Jürgen Stark: Some new trends in financial markets
Keynote address by Dr Jürgen Stark, Vice President of the Deutsche Bundesbank, at the symposium
on building the financial system of the 21st century - an agenda for Europe and the United States,
Eltville, 23 April 2005.
* * *
1. Introduction
Ladies and gentlemen
It is a great pleasure for me to address this distinguished audience at Harvard Law School's "Program
on International Financial Systems". Of course we should not misunderstand the title "building the
financial system of the 21st century". Financial systems don't need to be actively built for they are
great at evolving on their own, as can be seen in trends both past and present. What needs to be built,
however, is a sound and proper framework, where evolution can safely take place. By "safely" I mean
without compromising financial stability. The architects responsible for designing and adapting the
framework need to monitor closely the permanent change in financial systems.
In this vein, I would like to comment today on two trends in financial systems: the phenomenon of risk
transfer to private households and the recent strong growth in unregulated financial business.
2. Some reflections on financial stability
First, however, I would like to set the general backdrop of financial stability. Financial stability now is a
very topical issue. A growing number of international committees regularly debate financial stability
issues. The Financial Stability Forum that met last month in Tokyo is a good example. A growing
number of central banks and other financial institutions have taken to publishing financial stability
reviews. This is no different at the Bundesbank; we published our first financial stability review in
December 2003.
The increasing preoccupation with financial stability is by no means just a fashion or due to central
bankers' "search for new tasks". It is based on the recognition that financial stability is an important
precondition for our economic well-being.
So, what exactly is financial stability? Up to now no generally agreed definition exists. Thus, many
attempts have been made by describing its opposite, financial instability. But then, no definition of
financial instability exists either. Financial instability comes in various shapes. Charles P Kindleberger
in his modern classic "Manias, panics and crashes" described financial crises as being "like pretty
women: hard to define but recognizable when encountered". That's nicely put, but not quite
operational.
The Bundesbank favours an eclectic approach to describing financial stability. Financial stability
basically means that the financial system properly performs its functions of allocating capital and risk,
even if put under pressure. Thus, robust financial institutions are one cornerstone of financial stability.
A resilient market infrastructure, incorporating payment and securities trading systems, is another
cornerstone of financial stability. And last but not least, there are transparency and market integrity.
Thus, the three panels of this symposium - Basle II, market structure and IFRS - neatly cover three
major facets of financial stability.
Why has financial stability attracted so much attention recently? During the second half of the 1990s a
series of international financial crises set the spotlight on financial stability and its significance for
steady economic growth. Financial instability comes at a great economic cost.
Monetary policy makes use of the financial system to transmit changes in official interest rates into the
real economy. In a stable financial system, monetary policy signals are read and acted upon fast and
reliably, thereby facilitating the pursuit of price stability.
Financial stability is a necessity. A modern necessity, yes, but not at all a new one. Financial stability
in part is a new catch-all phrase for a set of tasks that have been conducted by central banks for a
long time. In many respects, financial stability is little more than just the same old thing in a new guise.
It is just a new way of looking at old things. This is not to ridicule financial stability. Quite the contrary.
I regard this concept as very useful to describe the second leg of central banking - the first leg, of
course, being price stability.
If financial stability is so crucial to our economic well-being, then how can it be maintained? In a
nutshell, it's the framework for the financial system that counts. A suitable framework for financial
stability boils down to sound institutions and a proper set of incentives. Key institutions in this regard
are
•
first, central banks that deliver price stability
• second, a system of financial supervision that ensures the strength of financial
intermediaries, as far as supervision can do that
•
third, safe and efficient state-of-the-art market infrastructure
• and, finally, a trustworthy legal system.
As regards the incentive structure, financial stability can benefit tremendously if market forces are
strengthened. Furthermore, this approach is the one that is most compatible with a market economy.
Ideally, financial market participants foster financial stability as a by-product of their pursuit of their
own best interests. If, for example, financial institutions expect to be bailed out, it might be optimal for
them to divert some resources from risk management, a phenomenon known as moral hazard. If no
bail-out can be expected, risk management must be conducted thoroughly. Then, risk pricing in
financial markets would correctly reflect the risks entrenched in financial instruments: market forces at
work to underpin financial stability.
3. Some new trends to be watched
Global imbalances have taken centre stage in the debate on the international financial system
recently. These may cause major disruptions if they are unwound in a disorderly way. Sharp and
unexpected movements in exchange rates and interest rates would affect financial intermediaries
directly and detrimentally - and all the more so if these were highly leveraged. Such turmoil would
most probably produce spill-over effects in other financial markets and lead to adverse
macroeconomic developments that would seep back into the financial system. The fact that these
imbalances have been around for quite some time without spelling trouble must not lull us into
complacency. Potential triggers - diminished expectations as to growth and inflation performance or
reserve policy in Asia, to name but a few - are real, and they warrant attention.
Beyond these topical issues, however, more fundamental and longer-term trends are arising in the
international financial system. They are driven by financial innovation and technological progress, and
they challenge financial stability on an ongoing basis. Central banks, supervisors and regulators must
therefore watch out for new trends and monitor them carefully. Potentially relevant changes need to be
assessed at an early stage to ascertain their possible impact on financial systems and their
implications for stability. Complacency never pays.
The two trends which I want to highlight today are both rather new, quite fundamental, and they share
the key feature of reducing transparency.
In a market economy, transparency is a key tool for preserving financial stability. If a high degree of
transparency prevails, market discipline can largely replace regulatory intrusion. Transparency
enables market participants to monitor their counterparties and to manage their risks effectively. As
long as incentives are undistorted, transparency can do its job.
Transparency also facilitates the supervisors' job of identifying possible weaknesses early on.
Supervisors need to have a clear picture of where risks are allocated and whether and where undue
risk concentrations might be growing. Hence, developments in the financial system that impair
transparency warrant scrutiny.
3.1 Risk transfer "to" the household sector
New techniques of risk transfer have greatly enhanced one of the core functions of the international
financial system: the process of risk allocation and risk reallocation. A vast array of formerly
non-tradable risks have become tradable. Financial institutions can now shed risks that used to be
stuck in their balance sheets. Institutional as well as retail investors can much more easily diversify
their portfolios. Risks can be transferred without difficulty to those who are best placed to bear them.
Overall financial stability - and also economic efficiency - should benefit from such improved risk
allocation.
Credit risk, for example, is no longer the domain of commercial banking. Insurance corporations and
pension funds acquire credit risk both for portfolio diversification purposes and as a stable source of
income. Beyond conventional asset-backed securities, financial intermediaries now have additional
derivative instruments for credit risk transfer at their disposal: plain vanilla credit derivatives such as
single name credit default swaps or, at the other end of the spectrum, complex structured products
such as CDOs of CDOs. In some countries, even retail investors now have direct access to credit risk.
The prospect of new and increasingly risk-based capital requirements for banks and insurance
corporations - Basel II and Solvency II - coming into effect over the next few years is reinforcing the
financial industry trend of shifting risks. Mark to market accounting sharpens the awareness of risks,
thereby also setting incentives to adjust risk portfolios.
The flip side of the constant risk reallocation is a certain reduction in transparency. More and more
often, risks end up in portfolios where you wouldn't expect them in the first place. Tracking the flow
and the location of risks has become trickier for market participants as well as for supervisory
authorities. The question is whether today's statistics are keeping up with this dynamic development
and whether they accurately reflect reality, ie the overall risk allocation and risk concentration in
financial systems.
At the end of the day, all financial risk is borne by private households. All the risks that financial
institutions carry in their balance sheets are effectively held by their shareholders. These shareholders
are ultimately private households, even if a chain of ownership relations may conceal this fact. The
same holds true for risks assumed by the government or its institutions. The taxpayer, ie again private
households, is the true holder of governments' financial risk.
Thus, talking of a "risk transfer to the household sector" is slightly incorrect. But the phenomenon of
changing risk profiles within in the household sector is real. This subject is still under-researched,
though.
Changes in an individual household's risk profile may be the result of active choice. However, even in
the case of intended portfolio restructuring, we cannot be entirely sure that households fully
understand all the risk which they take on, for example, when buying structured products. Given the
low level of financial literacy revealed in some recent studies, unintentional risk acquisition is a
possibility not to be underrated. Inadvertent changes in risk profiles may also occur via institutionalised
investing, when financial intermediaries modify their investment habits. During the last decade,
German life insurance companies had increasingly taken to riskier assets in order to bolster returns.
Most probably, life insurance policy holders were not fully aware of these alterations in their individual
risk profiles [that more recently have been partially reversed].
Over the past couple of years, pension reforms have been a key driver of risk transfer. In recent
reforms of pay-as-you-go public pension systems, benefits have been cut. Such reforms effectively
shift a higher portion of the longevity risk that was previously borne by (payroll) taxpayers back to
households. To the extent that households try to cushion their prospective loss of retirement income
with private provisioning, they have to assume additional investment and market risk. Corporate
pension plans migrating from defined benefits to defined contributions also burden households directly
with market risk.
As ultimate bearers of all financial risk, private households also feature as the ultimate absorbers of
shocks to the financial system. Solvency, liquidity, ability and willingness to ride out losses determine
the shock absorbing capacity of the household sector. Therefore, striving to assess the scope and
direction of risk reallocation among different groups of households is of the essence. Income, wealth
and age have significant influence on the readiness to bear risk and tolerate possible losses.
Knowledge of the nature of risks, how to measure and how to mitigate them becomes crucial for those
households that have to assume more risk.
What is the upshot of all this risk redistribution?
Up to now little is known [for sure] about the macroeconomic consequences of altered risk profiles in
the household sector. Macroeconomic dynamics might change. For example, in the wake of risk
transfer from relatively wealthy households to those less well-off, consumption and saving levels might
become more volatile. This appears to be a reasonable guess, if financial institutions, ie their rather
wealthy owners, shed risk, while the man in the street is being switched from a defined benefit to a
defined contribution pension plan. In the course of such risk transfer and due to uncertainty as to their
future income, households will tend to increase their savings rate, at least during a transition phase.
As to financial stability, the jury is still out on whether large- scale risk reallocation has rendered
financial systems more stable. Initial evidence seems to point in this direction because financial
institutions on the whole proved quite resilient during the market downturn and recession following the
new economy boom.
Instabilities typically arise when financial intermediaries run into trouble - irrespective of who the
ultimate bearers of risks are. Financial intermediaries' risk management techniques are deemed to
have been greatly refined and improved. State-of-the-art risk management systems, however, have
not yet been tested in adverse market developments. We must beware both overconfidence and
outright complacency.
3.2 Unregulated financial business
Over the past couple of years, financial intermediation that is not subject to prudential regulation and
reporting has experienced rapid growth. In an environment of low interest rates and abundant liquidity
the inevitable search for yield has tempted many investors to take on more risk than they used to.
Large amounts of money were channelled into risky and scarcely regulated asset classes. Hedge
funds and private equity recorded sizeable inflows.
The growth of the hedge fund industry has drawn particular attention and controversy. As this industry
is not subject to official reporting, we can only guess its true size. Commercial hedge fund databases
tend to provide only partial coverage of the industry. Therefore, we cannot preclude that this industry is
considerably larger than the well-known ballpark figures of 8,800 hedge funds with USD 1 trillion
assets under management [IMF GFSR Sept 2004] suggest. The fact that these investment entities are
often domiciled in off-shore locations does not help their transparency either.
But let me make it clear about one thing: the existence of the hedge fund industry benefits the
international financial system.
•
As active traders hedge funds provide liquidity to financial markets. Thus, they contribute to
the breadth and depth of markets and promote the price discovery process.
•
Hedge funds are constantly on the spot to find and thereby eliminate arbitrage opportunities.
Thus, they strengthen market efficiency.
•
Hedge funds acquire risks unwanted elsewhere. Thus, they can contribute to a more efficient
overall risk allocation and expand opportunities for portfolio diversification.
The flip side of this coin are financial stability concerns arising predominantly from the substantial lack
of transparency. Even if comprehensive data on hedge funds' assets under management were
available, we would still have a hard time assessing the true economic risk they carry. For they
typically make extensive use of derivatives and hold leveraged positions, not least in rather illiquid
markets. A partial industry survey conducted by the FSA in the UK found out that hedge fund equity of
USD 250 billion translated into gross counterparty positions in the range of USD 860 billion.1
The opaqueness of risk profiles is an issue in at least three respects. First, with their high leverage and
active trading, hedge funds now wield considerable clout in some financial market segments. Second,
hedge funds are important counterparties to systemically relevant financial intermediaries, for
example, to their prime broker banks. And, third, institutional investors such as pension funds have
turned to hedge fund investing, a trend that is expected to continue.
What does all this mean for the international financial system?
• There are some blind spots in the system.
• These blind spots have recently grown in size and number.
•
And more and more often, these blind spots are related to systemic players.
Owing to the lack of transparency, the overall risk allocation in the international financial system and
the potential for disturbances have become harder to gauge. Possible systemic risk has become
harder to spot. The lack of transparency hampers market discipline and, as a logical consequence, its
use as an important pillar of financial stability.
However, direct regulation of the hedge fund industry is hardly feasible, if not impossible, and the
efficiency of indirect regulation via the regulation of counterparties is limited. This means that
authorities responsible for safeguarding financial stability have to rely on banks monitoring their hedge
fund credit clients. However, aggregating their total hedge fund exposure and assessing their hedge
fund clients' total risk profile have become more difficult for lending institutions since hedge funds are
being served by multiple prime brokers.
When looking at new trends in the financial system, we need to consider both sides of these coins.
Shining improvements to financial stability must be weighed against the darker side of
stability-impairing features. The challenge is to harness the benefits of new financial trends while
minimising their potential costs. Unfortunately, there is no instant recipe for safeguarding the stability
of evolving financial systems. Case by case assessments are required.
4. Concluding remarks
Ladies and gentlemen
The financial industry is one of the most globalised industries in the world. Supervisors cannot limit
their attention to what is going on within their national boundaries. If they don't see beyond the ends of
their noses, they will not be up to dealing with financial stability issues. The appropriate response is
cooperation of supervisors on an international scale. As financial globalisation progresses, new
challenges will arise providing not least plenty of topical issues for future seminars on the international
financial system. International co-operation is essential, and symposia such as today's help to deepen
the mutual understanding that is so indispensable for effective co-operation.