Glenn Stevens: Recent financial developments
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Smart Capital
2008: The Euromoney Australian, Financial Markets Innovation Congress, Sydney,
27 March 2008.
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Welcome to Sydney. It is a pleasure to be here to make some remarks at the opening of your
conference. The opportunity this forum provides to exchange ideas and participate in
vigorous discussions is undoubtedly valuable, not least at this particular juncture.
The past nine months have certainly been a very challenging time in international financial
markets. We have seen a significant reappraisal of certain categories of risk and
considerable financial turbulence in key international markets. Economic prospects in the
United States, in particular, have taken a significant turn for the worse. The extent of
disengagement in some core markets, which hitherto had been thought to be extremely liquid
and reliable, has been quite unsettling.
The fact that your conference has a focus on innovation is apt as well. It will not have gone
unnoticed that difficulties associated with some particular innovations of the past decade
have been prominent in the recent period. It has been remarked by others that the
complexity of some new instruments meant that they were not well enough understood by
investors, and perhaps even by those promoting them.1 Complexity is also the enemy of
liquidity, which proved to be much less reliable than had been assumed. Perhaps future
innovations will need to take account of the difficulty people inevitably have in grappling with
complexity, and the dangers of illiquidity. In the end, though, human nature, with its
propensity initially to underestimate risk in good times, then to over react when risk
materialises, is probably a permanent feature of the landscape.
I will organise my remarks today under three headings: How did we get here? Where are we
now? And what policy issues arise for future consideration?
I should be clear that my remarks are principally about global events. They are not directed
towards the Australian financial system in particular. The local financial community has
certainly been affected by the global turmoil but, on the whole, as the Reserve Bank's
Financial Stability Review being released later this morning sets out, is weathering the storm
well. Profitability remains very strong and capital sound. There is very little direct exposure to
the US sub prime problems, but the main reason for the resilience is many years of robust
economic growth, sound regulatory foundations and prudent risk management. The Reserve
Bank has been carefully monitoring access to funding, including offshore funding. We judge it
to have been more than adequate, even if more expensive, though, of course, we will
continue to watch the situation closely. But the centre of recent developments has been
offshore, so my remarks today are about the global scene, not the Australian one, unless
specifically noted.
Background to the present international situation: how did we get here?
Although the headlines of the past year have been dominated by stories about the sub prime
loans in the US mortgage market, in fact the genesis of the problems was much earlier. For
much of the preceding decade, international capital markets were characterised by the
search for yield. An excess of saving over investment in Asia was a feature, resulting partly
from the reaction to the late 1990s crisis and the determination to avoid a repeat of it. The
rapid growth of Chinese incomes and the lag between that trend and a corresponding rise in
consumption was also a factor. These trends, associated as they were with a surplus of
internationally tradeable goods and services, carried a degree of disinflationary impact for the
rest of the world, which made strong growth in demand and low inflation easier to combine.
They also lowered the marginal cost of financial capital in global markets. Somewhat later, oil
rich nations also provided funds to the global economy and spurred on this search for yield,
since mounting revenues from higher oil prices were invested rather than spent by
governments that were now more fiscally conservative. In the major developed countries,
interest rates at the short end were also lower than normal for a long period after the mild
2001 recession in some of the G7 countries, as monetary policies sought to manage the
particular circumstances each country faced.
This was associated with an unusually stable period for macroeconomic conditions. The
"great moderation" in volatility of output and prices had been under way in the United States
since the mid 1980s but it became more obvious in many other economies in the 1990s and
2000s. In my mind, there is little doubt that this lowered perceptions of risk, and indeed it is a
fact that default rates on corporate debt, even sub investment grade debt, were unusually
low through the past decade. They remain low even on the latest data, up to end 2007,
though they will presumably rise somewhat over the next couple of years.
In this environment, the search for yield continued. This saw end investors consciously begin
to accept more risk in order to find the returns they were seeking. Additionally, the easy
availability of credit and benign macroeconomic environment led to an increase in the use of
leverage to increase returns further.
It also provided the demand side backdrop for the development of new instruments. The
innovative financial community obliged and provided ever more sophisticated ways of
achieving the returns desired by investors. The innate complexity and, in some cases,
opacity of these instruments made their properties hard to assess. With this reduced
transparency, it was easy for investors to underestimate the risks that they were taking on.
Observable compensation for risk declined over time, as evidenced by various market
spreads, non price terms of loans and so on. This was something about which numerous
prudential supervisors, central banks and private bankers commented on over some years.
Eventually, something was going to occur that would trigger a reappraisal of risk. It is
remarkable that this took so long. Over several years, we had a string of events that could
have, and in other times surely would have, triggered a reassessment: prominent credit
rating downgrades of some major US corporations to sub investment grade status; a default
on foreign debt by Argentina, followed by rather rancorous negotiations over restructuring;
political instability in several countries; a very large rise in the price of oil; significant
tightening of US monetary policy up to 2006; the list goes on. Through all this, financial
sentiment barely missed a beat.
Then, in early 2007, the escalating losses on the 2006 vintage of US sub prime mortgages
first started to come to light. It took some months for those losses to show up in certain
hedge funds, structured investment vehicles and so on. But by July and August 2007,
enough had emerged for there to be a marked change in sentiment.
There is no need to give a detailed treatment here of subsequent events: they are well
known, so it is enough to observe the broad outlines. As the scope of potential losses
became clearer, the business models of some of the entities that were exposed came under
pressure, particularly those which were reliant on short term wholesale funding and/or
securitisation. Markets for asset backed commercial paper stopped the flow of new funding,
and for a time were very reluctant to roll over existing funding for entities that were seen to
have sub prime exposure. Much of the resulting funding pressure came back to the balance
sheets of the major international banks and investment banks that had initially sponsored
these entities. Essentially, they took the responsibility for funding sub prime assets. At the
same time, these and other institutions found that a number of other markets had also
become difficult to operate in. This saw them unable to shift loans originated from their
balance sheets, even though these loans were unrelated to the US sub prime mortgage
market - for example, loans associated with merger and acquisition activity.
In this climate of uncertainty over both credit exposures and funding needs, funding liquidity
pressures became acute on occasion during the second half of 2007. Short term market
yields became much less closely connected to the overnight rates that central banks typically
control. Central banks responded by expanding the scope and scale of their routine market
operations, adding additional liquidity, accepting a wider range of assets in their operations
and expanding the maturity of their lending facilities. There were also some internationally
coordinated actions to provide foreign currency funding under swaps between some of the
major central banks. Practices have continued to evolve.
The current international situation: where are we now?
Over the recent period, disclosures of losses associated with various credit products have
continued. Financial institutions and investors have continued to be wary of what credit
losses may yet be unearthed. Institutions have generally made strong efforts to disclose
exposures appropriately, but there are major difficulties in valuing the relevant assets, not
least because some markets have effectively ceased to operate - so no price can be
observed. It appears that some very high quality assets are valued at prices that embody
extremely pessimistic assumptions about returns.
Key segments of credit markets remain in difficulty. There have been few, if any, issues of
mortgage backed securities in recent months, though the commercial paper markets have at
least stopped contracting. It appears that the most highly rated corporate names can still
access capital markets, but many corporates are approaching their banks for funding.
Business credit provided by the banking system has accelerated in the United States over
the period since mid 2007.
This process of reintermediation is a very necessary one, if the flow of credit to the major
economies is not to be seriously disrupted. For the time being, and perhaps for some time
ahead, the financial intermediaries need to fill some of the gap that the capital markets have
suddenly left. With this comes, of course, the need for those intermediaries to have adequate
funding themselves - one obvious reason for the pressure on term funding costs. They will
also need sufficient capital to take on the risks inherent in the lending, since capital markets
apparently no longer wish to accept those risks. This is, in fact, a key element of the whole
situation: more capital needed to be carried by the big international banks to support the risks
they were taking, and that capital has to be found now. In addition, the risk capital that was
available from markets is no longer there to the same extent.
The intermediaries have found substantial capital over recent months. By curtailing share
repurchases and reducing dividends, several intermediaries have generated some of the
necessary capital internally. More crucial has been the fresh capital raised though selling
stakes in their businesses to individuals, institutions and governments.2 These deals,
however, have been costly, leading to a significant dilution of the interests of their existing
shareholders. Irrespective of this, with both these sources of capital, intermediaries have
been able to maintain, and in some cases increase, their capital ratios - even when they
have reported significant losses. With this being the case, they have also, at least so far,
been able to step in to fill the gap in corporate funding.
In addition to reintermediation and the pursuit of new capital, we are seeing a significant
process of de leveraging. Entities with high leverage and/or complex structures have come
under significant pressure in recent months as share markets question their resilience, and
lenders seek a reduction in risk. We have seen some notable cases of this in Australia, but
they are merely a reflection of what is going on in the major markets of the world. Private
equity firms, hedge funds and so on, all find the environment much less accommodating than
was the case a year ago. This process of balance sheet contraction has been an additional
further factor disrupting markets of late, as asset sales have to be absorbed under already
skittish conditions.
In the meantime, real savings are still flowing into pension funds, insurance companies and
other institutional investment vehicles. This is genuine capital, seeking a productive use. But
these investors appear to be taking a more cautious approach to risk, given the short term
uncertainty over asset valuations. It is a fair bet that they have higher positions in cash -
overnight or very short term highly rated securities - than would normally be the case. This is
placed largely in banking systems, so the major intermediaries are, I expect, generally flush
with very short term liabilities, even though longer term funding remains difficult. This means
that these intermediaries may be undertaking more maturity transformation than they would
ordinarily find comfortable.
Increasingly, there are good quality assets at prices that would, in normal times, be very
attractive. At some point, investors who are currently on the side lines will need to summon
enough confidence to take up the opportunities for profitable exposure to risk. It is impossible
to say when this will occur, but we can perhaps outline what the pre conditions are. Investors
will want a reasonable level of confidence that the bulk of the losses in the most important
institutions have been accounted for and disclosed, that remaining "excess" leverage has
been essentially sorted out, and that any remaining downside risks to asset quality stemming
from slowing growth in the major countries are manageable and within the set of normal
parameter variation that their portfolios can cope with.
Where to from here? Issues for policy makers
This financial instability presents a difficult set of challenges for policy makers around the
world. First, central banks have the obligation to maintain liquidity at the core of the system.
In the face of repeated system wide surges in the demand for liquidity, they have
accommodated that demand. They have also been prepared to lend at longer terms than
usual, and deal with a broader range of counterparties in order to foster a little more
confidence in the availability of funding beyond the very short term. The Federal Reserve has
also facilitated the absorption of Bear Stearns by a stronger competitor, by being prepared to
use assets from its own balance sheet in a collateral swap. This is, however, not a "bail out"
- the shareholders and managers of Bear Stearns have lost a great deal of money, but the
system will be stabilised.
Turning to the Australian setting for a moment, in the Reserve Bank's case, we have been
prepared to increase the total amount of liquidity substantially, as required. We have widened
the range of eligible collateral for repurchase agreements (we already had a pretty wide
range of counterparties prior to last August). We have also been prepared to enter into
repurchase agreements for six months and longer on occasion, given the pressure on market
funding rates at that horizon. Even with that, however, the relationship between the cash rate
(or, more correctly, the expected future cash rate) and rates on high quality private paper at a
three to six month term is much looser at present than it has tended to be over recent years.
This means that the cost to banks of raising funds in the market has moved independently of
the overnight rate. The presumption that their lending rates would and should move only in
line with the cash rate, which had arisen in an earlier period when all these rates were much
more closely related, has not been a realistic one in the recent environment. Of course, in
setting the cash rate, the Reserve Bank has taken account of these shifting relationships, just
as it does shifts in other relationships in the monetary transmission mechanism.
Returning now to the global scene, central banks are continually assessing the potential
impact on economic activity and inflation from these events, as they evaluate monetary
policy settings. In the United States, the Federal Reserve has responded to evident
weakness in economic activity, and the risks posed by the possibility of a significant
disruption to credit provision, by lowering overnight rates quickly.
Elsewhere, policy makers are trying to assess the potential spillovers. The weak US
economy and depreciating US dollar will have some impact via reduced trade in goods and
services. But that channel is less important than the possibility of financial contagion from a
set of forces not confined to the United States but affecting international capital and money
markets generally. What complicates matters is that policy makers have to consider that
possibility at a time when they are also confronted with a troubling level of inflation in a
number of cases.
Longer term, a number of issues arise that are the subject of intense work in the central
banking and supervisory community. Arrangements for the provision of liquidity by central
banks have been changing in response to the events of the past eight months, but it is likely
that there will be continued discussion about whether further refinements might be sensible.
These will include how to make arrangements sufficiently flexible and adaptive, including
across borders, which may be needed given the globalised nature of markets.
The discussion will also need to pay due regard to the potential for other consequences of
changes to practice in this area, including the possibility that private entities become so
confident that liquidity risk has effectively been removed that they end up taking more risk of
other types. That could leave both themselves and their central banks in an awkward position
at some point down the track. So in parallel with ongoing development of liquidity
arrangements by central banks, there will need to be a focus in the supervisory community
and the banks themselves on liquidity management.
Conclusion
International financial events over the past nine months have been a source of considerable
instability. Risk that was always in the economic environment has belatedly been recognised.
The ensuing process of assessing and disclosing losses, finding new capital and de
leveraging has been very difficult. Matters have not been helped by the opacity and
complexity of some of the financial instruments involved, and the associated problems in
valuing them.
For market participants and policy makers alike, this environment has been challenging
indeed. Those of you in the markets are dealing with heightened volatility and uncertainty.
Policy makers, meanwhile, are working hard to stabilise the present international situation. In
some countries, especially the US, that involves being prepared to take measures quite
aggressively, in an effort to avert a cumulative spiral of declining asset values and
deteriorating creditworthiness feeding back on itself and doing great damage to the
economy. In other countries, where financial strains are also occurring though not always to
the same extent, it has thus far involved significant changes to liquidity management, while
balancing the financial risks against other macroeconomic risks in an effort to foster long run
stability. In all countries, though, policy makers are also keeping an eye out for the potential
low probability, but high cost, downside events that could emerge.
It looks as though the environment will remain quite challenging for us all for a while but the
strength of the Australian financial system is, for Australia, a good basis for meeting the
challenge.