in these products.
So, no, I don't think it will disappear, but I hope that practices will improve, and that may effect the speed at which these markets continue to develop. But I think it will be healthy for the market if we draw the right lessons. So it would be very important. And we also signal that it is very important to strike the right balance so that we correctly analyze what needs to be changed.
At the same time, we keep the incentives for this innovation to continue. This innovation has facilitated the access to finance to many sectors of the economy, and so it has many positive features. I don't think these will disappear. But it will be handled in a different way, in a better way, and probably growth will not be as explosive as has been in the past few years.
About sovereign wealth funds, yes, we are following them. These are investors that are gaining importance, and I will say that we are still in a kind of learning mode. These are relevant investors in terms of size, and we are following them, but it is too soon to say much about their behavior, and we don't think that they have played a special role in this kind of turmoil.
I think there are many other elements that have much more relevance in this turmoil. We will continue to monitor them in a positive way, the same way that we monitor other financial institutions and the way they act in the market.
MR. MURRAY: We have a question from Mexico. Mexico has a growing internal debt led by pensions. This problem is deepening the fiscal deficit. Is Mexico more exposed to global risk in this condition?
MR. CARUANA: I'm not sure that I understand completely the question. I think emerging markets have improved in many ways. One of the ways has been better debt management, and Mexico is an example of this. Also, by developing local markets. We think this has been a positive development. But it is true that, at the same time that it is positive, it raises additional questions. Investors in these countries are now exposed to additional risks, and there may be volatility in the flows. And this is an area that we will continue to monitor. I think deep markets contribute to a better management of the fiscal constraints of a country, and fiscal management and budget management of a country. So we think that this is all in all a positive direction to work for emerging markets.
MR. MURRAY: Let me also remind everyone that on October 16th, here at IMF headquarters, the Global Financial Stability Report will be updated by Mr. Caruana and his team from the Monetary and Capital Markets Department. That update will come in as a precursor to the 2007 Annual Meetings which will convene later that week.
I would like to thank everybody for joining us.