Financial Stability Review
Themes and Issues, Issue 11
13 December 2001
Issue 11 December 2001 - Themes and Issues (Full Article)
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Recent months have illustrated the pressures which can confront the international financial system. The broadening world economic slowdown, with the attendant rise in credit risks; the deepening problems in Argentina, spreading to its banking system; and the events of 11 September, creating temporary liquidity and infrastructure strains in New York and elsewhere - each has presented its own challenges. But perhaps more important, taken together they highlight the diversity of risks - sometimes low probability but high impact - which financial firms and infrastructure providers have to monitor and manage if the overall stability of the financial system is to be preserved, as it has been. This edition of the Bank of England Financial Stability Review accordingly ranges across a wide set of issues raised by the complex linkages in modern domestic and international financial systems.
As usual, the Bank's latest survey of the financial stability conjuncture and outlook opens the Review. It concludes - partly against the background of the developments highlighted above - that, in terms of direction, while the risks facing the system have probably diminished since the immediate aftermath of the 11 September attacks, they have increased somewhat since the June Review ; but that, in terms of the level of risk to stability, the international and UK financial systems, taken as a whole, nevertheless remain well placed to absorb unexpected losses.
At a more general level, the contribution which capital resources can make to crisis prevention featured strongly at a Bank of England-hosted conference on Banks and Systemic Risk in May. Glenn Hoggarth's article briefly summarises the proceedings, which will be reproduced in a forthcoming special issue of the Journal of Banking and Finance.
The focus on banks at that conference, as in discussions more generally on systemic risk, reflects their core roles in the money and credit markets and, related to that, in payment systems. Much has been done over the past decade or so to make the key wholesale payments arrangements more robust to shocks. Put simply, the aim has been to eliminate avoidable intra-day credit exposures amongst banks. In most countries, including the UK and across the euro area, that has been achieved by moving from so-called deferred net settlement (DNS) systems to real-time gross settlement (RTGS) systems, where smooth payment flows are facilitated by central banks lending intra-day, in the majority of cases against high quality collateral. More recently, payment system operators - notably in France, Germany and the US - have been developing 'hybrid' DNS/RTGS designs which may be able to combine low settlement risk with low liquidity costs. The opportunities opening up in this area are reviewed by James McAndrews of the Federal Reserve Bank of New York, and John Trundle, Head of the Bank's Market Infrastructure Division and chair of the G10 central bank task force which produced the Core Principles for Systemically Important Payment Systems.
While financial stability analysis has tended to focus principally on banks, increasing interlinkages with other financial sectors have broadened the range of markets which central banks, as well as regulators, follow. The need for this was underlined in an article by David Rule in the June 2001 Review on the growing market in credit derivatives, in which insurance companies as well as banks and securities dealers are active participants. In follow-up work reported here, drawing on discussions in London, New York and Bermuda with market participants, rating agencies and others, Rule traces out the increasing use of some relatively new techniques for transferring credit, market and insurance risks between banks, capital markets and insurers; and explores the varying involvement of reinsurers and life, general (property and casualty) and specialist 'monoline' bond financial guarantee insurers. The growth of risk transfer markets is welcome insofar as it disperses risks across the system, to those best able to hold and manage them. For financial stability authorities, it raises some new questions about, for example: the macroprudential tracking of risks; increased linkages between banks and insurers, and the associated counterparty risk management; and about the potential behavioural consequences of changes to regulatory, accounting and tax regimes.
Links of a different kind motivate the work by Andrew Benito, John Whitley and Garry Young on UK corporate and household sector balance sheets. These two sectors, taken together, account for almost half of UK-owned banks' on-balance-sheet lending. Assessing their resilience requires, however, more than a static interpretation of key financial ratios such as debt-to-income and debt-to-net-assets. It is necessary to be forward-looking, since the path of their debt, income, wealth etc will each be affected by developments in the macroeconomy, and by changes in the distribution of debt across individual companies and households. Benito, Whitley and Young report one possible approach to this task. They make additions to the Bank of England's main macroeconomic model, so that it can be used to produce projections of balance sheet ratios, company liquidation rates, and household mortgage arrears, together with calibrations of uncertainty and risk using stochastic simulations and stress tests. Their work represents one contribution to a wider medium-term objective at the Bank of enhancing qualitative assessments of stability with more quantitative analysis.
A concern to develop the assessment of a third variety of financial system links - those operating amongst countries, and in particular emerging market economies (EMEs) - lies behind the articles by Alastair Cunningham, Liz Dixon and Simon Hayes on analysing EME sovereign bond yield spreads and banking systems. Changes in the dispersion of EME bond spreads can, for example, help in assessing whether or not different countries are being simultaneously weakened by the same adverse developments. Against that background, it is striking (and reassuring) that dispersion has recently remained high, which is consistent with relatively little contagion from the problems in, for example, Argentina and Turkey. The maturity structure of EME yield spreads, which typically slopes upwards, can also provide some insight into the severity of a country 's problems. Since the summer, Argentina's spreads have been much higher at short maturities than at longer maturities, suggesting a rise in the probability assigned by the market to an early breakdown in debt-servicing capability. The crises in various EMEs since the mid-1990s have not, though, been limited to the sovereign sector. In many cases - for example, Thailand, Korea, Indonesia and, more recently, Turkey and Argentina - the banking system has been a complicating source of vulnerability, and sometimes the sector in which confidence first broke. Alastair Cunningham's short article outlines some of the techniques which can be employed to assess EME banking system robustness using publicly available data.
Just as they highlighted new challenges for financial stability surveillance, the various EME crises have prompted an active debate about crisis management. Most obviously, the tools used by the international community in the 1980s and earlier have needed adapting given the massive increase in EME financing from international capital markets on top of that provided by banks, and in the amounts involved relative to the limited resources of the International Monetary Fund. As one contribution to that debate, in November the Bank of Canada and the Bank of England published a joint paper - reprinted here - by Andrew Haldane and Mark Kruger, introduced by Deputy Governors Paul Jenkins and Mervyn King. In it, they urge the need for a clearer framework for crisis resolution, and in particular for presumptive constraints - relaxable only in truly exceptional circumstances - on IMF lending, which they argue would help to encourage debtors and private sector creditors to reach co-operative solutions. Given clarity about how much finance the official sector would provide and on what terms, both debtors and creditors could make better-informed choices between the strategies available to them. Occasionally, one option will be a payment standstill. If implemented in an orderly way, the official sector should stand ready to support that route. The IMF's First Deputy Managing Director, Anne Krueger, has recently set out some ideas in a similar vein.
The issues about how to secure effective debt workouts procedures are not unique to sovereign debt. They recur, with some important differences, in the corporate arena and in the handling of problems in major financial institutions. In a speech to the Sixth World Congress of INSOL International in London in July, Deputy Governor David Clementi examined some of those similarities and differences. While a key difference is the absence of a court-based sovereign bankruptcy mechanism, the Deputy Governor emphasised the importance of effective workout procedures at the pre-insolvency stage for all types of debtor. As well as providing the context for much of the debate on private sector involvement in sovereign debtor problems, this has also been the focus of the Statement of Principles for a Global Approach to Multi-Creditor Workouts, developed under the auspices of INSOL International by the INSOL Lenders Group, which the Deputy Governor welcomed. Compatible formal insolvency mechanisms are, though, clearly desirable. The Deputy Governor also reviewed how the principles underlying effective corporate workout and insolvency mechanisms might be applied in the international banking field. He noted the merits, if international agreement could be reached, of applying a 'single entity' approach, with creditors in the same class entitled to equal treatment worldwide in relation to a bank's worldwide assets. At present, some countries, including the US, have a 'separate entity' (or 'ring-fencing') approach.
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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