European Affairs

The World Financial System Has Weathered Unprecedented Shocks     Print Email
André Icard

At a high-level meeting between representatives of the private sector and central banks last spring, everybody agreed on the strong resilience of the international financial system in the face of an unusual confluence of shocks. But the discussion, organized by the Bank for International Settlements, also revealed a dichotomy of views between the public and the private sector on the economic outlook.

While the public sector representatives, basing their analysis on recent positive indicators, had become fairly upbeat about economic prospects, the private sector appeared to be still pessimistic on the grounds of low investment, global excess capacity and lack of pricing power in manufacturing.


It was clear at the time that robust growth would be needed to wash away or at least abate the shocks that had accumulated until then, and to restore cushions of comfort in the financial system.

This fall, the prospects for a rapid and significant recovery are less evident in the macro statistics, and another series of significant events has occurred, probably triggering additional vulnerabilities. In this respect the pessimistic vision of the private sector representatives seems to have materialized. Nevertheless, and this is the good news, the financial system continues to display remarkable resilience.

The three main themes that need to be examined at this point are the unprecedented nature of the shocks that have affected the financial system, the reasons why the system has so far proved resilient and the growing vulnerabilities that must not be ignored.

The first point is that the confluence of shocks to the global financial system over the last 18 months has challenged private and official crisis management capacity and put to sharp test the three pillars of the financial systems: financial markets, financial institutions and key infrastructure.

The slowdown of global growth has had a strong effect both on the banking system and on financial markets. First of all it produced a large-scale credit deterioration that the financialsystem had to absorb. The bursting of the tech bubble, in particular, had a very significant influence, not only on the value of bank assets, but also on the equity market where it triggered a marked downward trend.

There is no doubt that disappointing economic developments have been a key factor in the deterioration of market sentiment, profit expectations and credit quality. Nor is there any doubt that a restoration of at least reasonable growth is a key condition to better market trends and a lessening of financial vulnerabilities.

The decline in the financial markets, and especially in equity markets, has brought in its wake an exceptional erosion of wealth. This seems so far to have hurt financial institutions - mainly in the insurance and pension fund sectors - more than households, which have generally benefited from rising property prices.

The accounting scandals that caused the sudden collapse of Enron, the largest-ever corporate bankruptcy, were a big shock to the system. If at the start there was some tendency to see Enron as a singular event, and if the fraudulent behavior of the company's management could not be generalized, it became rapidly obvious that the episode had revealed general weaknesses in corporate finance and governance that needed to be addressed.

Clearly, this episode added greatly to market uncertainty. The reaction it created in favor of more stringent accounting and certification rules probably led to a downward revision of profit expectations, which, added to gloomy general economic conditions, has contributed to the fall of equity prices.

It should be noted, however, that at the price of higher volatility and marked turbulence the market has adjusted rapidly to embrace more stringent corporate governance principles and enhanced transparency. This is a clear indication of how effective self-correction by financial markets can be.

The terrorist attacks of September 11, and the consequent loss of life and damage to infrastructure in New York, led to major disruptions in U.S. financial markets and in the infrastructure critical to the operation of domestic and international financial activity. Policy makers and market participants, however, were quick to respond. The U.S. Federal Reserve injected large amounts of liquidity, while in the markets settlement hours were extended and market participants increased their cooperation to facilitate the distribution of liquidity.

These efforts were greatly aided by the resilience of the payment and settlement system and by contingency plans made two years earlier in preparation for possible Y2K (Year 2000) computer problems. All in all, markets, participants and systems reacted in exemplary fashion to this dramatic event and very quickly returned to normal.

The default of Argentina is the largest-ever sovereign bankruptcy. Until now this failure has not materialized in financial distress on the part of creditors: part of the debt is in the hands of robust institutions and another part has been passed on by financial intermediaries to a large number of individual investors, in Italy and Germany in particular. The effects of this bankruptcy could take time to emerge and the main immediate danger is a spill over effect on other Latin American countries.

This impressive series of shocks - the slowdown in global growth, the bursting of the tech bubble, the sharp decline in equity prices, the collapse of Enron, September 11 and Argentina's default - is the first serious test for a financial landscape that is emerging from several years of integration, concentration and conglomeration.

Nevertheless, the financial system resisted the shocks without apparent damage. Despite an unusually large number of sharp and sudden price movements, liquidity remained satisfactory in most markets, and, contrary to past experiences, there has been no major failure of institutions active in traded debt markets.

While it is too early to draw firm conclusions, given that credit problems take time to materialize and that some of these shocks have not yet had their full effects, the financial system has so far proven remarkably resilient.

So, the second issue is: what are the reasons for this resilience? The explanation probably lies in a combination of conjunctural, structural and technical factors. While it is difficult to quantify their respective roles, they can help to explain the performance of the U.S., European and Japanese financial systems in a stressful environment.

First and most importantly, the financial system is benefiting from the legacy of a decade of growth. In recent years, banks have enhanced their three principal means of absorbing problems: earnings, reserves against loan losses and capital. This has been particularly notable in the United States, and somewhat less in Europe. By contrast, Japanese institutions have not been able to rely on economic growth to erect similar lines of defense.

In addition, progress has been made by a large number of emerging countries in reducing their vulnerability to the uncertainties of the international capital market. Better macroconomic policies have often been implemented - generally under the aegis of the International Monetary Fund - exchange rates have been rendered more flexible and external reserves have been reinforced.

A second strength results from the fact that institutions are often larger and more diversified. Recent years have witnessed the growing significance of diversified, large and often complex financial institutions.

It seems that large financial groups have been well able to withstand the shocks so far. It is noteworthy that, unlike past periods of difficulties, financial institutions have not been threatened to the same degree by large exposures to a single sector, such as real estate.

A third element is better risk identification and management. It is possible that the repetitive nature of financial problems since the mid-1990s has, other things being equal, reduced the appetite of firms for risk: as perceptions of risks have increased, firms have been more cautious and therefore less leveraged.

But, probably more fundamentally, continuing pressures to deliver strong and sustainable risk-adjusted returns on capital have motivated financial firms in all sectors to invest in improved methodologies for quantifying risk. This investment in risk management capacity has clearly paid off.

A fourth explanation of the financial system's resilience is financial innovation. Along with progress in identifying risk, market innovations have expanded capacities for managing it. The growth of secondary markets for credit risks, through securitization, loan sales or credit derivatives, have helped disperse and diversify risk, thereby increasing the capacity of the banks that are at the core of the system to buffer the first rounds of adverse shocks.

A fifth factor is that efforts by the private and public sectors to strengthen the functioning and the structure of financial systems have started to bear fruit.

Much progress has been made in improving the monitoring and the functioning of financial markets. The private sector, for instance, has established a list of "good practices" covering foreign exchange market trading. Similarly, in close contact with market practitioners, several initiatives have been launched to improve transparency in market operations.

This has helped to reduce the room for bad surprises and the accumulation of un-addressed problems. Disclosures, however, are uneven across countries and types of institutions and still probably incomplete. Market infrastructure has also received much attention.

The third part of the overall picture that needs attention is that the achievement of sounder financial systems and institutions still leaves open the possibility of disruptive forms of financial turmoil. These could be generated by vulnerabilities that have been insufficiently corrected or by new patterns of potential difficulties that built up progressively during recent phases of market instability.

At the general level, various pre-existing imbalances continue to weigh on the system and, unless financial resilience has improved in an entirely radical way over the last years, the shocks that have occurred could have eroded the system's capacity to absorb additional strains.

A large part of the absorption of shocks has been due to the ability of financial markets to intermediate risks. As indebtedness remains high in several sectors, any disruption in this intermediation function could weigh especially on banking systems that, after two years of unfavorable conditions and lower profitability, have less capacity than before to provision their risks adequately.

Until recently, the insurance industry was an active investor on secondary markets for credit risk. Now that its financial strength has been largely eroded by the fall of equity prices, and by increased liabilities linked to terrorist attacks and to natural disasters, it is unlikely that it will continue to fulfill this function to the same extent.

There is a risk that the secondary market for credit risk could dry up and that both the insurance industry and the banking sector could face greater difficulties in addressing their own problems.

The fall in equity prices has badly affected not only the insurance industry but also pension funds systems. Many funds are now largely under-capitalized. A further fall in asset prices, or just no rebound from their current levels, would leave no choices other than to re-capitalize these entities or to reduce benefits.

In the first case, the financial effort to be accomplished by the corporate sector would damage the financial situation and the profits of many companies, with further possible negative impacts on stock markets. In the second scenario, households would be adversely affected, resulting in greater propensity to save rather than to purchase goods and services, less consumer confidence and thus less capacity for the world economy to grow.

Negative shocks to growth resulting from rising oil prices, further declines in asset prices, a deterioration in Latin America or a wider conflict in the Middle East could also have adverse impacts on the financial sector, which could feed back into the real economy.

Difficulties in the Japanese financial system should also be added to the list of uncertainties. The size of the problems faced by banks and insurance companies is hard to assess, but it is in any case significant - and the measures to be taken are the subject of heated debate among the Japanese authorities. Rapid and strong action is required to avoid a financial crisis, which could be damaging not only to the Japanese economy but also to the international financial system.

Much will depend on the capacity of the economic expansion to continue and, if possible, to accelerate. Macroeconomic conditions look broadly favorable in this respect, and all economic forecasts agree that the world economy is set to stay at least on its current path of growth this year, and to register a stronger recovery next year.

Monetary conditions are favorable to growth, with ample liquidity and both long-term and short-term real interest rates below their historical averages. In many countries there is room to ease monetary conditions further.

On the structural front both the euro area and the U.S. economy are showing strengths and weaknesses. The euro zone is displaying no fundamental imbalances but is still hampered by significant rigidities; the United States is enjoying resilient productivity gains and good growth potential but showing no improvement in the current account deficit at the end of the recession phase.

Finally, one can expect that investors will soon have to make up for investment spending that was put off during the downturn. We are not looking at a black and white picture, with black for the future and white for the past. There is no doubt that vulnerabilities exist and that they have increased in the recent past; but a positive outcome, coupled with a rapid recovery, remains a credible scenario.

 

This article was published in European Affairs: Volume number III, Issue number IV in the Fall of 2002.