Global Financial Stability Report: Monitors global financial markets and spotlights emerging risks!

The Global Financial Stability Report (GFSR) assesses global financial market developments with a view to identifying systemic vulnerabilities. By calling attention to potential fault lines in the global financial system, the report seeks to play a role in preventing crises, thereby contributing to global fi nancial stability and to sustained economic growth of the IMF’s member countries.

The analysis in this report has been coordinated in the Monetary and Capital Markets Department (MCM) under the general direction of Jaime Caruana, Counsellor and Director. The project has been directed by Hung Q. Tran, Deputy Director; Peter Dattels and Laura Kodres, Division Chiefs; and L. Effie Psalida, Deputy Division Chief, all of MCM. The report benefi ted from comments and suggestions from Christopher Towe, Deputy Director, and Mahmood Pradhan, Assistant Director, both of MCM.

Shannon Bui, Norma Cayo, and Christy Gray were responsible for word processing. David Einhorn of the External Relations Department edited the manuscript and coordinated production of the publication.

This particular issue draws, in part, on a series of discussions with banks, securities fi rms, asset management companies, hedge funds, pension funds, credit rating agencies, fi nancial consultants, and academic researchers, as well as regulatory and other public authorities in major fi nancial centers and countries. The report reflects information available up to September 4, 2007.

The report benefi ted from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on September 14, 2007. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the Executive Directors, their national authorities, or the IMF.

Download Global Financial Stability Report 2007

PDF version, 2.8mb, 196pages.

World Economic and Financial Surveys, Global Financial Stability Report
Financial Market Turbulence: Causes, Consequences, and Policies
October 2007, ©2007 International Monetary Fund

EXECUTIVE SUMMARY

Since the April 2007 Global Financial Stability Report (GFSR), global fi nancial stability has endured an important test. Credit and market risks have risen and markets have become more volatile. Markets are recognizing the extent to which credit discipline has deteriorated in recent years—most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets.

This has prompted a retrenchment from some risky assets and deleveraging, causing a widening of credit spreads in riskier asset classes and more volatile bond and equity markets. The absence of prices and secondary markets for some structured credit products, and concerns about the location and size of potential losses, has led to disruptions in some money markets and funding diffi culties for a number of fi nancial institutions, as some counterparties have been reluctant to extend credit to those thought to hold lower quality, illiquid assets. The resulting disruption has required extraordinary liquidity injections by a number of central banks to facilitate the orderly functioning of these markets.

The potential consequences of this episode should not be underestimated and the adjustment process is likely to be protracted. Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change.

At the same time, the global economy entered this turbulent period exhibiting solid growth, especially in emerging market countries. Systemically important fi nancial institutions began this episode with adequate capital to manage the likely level of credit losses. So far, despite the signifi cant ongoing correction in fi nancial markets, global growth remains solid, though some slowdown could be expected. Downside risks have increased signifi cantly and, even if those risks fail to materialize, the implications of this period of turbulence will be signifi cant and far reaching. Eventually, lessons for both the private sector and the regulatory and supervisory arenas will have to be drawn in order to strengthen the fi nancial system against future strains.

The threat to fi nancial stability increased as the uncertainty became manifest in the money markets that provide short-term fi nancing (especially commercial paper markets). At the center of the turmoil is a funding mismatch whereby medium-term, illiquid, and hard-to-value assets, such as structured credit securities, were being funded by very short-term money market securities—often asset-backed commercial paper.

The market illiquidity and the diffi culty in valuing the complex, structured products held as assets has compounded the risks of the funding mismatch. Thus, while potentially helping protect the fi nancial system from concentrations of credit risk in banks, the dispersal of structured credit products has substantially increased uncertainty about the extent of the risks and where they are ultimately held.

This funding mismatch was undertaken by a signifi cant number of conduits and special purpose vehicles that had assumed they could hold their illiquid assets to maturity. Many have been associated with regulated banks, and to a large extent their funding strategies were backed by contingent liquidity lines from those banks. When doubts about the quality of some of the underlying assets emerged and the high ratings were perceived as less reliable, prices of the assets fell, the rollover of associated asset-backed commercial paper became very difficult, and funding began to be squeezed.

As a consequence, what had been contingent, off-balance-sheet liabilities for regulated banks threatened to move “on balance sheet.” The funding diffi culties were fi rst felt in Europe and, subsequently, in a number of other places. The rapid transmission of disturbances in one part of the fi nancial system to other parts, sometimes through opaque and intertwined channels, has surprised both market participants and the official sector. The uncertainty about where off- balance-sheet bank exposures will materialize next has led to a tiering of interbank lending rates.

Banks that are believed to either have structured credit product losses, or that need to satisfy contingent credit lines to their conduits or special purpose vehicles, face higher interbank rates. In some cases, the flows in the interbank market are stymied by some large banks’ desire to hold onto liquidity in case they need to fi nance other activities, such as the large pipeline of leveraged buyouts scheduled for the remainder of the year. Overall, there has been a sharp rise in perceived counterparty risk, and a desire to keep the additional liquidity on hand, at least for now.

The April 2007 GFSR flagged the underlying causes of the current correction. The weakening of credit discipline and the potential complacency, which were highlighted in that edition, led to a buildup of credit risks in the U.S. mortgage market, leveraged buyout market, and some lending to emerging markets. The benign economic and financial conditions of recent years weakened incentives to conduct due diligence on borrowers and counterparties. Moreover the “originate and distribute” model used for credit products by many fi nancial institutions meant that many such institutions could choose not to hold the credit risk they originated, reducing their incentives to monitor borrowers.

Investors in the distributed securities may have relaxed their due diligence in assessing liquidity and leverage risks or chosen to rely excessively on ratings agencies to analyze risks in complex financial instruments. Stress in the U.S. housing market then weakened mortgage-backed securities, an important component of the global financial system. The resulting multiple credit downgrades of these securities by ratings agencies led to downward pressure on their prices and started to deepen the repricing episode that began some time ago.

Leverage has played a key role in amplifying the disturbances. The ease with which some banks and other investment vehicles, including hedge funds, were able to borrow against diffi cult-to-price collateral traded in illiquid markets severely aggravated conditions when market liquidity evaporated, resulting in a process of forced deleveraging at “fi re sale” prices and the failure of some funds. Institutions that have suffered the most have had strategies that were based on high levels of leverage and had assumed continued liquidity in secondary markets.

A long period of abnormally low market volatility likely exacerbated the episode. Risk premia in many markets had fallen to historically low levels as more and more investors bet on a continuation of the benign, low-volatility environment. Returns became more correlated. As markets fell, risk premia expanded quickly. Similar risk management techniques, common investors, and similar positions may have exacerbated the situation. Losses were magnifi ed as many market participants tried to exit similar positions simultaneously. ...

Visit Global Financial Stability Report's Web Site

Since the April 2007 Global Financial Stability Report (GFSR), global financial stability has endured an important test. Credit and market risks have risen and markets have become more volatile. Markets are recognizing the extent to which credit discipline has deteriorated in recent years — most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets.

About The Global Financial Stability Report:

The Global Financial Stability Report replaces two IMF publications: the annual International Capital Markets Report (published since 1980) and the quarterly Emerging Market Financing (published since 2000). The report was created to provide a more frequent assessment of global financial markets and to address emerging market financing in a global context.

The report focuses on current conditions in global financial markets, highlighting issues of financial imbalances, and of a structural nature, that could pose a risk to financial market stability and sustained market access by emerging market borrowers. As a quarterly, it will focus on relevant contemporary issues and not try to be a comprehensive survey of all potential risks, and on drawing out the financial ramifications of economic imbalances highlighted by the IMF's World Economic Outlook. It will regularly contain, as a special feature, articles on structural or systemic issues relevant to international financial stability.

Comments (0)

Show/Hide comments

Name

Email

Website

Title

Comment

smaller | bigger

Add Comment