Financial Stability Review
Themes and Issues, Issue 16
28 June 2004
Issue
16 June 2004 - Themes and Issues (Full Article)
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The near-term risks to UK financial stability from credit losses have eased somewhat over the past six months as the economic outlook, both in the United Kingdom and elsewhere, has improved. But considerable challenges remain in an environment of firming interest rates and, for many borrowers, historically high levels of debt. And the uncertainty about the future paths of interest rates and what impact that could have on the 'search for yield' highlighted in previous Reviews has brought potential market and liquidity risks to the fore. Against this background, UK financial institutions generally remain in sound condition, as do the major internationally active financial institutions to which they are exposed, primarily through activity in global banking and capital markets. These issues are discussed in the Bank of England's regular assessment of the Financial stability conjuncture and outlook.
Efforts to improve the resilience of financial systems are reviewed in Strengthening financial Infrastructure, which focuses in this issue on two international aspects of supervision: the regulation of multinational providers of infrastructure, and the Basel II framework for capital adequacy, on which agreement has now been reached. Recent focus on the former reflects the growing internationalisation of infrastructure providers and the challenges this poses for financial authorities. The latter represents a significant achievement in the development of an improved framework for the regulation of financial institutions.Although central banks have long been concerned with maintaining financial system stability, there remains no consensus on how it should be defined and measured, or on a framework within which to analyse financial stability issues. In Financial stability and macroeconomic models, Andrew Haldane, Victoria Saporta, Simon Hall and Misa Tanaka propose a definition of financial stability which recognises the cost - in terms of economic welfare - of deviations from optimal savings and investment plans due to financial sector imperfections. Using a range of macroeconomic models, the authors demonstrate that financial frictions can have significant macroeconomic implications.
Considerable work remains to develop an overarching analytical framework for financial stability. But, meanwhile it is still possible to identify some of the potential vulnerabilities - a key aim for financial stability authorities. In emerging market economies (EMEs), for example, periods of financial instability have often followed a sharp reversal in private sector capital flows. In Understanding capital flows to emerging market economies, Gianluigi Ferrucci, Valerie Herzberg, Farouk Soussa and Ashley Taylor analyse the determinants of these flows and the cost of financing for EMEs. The authors find that factors specific to creditor countries ('push' factors) are important, and have accounted for the majority of the compression in EME bond spreads that has occurred since late 2002. They argue that this points to the need for EMEs not to borrow too heavily abroad when financing conditions are benign, because a reversal in credit conditions may only partly be determined by fundamental factors in EMEs ('pull' factors).
Developments in financial markets and products more generally are also a key focus for financial stability surveillance as activity and the capacity to transfer risk in these markets has increased. In Structured note markets: products, participants, and links to wholesale derivatives markets, David Rule, Adrian Garratt and Ole Rummel examine developments in the market for structured notes: bonds with embedded derivatives. These increasingly complex products have developed hand in hand with growth and innovation in wholesale derivatives markets. The authors pointout that positions in exotic derivatives have the potential to lead to 'crowded trades' - where traders simultaneously try to unwind common positions in potentially illiquid markets - which have in the past been associated with episodes of market stress. As such, there is a need for authorities concerned with financial stability to understand how the use of structured notes influences the distribution of risk among market participants.
As financial instruments have become more complex, there has been increased attention to the importance of adequate disclosure of meaningful information to financial market participants. In Accounting and financial stability, Ian Michael considers the important role accounting standards play in facilitating this disclosure and hence in promoting market discipline. He argues that recent initiatives to promote the convergence of accounting standards globally should improve the transparency of accounting information but, on a range of issues, agreement has yet to be reached. The author argues in favour of prompt resolution of these issues in order to reinforce the benefits of international convergence.
Another important aspect to financial stability surveillance is the identification of key structural developments. In the late 1990s, the pace of merger and acquisition activity in major industrial nations increased. Andrew Logan, in Banking concentration in the UK, analyses a Bank of England data set on UK banks' balance sheets to assess concentration in the UK banking sector and how it has changed over the past 15 years. He finds that the majority of non-financial private sector deposits and loans are held by relatively few banks, with UK-owned banks having the dominant market share.
While regular surveillance of the threats to financial stability and an understanding of structural developments can help avoid the costs of financial stability, the strength and resilience of the financial infrastructure are also vital factors. In Assessing operational risk in CHAPS Sterling: a simulation approach, Paul Bedford, Stephen Millard and Jing Yang use a stress-testing approach to assess the resilience of a key part of the UK's financial infrastructure - the large-value payment system CHAPS Sterling - to operational disruption. Based on analysis of various scenarios, the authors conclude that CHAPS Sterling is a highly resilient system, because of the effectiveness of the operational risk controls in place and the ample liquidity in the system. Nonetheless, control of operational risk should be seen as a constant objective for sound risk management.
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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