Yves Mersch: The recent sub-prime turbulences and their consequences
for Luxembourg
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Association
of the Luxembourg Fund Industry (ALFI) Spring Conference, Luxembourg, 19 March 2008.
* * *
Ladies and Gentlemen,
I want to thank the ALFI organisers' for inviting me to this conference and share with you
some thoughts on the challenging question regarding the recent sub-prime turbulences and
their consequences for Luxembourg. In fact, several months after the beginning of the
financial turbulences as we experience yet another wave shock of a propagating crisis, this
conference is now timely appropriate for such an exchange of views in order to assess, in an
environment still characterized by vast uncertainties, the impact of the turmoil and identify
areas for action to minimize risks and safeguard our financial system.
1 Factors underlying contemporaneous financial turbulences diffusion process
Let me begin by recalling that until recently, the valuation of the impact of the sub-prime
turbulences was focused on asset-backed securities, and particularly those backed by US
sub-prime mortgages and to some extent leveraged loans. Given that the origin of the
turbulences is mainly linked to the US mortgage market, some experts were suggesting that
the developments linked to this negative shock would remain to a large extent confined to
the US Economy. However, there are several reasons to wander from this optimistic view.
First, the process of globalization in the financial system has advanced more rapidly than in
other economic sectors. This is particularly relevant for the money market, bonds and
equities markets, OTC and derivatives markets. Unfortunately, as usual, one aspect of this
process is: "there are no free lunches in the economy" which means that globalization has
also negative effects on financial stability. The outcome of globalization might certainly
spread risks but in the same time pave the way for shocks to propagate rapidly among
markets and participants. Contagion becomes a realistic scenario.
Secondly, large banking or financial institutions now operate internationally either through
branches and subsidiaries or through several segments of the financial system, thereby
easing co-movements and exposure to common shocks. A simple measure of the intensity of
the geographical scope of foreign activities is the total assets held by banks outside their
home country and/or world-wide assets held by intermediaries in their balance sheets. In this
respect, the foreign assets held in non-EU countries by the EU key cross-border banking
groups' account on average for 29% of total foreign assets of these groups, reaching up to
around 50% for some institutions. An additional indicator illustrates the increasing intensity
and scope of the international financial activities relative to the world trade one. In this
regards, chart 1 shows both the proportions of global trade and cross-border holdings of
assets that are accounted for by developed economies. It is certainly useful to notice that
over the past decade, the world trade share of these economies has declined significantly,
while their holdings of the cross-border financial assets have increased substantially. This
indicates that foreign markets have become as important as domestic markets, and banks
now compete throughout the world. Indeed, the globalization process enlarges the
opportunity for banks to diversify their portfolios and risks associated with their financial
decisions. However, while this may be true for individual intermediaries, the system as a
whole may become less diversified if its exposure to the same sources of risks or shocks
increases.
The third reason is that IT technologies and technical progress has contributed significantly
to minimizing costs of conducting financial activities around the world. In this context, we all
agree that the appearance of a shock in one country or financial difficulties affecting a sector
or an individual banking group may spread to other countries through numerous channels
which are more or less known. The US sub-prime market crisis, although not the only one,
illustrates the speed of the spill over and its severity for other areas and asset classes.
2 The recent sub-prime crisis: contagion effects and implications
I would now like to move to the development of the contagion process in relation to the
recent financial turbulences. To that end, four distinguished phases can be identified:
•
From August 2007 until December 2007, emergence of market liquidity problems
and decrease of investors' risk appetite. Individual actions of central banks
combined to coordinated liquidity operations since December have led to a short
term easing of strains in money and interbank markets and contributed to diminish
the risk of downward market turbulences to go forward. Without a flexible and rapid
response by central banks, the widening of strengthened market liquidity constraints
would be harmful to financial stability. Notwithstanding the improvement in
conditions in short term money and banking markets, there are indications that
funding markets continue to be a cause of concern for several banking groups.
•
Given the magnitude of the sub-prime shock, the second phase relates to the
emergence of problems closer to solvency issues. The impact was indeed less
pronounced in the EU compared to the US, but, we have to be conscious that in
some cases and without public interventions, as in Germany and the UK, a few
banks would have been in serious trouble. At a recent conference at Banque de
France, Professor H. Rey of London Business School assigns the contagion from
relatively small losses in the U.S. sub-prime market of a magnitude of USD 200
billion into a global financial turmoil to three major market dysfunctionalities: 1) the
first one is due to the originate and distribute model; 2) the second one can be
explained by a process referred to as the CDS vicious circle; and the third one 3) is
attributed to mark to market asset valuation. In fact, one of the core lessons of the
current financial turbulences is the failure of the "originate-and distribute" business
model. Until the sub-prime crisis, a number of experts argued that securitization had
contributed to a stabilizing effect on the global financial system through diminishing
the degree of risk on the banking sector by sharing it more widely. Theoretically, this
will be the case. But, excessive recourse to securitization in reality may create a lot
of uncertainty and increase the opaqueness of the financial market. Indeed, several
financial institutions were unable to give us their real exposure to the sub-prime
market. In addition, the still heterogeneous disclosure across firms raises doubts on
the realism of the valuation provided by the industry. Many have to confess that they
did not understand the complexity of various financial products they use. In addition,
the impact of the US mortgage defaults has spread to other asset classes and
across the global financial system. Investors did not know which parties were
exposed and how big their exposures were! Uncertainty got settled and gave rise to
both more market volatility as we have seen in recent months and to a sharp
increase of investors' risk aversion (see chart 2).
•
Since December 2007, attention has been drawn to insurance companies and their
monoline financial guaranty activities. The monoline insurers became the next
potential victim of both sub-prime crisis and financial market turmoil. Until the recent
turbulences, monoline insurers were very successful at avoiding losses and their
business model exhibited a very high operating leverage with a fairly low capital
base and reserve positions compared to the amount of insured risk. This common
practice was allowed in the past, but has become a major source of concern at
present. In this context, I would just recall that monoliners activity was traditionally
limited to guarantee US-municipal bond issues with low default probabilities that
involve small capital cushions. However, extending their activities through insuring
ABS structures coupled to current market conditions are putting pressure on their
capital cushions. In fact, the loss assumptions for the bucket of structured finance
bonds wrapped by monolines, which are partly formed by US sub-prime mortgages
and CDOs, have been revised sharply higher. Under these new assumptions, the
excess capital of many monoliners is insufficient and requires fund injections to
meet their capital requirements or avoid a downgrading. In addition, banks may
exhibit numerous types of exposures to monoline insurers. In the case of
materialization of these risks, banks are likely to face more provisioning or write-offs.
•
As for the CDS vicious circle (see chart 3) some banks with no exposure to
subprime saw a sharp rise of the spread of their traded CDS from 30 basis points in July
2007 to 700 basis points during the recent turbulences. This is mainly due to a
pronounced increase of doubts and uncertainties. In this context, banks cannot raise
as much funds on the market as they need because of both rising costs and fierce
competition for collecting customer deposits. As a consequence, the balance sheets
of banks deteriorate. The CDS spreads widen further and downgrading looms
potentially intensifying the negative impact on capital cost and balance sheets.
Overall, the procyclical spiralling down of asset values stems from the
implementation of the so called fair value accounting methodology. As we know, in
distressed times, the mark to market valuation is even worse for illiquid and/or
senior asset classes with long maturities. The recent experience shows that this is
typically the case for most of the assets hold by financial intermediaries, banks and
insurers. The impact on banks' net worth has henceforth been more noticeable. This
is due to falling mark to market investment values rather than to impaired credit
quality or defaults.
• Still, the is the current focus of
impact of turbulences on the real economy
attention. As you know, in recent decades many countries have experienced some
financial turbulences and banking crises. Much of the economic literature reveals
that financial turbulences involving the banking or financial sectors may lead to
disruptions in the real economy. The past banking crises in the developed countries
illustrate the importance of the damage, both in terms of direct fiscal costs relating
mainly to managing the crisis and loss of economic activity. In this regard, an
academic article published in Journal of Banking and Finance in 2003, assessed the
cumulative consequences of past banking crises in terms of output dip and fiscal
costs for nine developed countries. As indicated in the table (1), the impact for
Japan, since 1992, amounts to 28% in terms of GDP and 20% in terms of fiscal
costs. While the fiscal costs of the 91-94 crisis in Finland reached 11% and the
output dip was around 23% of GDP.
While all of these results are consistent with the credit and exchange rate channels theories
regarding the impact of banking instability on real economic activity, we need to explore other
alternative explanations of the recent financial turbulences before drawing any hasty
conclusion. In particular, we need more understanding of the financial market channel,
which is usually neglected in economic theory as well in empirical studies.
In this context, let me briefly touch upon the differences between the US and the Eurozone
financial structure as illustrated by table (2) below. While the US financial system is often
described as a market based system, the Eurozone financial system is recognized as a
bank-based system. Given this idiosyncratic feature, the financial market channel could be
favoured to assess the consequences of the financial turmoil on the US real economy,
whereas the credit channel seems to be more suitable in the Euro area. This means that
monetary policy in the euro area can more easily affect the balance sheet of banks and may
affect the economy in a wider sense compared to the US. Beside, the impact of the
Eurosystem interventions in order to prevent or limit contagion may materialize in shorter
time-frame. So far for theory.
Nevertheless, the views should not be confined to this divergent financial system structures.
Indeed, the euro area financial system shows a trend towards more financial market
activities. The growth of securitization market in the euro area has been remarkable despite
the recent slowdown owing to the unravelling of the credit market turmoil since mid-2007
(see chart 4).
Thus, the annualized issuance of the euro-denominated asset-backed securities increased
from €50 billion in 1999 to almost €400 billion in mid-2007. It is worth noting, however, that
securitization activity in the euro area despite the strong growth observed in recent years
remains well below the level of activity in the US and the UK. In fact, chart 5 shows that the
amount of securitization in the euro area remains at a marginal level (less than 3% of GDP),
while in the US the peak reached 16% of the GDP in 2005 and in the UK the peak reached
11% in 2006.
Similarly, the issuance of euro-denominated collateralized debt obligation (CDOs), as
illustrated by chart 6, increased from basically nil in 1999 to a peak of almost €70 billion in
2006. While at a global level, the issuance of CDOs between 2004 and 2006 has tripled
amounting to around €330 billion in 2006. A major part of the CDOs are so-called synthetic
securitization instruments and collateralized loan obligations (CLOs) have been the
predominant type of CDO in the euro area (see chart 7). However, it is useful to note the
substantial drop of these figures in the most recent months. I draw the attention to the
deceleration of securities issues in the euro area published one hour ago.
These developments reveal a gradual decline during the past decades in importance of the
traditional model of financial intermediation in the euro area whereby banks obtain funding
mainly via deposits and use these funds to grant loans that they hold to maturity. In fact, as
already mentioned, a new business model qualified as the "originate-and-distribute"
business model was in the process of replacing, if not complementing the traditional one.
Through the originate-and-distribute model, banks are increasingly relying on market-based
funding and transfer a significant part of their credit risk off-balance sheet. However, this new
model raises several issues due in particular to the loosening of the link between the debtor
and the creditor. Whereas in the conventional model, banks favour customer relationships
meaning that banks have the necessary incentives to monitor carefully the lending activities
and assess properly credit risks. The convergence towards the new business model
stimulates an increasing information asymmetry and uncertainty and thus affects the degree
of market efficiency.
Recent experience has shown the limits of this model and the opacity emerged from the use
of highly complex instruments and derivatives. In this context, how strong is the risk of
adverse selection underlying this model in particular in securitizations? Is the
substitution process between the two models reversible? If not, what are the
corrective measures to be taken to promote financial stability?
3 Reflections on the implications for Luxembourg
In the next part of my speech, I will try to shed light on how Luxembourg has been impacted
by these turbulences and what we expect in the near future.
As regards the most pressing concerns, the liquidity position of the Luxembourg banking
sector was hardly affected according to the standard indicators which display a liquidity level
considerably higher than the minimum required which is currently set at 30%. However, as
central bank we follow with a great attention the liquidity needs of the Luxembourg banking
system. As a result, during the turmoil months, we have observed the participation of 4 to 5
additional counterparties for some MROs even if on the average the number of bidders has
remained unchanged. Furthermore, as regards LTRO operations, we have also noticed an
increase in the average bid amount from €3.9 to €4.3 billion. However, the average
aggregate amount of liquidity provided by the BCL to its counterparties has not risen
compared to the end of July. Notwithstanding this fact, an increase of 20 % in the total
collateral deposited at the BCL by our counterparties has been observed from July to
December 2007. By this, counterparties might have intended to ensure a potential access to
liquidity if needed. Finally, the BCL as a member of the Eurosystem is participating in the
joint actions of the ECB and the Federal Reserve, providing US dollar funding to Luxembourg
counterparties. The relative portion of central bank provision of liquidity shows, however, that
other national central banks than Luxembourg have increased their shares in the total
liquidity provisions. This would allow for two deductions: Either the Luxembourg financial
sector is less affected by the crisis and the stable need of domestic intermediaries for central
bank liquidity may reflect the net creditor position and the soundness of the aggregate
balance sheet as well as the relative independence of these banks inside their groups. Or, as
a consequence of the crisis, core functions of banking groups have been further centralized
and funding and liquidity management is concentrated even more at headquarters than
before.
Let me add that the relative share of Luxembourg banks in securitization is low relative to
international standards. Therefore, banks in Luxembourg might be less affected on the
liquidity side of the balance sheet than on the asset side.
As regards the impact on the economic activity, the fallout from the US housing market
problems has provoked a downturn that proves to be more severe and more protracted than
initially assumed. In this respect, the euro area and the Luxembourg economy can hardly
escape the ripple effects of the slowing US demand and possibly also the exchange rate
channel. A fortnight ago, the Eurosystem published an updated set of the staff
macroeconomic projections, which, in the context of the financial market turmoil, are
characterised by an exceptionally high level of uncertainty. Currently, the ECB staff expects
real GDP growth to turn out at around an average of 1.7% in 2008 and 1.8% in 2009 while
the inflation forecast has been revised upward respectively. to 2.9 and 2.1%.
But beyond these traditional channels, are there symptoms of impending problems with
potentially more profound consequences? It is well-known that the banks have in the past
relaxed their lending standards, by accepting higher loan-to-value ratios or by lengthening
the duration of mortgage loans, from the typically 20 years to up to 30 years or more. A more
aggressive pricing policy via a lowering of the compensation for the incurred risk has also
been observed. But that is still a far cry from the practices of some US banks. So-called
subprime loans are also not relevant for Luxembourg.
That may actually be the direct consequence of a more conservative approach to financial
innovation. Though Luxembourg cherishes its position as an international financial centre
and ought to promote the innovation process, it should nevertheless be wary of excesses
and perverse side-effects. Unlike in the USA, the securitization of mortgage loans is not
widespread and these loans usually remain on the banks' books. That in itself should provide
- and it probably has provided - the necessary incentive for the banks to monitor carefully
their lending activities and to assess properly the reimbursement capacity of the borrowers.
What were the immediate consequences of the financial market turbulences on the
Luxembourg financial centre?
Despite recent favourable information on the relative growth performance of the Luxembourg
fund industry, monthly data as illustrated by chart 8, show a decreasing trend of net asset
growth rates. This trend can be attributed to both the cyclicality of funds' activities and their
dependence on market performance as well as to a strong competition from other major
financial centres. .
The sharp drop in financial markets prices and the ensuing prudent behaviour of customers
has also impacted on the banks' trading income. According to the banking sector's
aggregate profit and loss account, the net trading fees have fallen continuously, though not
at dramatic proportions, since the beginning of 2007. These developments are also borne out
in the National Accounts data. However, for 2008 interest income may still benefit from the
positive impact of business inertia. Amid a sharp drop in gross value added in the financial
services sector, real GDP growth in 2007Q3 turned out at 0.7%, below trend estimates. The
decline of net results for 2007 by 11.5% does also not warrant optimism for the contribution
of the financial sector to GDP in the last quarter of the year. This figure is, however, not yet
published for Luxembourg. The renewed fall in equity markets at the beginning of the year
coupled with a 5% drop in January of net assets of the fund industry, is also likely to be a
further drag on economic activity in Luxembourg.
Among the series of stress testing tools and macro-prudential indicators designed by the
BCL, the BCL built its own index to evaluate the degree of the banking sector's vulnerability.
The recent estimates (see chart 9) show an increase of the degree of banks' vulnerability
from the end of 2006 to the third quarter of 2007. However, the index forecast for 2008 and
2009, based on the December Eurosystem macro-economic projections, seems to indicate
that the degree of vulnerability would tend towards its average level. Still, it remains to be
seen how profitability in 2008 will be affected adversely by further valuation losses, increased
funding costs, slowing credit growths, declining non-interest income.
The BCL's retail interest rate statistics reveal that the banks' response to the money
market disruptions and the increase in wholesale funding costs falls short of what several
observers had feared. According to the data up to December 2007, the bank lending rates
applied on new loans (at variable rates) to households for house purchase have in the
course of 2007 actually eased by 20 basis points relative to the 50 basis points increase in
the ECB minimum rate. As regards non-financial corporations, the reference rate of loans at
variable rates is very often the 3-month Euribor. On this segment, we have noted a strong
impact as the lending rates rose by more than 70 basis points in 2007, hence 20 basis points
more than the adjustment in the key central bank rates. But that is still substantially lower
than the rise in the money market rates which, at their peak, reached more than 100 basis
points since January 2007.
Interest rates however are only one criterion of credit conditions. Banks can also adapt to
more stringent credit standards by raising the collateral requirements for example. Our bank
lending survey, which is part of the wider Eurosystem bank lending survey, provides very
useful information on issues such as the banks' lending policies, their demand perceptions
and their risk assessments. The September 2007 and January 2008 results highlighted the
tightening in credit conditions on accounts of the higher cost of funding. They were
nevertheless more optimistic than those of the euro area, and banks reported particularly
sustained demand by both non-financial corporations and households.
Reminiscent of the effects of the 2001-2003 downturn on financial markets, fiscal policy in
Luxembourg is not oblivious to the current developments. The financial services sector
accounts for about 30% of total tax receipts and complacency in the early stages can have
dire consequences for the medium term policy. After three years of significant revenue
windfalls, the development in 2007 continued to be stronger than what could have been
expected on the basis of the regular tax assessment bases. According to the preliminary
results, the central government balance also returned to a surplus equivalent to 0.7% of
GDP, for the first time after five years. Nevertheless, the outlook for 2008 is highly uncertain,
and, if the downturn on financial markets were to persist or to worsen, that would, akin to the
real GDP prospects, weigh on tax receipts.
4 Lessons to be drawn and concluding remarks
Let me now share with you some reflections about lessons that may be drawn from the
recent turmoil. There are a number of weaknesses that have been highlighted during the
recent months and call for corrective actions by the private and public sectors. A financial
sector that generates on the one hand huge revenues for some of its participants but on the
other hand regular crises with high costs for non-participants, is in my view ripe for a hard
look at the balance of existing incentives.
The first issue that I would like to stress is the obvious underestimation by financial actors
and supervisors of the actual degree of leverage in the financial system. This leverage is
not only generated by traditional banking activities but also by highly leveraged institutions,
SIVs, conduits, LBO-financed firms etc. Yet there has been an imperfect assessment of the
existing risks arising from the linkage between the banking sector and all these SIVs and
conduits. Indeed, the recent financial turbulences have pointed out that significant risks may
be transferred back to banks using puts, guarantees, credit lines or other mechanisms.
Hence it seems urgent for the financial industry to improve its risk management practices
and the transparency in this respect. These characteristics, coupled with inadequate pricing
and valuation, were at the heart of the present liquidity turbulences, implying a high degree of
uncertainty about the size and location of the risks in the securities market.
Another key issue of concern is related to the respective responsibility of
credit rating
agencies and professional investors. Banks appear to have outsourced a significant part of
their risk assessment and due diligence to rating agencies and credit scoring programs. It
might however be worth recalling that credit agencies only measure the probability of default
but with no responsibility or legal liability to those who use the ratings. In that sense, the
information provided by rating agencies to investors on structured finance products definitely
needs to be enhanced in order to increase investors' awareness of the effective risks
associated with these products. Also, I believe that the market needs to find a better balance
between investor due diligence and agency ratings. Finally, potential conflict of interest
should be raised in this context, whereby rating agencies are paid by the issuer they rate. In
response to these critics, the three major rating agencies have now taken a first step in
announcing a set of measures intended to address these diverging interests and enhance
their valuation methods.
Besides self-regulatory responses to be urged in the areas of risk management, disclosure,
asset valuation and credit rating agencies, several initiatives have been launched recently or
are currently being discussed by regulators, supervisors and central banks in order to
promote a stable financial system. There is a consensus towards the need to strengthen
for the banking sector, in particular regarding the treatment of
EU's prudential framework
large exposures, banks' capital requirements for securitisation including liquidity facilities for
SPV's as well as liquidity management. Do we need supplementary capital buffers to
complement risk-based capital measures? Do we need to address the procyclicality still
embedded in the new Basel II capital standards? Supervisors should also undergo an
analysis of the incentives that prompted banks to move some assets off balance sheet, even
though they still held the risk exposure.
As I mentioned, the new IAS/IFRS accounting standards raises some concerns regarding
procyclicality of mark to market valuation. It might be appropriate from a financial stability
point of view to reflect again on the proposal of a dynamic provisioning approach.
Let me now bring up a final area that has been recently emphasized by the finance ministers
and central bank governors alike. Indeed, the past turbulences have highlighted the
necessity of adequate cooperation and information exchange mechanisms between
central bankers, bank supervisors, and financial regulators at the national and international
level. These mechanisms should ensure a timely and appropriate response to market and
institutions in stress situations. The prominent role of recent central banks in the resolution of
potential financial or banking crisis by the provision of liquidity has again been underlined
during the recent months. It seems to me that central banks have the ultimate responsibility
for financial stability and central banks alone have the resources to serve as potential lender
of last resort when the need arises. In order to allow for a timely decision by a central bank to
potentially grant emergency liquidity assistance, it is of outmost importance that it has
access, in normal and in times of crisis, to adequate information. And this includes
supervisory information.
Looking at the Luxembourg legal and institutional framework for crisis prevention and
management, important weaknesses need to be settled. Given the relevance of the financial
sector, I hope that the legislator will in the end acknowledge the mission of the BCL in that
field. I will also not repeat my concerns about the non funded depositor guarantee scheme in
Luxembourg.
Let me conclude by saying that the present financial crisis will probably drag on for longer
than initially foreseen. The process of deleveraging and re-intermediation, the repricing and
quality deterioration of assets amplify uncertainties. The later will persist until the full
magnitude of losses on individual financial institutions will be clear. Given the size of our
financial sector and its role of engine for the economy, Luxembourg authorities need to take
a step ahead and put in place an institutional framework that allows for an effective response
to stress situations and thus, ensures the promotion of a stable financial system.
Thank you for your attention.