By John Lipsky in Jackson Hole
Despite tentative signs that the global recession is ending, it’s clear that a full recovery will remain inhibited until financial markets are restored to health. While financial market conditions have improved—reflecting among other things massive public sector support—key credit channels remain strained, creating a drag on growth.
One of the keys to strengthening financial markets will be to put securitization markets on a sounder footing, an issue I discuss below.
Rebuilding active and innovative financial systems will be critical for sustaining a new global expansion. After being propped up by government intervention, a recovering economy increasingly will need to rely on private capital. As confidence and trust are restored, government guarantees will be rolled back gradually, and the crisis-driven expansion in central bank balance sheets will be unwound.
The latest financial market developments have provided positive signals. Most markets have strengthened in recent months, and some asset prices are higher today than prior to last September’s severe turmoil. Equity prices have risen notably, while investment grade corporate and sovereign emerging market debt spreads have narrowed, mainly in response to reduced risk perceptions, but in the case of corporate debt also reflecting better-than-expected economic data.
However, banks’ willingness and ability to lend remain weak in the euro area, the United Kingdom, and the United States. Credit standards are still being tightened—albeit at a slowing pace—and bank credit growth is meager. At the same time, the increased issuance of corporate bonds largely has been motivated by refinancing and debt restructuring. Thus, the overall deleveraging process does not appear to have reached an end.
Regarding banks, the healing process inevitably will involve raising additional capital and writing down impaired assets. This process appears to be further along in the United States than in Europe. However, the stress-testing process under way in the euro area should help to move the healing process forward. Nonetheless, no important acceleration in overall bank credit is expected anytime soon.
Reviving securitization markets
Securitization markets are still impaired, as issuance remains anemic despite narrower spreads. Gross issuance of securitized instruments by private-sector companies soared from almost nothing in the early 1990s to peak at almost $5 trillion in 2006, before dropping off sharply as the crisis escalated. Issuance is picking up in some specific market segments, but mostly those supported by public intervention. Structured credit markets remain essentially shut. Operations by key central banks—the Federal Reserve, the European Central Bank, and the Bank of England—have helped to support and calm these markets, but the prospects for a rapid return to adequate functionality remains cloudy.
Mobilizing otherwise illiquid assets and transferring credit risk away from the banking system to a more diversified set of holders is the underlying justification for securitization.
Of course, this market has acquired something of a bad name following the subprime debacle. One of the key problems of the current financial crisis was that several major financial institutions didn’t follow basic tenets of the “originate-to-distribute” model. Not only did underwriting standards deteriorate severely in many key market segments, but many originators didn’t distribute and retained far more risk than was prudent, often in opaque off-balance sheet entities whose relationship to the sponsoring institution was frequently misunderstood.
The result was disastrous.
In this sense, the market discipline that implicitly should underpin the securitization model simply failed. In restarting these markets, therefore, it will be important that the right balance is struck between allowing financial intermediaries adequate flexibility to create the intended benefits from securitization, while protecting the financial system from the instability that may arise from inadequate risk monitoring and control. There is little doubt that key market participants will have learned brutal lessons about risk management from the events of the past two years, and they are unlikely to simply repeat recent missteps. At the same time, financial regulators and supervisors are working together in various national and international fora on measures that can be taken to make securitized markets more reliable.
Regardless of remaining problems, a key point shouldn’t be missed: Securitization markets have become such an important component of the credit creation process, especially in the United States, that restarting them would represent a major contribution to restoring the credit channel.
Part of the discussion at Jackson Hole this year focused on the extent to which central banks should be involved in financial market regulation. While views differ on this aspect, it is agreed almost universally that the regulation of financial markets and institutions needs to be overhauled. The principal goals are to broaden the regulatory perimeter in order to bring all systemically important institutions under regulatory oversight, to establish more effective tracking of systemic risks, and to promote more robust risk management.
In other words, traditional regulation—that focuses almost exclusively on individual institutions and specific financial instruments—should be supplemented by a macroprudential approach that would take account of systemic and cyclical factors. This would create awareness of overall systemic leverage and interconnections and mitigate potential pro-cyclical effects of regulation. Market discipline will need to be strengthened through improved transparency, better governance structures, and more incentive-compatible compensation structures. To maintain a level playing field and alleviate risks of regulatory arbitrage, strengthened international cooperation and coordination will be essential.
Some steps are being taken already:
- Recent proposals by the United States to bring under stronger supervision large, systemically important firms, such as insurance companies and other financial institutions that are not banks, break new ground. The IMF has also strongly endorsed the ambitious reform of the European Union’s financial stability architecture that was agreed in June.
- Institutional arrangements for dealing with impaired assets are being put in place (notably in the United States and the United Kingdom), but difficult operational issues relating to the valuation and disposal of these assets still need to be addressed.
- Following rigorous stress tests of balance sheets, viable banks should be quickly recapitalized, if necessary. Insolvent institutions should be promptly intervened, and either closed or merged.
The creation of the Financial Stability Board—of which the IMF is a key member—has energized international cooperation regarding regulatory reform. The FSB, working together with member country authorities, standard-setting bodies, and other international institutions —including the IMF—aim to produce concrete proposals in the coming months that would improve systemic stability and market efficiency. This process will not be simple, but there was complete agreement at Jackson Hole that it is critically important.
In my next post, I’ll explore the need for rebalancing in the global economy as we emerge from this crisis.