Latest IMF report touches on global credit markets

Subprime fallout
Global Markets Face Protracted Adjustment
September 24, 2007

Synopsis:
- Markets face difficult period ahead
- Credit difficulties likely to have broader economic effects
- Market framework needs strengthening

Markets are likely to go through a protracted adjustment period following recent financial turbulence triggered by the collapse of the U.S. subprime mortgage market, according to the IMF's latest Global Financial Stability Report (GFSR).

The report, released on September 24, said the turbulence represents the first significant test of innovative financial instruments and markets used to distribute credit risks through the global financial system, with markets recognizing the extent that credit discipline has deteriorated in recent years. This has caused a repricing of credit risk and a retrenchment from risky assets that, combined with increased complexity and illiquidity, has led to disruptions in core funding markets and increased market turbulence in August.

Central banks in several countries have stepped in to help stabilize markets and mitigate the impact on the broader economy. But the GFSR said the period ahead may still be difficult as bouts of turbulence are likely to recur and the adjustment process will take time. "Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change," it stated.

Slowing global growth
The report, prepared by the IMF's Monetary and Capital Markets Department twice a year, said the turbulence could impact global economic growth. "Although the dislocations, especially to short-term funding markets, have been large, and in some cases unexpected, the event hit during a period of above-average global growth. Our assessment is that credit losses and the liquidity constriction experienced to date will [nevertheless] likely slow the global expansion," it stated. The IMF will give its next forecast for world growth on October 17.

The GFSR noted that systemically important financial institutions began this episode with adequate capital to absorb the likely level of credit losses. "Corporations, have, for the most part, been able to secure the financing they need to maintain their operations. However, the adjustment period is continuing and if the intermediation process stalls and financial conditions deteriorate further, the global financial sector and real economy could experience more serious negative repercussions," the report added.

Risks to macroeconomy
The report said that tighter monetary and credit conditions could reduce economic activity through a number of channels. A tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the U.S. housing market, while falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment. Capital spending could also be curtailed owing to a higher cost of capital for the corporate sector. In addition, the dislocations in credit and funding markets could slow the overall provision and channeling of credit.

So far, emerging markets have weathered the turbulence relatively well in part because global growth has been strong and domestic macroeconomic policymaking has improved, though vigilance is still needed. Lower sovereign risks and their improving balance sheets supported by strong fundamentals are balanced against rising risks in some economies experiencing rapid credit growth, particularly where banks are using capital markets to finance credit growth. Furthermore, some private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing.

Building a stronger system
Jaime Caruana, the IMF's Financial Counsellor and Director of the Monetary and Capital Markets Department, told reporters in Washington that the task for policymakers and market participants now was to learn lessons from the turbulence and use them to help make the global financial system stronger. "This does not require, as some have suggested, a new regulatory paradigm, but we must be ready to reexamine some elements of the framework we have, and to enhance it where necessary," he stated.

Key components of that framework include:
• Greater transparency. Accurate and timely information about underlying risks is critical for the market's ability to properly differentiate and price risk. Importantly, financial institutions need to make sure that they have robust funding strategies appropriately suited for their business model and that such funding strategies can accommodate stressful conditions. Greater transparency is needed on links between systemically important financial institutions and some of their off-balance sheet vehicles.

• Better risk monitoring. While securitization—and financial innovation more generally—has made markets more efficient, enhanced risk distribution, and facilitated the ongoing globalization of markets, there is a need to understand how securitization contributed to the current situation. In particular, the incentive structure may have weakened credit discipline, including incentives for originating lenders to monitor risk. Generally, the "originate and distribute" business model may need to be re-evaluated to ensure that adequate incentives are present.

• Improvements by rating agencies. Ratings and rating agencies will continue to be a fundamental component in the functioning of financial markets. Differentiated ratings scales for structured products could alert investors to the scope for more rapid ratings deterioration in such instruments, compared to, for instance, traditional corporate or sovereign bonds. Similarly, investors should ensure their portfolio allocation decisions are not overly reliant on letter ratings, and that such ratings should not be used as a substitute for appropriate due diligence.

• Better valuation. The valuation of complex products in a market where liquidity is insufficient to provide reliable market prices requires more consideration, in particular when assessing the appropriate allowance for liquidity risk premiums and financial institutions holding such securities as collateral. More work on best practices in liquidity management is necessary.

• A wider risk perimeter. The relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting or legal perimeters. The result is that risks that appear to have been distributed may yet return in various forms to the banks that distributed them. Reputational risk may force banks to internalize losses of legally independent entities, and new instruments or structures may mask off-balance sheet or contingent liabilities.

Policymakers face a delicate balancing act, the report stated. They must refine their prudential frameworks to encourage investors and institutions to maintain high credit standards and strengthen risk management systems in good times as well as bad, while preserving the enormous benefits from financial innovation seen in recent years.