Krzysztof Rybiński: Innovations in the financial markets - globalization
of the infrastructure
Panel presentation by Mr Krzysztof Rybiński, Deputy President of the National Bank of
Poland, at the conference "Innovations in the financial markets 2007", Warsaw, 16 October
2007.
* * *
Ladies and Gentlemen,
Since I have little time to deliver this presentation, I will skip the introduction and the
anecdote and get straight to the point. The global financial markets have recently reported
episodes of strong volatility; liquidity was suddenly lost, some markets failed to perform their
functions in an adequate manner, others ceased to operate altogether. The liquidity and
solvency of some financial institutions were put at risk, whereas some investors suffered
loss. Disturbances originated from underestimation of risk by a number of agents on financial
markets, ranging from subprime lenders to institutions which purchased structured credit
facilities offered by banks and their vehicles. A thorough review must be performed with a
view to examining the role of rating agencies and supervisory authorities, which appear to
have underestimated the risk generated by the rapidly expanding market of asset-backed
instruments and the market of credit derivatives. It is not yet certain whether the worst stage
of disruptions is over. In the light of the above, strong asset appreciation, especially visible
on the emerging markets, should be assessed with caution.
Thanks to the low exposure of Polish financial institutions to the main infected markets and
good economic conditions in Poland, the Polish financial system remained practically
unaffected by the turbulences which unwound on the global financial markets. Nevertheless,
some negative effects of those turbulences may yet materialize. In addition, two areas in
Poland require a special watch of supervisory institutions: the property market and the equity
market in view of the risk of an asset bubble developing on those markets.
The development of asset bubbles on asset markets constitutes a potentially very dangerous
phenomenon. As shown by experience of many countries, shrinking credit supply (credit
crunch) materialized at commercial banks in the wake of a bubble burst was a strong shock
for the whole economy.1 In some cases it may lead to a long-term economic recession, like
the one which Japan experienced in the 90s. Bearing in mind the severe macro- and micro-
economic consequences of bubble burst, we should determine the appropriate reaction of
public authorities, including the institutions responsible for the economic policies of a country
and the supervisory authorities. However, the key questions are whether there should be a
reaction, who should react and when.
A number of arguments may be quoted for and against undertaking action by central banks
during a boom phase of a bubble2. I enumerated them in my book on globalization3. On this
opportunity, I wish to quote the three premises which, according to Donald Kohn4, the
Federal Reserve Vice Chairman, are necessary to justify the activities undertaken by central
banks to pursue this aim:
•
a central bank must be able to identify bubbles on an asset market in a timely
fashion with reasonable confidence as to the adequacy of the findings of its
analysis,
•
there must be a fairly high probability that a modestly tighter policy will help to check
a further expansion of speculative activity on a given asset market,
•
the expected improvement in future economic performance must be sizeable and
bigger than expenses disbursed by the economy as a result of conducting those
activities.
The last condition points to the restricted use of interest rates for the purpose of bursting a
bubble, since the level of interest rates has a bearing not only on decisions taken by entities
directly engaged in the process of forming a bubble but in fact on all the entities operating in
the economy. To evoke a vivid picture, the use of interest rates to this end may be compared
to the use of an atomic weapon in the battlefield - for an atomic bomb makes no distinction
between friend and foe.
Donald Kohn's conditions are not easy to meet. Therefore, the opinion now prevails that
supervisory authorities must enhance their macroprudentail activities5. Consequently, one of
the conclusions is to take recourse to supervisory instruments with a view to bearing on
decisions of those market participants which are primarily responsible for bubble formation
and report to supervisory authorities. By way of illustration, although the supervisory
authorities do not interact with financial institutions which extended a large part of subprime
loans or with arbitrage funds which purchased instruments backed on those loans, they
continue to oversee the process of credit risk management and liquidity at banks. Banks
played an important role in the process of spreading the crisis. as investors and providers of
liquidity to companies - intermediaries in the sale of assets and companies investing in those
assets, as well as by organizing the securitization of those assets.
The role of good supervisory policies cannot be underestimated6. First, the negative impact
of a bubble burst will be less severe both for the economy as well as for financial institutions
as such, provided that a banking system is well supervised, the level of exposure on this
market is low, the system has quality assets and the capital stock is adequate to absorb the
effects of the shock. Second, if the bubble expansion reflects the expectations of
extraordinary gains, the supervisory policy may substantially diminish the economic benefits
from and the scale of speculation, e.g. by way of reducing the LTV ratio, restricting the loan
term or introducing the requirement to provide own contribution for housing loans. Third, the
supervisory activities - as an instrument preventing asset bubble formation - have the
advantage of affecting directly one selected group of entities which may play an important
role in bubble formation. Compared to interest rates, those measures have an effect of a
conventional intelligent bomb, which is both selective and precise.
Supervisory activities pursued in order to prevent the creation of an asset bubble may be
especially effective if bubbles occur, among others, as a result of the legislation the sector is
regulated by. In Poland, this principle is illustrated by regulations which restrict the
investment policy of open pension funds and the impact of those regulations on the stock
market. The currently effective legislation may contribute both to aggravating the
supplydemand imbalance which supports the divergence of stock prices from the fundamentally
reasonable levels and also towards the growth in the scale and impetus of price adjustments,
should a bubble burst.
Open pension funds are one of the main sources of demand on the stock market. From their
very beginning, they have recorded average monthly inflows of PLN 870 million, the value of
equities in their portfolio have exceeded PLN 51.5 billion, whereas their share in free float
has amounted to ca. 22%. The assets held by open pension funds are likely to continue their
rising path. As estimated, their credit debit balance will stabilize to report a balanced position
only in 20317. In addition, the past quarters saw high demand of investment funds for
equities.
Meanwhile, despite a large number of debuts, the value of equities introduced to the Warsaw
Stock Exchange is relatively low. By way of illustration, in 2004, the value of public offers
amounted to PLN 13.2 billion (including PLN 7.9 billion of PKO BP's issue); in 2006 it was
PLN 4.2 billion, whereas in the first nine months of 2007 it was PLN 6.4 billion. The
prevalence of SME sector in the structure of WSE debuts is the factor behind these statistics.
Consequently, the supply-demand imbalance on the stock market was one of the reasons for
the strong price rise, which may not always be explained by fundamental factors. For
example, the P/E ratio for medium-sized companies included in the mWIG40 index rose from
9.0 to 34.7 between January 2005 and June 2007, and this growth was even higher in the
category of smaller companies.
Excess concentration of investments on a small number of markets poses a particular
challenge, should an asset bubble develop and burst. This development would be the more
dangerous that open pension funds cannot hedge their portfolios against the fall in prices. It
is worthwhile to mention that pursuant to the Regulation of the Council of Ministers of 13
September 20058, it was anticipated that as from 1 January 2006, open pension funds could
take recourse to derivatives to provide hedging to their investment portfolios. Regretfully, in
December 2005, this Regulation was repealed9, and henceforth, as of today, should prices
go into a significant decline, open pension funds have no other instruments to hedge the
value of their portfolios but to sell some of their equities . Given a high value of share
portfolio, such a sale would significantly aggravate the decline.
I believe that joint actions must be undertaken in order to minimize the threats of asset
bubbles resulting from effective regulations in the sector of open pension funds, to better
diversify investment portfolios as well as to enhance the sector's prospective levels of return.
In order to achieve those goals, we have to commit ourselves to:
•
increase the limit on foreign investment and gradually modify some terms and
conditions of using them from the current level of 5% to 30% of assets,
•
allow open pension funds to take recourse to derivatives with a view to hedging their
investment portfolios,
•
in a longer perspective, gradually raise the open pension funds' limit on investment
in equities from 40% to 60%.
Pension funds should invest a large part of their portfolios in equities because the return on
equities should exceed that of debt instruments over a long horizon. CalPERS, the world's
largest pension fund, invests 45% of assets in equities on the US market and 20% in equities
quoted on foreign markets. In Chile, the structure of pension fund portfolio as of the end of
2006 was as follows:
domestic Treasury bonds -13%, domestic equities -17%, other domestic debt securities
-22%, foreign equities and certificates of participation in investment funds -32%. In Argentina
and Peru, the foreign assets accounted for ca. 10% and 14%, respectively, of pension funds
assets.
The findings of Fisher Black's studies indicate that the foreign positions should be hedged
against exchange rates risk. His famous work shows that the optimal hedge ratio amounts to
77% for investment in equities10. Open pension funds could manage their investment
portfolios more effectively if they were allowed to invest in derivatives (equities, interest rate
instruments and currencies), because - not infrequently - transactions costs on derivatives
are much lower than the costs involved in cash market. By way of illustration, the costs in the
US cash market are over five times higher than the costs in the market of stock index
futures11. Additionally, this step could also contribute to the development of the derivatives
market in the WSE.
It is worth remembering too that as early as in 1974, a well-known study by Bruno Solnik12
provided an example of American investors to show that the risk of investment portfolio
composed of ca. 20 international equities (international dispersion) is twice lower as
compared to the portfolio of domestic equities only.
Amendments introduced the legal provisions with the aim to extend investment possibilities
of open pension funds, to provide better diversification and to decrease investment risk
would fall within the trend currently observed in many countries. All over the world, pension
funds may invest abroad, taking even recourse to hedging funds to this end13. In most OECD
Member States, pension funds may hedge the value of investment portfolio on derivatives14.
Those changes depend on thorough restructuring of supervision over the open pension
funds sector, i.e. the development of a supervision system based on the assessment of risk
of open pension funds' portfolio (risk-based supervision). The supervisory institutions should
not concentrate on analyzing formal restrictions imposed onto open pension funds by law,
but they should examine the risk of the entire portfolio instead. This development has been
widely observed also in other supervisory areas (banks, insurance companies).
By way of recapitulation, let me outline the infrastructure of the European clearing system in
about 10 years' time, as prepared by the NBP.
At first, let me define the main elements of this infrastructure, which include:
1. trade platform where transactions on the capital market are performed,
2. central counterparties (CCP) performing the clearing functions on the capital market,
3. securities settlement systems (central depositories) performing the depository and
settlement functions
4. payment systems, which process the cash settlement of a transaction,
Beyond doubt, this model is simplified a bit and serves only as a starting point for further
analysis. I would like to confine it to two elements: securities settlement systems and
payment systems.
Securities settlement systems and payment systems currently comprise a couple of large
systems of international, pan-European or even global character (e.g. CLS) operated either
by private institutions (Euroclear, Clearstream, EURO1 and STEP2) or by central banks
(TARGET) as well as by many domestic and local systems, including central depositories of
securities and depositories maintained by central banks, clearing houses and other systems,
e.g. card systems.
On account of the adopted diverse legal and market solutions, the present system of capital
market infrastructure cannot be deemed optimal. For many years already, significant action
has been adopted on the EU level with a view to establishing an efficient and safe European
market, where those transactions will be executed with similar effectiveness both on
domestic and cross-border levels.
Those activities, undertaken both by the public authorities and by the market, are aimed at
achieving:
1. legal harmonization,
2. systemic standardization and harmonization,
3. subjective consolidation,
4. systemic integration, and
5. technical integration.
It is extremely difficult to predict future developments in each of those domains. Apparently,
the harmonization and integratory action which I have just mentioned and which has been
undertaken recently, will lead to a situation that can be predicted to some extent. What
changes will the future bring in comparison to what we have now?
As regards the securities settlement system, a new large player is about to appear in a
couple of years. TARGET2-Securities operated by the European Central Bank will integrate
the settlement function which is now executed by domestic systems of securities settlement.
It may also be assumed that owing to consolidation processes, the number of central
depositories in the EU will diminish. I would venture the claim that in the context of the
development of TARGET2-Securities and CCBM2, the number of deposits maintained at
central banks is going to decline15.
As regards the payments systems, in a month, the TARGET2 system will be established to
take over RTGS systems in individual EU Member States. Furthermore, an additional system
will be launched soon to offer communication between the domestic clearing houses under
the auspices of their organization, the EACHA16. Thus, the most effective and best adjusted
to SEPA standards local clearing houses may become less numerous but they should not
close down, contrary to the least effective ones or those which will not switch into SEPA
standards in due time.
I would then put forward a hypothesis that harmonization and integration will lead to the
enhanced integration of the systems within the area of payment and settlement services,
new systems of pan-European character will develop or will be launched but domestic
systems will not come out of use altogether. They will either adjust themselves to the
allEuropean standards or are likely to continue operating also transactions of local or specific
character, which will not be eligible for processing via the all-European standards.
Ladies and Gentlemen, despite turmoil on the global financial markets, the financial market in
Poland is developing very fast. However, there are probably serious challenges in the
pipeline, related to developments on some markets and to the changing architecture of the
financial system in Europe. We have to face those challenges so that future generations of
Poles can benefit from the ever better functioning of the financial market in Poland over the
decades to come.
References
Bernanke B., Asset price "bubbles" and Monetary Policy speech before the New York
Charter of National Association for Business Economics, 15 October 2002.
Bernanke B., Reflections on the Yield Curve and Monetary Policy, Remarks by Chairman B.
Bernanke Before the Economic Club of New York, 20 March 2006.
Bernanke B., Gertler M., Monetary Policy and Asset Price Volatility, [in] New Challenges for
Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas City,
Jackson Hole, Wyoming 26-29 August 1999.
Bernanke B., Gertler M. Should central banks respond to movements in asset prices?,
American Economic Review, May 2001.
Blinder A., Reis R., Understanding the Greenspan standard, [in] The Greenspan Era:
Lessons for the
Future, a symposium sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming 25-27 August 2005.
Bordo M., Stock Market Crashes, Productivity, Boom, Busts and Recessions: Some
Historical
Evidence, Rutgers University, unpublished manuscript.
Bordo M. Jeanne O., Boom-Bust in Asset Prices, Economic Instability and Monetary Policy,
NBER Working Paper, No. 8966, June 2002.
Asset Prices, Financial and Monetary Stability: Exploring the
Borio C., Lowe P., Nexus, BIS
Working Paper, No. 114, July 2002.
Cecchetti S., What the FOMC Says and Does When the Stock Market Booms, article
presented at the conference held at Reserve Bank of Australia, Asset Prices and Monetary
Policy, Sidney, 18-19 August 2003.
Cecchetti S., Genberg H., Lipsky J., Wadhwani S., Asset Price and Central Bank Policy,
Geneva Report on Global Economy.
Cecchetti S., Measuring the Macroeconomic Risks Posed by Asset Price Booms, NBER
Working Paper, No. 12542, September 2006.
Chadha J., Sarno L. Valente G., Monetary Policy Rules, Asset Prices and Exchange Rates,
IMF Staff Papers, vol. 51, No. 3 International Monetary Fund 2004.
Monetary Policy, Asset Price Bubbles: calibrating the monetary policy
Filardo A., trade-offs,
BIS Working Paper, No. 155, June 2004.
Gruen D., Plumb M. Stone A., How Should Monetary Policy React to Asset Price Bubbles?,
International Journal of Central Banking, December 2005.
Are they in all the same boat: The 2000-1 growth slowdown under
Helbing T., Bayoumi T.
the G-7 Business Linkage, IMF Working Paper 2003.
Kohn D., Remarks by Donald Kohn at Monetary Policy: A Journey from Theory to Practice,
An ECB Colloquium held in honor of Ottmar Issing, 16 March 2005.
Miller M., Weller P. Zhang L., Moral Hazard and the US Stock Market: Analyzing the
Greenspan Put, Economic Journal 112, 2002.
Asset Prices and Business
IMF, Cycle, World Economic Outlook, Washington D.C., May
2000.
IMF, Growth and Institutions, World Economic Outlook, Washington D.C., April 2003.
US Stock Market Crashes and their aftermath: implications for monetary
Mishkin F, White E.,
policy, NBER Working Paper, No. 8922, 2002.
Posen A., It Takes More Than Bubble to Become Japan, [in] Asset Price and Monetary
Policy (ed.) A. Richards, Reserve Bank of Australia 2003.
Posen A., Why Central Banks Should Not Burst Bubbles, Institute of International Economics
Working Paper WP 06-1, January 2006.
Roubini N., Why Central Banks Should Burst Bubbles?, NYU Stearn School of Business
mimeo, January 2006.