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Transcript of a Press Conference on the Update to the October 2007 Global Financial Stability Report by Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department
October 16, 2007
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MR. MURRAY: I'm William Murray, Chief of Media Relations at the IMF, and this is an update of the IMF's October 2007 Global Financial Stability Report. Let me introduce the panel today. In the center is Mr. Jaime Caruana, the Director of the Monetary and Capital Markets Department. To Mr. Caruana's right is Peter Dattels, chief of the Global Market Monitoring and Analysis Division, and to my right is Laura Kodres, Chief of the Global Financial Stability Division of the Monetary and Capital Markets Department. Mr. Caruana will have some brief opening remarks. I encourage those watching via the Media Briefing Center to begin submitting questions.
MR. CARUANA: Good morning, everybody. On September 24th when we issued the latest edition of the GFSR, we spoke about how the global financial system was undergoing an important test. Today, I want to emphasize that while some of the worst turbulence may have subsided, the period of adjustment will take some time and setbacks are possible. Let me first briefly recap the causes behind the turbulence, as we explained last time, and then I will discuss the challenges and policy areas that will be the subject of the ongoing work.
As you know, mature financial markets have been experiencing significant turbulence in recent months, as the deterioration in credit discipline became more evident in the U.S. subprime mortgage market, and, to a lesser extent, in the leveraged loan market. Over the summer months, the performance of underlying loan collateral deteriorated sharply, and the U.S. housing market was weaker than expected. Rating agencies continued to downgrade a large number of securities backed by subprime mortgages, and spreads on these securities remain wide.
The complexities and lack of transparency in how such risks were embedded in structured credit products has created uncertainty about valuations, and also about the size and distribution of potential losses. These, combined with maturity mismatches in some structure investment vehicles, using asset—backed commercial paper, added more uncertainty, and in turn a deterioration in one sector into a more widespread liquidity and funding dislocation prompting, as we all know, central bank interventions. The good news is that these developments are occurring against the backdrop of solid global growth, especially in emerging markets, following the volatility experienced in late July, early August, equity markets, in particular, have regained their footing, reaching new heights in many mature and also, most importantly, in emerging markets.
Furthermore, investment grade corporate issuance has rebounded, volatilities across a range of markets have sub avoided after rising sharply during the peak of the turmoil, and it is important to note that most systemically important financial institutions had built up substantial capital cushions, and this is helping to absorb the losses.
Nevertheless, as I said at the beginning, the coming months are likely to remain challenging for many markets and institutions.
While the turbulence in money markets and credit markets may have subsided, the adjustment process will take more time, and it will not be costless. Some markets that seized up during the peak of the crisis have now only begun to show some signs of life. Rates on asset—backed commercial paper have receded by the outstanding stock has continued to decline, though at a slowing rate.
Some progress is also being made in distributing buyout debt and prices have firmed somewhat. But, again, the pipeline of buyout is debt is still large and continuing to closing credit channels under this cloud of uncertainty about the ultimate impact on balance sheets.
Importantly, also, funding markets have still not completely normalized. Term interbank rates remain elevated and credit concerns among banks are inhibiting normal intermediation. In our judgment, money market conditions will normalize only when there is greater clarity on how liquidity providers will handle their commitments to their off—balance sheet vehicles and how much of the off—balance sheets will migrate to bank balance sheets, or will have to consolidate with the balance sheets.
That brings me to the implications for the real economy, the transmission channels to the real economy. Even though the global economy entered this period of financial instability with generally strong fundamentals, financial market turbulence is expected to reduce global growth, and as you know, this will be discussed in detail at tomorrow's presentation of the WEO. And also, uncertainties have intensified.
Sustained pressure in the interbank lending markets and in credit markets will likely increase the cost and reduce the amount, and may hamper the distribution of credit generally. In the United States, tightened lending standards are likely to claim the overall supply of credit to the housing sector and weaker borrowers will face higher mortgage rates, including as adjustable rate mortgage resets, and there is a lot of resets coming.
Emerging market countries have weathered the turbulence quite well, as underlined last time and would like to do it again today. And that is attributable to the improvements in the macroeconomic polices and financial resilience. However, a few emerging market countries have experienced higher rates of credit growth that have relied heavily on international borrowing have experienced some stress.
Finally, the turmoil has highlighted areas of focus for both policy makers and private financial institution, to help ensure financial stability and mitigate the cost of adjustment in the period ahead. And, as you know, in our Chapter 1 of the Global Financial Stability Report we highlighted several areas that require increased attention. First, market developments since the height of the turbulence has shown that lack of transparency was a corrosive factor. Recent developments have highlighted that confidence can easily be shaken when losses are unknown and off—balance sheet commitments are transparent. So one lesson from this episode is the need for greater disclosure of the links between systemically important financial institutions and off—balance sheet vehicles.
Second, financial innovation has enhanced the ability to transfer credit risk away from banks, but it has also altered the incentive structure for borrowers, lenders, rating agencies, investors, and others, in ways that may have contributed to the relaxation of credit standards. Generally, the checks and balances throughout the supply chain of structured products will need to be carefully reviewed.
Third, the rating methodology of complex products will need to be reevaluated, as we have said in previous reports, differentiated rating scales for structured products could alert investors to the inherent liquidity and market risks. Likewise, investors use of ratings should not be seen as a substitute for the due diligence and appropriate risk management that is expected from them.
Fourth, the evaluation of complex products in illiquid markets require more consideration. This period of turbulence has demonstrated that continuous market liquidity is not attainable for all securities. And in addition, the way market illiquidity has evolved into funding illiquidity also calls for a more robust funding strategy in financial institutions.
Finally, the fifth, is other risk management issues, and the one we underline is the relevant parameter of risk consolidation for banks that has proved to be larger than the usual accounting and legal parameters. Some banks have needed to step in and support affiliated entities such as these 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 and supervisory frameworks so that investors are encouraged to maintain high credit standards, and strengthen risk management systems, both in good times and as well as in bad times, and at the same time they must be careful not to discourage financial innovation. Private financial institutions must do their part to ensure that credit discipline can be better maintained through the credit cycle. In this context, advances in risk management methods for complex instruments will play an important role.
As we go forward, the IMF will continue to advise on the appropriate policy response in collaboration with national authorities and international fora. This experience will also help inform our advice to emerging markets as they become more integrated into the financial system, and help them to build on, as the Managing Director said yesterday, build on the success, learn from the success they have had with a lot of these policies.
Let me just mention that in the Global Financial Stability Report there are another two chapters, Chapter 2 examined the extent to which market risk management methods may have encouraged more risk-taking during the benign period, hypothetically resulting in a more rapid withdrawal from risk assets when conditions change. I think it is an interesting, more theoretical chapter that perhaps you should have a look at.
Also, Chapter 3 examines the rapid capital inflows experienced by some emerging market countries, and the role institutions and financial markets can play in maximizing the benefits of such flows, and best dealing with their potential volatility. The results show that over the medium term greater equity market depth and liquidity, and financial openness, positively influenced the level of capital inflows while more financial market openness reduces the volatility of inflows. There are other lessons, and I think it is also a very interesting chapter.
So, let me conclude by saying, and before I open the floor to questions, let me note that we expect to again update this edition of the Global Financial Stability Report around January, and that the new edition of this GFSR, the full edition, will be published in the spring of 2008. Thank you very much for your attention.
MR. MURRAY: I would like to note, Mr. Caruana referred to remarks yesterday by the Managing Director. For those of you who aren't familiar with those, there is a transcript of those remarks on the home page of the Fund's website. You can go visit that after this briefing.
Let me open the floor to some questions.
I will give you time to get to the mike. If you could identify yourself for the transcript and for those watching.
QUESTION: I wonder if you could give us your opinion on the initiative from some of the major U.S. banks to create a fund to sustain, the initiative to announce yesterday, and if you think it would be advisable to replicate this initiative, say, at the European level, or even at the global level? The other question I appeal to your former task of head of the Basle committee, as well. I wonder if you have any assessment or any idea on how Basle should proceed considering that the ratings agencies have been under serious scrutiny, if you think there should be a rethinking of the role in the new Basle framework?
MR. CARUANA: On the first question, this initiative, I think we don't know the details enough, but in principle I think private initiatives that bring private money to help and support valuations and support and ease market tensions should be welcome. But, again, to make a full assessment of that, we need more details than we have at this very moment, and probably this is because it is not known yet all the details. Again, I think the private sector has an important role in easing these market tensions, in providing liquidity and providing bids for these trades that are difficult to value. If that is the role that these kind of funds are playing, I think it should be welcome. The final assessment, we can make it when we know all the details, and in terms of replication in other areas, again, I think private initiatives that help to ease market tension can be welcome, in different markets.
On the Basle initiative, I guess you are talking about Basle II, and it will take me a very long time to give my views. Let my say just a few things.
First, I think Basle II is a much better framework than the present system. It has been started to be implemented in some areas, but it is not fully implemented. I think it would be a positive development that this implementation is moved forward. I think it is a much better system. It is a much more comprehensive and it is a risk—based system, and incentives contained in Basle II would have helped to mitigate these kinds of situations. I think if we had had Basle II a few years ago, the situation would have been a better situation.
I think you asked for a very specific question, which is the ratings in the Basle II. As you know, ratings play a role, because they play a role in the real financial markets. And, Basle II tried to take the best practices in the market, but Basle II brought all the incentives to move toward internal ratings, and these internal ratings approach are a very, very important part of the Basle II. So it is not necessary to have these rating agencies in terms of deciding risks. It can be, banks can use their internal models to do that. In that sense, Basle II is a new kind of regulation, that it would be much better adapted. Let me give you one specific example. Under Basle II there would have been capital charged for these backup lines that back up these conduits. That would have reduced incentives for this kind of product. Banks would have had to evaluate much better what were the risks involved in this kind of product. So, I think, again, Basle II is a capital regulation, it is not a liquidity regulation. So, it is not something that was intended to address this kind of situation. This has been basically a liquidity one, but the incentive structure in Basle II would have been much better in terms of moderating some of the incentives that we have seen throughout this process. It would have been better, it would certainly not have been the full solution. But, I think it would be also advisable to move forward implementation of Basle II.
MR. MURRAY: This gentleman in the front and then the lady in the back.
QUESTION: I would like to know, let's say, do you think that the patient is still in the intensive care room, or is in the immediate therapy?
MR. CARUANA: I think the intensive care room was basically August and perhaps early September. But I think the situation has some elements of fragility that deserve really careful monitoring. That would be my description. So, the situation has improved significantly, in some areas. But, still, as we were saying here, the adjustment process will require some time. It requires time because it is a question of confidence and it is a question, also, of digesting in the balance sheets some of these conduits. So I think it requires time, but the situation as it was in August and perhaps early September, has improved significantly from that moment.
MS. KODRES: Probably useful to note that the markets that have had the most trouble adjusting are the ones in which the uncertainty about information is the highest. So, areas that are more well known and in which information flows are more deep, those markets have recovered more quickly. .
QUESTION: I want to question something, in Mexico, like in all emerging markets there is an openness in the capital side of the balance sheet, especially the participation of the global groups, CitiGroup, J.P. Morgan, etcetera, in this economy, and worries about the possibility that the credit crunch could affect the decision—making process about distribution of the capital all around emerging markets, especially for example, in Mexico. They have a stance for Mexico, they have a stance for Brazil, for Argentina, something like that. This credit crunch could crunch the credit quality in our countries?
MR. DATTELS: In our discussion with major banks, there has been no indication of any pull back in terms of lines of credit or activity in Latin American markets, whatsoever as a result of this. More generally, on emerging markets side, where we have laid some concerns has been more in emerging Europe to the extent that some of those banking systems have relied more extensively on international financing to support their credit growth, and that is where we see some stresses.
QUESTION: You mentioned that there are parts of the financial system that are still not working, and I wonder if you could elaborate on that, what are the weaknesses right now that you see in the financial system? And also, given the fact that there are markets that don't function well yet, at the same time the shares have increased very drastically in this period, so do you see that as a potential problem in the sense that you have shares increasing very rapidly when the general financial market is not fully functioning? Do you foresee that there will be a correction in the future, for example?
MR. CARUANA: What was the second part? I missed the second part.
QUESTION: The fact that shares have recovered quickly, and so you have a system that doesn't work properly whereas the prices have increased very drastically.
MR. CARUANA: As I said, there are a number of elements that have improved since the top of the turmoil which was in August, where the liquidity issues were more difficult to manage. I guess that still in the interbank, in the term lending, in the interbank, in the 30 days, etcetera, is not completely normalized, and there are also some credit markets, especially the asset—backed commercial paper that is still not, are not working properly. In addition to that situation, the pricing of risk is much higher, and this is, and you can see that in basically all over the different markets. So, you will find that the tightening of financial conditions, it is now much higher than before the crisis. So, there are all these elements that contribute to what I said, that the situation is not completely or fully normalized and adjustment is going to take sometime. I will ask Mr. Dattels to expand a little bit on that. Let me try to answer the other question.
I think what we have seen in the shares in the equity markets is perhaps a reflection that the, I would say, the extreme event, meaning the extreme negative event, the extreme probability of a recession, is now considered by markets to have a less probability, and I think it is a better understanding on the part of the markets that these extreme negative event has less probability that has perhaps fueled equities. In addition to the fact that I think markets understand now that central banks are on top of the situation and they understand what it is needed to do when there are liquidity issues, pressing liquidity issues. So I think now, part of the uncertainties that were in August of been improved, have improved, at least in these two areas. I think this has reflected in equity markets. In some cases, these equity markets may start to see some stretching of the valuation, could be a little bit stretched, than is something the markets will continue to evaluate in the future. I would like Mr. Dattels to perhaps expand on these issues.
MR. DATTELS: Just on, in terms of, as Mr. Caruana mentioned, the clogging of credit channels and impact on the economy, what we see is that, I should mention we're distributing a chart pact along with this press conference and we highlight some of these elements, what you see is a very strong rebound in investment grade corporate issuance, so corporations have been able to extend access financing in terms of replacement of commercial paper borrowing and other costly forms of borrowing. We're seeing some loosening in the leverage buyout area. However, this overhang of LBO pipeline remains, and we'll have to wait to see how that goes. This is clearly reflected in very low high-yield issuance, so it is perhaps the weaker grade corporates which will experience a higher cost of funds.
And, in the asset backed area, of course, as a result of this price, this remains fairly much more lagging and will take sometime to clear.
MS. KODRES: Probably worth noting that at the very beginning of this episode corporations in most countries were doing very well, debt equity ratios were relatively low, cash flows were robust, profit margins were still quite fat. And so they entered the period really with an ability to not have to go to markets to fund themselves as they had enough cash to continue to do any investment that they preferred. So, I think that really has helped stabilize particularly the high quality corporations in terms of being able to borrow when and if they need to.
MR. MURRAY: We have a few questions on the Media Briefing Center, which I'm going to turn to briefly here, and I would recommend journalists watching on the Center to submit questions.
This question is actually one that I'm probably going to punt to the WEO tomorrow but for the sake of transparency I'll read it for everyone's benefit.
"Yesterday the Managing Director said we can expect a deep depreciation of the U.S. dollar. Do you agree with the statement and do you think the weakness of the U.S. dollar could affect the financial markets?"
MR. CARUANA: I think you were right. This is a good question. I will not argue with it. I think it is a good question for the WEO.
MR. MURRAY: That briefing is at 9 a.m. tomorrow in the same room. Please tune in, then.
Additionally, we have a question from a journalist in Germany. He wanted to basically know when will this crisis, the current financial subprime mortgage crisis, play out? What is your timeline?
MR. CARUANA: Obviously, it is impossible to answer these questions, but we are thinking more in terms of weeks and months than in terms of days. I think it would be very important if we want to speed up the process that financial institutions to provide all the necessary information, about what are the situation. I think the more additional information is coming, this will help a lot in clearing this sense of uncertainty that is still surrounding some of these markets, especially the interbank market. So, again, making clear what are the conduits, what they are going to do with that, how they are going to be absorb, how they are going to consolidate the positions, what are the risks they have taken, that would be helpful. What we are seeing is that, even if there are losses, when you openly have to declare and present the losses, this is even better than, this bad news is even better than uncertainty. Again, giving more clear and transparent communication about the real situation of financial institutions certainly will help to make this period of transition shorter.
MR. MURRAY: Any questions from the room here?
Yes, the gentleman on the right.
QUESTION: You mentioned before that the recovery was slower, where there was more uncertainty about information. Are you referring to specific segments of the credit market or specific countries?
MR. CARUANA: Certainly, what I have been talking about information, I was not talking about countries. I was talking about markets, and I was talking about what I have just referred to, all the necessary information that is vital for markets to get the valuation process right. And, this has not been easy. And, this has not been easy for different reasons. The uncertainties have come from different sources, one is the valuation of complex products, which is a very difficult topic that would require additional work, as we have said. And, also, the positions and the uncertainties about the balance sheets of the banks that will have to absorb or consolidate some of these conduits, and these two areas are areas where additional information or transparency would be helpful. So I was not referring to countries. I was referring to markets.
QUESTION: I was wondering if you could characterize some of your discussions you have had with these systemically large financial institutions when you tell them you want them to be more transparent? What kind of response have you been getting?
MR. DATTELS: I think that the kinds of responses you get is that there is a much greater understanding of the need to, for transparency, and I think the challenge is how best to bring that about to investors. Particularly in terms of the clarity of disclosure. And, the timeliness of that disclosure. I think it is not a question of whether that is garage thing or a bad thing. I think that it is well recognized it is a good thing. It is a question of modalities, how to bring that forward. And, I think for the industry as a whole, as a whole, in terms of bringing it about in a uniform and clear way.
MS. KODRES: In the context of Chapter 2 where we evaluate a number of risk management practices, we spoke to a large number of systemically important institutions, and one of the features that we noticed that would be very important in this regard is for them to present more about how they manage their risks. Typically in their disclosures they do provide some information about their value at risk models and various exposures in various areas, but we would like to encourage them to discuss more specifically what kinds of stress tests they do in order to adapt to various large shocks, and how they intend to manage liquidity a bit better. So, we found that the areas that they were still relatively weak are in terms of their liquidity risk management practices, and some specifics about how they would manage large, perhaps fairly improbable, but still possible types of large shocks. And that is our recommendation in Chapter 2 that you can look up and cite if you would like to.
MR. CARUANA: If I may add something, there was a question about Basle II. I would like to say that this is another example, for example, the pillar three of Basle II requests banks to disclose much more information in terms of their risk management systems, qualitative and quantitative and especially on the risk transfer, when they transfer these risks. And, I think if you have a look to this pillar three, you will find that it is a much better adapted to the needs that are today required. So as we have been saying, it is important to move forward some of these regulations that are in the pipeline, or early implemented, and perhaps to be more careful about bringing new regulations, where things need to be examined very carefully, because the complexity of all these issues cannot be solved with simple regulation. So, that was part of our recommendation in the GFSR.
MR. MURRAY: Thank you, Mr. Caruana.
We will take a few more questions.
QUESTION: This is in reference to a lot of discussions in your report on the sovereign wealth funds. Our region is known for a lot of sovereign funds. Is there any move, from the IMF side, for an initiative to regulate these funds as far as the transparency is concerned?
MR. CARUANA: As far as sovereign wealth funds, what we are doing is to analyze them in the same way that we analyze other big institutions, investors, because we, in order to understand capital flows, in order to understand the linkages between different countries, we need to understand how different, big investors do work, and take their decisions. And in the same way that we analyze other investors in the same way we analyze hedge funds and other funds, we want to analyze this group of investors which is very diverse, and cannot be categorized in one category, although we put this name to all of them, but it is really very diverse. But, it is growing in size, and therefore, it is, we will monitor in the same way that we monitor the rest of the financial markets, what they are doing. We are not thinking in terms of regulation.
QUESTION: Do you think the U.S. economy will affect China's economy? And signal that China's economy is going to be hot such as the stock market is going higher than before? So, what is your opinion on China domestic economy? Thank you.
MR. MURRAY: A very good question. I appreciate you asking this. This is in line with our briefing tomorrow morning here at 9 o'clock on the WEO. So Mr. Johnson, the Economic Counselor at the Fund, will get into global forecasts, including country-specific forecasts, particularly China. So, please come back tomorrow, and pose that question. It is a legitimate question to be asking.
Do we have any others related to the GFSR?
Okay. I think we will wrap up.
Again, a reminder that the text of the GFSR is available on the Media Briefing Center. There are hard copies here in the press room for the 2007 Annual Meetings. We will brief here in this room at 9 o'clock tomorrow morning on the WEO, there are also video clips on our NewsMarket distribution system regarding the GFSR.
I look forward to seeing you tomorrow. Thank you.
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