Nout Wellink: Financial globalisation, growth and asset prices
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the International Symposium on "Globalisation,
Inflation and Monetary Policy", organised by the Bank of France, Paris, 7 March 2008.
* * *
Financial globalization and financial innovation
I have been asked to introduce the round table with a group of very distinguished panellists
who will discuss the topic of "Financial globalisation, growth and asset prices". I was pleased
to see that the panellists, through their different fields of expertise, will be able to illuminate
us with a broad range of ideas on this topic.
Before giving them the floor, let me raise a few issues. Financial globalization, like most good
things in life, has its doses of risks and challenges. The recent wave of financial
globalization, which began in the mid 1980s, has been seen as a catalyst for financial
innovation. We have witnessed borders opening for banks and other market players. As a
result, global financial markets have become deeper and more diversified and financial
products have become more complex. In response to these changes, supervisors and the
industry have had to keep pace by adapting the regulatory structures. The Basel II
framework in that sense is inherently flexible with its risk-based approach. Even so, as
lessons from the turmoil become clearer, it may be necessary to fine-tune certain elements
of Basel II.
To make our work as central bankers even more interesting, financial globalization has
changed the environment for monetary policy with the growth of cross-border financial flows
and the transfer of risk across different jurisdictions. In response, central bankers have also
taken a number of steps to adapt their strategies to support financial markets and price
stability. Just to mention a recent example, the collective actions among central banks to
facilitate liquidity provision in short-term money markets were an important initiative in this
sense.
But to what extent does increasing financial globalization affect the efficiency and stability of
asset prices and economic performance in general?
Financial globalization, growth and asset prices
In the past years, as financial globalization and deeper financial markets became more
prominent there was an improvement in the stability of the macroeconomic environment.
Global inflation was contained, accompanied by a decline in the volatility of economic growth,
exchange rates and interest rates leading to the so-called Great Moderation.1 These factors
contributed to improving market sentiment. Liquidity seemed plentiful and this perception had
a strong influence on the behaviour of investors and their risk tolerance, which grew with the
search for yield. Alternative asset classes began getting large injections of liquidity. Real
estate, high risk credit products, private equity and art, for instance, saw their prices rise
considerably, which increased the potential for financial bubbles. Capital flows to and from
emerging markets have also been surging. In the past five years, emerging markets have
seen capital inflows almost six fold, raising challenges for many economies.
This environment contributed to a new trend in financial innovation, mainly through
securitization and a change in banking strategy to the so called "originate-to-distribute
model". This model allowed banks to originate loans, pool credit risks and sell them on to
investors. The securitization of mortgage loans became an important platform for the
originate-to-distribute model. Initially, a problem that started in the US housing market,
spread rapidly across borders and across other financial markets, particularly to where credit
risk had been transferred but not exclusively. There continues to be a generalized
uncertainty related to valuation losses of securitized products ($250-600 billion), the use of
credit ratings, possible spillover effects to other financial institutions (including monoliners)
and the overall impact of the turmoil on global economic growth. The recent developments in
the US and in foreign financial markets are stimulating considerable review and analysis.
Regulators, supervisors, central banks, accounting boards, rating agencies and academics
are trying to distil lessons from the crisis. To help address and coordinate this endeavour, the
Financial Stability Forum for instance, has set up a working group on Market and Institutional
Resilience. This group has analyzed the causes of the market turbulence and proposes
policy directions to strengthen financial resilience. The results of the report will be available in
April 2008.
The quality of financial globalization matters
If markets remain fragmented, not all the fruits of financial globalization can be reaped.
Consequently, we probably need to work more in a concerted fashion to enhance the quality
of globalization. Let me address some lessons from the recent turmoil:
•
First, I would stress that complacency in risk management is often fertile soil for
financial distress. Complacency spread through global markets has contributed to
over-optimistic assumptions for market liquidity conditions and led to a great reliance
in rating agencies.
•
Second, in the past, liquidity risk management had not been at the centre stage.
Most improvements in liquidity risk management were tailored for each country.
Today, there is consensus among supervisors and the banking industry that liquidity
risk management needs to be upgraded to capture the implications of a more
globalized financial system and the rapid growth in financial innovation.
•
Third, the originate-to-distribute model encountered several shortcomings: The
suboptimal incentives in the chain of origination, acquisition and distribution led to a
poor assessment of risks, based on the expectation that credit risk could be quickly
transferred through securitization. Another important weakness was the inadequate
information on products and the quality of underlying assets. Moreover, the model's
dependency on market liquidity made it extremely vulnerable.
•
Fourth, recent events that have led to changes in the implementation of monetary
policy through open market operations. G10 central banks took coordinated
measures to bring money market rates back down to target levels.
• Finally, from our specific experience at the Dutch Central Bank, I must add that the
combination of central bank and supervisor led to a successful internal
communication structure and to timely interaction with the financial industry during
recent events.
Follow-up issues
To conclude, the pace of financial developments has accelerated with financial globalization.
Consequently, we must remain exceptionally alert and flexible to encounter adverse
dynamics that may threaten financial or economic stability. In my opinion, developments that
should be followed closely are the strengthening of risk management and the implementation
of Basel II. There are other interesting issues to follow-up such as the role of sovereign
wealth funds in a context of globalized financial markets. I trust that the panellists will focus
on this and other interesting issues in the coming hours.