Financial Stability Review
Themes and Issues, Issue 15
11 December 2003
Issue
15 December 2003 - Themes and Issues (Full Article)
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The stresses afflicting financial systems have continued to abate over the past six months, and the strengthening global economic outlook should help to contain credit risk. Most financial institutions in the United Kingdom and overseas appear to have weathered the episodes of equity market, interest rate and exchange rate volatility during 2003. But the past and prospective rises in market interest rates pose risk-management challenges for both lenders and borrowers, particularly in the light of the historically high ratio of household debt to income in many countries, including the United Kingdom. These issues are explored further in the Bank's regular assessment of The financial stability conjuncture and outlook. Some of the continuing efforts of the UK and other authorities to make financial systems more resilient - for example, by improving banking liquidity regulation - are reviewed in Strengthening financial infrastructure.
One way in which the authorities can promote systemic stability is by being clear about their objectives and demonstrating that they are acting to achieve them. In Transparency and financial stability, Prasanna Gai and Hyun Shin argue that greater transparency, in general, acts as a discipline for policy-makers and financial market participants. For policy-makers, the discipline derives from the desire to preserve and enhance reputation; whereas, for the private sector, discipline tends to be imposed through market prices. However, disclosures can be a two-edged sword, particularly with respect to financial stability. If a financial institution or system is fragile, the provision of information can act as a lightning conductor that co-ordinates and channels the pessimistic expectations of market participants. The authors argue that a central bank can guard against this threat by presenting its analysis of financial stability and its policy stance as a whole regularly and in a coherent format. Thus financial stability reports, for example, can be of some assistance in trying to guard against short-run market movements brought about by incentive or information problems affecting private economic agents.
It may also help to mitigate stresses on a financial system if private agents are confident that the authorities would act effectively in the event of a financial crisis, systemic or otherwise. Glenn Hoggarth, Jack Reidhill and Peter Sinclair, in Resolution of banking crises: a review, consider the merits of the various techniques that have been used by authorities in different countries. The article draws on information gathered at a workshop organised by the Bank of England's Centre for Central Banking Studies, involving officials from a number of developed and emerging market economies. In widespread banking crises, the authorities often face a trade-off between maintaining financial stability today through intervention and increasing financial fragility in the future by increasing moral hazard. Amongst other challenges, this also complicates the authorities' communication strategies (illustrating Gai and Shin's thesis). The authors draw out four main conclusions about system-wide banking crises. First, central banks have usually provided liquidity at an early stage to failing banks and extended government blanket guarantees to depositors. In nearly all cases, investor panics have been quelled, but at a fiscal and moral hazard cost. Second, open-ended central bank liquidity support seems to have prolonged crises, thus increasing rather than reducing the output cost to the economy. Third, bank restructuring has usually occurred through mergers, often government-assisted, and some government capital injection or increase in control. Bank liquidations have been rare and creditors - including uninsured ones - have rarely made losses. Fourth, resolution measures have been more successful in financial restructuring than in restoring banks' profitability or credit to the private sector.
Even where banking crises have been resolved quickly, there has been a lingering impact on credit conditions and the effectiveness of financial intermediation. This highlights the importance of effective surveillance by the authorities, and an understanding of when problems in individual financial institutions could be symptomatic of systemic difficulties. Two articles in this Review contribute to that goal by examining aspects of the interrelatedness of banks.
In Large complex financial institutions: common influences on asset price behaviour?, Ian Marsh, Ibrahim Stevens and Christian Hawkesby investigate the behaviour of some key financial firms' share prices and credit default swap (CDS) premia. Their goal is to establish to what extent large complex financial institutions (LCFIs) appear to be influenced by common factors. If, statistically, common factors turn out to be important, that would suggest that LCFIs share exposures to similar shocks, or that, because of links amongst them, adverse shocks can be propagated from one to another. In either case, a fall in the share price of an individual institution, or a rise in its CDS premium, would be of greater concern to a central bank. The authors find that there is indeed a relatively high degree of common asset price behaviour amongst most LCFIs, especially when compared with non-financial companies (matched with the LCFIs for size and country of origin). But some LCFIs are more closely related than others on this metric; for example, US LCFIs appear closely related to each other, but less so to European LCFIs.
Asset price correlations cannot by themselves reveal why particular financial institutions seem vulnerable to the same shocks. One possible explanation is linkage through counterparty relationships. That is one reason to investigate the extent to which banks fund their lending by borrowing from other banks. With this in mind, George Speight and Sarah Parkinson examine changing funding strategies in Large UK-owned banks' funding patterns: recent changes and implications. They point out that, in recent years, borrowing by the UK corporate and household sectors from banks and building societies has outstripped deposits from those sectors. The large UK-owned banks have increasingly funded the growth in their assets by drawing on a variety of wholesale sources (including other banks and foreign currency money markets) and borrowing at a range of maturities. The Financial Services Authority's ideas for changes to the quantitative elements of UK bank liquidity regulation, outlined in a recent discussion paper, address the need for an all-currency approach to liquidity monitoring and control, as summarised in Strengthening financial infrastructure.
Wholesale counterparty relationships are a possible route for contagion in the event of adverse shocks hitting an individual bank. But systemic problems are also more likely to arise in the event of common shocks to several banks at the same time. One possible source of such shocks is an unexpected deterioration in business conditions. In Company-accounts-based modelling of business failures, Philip Bunn considers how to identify companies with a relatively high probability of failing. He estimates a model using a dataset of up to 12,000 UK public and private non-financial firms, covering the period 1991-2001, to generate firm-level probabilities of failure. These are found to depend on profitability, capital gearing, interest cover, liquidity, company size and structure, industry and overall macroeconomic conditions. An aggregate measure of 'debt at risk' is then constructed by multiplying each firm's debt by the corresponding failure probability. It turns out that debt at risk is concentrated amongst a small number of mainly large firms. The overall debt-at-risk measure derived in this way performs better in predicting the aggregate corporate default rate than does a model that does not utilise company-level information. Aggregate debt at risk as a proportion of total corporate debt was at its highest in the early 1990s, fell back in 1993 and then remained fairly stable. But, using post-sample data, it appears that this ratio may have increased modestly since 2001.
In emerging market economies (EMEs), sovereign debt is often the main focus of concern. In Assessing sovereign debt under uncertainty, Gianluigi Ferrucci and Adrian Penalver make the point that it is desirable when assessing the sustainability of debt to take account of the uncertainty about the future path of the economy. The inherent uncertainty about future debt dynamics is illustrated by developing explicit probability distributions for the evolution of debt over time, calibrated using historical means and variances of key determinants of debt sustainability, such as GDP growth, interest rates and exchange rates. These distributions are analogous to the so-called 'fan charts' for probabilistic inflation forecasts published in the Bank of England's quarterly Inflation Report. The method offers some improvement over the standard techniques commonly used to assess debt sustainability. It considers, for example, the persistence of and interrelationship between shocks to explanatory variables. The method could prove useful in helping to evaluate the likely success of IMF programmes, especially in the context of exceptional access to IMF funds.
Another aspect of assessing EME debt sustainability is judging whether IMF programmes are likely to lead to renewed private sector capital flows. In The catalytic effect of IMF lending: a critical review, Catherine Hovaguimian considers the theoretical and empirical evidence about the effectiveness of IMF finance as a catalyst for such capital flows. Theory suggests that the window of opportunity for such effects is a narrow one. And the empirical evidence tends to conclude that catalytic effects have rarely been evident in practice. Against this backdrop, other means of dealing with capital account crises may need to be considered carefully in cases where the probability of the catalytic effect working is low.
Finally, the Review reprints a speech on Financial stability: maintaining confidence in a complex world by Sir Andrew Large, Deputy Governor for Financial Stability. Sir Andrew sets out some of the broad challenges faced by the Bank in pursuing financial stability, one of its three core purposes, and discusses some examples of its recent work. The speech reflects the Bank's continuing efforts to promote the kind of transparency about financial stability policy advocated by Gai and Shin.
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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