12 Ongoing National and Global Challenges
- Garry Schinasi
- Published Date:
- December 2005
The changes in the financial market landscape since the early 1970s, and the rapid acceleration of those changes in the 1990s and beyond, have resulted in unprecedented growth and unprecedented challenges, including the growing importance of safeguarding financial stability.
Part I of this study examined finance as a mechanism that facilitates economic processes such as resource allocation, risk pricing and distribution, and economic growth and social prosperity. It also established a conceptual foundation for understanding financial stability as a public good and why both private-collective and public policy involvement might be beneficial and even necessary for achieving and maintaining financial stability.
Building on this conceptual foundation, Part II proposed a practical definition of financial stability and a broad generic framework for safeguarding it. It further identified and examined the important analytical and measurement challenges in both applying a framework and improving it. It also discussed the natural interest and role of a central bank in ensuring financial stability.
Part III examined how developments during the past several decades have dramatically altered the nature of national and international finance. The forces of globalization, as detailed in Chapter 8, have combined with the development of ever-more sophisticated financial instruments and markets (illustrated in Chapters 9 through 11), to produce an international financial system open to more participants, but cloaked in a level of complexity that masks the nature, ownership, and systemic importance of the system’s underlying financial risks. The national authorities and international bodies responsible for ensuring and maintaining the stability of this financial system are coming to grips with their need for a framework that allows them to monitor and regulate the system without reining in the benefits it provides, thereby safeguarding financial stability while maintaining efficiency.
Challenges in Review
The globalization of finance is a result of the same technical advances in communications and information technology that have made the world’s economies more interconnected on a business, personal, and political level. Financial markets are linked to one another, physically through computerized connections, and financially through the use of one market’s assets to diversify the risks created in another market. As reviewed more thoroughly in Chapter 8, globalization has led to tighter integration of national financial markets; the greater importance for markets of nonbank financial institutions, such as hedge funds, insurance companies, and pension funds; the greater engagement of nonfinancial institutions in financial activities; as well as the emergence of hybrid entities that added financial endeavors to their core businesses—auto manufacturers and industrial giants, for example. In addition, the once-staid backbone of finance, the banking sector, has diversified into new lines of business that allow it to compete more aggressively with new entrants into the business of finance. Thus, banks are providing more “finance” and doing less lending, as measured in relative terms.
The resulting advances make international financial markets more liquid, contribute to the worldwide mobility of capital, and allow financial flows and asset prices to adjust more quickly. On the whole, markets and market participants benefit tremendously from greater efficiency.
Along with such valuable benefits, of course, come new and unmeasured risks. Market interdependencies, and the complexity of those interdependencies, contribute to the potential for volatility, turbulence, and crises to spread far beyond the entity, or even the country, of origin. The speed with which globalization has occurred has left two clear gaps in the usual system of checks and balances. First, although the efficiency of private finance has been enhanced by globalization, the appropriateness and effectiveness of regulatory and supervisory approaches has lagged behind. Second, emerging market countries accessing international capital markets—in some cases for the first time—often are faced with riding a financial roller coaster as they experience good times and bad. Finance is now easier to obtain in world markets, and many emerging markets have benefited in good times from their newfound access to international finance. But because emerging-market countries often have not made concomitant reforms in their macroeconomic, microeconomic, and financial structures, they lack smoothing mechanisms and the resilience required to brake the adverse consequences of the roller coaster’s descent when faced with unexpected financial turmoil.
Chapter 8 suggests the crises and turbulence of the 1990s and early 2000s should result in three lessons: First, greater supervisory attention needs to be paid to internal risk management and control systems, to management’s understanding of risk issues, and to corporate governance mechanisms. Second, market discipline is an effective and crucial tool. Errant companies should be allowed to fail and be liquidated, and this can happen without causing instability if financial supervisors have insight into risk levels and interconnectivity through regulatory disclosure. Third, international financial stability is a global public good requiring more regular and effective—and perhaps even binding—international coordination mechanisms.
Delving one layer below the surface of globalization, Chapter 9 examines the development of over-the-counter (OTC) derivatives and markets, which in many ways make up the core of liquidity and finance in the international financial system. OTC derivatives allow financial risks to be tailored to preferences and tolerances, contributing to more complete financial markets. The trade-off is that OTC derivatives can also contribute to vulnerabilities because they are unregulated to a large extent, disclosure is poor, and transparency is an issue. OTC derivatives also can introduce layers of complexity that make risks harder to manage: not only must the risk of default and loss given default be assessed and managed, but the potential changes in the value of credit extended must be assessed, and the ultimate link between the derivative and the underlying asset market must be understood.
Roughly two-thirds of OTC derivatives instruments are simple forwards and swaps, generating little additional risk and thus not deserving of undue regulatory scrutiny. Nonetheless, OTC derivatives are emblematic of the widening gap between regulated and regulator. Regulation has had its greatest impact on OTC derivatives in the effort put into avoiding regulation—through choice of jurisdiction, legal structure, and the structure of trading, clearing, and settlement. The financial institutions that trade heavily in OTC derivatives—the top 20 or so global financial institutions—are safeguarded by virtue of being well capitalized, supervised (so far), and partially insured (with safety nets); but spillovers and contagion can affect the stability of markets and countries only indirectly linked, as demonstrated by the effects of the Long-Term Capital Management (LTCM) crisis in 1998.
The policy issues raised in Chapter 9 challenge those entities operating in areas that could be sources of instability to take responsibility for enhancing stability. Private financial institutions must improve risk management and control systems, but the fact that little has been done in this regard since the near collapse of LTCM suggests that it is a complex problem, perhaps somewhat ignored because of the existence of financial safety nets. The public and private sectors should work together to identify and overcome inconsistent incentives and signals. The official sector in league with national legislatures should work to reduce legal and regulatory uncertainties, especially with regard to clearinghouse arrangements, closeout procedures during bankruptcy, and netting. Supervisory bodies must also work with financial institutions to strike a balance on information disclosure. In principle, creditors would demand information sufficient to allow them to gauge risks and risk concentrations adequately; reality indicates otherwise, due to competitive pressures and the perception that confidentiality may be at stake. Therefore, the official sector must define its role such that counterparties receive adequate information, but not at the expense of reducing the private information advantage and efficiency. Finally, both private entities and the public sector must work to reduce systemic risk. Foremost among these efforts must be the drive within private institutions to be well managed and sufficiently capitalized. Authorities can provide additional incentives in this direction, including through capital requirements for off-balance-sheet credit risks.
Credit risk transfer vehicles, such as credit default swaps and collateralized debt obligations, allow credit origin to be separated from credit risk bearing, thus contributing to the efficiency and completeness of financial markets (Chapter 10). By allowing entities other than banks to take on credit risk, the overall concentration of risk becomes more dispersed and credit exposures can be managed more flexibly. Compared to OTC derivatives, the notional value of credit risk transfer vehicles is small; the associated risk, however, is huge, because credit exposure can rise to up to 100 percent of the notional amount.
Credit risk transfer vehicles subject financial market stability to the same challenges as OTC derivatives—complexity, regulatory arbitrage, new market participants—then add the additional uncertainties of poorly defined credit default events. The complexity of these vehicles combined with return-seeking but inexperienced market participants leads to a potential magnification of the risks, further exacerbated by the reduction in transparency of the institutional distribution of credit risk. Because exposures have been shifted outside the banking system—to hedge funds, pension funds, insurance companies—traditional regulatory and supervisory functions that would uncover potential volatile concentrations of risk do not come into play.
The Railtrack, Enron, and JP Morgan episodes examined in Chapter 10 illustrate that experiencing an outcome that credit risk transfer vehicles are designed to cover is not sufficient to trigger payment. The way in which that outcome occurs is also significant. Thus, better documentation is needed to help refine the definition of a credit event and what constitutes a default.
Retail investor involvement in credit risk transfer vehicles raises investor protection issues. In addition to high net worth individuals investing directly in such vehicles, other retail investors are becoming exposed through mutual funds and hedge funds that invest in credit risk transfers. Insufficient disclosure and transparency, combined with the inexperience of the investor could lead to investment mistakes, rapid unwinding of positions once the mistakes are discovered, and a tendency toward increased volatility in credit prices and spreads.
The insurance and reinsurance industry has become a significant player in the international financial market (Chapter 11). Several forces compelled the industry to step beyond its traditional role and pursue more finance-related activities. In addition to needing to offset underwriting losses and to pay for high guaranteed returns offered to policyholders in the 1980s and 1990s, insurance companies are fulfilling the demand from the remainder of the financial sector for insurance against capital risk. In doing so, insurance companies have brought an innovative approach to capital markets, developing new instruments that bridge the gap between insurance and banking. These instruments include “Cat” bonds, with payoffs triggered by catastrophic events, and customized reinsurance products available in the “alternative risk transfer” market.
Although observers foresee little possibility of a systemic impact from the possible failure of an insurance company due to its financial activities, issues similar to those that apply throughout the rest of the financial system arise. Among them are the balance between official oversight and market discipline, the need for disclosure and transparency, the understanding of legal obligations, and capital adequacy. Despite regulatory differences among countries, the overriding focus is on policyholder protection, with little concentration on the asset side of the balance sheet or on off-balance-sheet activities. Thus, little information is available regarding internal risk management and controls. Insurance companies also have different legal obligations than financial companies. Finally, although capital is typically more than adequate, it is not clear that some European and Japanese companies are properly capitalized on a risk-adjusted basis.
The challenges to financial stability identified in Part III, separately and collectively, lead to the strong conclusion that further and continuous reforms are desirable and should be aimed at striking a better balance between relying on market discipline and relying on official or private-collective action. In some countries—most of them advanced countries with mature markets—a rebalancing toward greater reliance on market discipline is desirable. In other countries—many with poorly developed markets—strong efforts need to be made to improve the financial infrastructure through private-collective and government expenditures and commitments, and to target the role of government to enhance the effectiveness and efficiency of market mechanisms for finance.
As the discussion in Part III suggests, the following areas are most in need of general reform:
- Private market incentives need to be realigned, including within firms, to improve internal governance at the board-of-directors level, to improve management and risk controls, and to improve the alignment of incentives at the board, management, and staff levels.
- Regulatory incentives need to be reevaluated, as does their consistency with private market incentives, to reduce moral hazard.
- Disclosure by a wide range of financial and nonfinancial entities needs to be enhanced, to improve the potential for effective market discipline and to improve private-collective and official monitoring and supervision.
- Market transparency needs to be improved, to reduce asymmetries in markets and the tendency toward adverse selection.
- Legal certainty needs to be clarified where it is still ambiguous, such as with closeout procedures for credit derivatives and other complex structured financial instruments.
- Comprehensive and appropriately targeted frameworks need to be developed and implemented for monitoring, assessing, and ensuring financial stability and to restore it when this fails.
- International cooperation and coordination in financial-system regulation, surveillance, and supervision needs to be increased, to eliminate international gaps of information and analysis and to reduce opportunities for regulatory arbitrage.
The complexity of the challenges and the rapidity and creativity with which new financial instruments are developed and disseminated require the systemic approach to safeguarding financial stability examined in Part II of this study, and in particular in Chapter 6. The financial system, working within the context of the broader economic, social, and political systems, affects the performance of the economy and well-being of society. In turn, those systems must operate hand in hand to safeguard the stability of the financial system, and the constellation of tools they provide must be used to ensure economic stability.
Ultimately, the goal is to maintain financial stability so that the financial system is capable of performing its three key functions: the intertemporal allocation of resources from savers to investors and the allocation of economic resources generally; the assessment, pricing, and allocation of forward-looking financial risks; and the absorption of financial and real economic shocks and surprises.