Financial Stability Review
Themes and Issues, Issue 10
28 June 2001
Financial crises often turn on linkages. That theme recurs through this issue of the Financial Stability Review. Whether a problem affecting an individual financial firm or major borrower has potential systemic implications depends, of course, on the general state of market confidence but also, more concretely, on linkages to other parts of the financial system, domestically and internationally: for example, via credit exposures, markets, or infrastructure such as payment and settlement systems.
In its macroprudential surveillance, the Bank is therefore trying to emphasise linkages, asking 'if a disturbance to X were to occur, what might be the potential spillovers - to the international financial system, to the UK etc?' In almost every case, providing a robust answer would require much more information than is available, not least because it would need to take into account the full reasons for and the context of the initial disturbance. But more can probably be done with publicly available information. The Bank's latest survey of the financial stability conjuncture and outlook, which as usual opens this Review, includes analysis of that kind.
A key data source for this work is the Bank for International Settlements' international banking statistics. That - and the exploration of linkages - also provides the basis for Liz Dixon's article on offshore financial centres (OFCs). While there have been various official initiatives in recent years addressing regulation, taxation and other issues in relation to OFCs, there seems to have been less work on whether there is any useful information in the pattern of banking and other financial flows via the large OFCs. Dixon argues that it might sometimes be possible to discern interesting developments in global finance from such data, highlighting for example the rapid growth during the mid-1990s of lending to those OFCs where many hedge funds are domiciled. Work of this kind can, of course, never pinpoint specific issues or risks, but it can potentially help to identify areas which could usefully be explored, including via market intelligence. Dixon also points out, however, that to the extent that risk can be transferred without an accompanying flow of funds, data on banking flows might mislead about the nature and extent of linkages in the international financial system.
That is a point of departure for David Rule's survey of credit derivatives. Drawing on wide ranging discussions in London and the United States with intermediaries, end-users, rating agencies and others, Rule describes the credit default swap market and its use as a basic building block in synthetic securitisations of loan and bond portfolios. This has been an area of rapid growth in recent years, and one which might have important implications for international finance. Like other types of derivative contract, credit derivatives unbundle risk - in this case credit risk - from funding. This has, for example, enabled new types of otherwise unmarketable loan portfolios to be securitised; and is extending the dispersal of credit risk beyond the banking sector, via the involvement in the market of investment funds and, in particular, insurance and reinsurance companies. These developments hold out the prospect of further enhancing the efficiency of financial markets, as well as introducing new interdependencies between the banking and insurance sectors. The market is by no means fully mature, however, and the full realisation of the potential benefits therefore lies somewhere in the future. Setting out the background to some of the issues already aired publicly by Deputy Governor David Clementi, Rule discusses a range of questions which market participants might usefully consider. These cover, for example, counterparty credit risk and 'willingness to pay' under stressed conditions; whether the incentives of banks to monitor their loan books might be changed; whether, for portfolio trades, sellers of protection understand the characteristics of the underlying portfolios; and whether credit derivatives might affect corporate and sovereign debt restructuring negotiations. While none of these issues will be unfamiliar to market experts, their significance perhaps needs to be more widely appreciated. Credit events tend to be bunched. The prospective weakening in global economic demand and consequent rise in credit risk, described in the 'conjuncture and outlook' piece, might therefore present a significant test for participants in the credit derivatives market.
There are also questions for the authorities. Most obviously, some thought needs to be given to whether officially collected data provide a satisfactory picture of the redistribution of credit risk both within and possibly outside the financial system. To this end, the BIS are already considering extending their data to banking system risk transfers via credit derivatives, and data on the credit derivatives market will be collected for the first time in this year's BIS derivatives survey. There is also an important set of questions about whether regulatory capital requirements provide any incentives for banks to transfer particular types of credit risk to other financial intermediaries.
Gertjan Vlieghe's article, on the determinants of corporate liquidations, deals more directly with the crystallisation of credit risk. It asks in a UK context to what extent company liquidations can be explained - and so perhaps, within a margin of error, predicted - by developments in the macroeconomy or in company finances. Perhaps unsurprisingly, he finds that failure is made more likely by combinations of high indebtedness and economic downturns, especially if accompanied by rising real wages or real interest rates. The work reported in Vlieghe's article is part of a broader research programme within the Bank to aid calibration of risks to the financial system.
Glenn Hoggarth and Victoria Saporta's article reports on another part of the Bank's research agenda: measuring the costs of financial instability. Since crises tend to occur infrequently, there is a risk that the large welfare costs of systemic disturbances - and, conversely, the benefits of financial stability - are assigned too little weight in countries' economic and financial policy making, a possible factor in the crises of the past few years. Hoggarth and Saporta document the fiscal costs of banking crises in 24 countries. More important, using data on 43 crises, they show that if welfare costs are proxied by losses in the level of output - rather than, as in a number of earlier studies, its growth - the impact of crises is significantly greater. The levels proxy seems to be better in principle assuming that households care most about the level of their consumption of goods and services. Interestingly, Hoggarth and Saporta's work suggests that, measured this way, output losses during past financial crises have on average been greater in developed than in emerging market economies - because they have, again on average, tended to drag on for longer and so output has remained below trend for longer. Japan may be a prominent recent example. Although varying markedly from crisis to crisis, over the past 25 years cumulative output losses during banking crises have, on average, been around 15 to 20 per cent of GDP. Banking crises may, of course, be a consequence rather than cause of recessions. Testing this, Hoggarth and Saporta find evidence that, if also suffering from a banking crisis, countries tend to suffer larger output losses than their neighbours during an economic downturn. Whether financial sector crises cause or are caused by recessions, they often seem to exacerbate subsequent output losses and to be costly to resolve.
Finally, we are glad to publish a speech by Andrew Crockett, General Manager of the BIS and Chairman of the Financial Stability Forum, delivered at a conference on 'Banking and Systemic Risk' held recently at the Bank. Crockett asks whether financial stability can be delivered by either market mechanisms or official policies on their own. Concluding that both are needed, Crockett enumerates a range of issues concerning incentives and so behaviour in the financial system that need to be analysed more carefully. He argues that strengthening the macro-prudential orientation of arrangements designed to secure financial stability would help to strike a better balance between official and market discipline. The Bank's own work on financial stability, as reported in the Financial Stability Review, is itself intended to work in this direction.
Key Resources
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Memorandum of Understanding between HM Treasury,
the Bank of England and the Financial Services Authority
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