Paul Fisher: The state of the financial markets
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, at the
Institutional Investor Institute, Bedfordshire, 29 June 2011.
All speeches are available online at www.bankofengland.co.uk/publications/speeches.
* * *
I would like to thank Ronnie Driver, Andrew Harley, Tanveer Hussain, Ben Wensley, Richard Windram and Chris
Young for their help in preparing this speech.
Any views expressed are solely those of Paul Fisher and should not be ascribed to the MPC or FPC unless
explicitly stated as such.
The Bank of England has two core purposes. The first is maintaining monetary stability. That
means achieving stable prices as defined by the Government and ensuring confidence in the
currency. The second is contributing to financial stability. That entails identifying, monitoring,
and taking action to remove or reduce systemic risks with a view to protecting and enhancing
the resilience of the UK financial system. The interim Financial Policy Committee (FPC) was
set up by the Government earlier this year to help meet this objective.1 It has now had its first
round of meetings and a record of its first policy meeting and the associated Financial
Stability Report
were published just last week.2
To help meet these objectives, the Bank runs a Market Intelligence (MI) programme, which
involves frequent meetings and conversations between Bank staff and a wide range of
external market contacts to gather and analyse information from market participants. The
Bank is uniquely positioned to run such a programme, given its public policy objectives, its
own sterling and foreign currency operations, and its location within one of the world's
foremost international financial centres. Up to 70 Bank staff, the vast majority of whom have
other, full-time operational duties, help to collect MI as part of their day-to-day
responsibilities. Personally, I estimate that, over the past 6 months, I have been involved on
average in two meetings with market contacts every working day. Our external contact base
is very extensive,3 internationally diverse,4 and covers a wide range of markets, from vanilla
instruments such as gilts and equities through to all manner of derivatives.
This MI programme makes a crucial contribution to meeting the Bank's core purposes by
(partially) making up for missing data (at least qualitatively and occasionally quantitatively)
and helping us to understand better the behavioural patterns that underlie movements in
financial variables. On the monetary policy side, for example, it can shed light on the drivers
of commodity prices and changes in market-based measures of inflation expectations. On
the financial stability side, the significant complexities in the financial system, the lack of data
and the constantly and rapidly evolving nature of financial markets mean that MI is
particularly useful in helping us spot the emergence of stress and new developments and
risks that might introduce potential vulnerabilities and fault lines in parts of the financial
system.
Today, I want to use the insights gained from our market intelligence work, together with
market data, to provide an overall assessment of the state of financial markets, including the
extent to which they have recovered since the depths of the financial crisis, the impact of a
renewed reach for yield on financial innovation, and the impact of the regulatory agenda on
market functioning.
The evolution of financial markets during the crisis
To set the scene, it is instructive to look at the general pattern in markets over the past few
years. Chart 1 uses a "heat-map" to summarise data on issuance and spreads in primary
and secondary markets for selected bonds and asset-backed securities (ABS), compared to
their historical averages. The widespread panic and financial market seizure of 2008 is
clearly visible in the concentration of red and grey segments. The latter represent those
periods in which there was no primary issuance or spread data because the markets were
effectively closed.
Chart 1
Market functioning "heat map" based on issuance and spreads data(a)
Sources: Bank of America Merrill Lynch Global Research, Bloomberg, Dealogic, JPMorgan
Chase & Co. and Bank calculations.
(a) Shading is based on a score that reflects, for unguaranteed debt, both issuance (relative to
GDP) and spreads in primary markets and secondary markets, expressed as a number of
standard deviations from average, using as much data as was available from January 1998.
Updated to end-May 2011; recent months use 2011 Q1 GDP.
(b) Insufficient data for UK CMBS secondary markets.
Since the nadir in late 2008, most markets have been on a course of gradual healing. The
heat map shows how issuance and spreads in these particular markets have recovered.
Advanced economy corporate bond spreads have fallen back sharply since their peaks
Measures of volatility and bid-offer spreads across a range of asset classes have
(Chart 2).
also fallen back since the height of the disruption (Charts 3 and 4). And most international
equity indices have picked up markedly since their troughs (Chart 5).
Chart 2 Chart 3
Advanced economy corporate bond Implied volatilities
spreads(a) in selected markets(a)(b)
Basis Points Basis Points
1000 2500
Non-investment grade
900
corporates (RHS)
800 2000
Investment grade
700
corporates (LHS)
600
1500
500
400
1000
300
200
500
100
0
0
2005 2006 2007 2008 2009 2010 2011
Sources: Bank of America/Merrill Lynch.
(a) Option-adjusted spreads over government
Sources: Bloomberg, British Bankers'
bond yields.
Association, Chicago Mercantile Exchange,
Euronext.liffe, JPMorgan Chase & Co. and Bank
calculations.
(a) Three-month option-implied volatilities.
(b) Data to close of business on 14 June 2011.
(c) WTI crude oil.
(d) Average of FTSE 100, S&P 500 and Euro
Stoxx 50.
(e) Average of five-year on-the-run iTraxx Europe
main and CDX North America investment-grade.
(f) Average of USD/EUR, EUR/GBP and
USD/GBP.
(g) Average of three-month short sterling,
eurodollar and Euribor.
Chart 4 Chart 5
Bid-ask spreads International equity prices(a)
on selected assets(a)(b)(c)
Indices: 2 January 2007 = 100
120
Indices: January 2005 = 100
1400
Corporate bonds
110
Government bonds
(d)
Equities
1200 100
Commodities
Currencies 90
1000
Interest rate swaps
80
800
70
600
Euro Stoxx
60
FTSE All-share
400
S&P 500
50
TOPIX
200
40
2007 2008 2009 2010 2011
0
2005 2006 2007 2008 2009 2010 2011
Sources: Bloomberg, Thomson Reuters Datastream
and Bank calculations.
Sources: Bloomberg, UBS Delta and Bank
(a) Denominated in units of local currency.
calculations.
(a) Monthly moving averages of daily bid-ask
spreads.
(b) iBoxx € Corporates for corporate bonds; S&P 500
for equities; iBoxx € Sovereigns for government
bonds; sterling/dollar exchange rate for currencies;
gold price for commodities; and euro five-year swaps
for interest rate swaps.
(c) Data to close of business on 10 June 2011.
(d) End of day bid-ask spread until 1 May 2011,
average intra-day bid-ask spread thereafter.
This recovery in markets has been neither uniform nor smooth. For example, a number of
markets were severely disrupted by concerns about the debt sustainability in Greece, Ireland
and Portugal in mid 2010, and once again during 2011 (Charts 6 and 7 show these
countries' bond spreads to German Bunds and sovereign CDS premia). And a number of
private sector markets, such as the "own label" US residential mortgage-backed securities
(RMBS) market and the UK commercial mortgage-backed securities (CMBS) market have
seen very little, if any, primary issuance since the crisis.5 In part that reflects continued
weakness in commercial real estate and (to a lesser extent) residential housing markets. But
it is also likely to reflect the combination of a large existing stock of ABS and a diminished
investor base as many of the funding mechanisms have been swept away. These factors
have slowed the recovery in primary issuance, and suggest that ABS markets are likely to be
much smaller in future. Indeed some markets that were at the epicentre of the crisis, such as
those for structured collateralised debt obligations (CDOs), may be permanently gone.
Chart 6 Chart 7
10-year sovereign bond yield spreads Selected European
to German Bunds sovereign CDS premia
Basis points
Ireland
Basis points Basis points
1400
Italy
Portugal Italy
2000 800
Ireland Greece
Portugal
1200
Spain United Kingdom
1800
Spain 700
1600
UK
1000
600
Greece (LHS)
1400
500
800
1200
1000 400
600
800
300
600
400
200
400
100
200
200
0 0
0
Jan. Apr. Jul. Oct. Jan. Apr. Jul. Oct. Jan. Apr.
Jan. Mar. May. Jul. Sep. Nov. Jan. Mar. May.
2009 2010 2011
2010 2011
Source: Thomson Reuters DataStream
Sources: Bloomberg and Bank calculations.
Chart 8 Chart 9
Major UK banks' unguaranteed term Aggregate SLS repayment profiles
issuance in public markets(a)
Sources: Bank of England, Dealogic and Bank
calculations.
(a) 2011 Q2 is up to and including 15 June 2011. Term
issuance refers here to securities with original
contractual maturity or earliest call date of at least
18 months. This excludes debt issued under HM
Treasury's Credit Guarantee Scheme.
(b) It includes subordinated lower Tier 2 and Tier 3
capital instruments with debt features.
Despite a number of shocks along the way, markets have been increasing in their resilience
over the past two years. For example, UK banks have been able to continue to issue debt in
both public and private markets during 2011, in spite of renewed sovereign debt concerns,
the natural disasters in Japan and civil unrest in the Middle East and North Africa.6 Moreover,
that issuance has been spread across an increasingly diverse range of instruments including,
more recently, UK RMBS (Chart 8). This has helped the UK banks alleviate concerns about
the "funding cliff" of official sector refinancing at the end of 2011. For example, it has
facilitated the remarkable pre-emptive reduction in the amount outstanding under the Bank's
Special Liquidity Scheme (SLS), from around £90bn at end-February to just £37bn at the end
of May (Chart 9).
Chart 10
Credit Default Swap premia(a)(b)
Sources: Bloomberg, Markit Group Limited and Bank
calculations.
(a) Five-year senior CDS premia. Data are presented as
fifteen-day end-period moving averages.
(b) Chart shows data for a subset of the major UK banks
peer group - Barclays, HSBC, LBG and RBS.
(c) December 2010 Financial Stability Report.
(d) Average of the CDS premia of companies that were
part of the iTraxx European non-financial corporates
index (series 10) at the beginning of the time series in
this chart.
But this is no time for complacency. UK bank funding costs, as proxied by their CDS premia,
remain elevated - both relative to their historical average, and relative to European
non-financial corporations' CDS premia (Chart 10). And there remain significant risks going
forward. Sovereign strains, and their potential impact on the European banking sector in
particular, represent the most immediate and material threat to markets generally and to UK
financial stability. As a result, the interim FPC have recommended that the major UK banks
provide improved and more comprehensive disclosure of their sovereign and banking sector
exposures. There is also event risk associated with the forthcoming publication of the EBA
stress test results, if the results are markedly different from market expectations.
The search for yield/assets
The significant recovery in many global financial markets reflects, in part, the actions of
policymakers around the world. In the United Kingdom, the Bank of England responded to
the collapse in economic activity and the risk of deflation by cutting official interest rates and
embarking on a programme of asset purchases financed by the creation of central bank
reserves (known as Quantitative Easing). It also separately sought to stimulate markets for
corporate debt and commercial paper, and put in place a Special Liquidity Scheme for banks
to swap their illiquid collateral for highly liquid T-bills. Other central banks took a variety of
similar actions. For example, the Federal Reserve began purchasing a range of private and
public sector securities in large scale. And in Europe, the ECB responded by offering its
counterparty banks unlimited refinancing operations at maturities of up to 12 months.
Despite these differences in policy, one end result was common - they led to a massive
expansion of central bank balance sheets (Chart 11) and a significant injection of liquidity
into the global financial system. That in turn pushed down yields on "safe" assets,
encouraging portfolio rebalancing (one of the key channels through which asset purchases
work) and a "reach for yield".7
More recently contacts, especially those in the United States, have reported that the reach
for yield has been exacerbated by a perceived reduction in the universe of acceptable assets
for real money investors.8 For example major corporates, especially those in the United
States, are reported to be relatively cash rich. Flow of funds data suggest that the US
corporate sector is holding around $1trn - or 7% of total corporate sector financial assets - in
cash. That has led to a reduction in US investment grade net bond issuance and an
associated shortage of high-quality corporate assets, at a time when relative demand for
those assets is strong. And there has also been a reduction in US T-bill issuance, amid
ongoing concerns about the extension of the US government's debt ceiling. Similarly, serious
concerns about the creditworthiness of a number of euro-area sovereign issuers have led to
a reduction in the quantum of euro-denominated assets perceived to be "safe", with some US
money funds reducing their exposures to European banking sectors. And a number of other
structured and synthetic assets, which had been rated AAA prior to the crisis, have recently
been shown to be unworthy of that accolade.
Chart 11 Chart 12
Central bank balance sheets US, UK and Euro area GDP
£ billions
Local currency billions
Indices: 2008 Q1 = 100
350 3000
102
100
300
2500
98
250
2000
96
200
94
1500
92
150
United Kingdom
90
1000
100
Euro area
88
Fed (right-hand scale)
500
United States
50
86
ECB (right-hand scale)
BoE (left-hand scale)
84
0 0
2004 2005 2006 2007 2008 2009 2010 2011
2007 2008 2009 2010 2011
Sources: Bloomberg and Bank of England. Sources: ONS, Eurostat and Bureau of economic
analysis.
It is still early days, but the combination of portfolio rebalancing and this reported shortage of
specific high-quality assets might have wider implications for financial stability if it
encourages investors to look for additional yield by moving into more illiquid products (by
investing in new asset classes or in derivatives of more liquid underlying instruments) or into
more complex products (which they might not fully understand, and which might not be
appropriately priced for correlation, optionality or underlying credit risk). Market intelligence is
crucial here, in that it can provide us with near real-time information about whether and
where these risks might be building (or eventually crystallising).
So far, there is little evidence of excessive risk-taking on a generalised basis across the
financial system. But the intelligence we have gathered during 2011, notwithstanding the
recent pull-back in June, has flagged a number of pockets of increasing risk appetite and a
few specific markets which have been showing signs of excess. That tendency seems to
have been most prevalent in the United States, where the financial and real economy
recoveries appear somewhat more established than in the UK and the euro area (Chart 12).
But during recent discussions, some market participants have noted that this tendency has
begun to spread to Europe as well.
One example comes from the high-yield corporate bond markets, where demand has been
very strong and where issuance, which reached record levels in 2010, has continued apace
in 2011 (Chart 13). That is likely to reflect the generalised disintermediation of stricken
banking systems - for those that are able to tap capital markets, bond issuance poses a
useful alternative to bank lending. Moreover the extent of high-yield issuance may reflect the
fact that it is smaller businesses, which are likely to be sub-investment grade, who are finding
it hardest to secure affordable bank finance.9 Given oligopolistic banking systems like those
in the UK, a deeper and more liquid capital market might help improve the supply of credit to
UK businesses. Indeed, recent MI has suggested that there has been some direct lending
activity to mid-sized corporates in the UK by non-bank institutions such as dedicated loan,
private equity and pension funds (although the absolute amounts are still very small).
Chart 13 Chart 14
Issuance of sub-investment grade Corporate bond valuation measure(a)(b)
corporate debt by region(a)(b)
Sources: Bank of America Merrill Lynch,
Bloomberg, Thomson Reuters Datastream and
Bank calculations.
Sources: Dealogic and Bank calculations.
(a) Shows the difference between actual and
(a) Emerging economies includes Africa, Caribbean,
estimated equilibrium spreads as a percentage.
Indian subcontinent, Latin America, Middle East,
Positive numbers represent overvaluation,
North Asia and South East Asia. "Other" includes
negative numbers undervaluation.
Australasia and Japan. Includes issuance in all
currencies. (b) Equilibrium corporate bond spreads are
defined as the total estimated credit component
(b) 2011 data are to 3 June 2011
plus a five-year rolling average of the illiquidity
premia. Full details of the approach used for the
decomposition of corporate bond spreads can be
found in Churm, R and Panigirtzoglou, N (2005),
"Decomposing credit spreads", Bank of England
Working Paper no. 253.
The Bank's model-based estimates suggest that US high-yield and investment grade
corporate debt currently reflect historically low risk premia, and so may be vulnerable to a
correction (Chart 14). Moreover although much of the recent issuance reflects refinancing of
existing bonds or loans (with companies seeking to lock in low interest rates and extend
maturities) and M&A activity, there have also been growing reports of US issuance to finance
"dividend recapitalisations" (where debt is issued to pay special dividends). Issuance of
covenant-lite leveraged loans (which include fewer of the usual protective covenants for the
benefit of the lending party) was $34bn in the first five months of 2011, compared with
$8bn in the whole of 2010. And US contacts have reported renewed issuance of bonds with
Payment-in-Kind (PIK) toggles (where issuers have the option of deferring cash interest
payments, choosing instead to roll interest payments into additional debt securities).
Although the incidence of these sorts of deals remains significantly below that associated
with the pre-crisis exuberance, these examples might be indicative of the reach for
yield/assets encouraging investors to chase returns via higher risk assets.
Despite the low-yield environment, market contacts have been telling us that some investors'
expectations of returns were little changed by the crisis, reflecting a combination of investor
inertia and the need to earn sufficient returns to cover their liabilities. But we also hear that
investment horizons are often shorter and tolerance of volatility and desire for leverage is
lower. Something clearly has to give here - investors know - and must remember - that
there is no such thing as a free lunch, and that additional return involves additional risk. The
macro-prudential concern is that the reach for yield encourages financial innovation and
growth in some parts of the financial system where the risks are not well understood,10
especially if it leads to greater interconnectedness within the banking system. This is one
area which is likely to warrant further attention and analysis by the FPC in due course.
Financial innovation and the emergence/growth of new products
The financial industry is characterised by its tendency to innovate, continuously designing
and offering new financial products to its customers. In my view, financial innovation should
be seen as a "good thing" in normal circumstances. It can lead to a more efficient allocation
of capital and a reduction in the costs of financial intermediation, both of which should help
sustain real economic growth. For example, the rapid growth of electronic trade execution in
the foreign exchange market has increased the speed and ease with which trades can be
conducted. That should ultimately make international trade cheaper, bringing with it the
associated benefits. Improvements in technology can, by facilitating wider market access,
also lead to improved price discovery and market liquidity. Moreover, innovation can help
issuers align the risk characteristics of new products more closely to those that investors
demand. In principle, that should promote greater and more efficient sharing and spreading
of risk across the financial system. In essence, the recession which followed the financial
crisis demonstrated how much the real economy depends on an efficient, functioning
financial system.
Financial innovation is a continuous process, and there are many examples of either new
products or rapid growth in fashionable markets during the past few years. For example
during 2010, there were significant developments in bank funding instruments such as
putable CDs and evergreen repos.11 These products offer higher returns to investors
compared with more conventional instruments, and also improve banks' ability to meet new
regulatory rules. There has also been an increase in the prevalence of long-term collateral
upgrade trades where, for example, a real money investor lends a bank gilts against less
liquid but higher yielding assets. Those repo transactions help the real money investor
achieve a higher return, while banks build up their liquid asset buffers and fund their less
liquid collateral. In that regard, these repo transactions look quite similar to a private sector
version of the SLS. Where appropriate, such transactions can both improve the returns to
pension funds and support lending to the real economy. Of course, the authorities need to
monitor the extent to which these transactions strengthen the links between the banking and
insurance sectors. And it is vital that the insurers fully understand the counterparty credit risk
they are running, the quality of the collateral they are taking and how to manage the
collateral in the event of default.
The more recent developments in markets for Exchange Traded Funds (ETFs) are another
example of financial innovation and growth in a previously small market. ETFs are in
principle a "good" financial innovation - for example, they offer retail investors a cheaper way
of getting exposure to the underlying asset (by cutting out the fund manager) and provide a
very liquid asset. Nonetheless, the rapid growth in ETF assets under management - which
have increased seven-fold since 2003 (Chart 15) - merit attention, given it has been
characterised by increasing complexity, opacity and interconnectedness, and as some
practices, if left unchecked, could grow to pose risks to the stability of the financial system.12
Chart 15
Global ETF assets under management
US$ billion
1600
1400
1200
1000
800
600
400
200
0
1999 2001 2003 2005 2007 2009 2011(a)
Source: Blackrock Global ETF Research and
Implementations Strategy Team.
(a) Data to end-May 2011
Take for example synthetic ETFs provided by asset management arms of banks. These
ETFs replicate an index return using derivatives but without necessarily physically
purchasing the underlying assets. Synthetic ETF providers (typically banks) might have an
incentive to collateralise the total return swap with illiquid collateral that is expensive to fund
elsewhere in the market. If the swap counterparty defaults on its leg of the transaction, the
ETF (and hence the end investor) would be left holding this collateral, which might have very
different liquidity and credit characteristics to the securities it originally planned to invest in. In
particular, if the investor unwittingly takes on collateral whose value is highly correlated with
the ETF provider (i.e. if there is so-called wrong way risk), then the collateral is likely to have
relatively little value in the event of default. Some of these issues are discussed in the June
Financial Stability Report.
The examples I have cited above involve fundamentally good financial products which should
improve economic efficiency and hence the welfare of society as a whole. But the growth of
the more opaque version of these products marks them out, and unmonitored excess could
compromise these markets in the future. Recent history is rife with examples of where
over-exuberance has led to opacity, severe market difficulties and financial instability
(e.g. the rise of CDO2 in the securitisation markets). In such cases, the costs of collapse can
easily outweigh the previous benefits. It is important that the authorities monitor the ETF
industry and make sure that market participants understand the risks they may be running. It
is for that reason that the interim FPC advised the FSA last week that its bank supervisors
should monitor closely the risks associated with opaque funding structures, such as collateral
swaps or similar transactions employed by ETFs.
Regulatory responses
The financial crisis exposed a need to not just strengthen but to completely re-design
aspects of financial regulation, to try to find a solution to "too big to fail" problem and hence
minimise the chances of something similar happening again (if financial institutions could fail
without large spillovers then much other regulation might be unnecessary). The resulting
regulatory agenda is formidable - including agreeing the detailed rules supporting Dodd
Frank in the US; EMIR and Solvency II in Europe; the new Basel rules on capital and liquidity
including the SIFI surcharge internationally; the final outcome of the ICB in the UK; various
FSB initiatives and many more besides. I do not intend today to discuss the merits of the
various ongoing regulatory initiatives. Rather I want to briefly comment objectively on their
impact on the state of financial markets.
It is clear that many individual regulatory initiatives are not yet parameterised or sufficiently
detailed for market participants to anticipate their effects fully. And the extent to which
regulations might eventually differ across geographical and legal jurisdictions is also still
unclear. There is no implied criticism here - re-designing the regulatory frameworks for,
among others, banks, insurance companies and rating agencies, takes time, and a lasting,
well-planned robust set of regulations that will stand for many years to come is surely
preferable to a hastily-agreed but inadequate framework. The authorities nationally and
internationally are pushing the agenda hard to come up with the right decisions as quickly as
possible.
The progress of the regulatory agenda has, however, created additional uncertainty in
financial markets which is reflected in investor behaviour and in some market prices. For
example, market intelligence suggests that it is one of the factors contributing to the
continued elevated funding costs for many banks. In due course, the various regulatory
initiatives will produce detailed rules. As that happens one can expect a variety of reactions.
On one level, there is likely to be some shift of activity between markets and business
models as participants evaluate where the new rules establish new incentives. Beyond that,
there might well be some general improvement in market functioning, reflecting the reduction
in regulatory uncertainty and the more resilient financial system that the regulatory agenda is
designed to deliver. At the moment, market intelligence suggests that market participants are
focussed on the elevated uncertainty and have not yet anticipated the benefits of, for
example, a safer banking system.
Conclusion
Financial markets have come a long way since the epicentre of the crisis in 2008, with many
markets that were significantly impaired in the crisis now functioning well. That progress is
encouraging in terms of financial stability and support for the real economy, but further
healing is still required. Looking ahead, there are some clear obstacles to that process. The
sovereign debt crisis, currently focussed on the euro area, is one. And the general recovery
in the macroeconomic outlook is another. There will also be a lot of uncertainty embedded in
markets until final details are available on the majority of the regulatory agenda. That agenda
must be allowed to take sufficient time to get the right answers, but as these become
available we should expect to see further improvements in market functioning. Meanwhile,
the authorities will need to pay particular attention to the next rounds of financial innovation,
especially given the prolonged low interest rate environment.