“International financial stability” was written by Roger w. Ferguson, Philipp Hartmann, Fabio Panetta and Richard Portes and published in the year 2007.The book provides an all inclusive perspective of financial stability in the consideration of great structural changes in the global financial system in the course of the last ten years. It is not an account of the events that occurred recently but it instead gives an analysis of “secular phenomenon” in a view point informed by “frontier academic research”. This report is going to look at the main issues raised by the authors in the book in relation to international financial stability.
The discussion under this topic in the book revolves around the “global imbalances” associated with the United States account deficit and also the possible “housing market bubbles” in certain nations. The present international global environment tends to be favorable in spite of the “credit market turmoil” that occurred recently. There has never existed any major independent debtor that has been in hardships from the time Argentina defaulted about ten years ago. The United States of America and a number of other nations have big current account deficits but on the other hand, it is reported that the capital markets are funding them with no noticeable tensions.
However, these authors of the book have a joint belief that the existing configuration of current accounts as well as the rates of exchange is unsustainable. A sudden “correction” could bring about “financial instability”. There could come about a great and abrupt depreciation of the dollar with great changes in the asset price and “real effects” in the case where there can be a sharp shift in expectations.
Beginning from the year 2004 up until in the very recent times, there was an observation of tremendous “financial quiescence”; there was experiencing of volatility that was unusually low in all asset markets and classes (Ferguson, Hartmann, Panetta and Portes 33). The “risk premia” was as well quite low. Volatility was increased by the recent disorder, but not to a higher level than other recent “volatility spikes”. As a matter of fact, the authors of this book identify a number of structural factors behind a clearly worldly “downward shift” in volatility.
More so, among the factors that bring down the level of volatility, there are those that undermine financial stability at some point. On the average level, market liquidity may be higher but more prone to abrupt shifts. The low interest rates as well as low volatility have brought about a desire to look for yield which may have boosted too much “risk taking”. In the case where the portfolio choices as well as market prices depend on expectations of having low volatility, those who engage in investing may be susceptible to “volatility spikes” (Ferguson, Hartmann, Panetta and Portes 34). On the other hand, the year 2006 and 2007, spikes were not particularly great, and they do not tend to have caused lack of financial stability.
“Cross-Border Financial Integration”
In the course of the last two decades, there has been remarkable acceleration of “cross-border financial integration” (Kalemli-Ozcan, Papaioannou and Peydro 1). This has been experienced to a higher level in developed nations than in the developing countries as well as emerging markets nations. According to Ferguson, Hartmann, Panetta and Portes in this book, basing on theory, it is suggested that there exist an unclear connection between “financial integration” and financial stability and the researches that were carried out in the recent times have established that there is no connection or there is a negative relationship between “liberalization of the financial account and the frequency or severity of banking and currency crises” (Ferguson, Hartmann, Panetta and Portes 60). These authors’ own analysis seems to confirm these results for “de facto measures of financial openness” (Ferguson, Hartmann, Panetta and Portes 60). Yet, the circumstances are not similar. For a large number of the developing nations, early financial account opening could be quite unsafe (Kalemli-Ozcan, Papaioannou and Peydro 1).
In considering as to whether particular emerging market nations could be sources of universal risk, these authors established that a domestic financial crisis in such nations as either India or China is not likely to stimulate powerful “financial contagion” in the rest of the major nations (Ferguson, Hartmann, Panetta and Portes 69). However, this could activate a considerable slowdown of the global economy that would, in itself, have repercussions on the financial stability. Another possible source of financial instability that is associated with cross-border capital flows is the “carry trade”. It is indicated in this book that the profitability of the “carry trade” is quite sensitive to the shifts in exchange rates volatility levels. It could slow down suddenly and particularly in a huge volatility spike. However, it is still unclear that this would bring in a universal risk (Ferguson, Hartmann, Panetta and Portes 65).
In the last ten years, in a large number of nations, the household sector has turned out to be subjected to financial risk at an increasing level challenges (European Commission 3). This gives a reflection of a constant increase in “the debt levels; a rise in real and financial wealth, a large weight of risky assets in financial portfolios; and a gradual shift from Defined Benefit to Defined Contribution pension plans” (Ferguson, Hartmann, Panetta and Portes 80). The direct as well as indirect exposure of the households to “long-life” risk has as well increased.
The ever increasing households’ exposure to financial risk and the ever increasing “household indebtedness” bring about policy challenges (European Commission 5). In the first place is the issue of consumer protection and transparency. The consumers experience hardships in coming to understand and carry out the evaluation of the new financial products. A large number of these new financial products are complex and are not transparent. The policy makers should look for ways of improving financial education and offering protection to those consumers who are not educated.
The ever increasing role of LCFIs may have caused them to turn out to be “too big to fail”, or on the other hand, “too big to rescue” (Ferguson, Hartmann, Panetta and Portes 97). This as well brings up the issue of “regulatory capture”. In a situation where the financial institutions turn out to be quite big and the local markets quite concentrated, the result of these is that the lobbying power of these institutions increases considerably. This gives a suggestion of a possible declining of “market discipline” which requires higher levels of disclosure.
Coordination problems are as well raised by the “cross-border financial consolidation” for such parties as the lenders of the last resort, supervisors and regulators. In addition, “liquidity pools” have now a higher likelihood of being international; “the evaporation of liquidity may quickly extend across borders, while LCFIs may access liquidity wherever it may be” (Ferguson, Hartmann, Panetta and Portes 98). This gives a suggestion that, in addition to the regulators, the major banks are supposed to offer close cooperation in handling the “liquidity shocks”.
“New Financial Instruments”
Basing on the fact that there are many benefits that accrue from the innovative financial instruments, the suitable question to be asked should be in line with the best way of making these instruments to be safer. In the first place, in order to attain success in managing the financial risk, it is vital to use those approaches that are market driven but that are “supervisory-authority-guided”. While new instruments are set up, this must move hand in hand with regulation. In the second place, it should be considered that the solutions to managing financial risk have to be global (Ferguson, Hartmann, Panetta and Portes 108).
An illustration of these principles is offered by the CRMPG – “Counterparty Risk Management Policy Group”. This group consists of twelve global financial firms. After having what was referred to as the “Long Term Capital Management” failure, this group carried out an examination on the way to bring improvement in the procedures of risk management. Based on the recommendations made by this group, at the present, the firms are now in a position to measure their “aggregate counterparty risk exposures” in a better way. More so, basing on these recommendations, there has been an improvement in documentation standards. There has also been an increase in the utilization of the collateral to reduce the level of risk, and the procedures for testing stress are now usual. In addition, there has been great improvement in the backlog documentation of the “credit derivatives trades” that are unconfirmed, bringing up the level of the utilization of “electronic trade documentation”, and bringing in improvement in the settlement protocol (Ferguson, Hartmann, Panetta and Portes 109).
Beginning from the year 1993 up until the year 1995, there were a number of great derivatives disasters. But in the current days, derivatives markets tend to be safer as compared to the way the situation was in the course of the 1990s. This impressive improvement gives out a suggestion that there is meeting of the market test by the derivatives of accomplishing a real purpose. In the meantime, the lower occurrence of great disasters in spite of the fast growth gives out a suggestion that those parties participating in the market are making use of the derivatives in a more responsible manner.
“Growth of Hedge Funds”
A large number of regulators in the United Sates of America and other major markets hold a belief that the most excellent way of engaging in monitoring the hedge fund activity is “indirectly, through their sources of funds” (Ferguson, Hartmann, Panetta and Portes 129). Banks have to, on a regular basis, carry out the assessment of the creditworthiness of the borrowers of their hedge funds as well as their counterparties. The brokers have to engage in the active monitoring of the hedge fund positions and control their exposure to them. There is need to have information sharing among these financial institutions in regard to the “counterparty exposures” to hedge funds that they have. Benefits could also be derived by the market participants from bigger emphasis on “tail risk” that is of specific “systemic relevance”. Important benefits can also be offered by a “Capital Markets Safety Board” whose role is to carry out investigation and gives out information about hedge fund debacles.
So far, there has been reaching of a global agreement in regard to the need for additional oversight. The authors of this book, as they point, see no clear benefit from “additional regulation” (Ferguson, Hartmann, Panetta and Portes 129). It appears to be that there has been no playing of a significant role by the hedge funds in setting off the existing “financial turmoil”. There are those who have derived benefits from it and there are still those who have suffered from it; “but their problems have had little systemic impact” (Ferguson, Hartmann, Panetta and Portes 129).
“The New Global Financial Model”
The banks’ business model is gradually undergoing evolution towards OTD – “originate-distribute” model from the traditional BH model – (Buy-and Hold). Under the BH model, there is funding of the banks with short-term deposits and investing in loans that are held till they mature. On the other hand, under the OTD model, there is originating of loans by banks and there is in turn, repackaging and selling of the loans to other investors, thus spreading risks all through the economy. A large number of these risks are passed over to other banks as well as to the insurance companies and leveraged investors.
Broader spreading of risks in the world financial system provides a large number of possible benefits. For instance, spreading or distribution of the risks causes a large number of assets to be more liquid. More so, it can also free additional resources fro investment and brings down the level of asset price volatility. For the reason that it ensures risk distribution across a range of diverse investors, it is supposed to bring down the level of the possibility of the occurrence of systemic events.
The developments that were carried out in the recent times in the United States subprime market and their implications give out a suggestion that a weakness exist in the OTD model as well, which might involve fresh forms of risk or intensify those that are already there. There is minimal drive among the banks to engage in the monitoring of “borrowers ex post”, though in principle they do posses more drive to monitor them ex ante. The banks have moved away from depending on “soft information” as well as relationships to “model-based” pricing. A large number of the fresh instruments are “illiquid”. Activity has been moved from the regulated investors to unregulated ones. In summary, this new model may have higher efficiency and is far much more complicated, having more legal risk as well as operational and tail risks. Ferguson, Hartmann, Panetta and Portes present an argument that moving away from the BH model to the OTD model is not supposed to be reversed and possibly, can not be reversed. However, those who engage in policy making as well as industry bodies have the responsibility of making it work in a better way; they have the responsibility of pushing it in the direction of a model that is market-based and more balanced (Ferguson, Hartmann, Panetta and Portes 138).
Recommendations and Conclusion
Ferguson, Hartmann, Panetta and Portes give a number of policy recommendations in this book in relation to international financial stability. One of the recommendations is that the regulators as well as the market participants are supposed to be attentive to the tail risk. There is also need to have continuous cooperation among the regulators as well as the main central banks since the liquidity pools are currently global. It is also pointed out that new regulations could call for the need for the originators to “retain equity pieces” of the finance products that are structured which they have.
More so, it is recommended that the regulators are supposed to have information concerning SF or structured finance “instrument holdings” and also to have information on risk concentration in order to help in the “regulatory process”. There should also be boosting of “product standardization” by the industry bodies and there should also be accurate pricing in the structured finance market. In addition, there should be no treating of the credit market transactions which do not certainly transfer risk by the regulators as if they certainly transfer risk. Last but not least, there should be insisting by regulators that the “prime brokers” as well as investors equip themselves with adequate knowledge about the strategies as well as positions of hedge funds that they transact with.
European Commission. “Assessment of the 2011 national reform program and convergence program for Sweden”. Commission staff working paper, 2011. Web. 14 June 2011.
Ferguson Roger w, Hartmann Philipp, Panetta Fabio and Portes Richard. International financial stability. Geneva: International Center for Monetary and Banking Studies, 2007.
Kalemli-Ozcan Sebnem, Papaioannou Elias and Peydro Jose Luis. Financial integration and business cycle synchronization, 2009. Web. 14 June 2011.