The Global Financial Environment | Financial Stability Review – September 2008

Financial Stability Review – September 2008 The Global Financial Environment

Over the past year, the US financial system has faced its most challenging conditions for many decades, prompting exceptional responses from the US authorities. In the early phases of the turmoil, the main concern was liquidity, with inter-bank spreads, particularly at longer terms, increasing sharply. The Federal Reserve, and other central banks, responded to these tensions with a number of measures that helped alleviate tensions in money markets. Attention then turned to specific institutions’ difficulties associated with sub-prime related products. These pressures prompted the US authorities to: assist with the sale of the investment bank Bear Stearns; place the government sponsored housing enterprises, Fannie Mae and Freddie Mac, under conservatorship; and provide the world's largest insurer, American International Group, with a secured line of credit up to US$85 billion. More recently, the authorities have announced several major initiatives intended to provide a comprehensive approach to relieving systemic stress in the financial system. These initiatives include a plan to purchase up to US$700 billion of troubled assets from banks with significant operations in the United States, and insurance arrangements for short-term money market funds. In addition, and reflecting spillover effects to the global financial system, the Federal Reserve, incollaboration with other central banks, has introduced new international swap agreements.

At the time of writing, it appears that the most recent announcements by the US authorities have seen sentiment improve somewhat in a number of markets. Nonetheless, conditions remain strained, with uncertainty and risk aversion still at elevated levels and concerns persisting about the capital strength of a number of the world's largest financial institutions.

At the centre of the problems in the global financial system has been a marked reduction in confidence in many financial institutions. One important reason for this is that investors have been uncertain as to the exact value of the assets on many financial institutions’ balance sheets and, as a result, about these institutions’ underlying capital strength. As many commentators have noted, reducing the opacity of banks' assets and increasing the level of capital in the global banking system are key to resolving the current problems.

The recent difficulties and the high level of risk aversion come after a number of years in which investors were prepared to borrow heavily to buy risky assets at fine margins. With the pendulum now having swung the other way, the adjustment is proving to be more difficult and costly than many had expected a year ago. Risk margins on many financial assets have increased to historically high levels, and investors are seeking to reduce leverage and are eschewing asset classes which up until a year or so ago were in extremely strong demand. This cycle has been reinforced by financial institutions which up until recently were eager to provide, on very favourable terms, the leverage that investors sought but are now tightening lending standards and becoming much more cautious about providing credit to both households and businesses.

An important factor weighing on a return to more normal conditions is the deterioration in various property markets, particularly the residential property market in the United States. Declines in property prices, together with the greater uncertainty within the financial system, have increased the risk of a damaging feedback loop running from the financial sector to the real economy and back to the financial sector. Rebuilding confidence in the financial system is obviously important here. From this perspective, the recent initiatives by the US authorities are to be welcomed.

Profitability, Capital and Balance Sheets of the Banking System

The ongoing fall-out from the sub-prime problems has resulted in a very large decline in bank profitability in both the United States and in parts of Europe. Since July 2007, large financial institutions have reported around US$520 billion of writedowns, mostly related to holdings of sub-prime mortgage-backed securities, CDOs backed by sub-prime securities and exposures to monoline insurers. Largely reflecting these writedowns, over the nine months to June 2008 the aggregate profits of all US institutions insured by the Federal Deposit Insurance Corporation (FDIC) were down by around 75 percent on the equivalent period a year earlier (Graph 1). While the sharp decline in profitability has been widespread, it has been most pronounced for the US investment banks and the larger commercial banks; since August 2007, the investment banks as a whole have recorded a loss of around US$14 billion, while the six largest commercial banks have recorded a combined loss of around US$7 billion. In Europe, there has also been a marked decline in bank profitability, although the decline has not been as widespread as in the United States. For a group of 16 large European banks that have recently published half-year results, profits were down nearly 70 per cent on the level of a year ago.

The large writedowns, together with the increase in risk aversion, have led to a significant contraction in some banks' balance sheets. As an illustration, between September 2007 and June 2008, the combined balance sheet of Citigroup, UBS, Morgan Stanley and Merrill Lynch declined by US$960 billion, or 13 per cent (Table 1). Many troubled banks are attempting to offload risky, capital-intensive assets, often at sharply reduced prices, in an effort to deleverage and ‘de-risk ’ their balance sheets. Some are also selling ‘non-core’ assets, such as wealth management units and insurance arms. This process has weighed on the prices of many financial assets, and the desire to preserve capital has contributed to a tightening of lending standards (see below).

As has been well documented, the catalyst for these problems was a sharp rise in arrears rates on sub-prime loans in the United States, particularly those with adjustable rates. The 30+ days arrears rate on adjustable-rate mortgages began to increase in mid 2005 and currently stands at around 21 per cent (Graph 2). The arrears rate on fixed-rate sub-prime loans has also increased markedly since early 2007, and arrears on prime loans have also risen. As a result, foreclosure rates on both sub-prime and prime mortgages have more than doubled over the past year, to be at ten-year highs, with 12 percent of sub-prime loans currently in foreclosure. Underlying this markeddeterioration in credit quality was a significant reduction in credit standards by mortgage lenders in the United States in the middle part of this decade. The reasons for this reduction were discussed in some detail in the March 2008 Review.

While internationally comparable data on housing arrears are limited, the available data suggest that there has also been an increase in arrears rates in a number of other countries, although the increases are considerably less than those seen in the United States, where the 30+ days arrears rate on all mortgages has risen from 4.3 per cent in mid 2005 to 6.4 per cent in June 2008. In the United Kingdom, for example, the share of rated (prime) securitised mortgages that are 30+ days in arrears has risen from 2.3 per cent in 2005 to 2.9 per cent in mid 2008. In Spain, another country that had experienced a very large run-up in house prices over a number of years, the 30-to-90 day arrears rate on rated securitised mortgages has risen from 1.2 per cent in 2005 to 2.5 per cent in March 2008.

For many institutions the losses arising from sub-prime problems have been amplified by the structured nature of the securities that they hold and the very large changes in the market value of these securities. For example, the ABX index of AAA-rated tranches of sub-prime RMBS that began trading in the first half of 2007 has lost half its value, while lower-rated tranches have incurred much larger price falls (Graph 3). These sharp declines reflect not just a reassessment of default probabilities, but also a significant increase in the uncertainty surrounding these probabilities, as well as a rise in the compensation that investors require for holding a given level of risk. In the early months of the turmoil, there was an expectation by some that these mark-to-market losses might be partly reversed, and while this remains a possibility, many institutions have, as discussed above, responded to the protracted nature of the turmoil by attempting to remove these assets from their balance sheets.

While the writedowns and losses that have occurred to date have been largely related to assets backed by sub-prime mortgages, there are signs of a more general deterioration in loan performance arising from the slowdown in the major economies and tighter financial conditions. This is most evident in the United States, where charge-off rates on banks' consumer loans have risen considerably (Graph 4). There has also been an increase in charge-off rates on commercial loans, although they remain well below the peak experienced after the dot-com boom. In Europe, reported loan charge-offs have been relatively unchanged but are likely to rise in the period ahead.

Given the large declines in some asset prices that have taken place, a central concern over the past year has been the overall capital position of the banking system and, in particular, the capital position of the institutions experiencing the largest losses. Indeed, many of the swings in financial prices seen this year can be directly related to the ebb and flow of these concerns. In some cases, the writedowns have made very large dents in capital levels and, in at least one prominent case, they exceeded the bank's total capital as at the middle of 2007. The US investment banks have been particularly affected, given their high leverage and the fact that some had built up sizeable portfolios of structured credit products as they moved away from their more traditional business of corporate advice and underwriting activities. Reflecting the difficulties, only two of the five large US investment banks that existed at the start of this year now exist as stand-alone entities, with both of these having been given approval to become commercial banks.

Notwithstanding the problems in the investment banking industry, for most of the past year the banks that have experienced large losses have been able to raise new capital, with total raisings by the largest banks since July 2007 amounting to around US$370 billion. These raisings, together with balance sheet contraction and ongoing net income generated from regular operations, have meant that many banks have been able to maintain or, in some cases, increase, their regulatory capital ratios. For example, for the six largest commercial banks in the United States, the ratio of capital to risk-weighted assets rose by almost 100 basis points over the 6 months to June, with strong capital raisings in the first half of 2008 significantly exceeding losses (and risk-weighted assets having been flat) (Graph 5 ). In the United Kingdom, the aggregate capital ratio for the largest six banks has declined only slightly.

Despite the capital that has been raised, the past couple of months have seen increased concerns regarding the health of the financial sector, particularly in the United States. These concerns reflect the continuing high level of uncertainty, and the fact that investors have incurred losses on some previous capital injections. In the United Kingdom, the difficulties were highlighted when a number of new equity issues were significantly undersubscribed, with the underwriters having to take up the shortfall. These concerns intensified in early September, contributing to the US Government's decision to appoint a conservator to Fannie Mae and Freddie Mac and to support the insurer American International Group (AIG), and to the quickly arranged sales of Merrill Lynch and HBOS.

Reflecting the difficult operating environment of the past year, bank share prices in the major countries are down by 35 to 45 per cent since mid 2007, and 5 to 15 per cent over the past six months (Graph 6). Volatility of bank share prices has also been at or near record highs over the past month, leading to concerns about the fair and orderly operation of equity markets. In response, the authorities in a range of countries, including the United States, the United Kingdom, Australia, France, Germany, Ireland and Canada have in the past week introduced temporary restrictions on the short sale of equities.

Credit default swap premia for banks are also markedly higher than they were in the first half of last year (Graph 7). These spreads increased significantly around the time of the Bear Stearns problems, and then declined in the immediate aftermath of the ‘rescue’ before rising again since May. In recent weeks there have been particularly large increases in these spreads, as markets reacted to a run of bad news, in particular the bankruptcy of the investment bank Lehman Brothers.

The difficult operating environment has also resulted in a significant number of credit downgrades. Of the 50 largest rated banks in the world, 12 have had their ratings downgraded since end June 2007, and 18 are on negative outlook. Also, after a number of years in which there were few, if any, bank failures in the United States, 13 banks have failed this year, and there has been an increase in the number of institutions that the FDIC considers to be troubled.

Recent months have also seen the spotlight on the capital position of monoline insurers and lenders’ mortgage insurers (LMIs), both of which have considerable exposure to residential mortgages through credit protection sold to institutions, including banks and the government sponsored enterprises (GSEs). Many of these insurers have been downgraded by the ratings agencies, and have seen their share prices fall by 75 to 95 per cent since mid last year. The downgrades of monolines and LMIs in June 2008 had a flow-on effect to around US$350 billion of structured finance securities, mostly in the United States.

Policy Responses in the United States

The difficulties in the US financial system have led to unprecedented actions by the US authorities to preserve financial stability (Table 2). As noted above, initial measures focused on easing liquidity pressures; in August 2007 the Federal Reserve reduced the cost of funding (relative to the target Fed funds rate) through its Primary Credit Facility and allowed term lending for up to 30 days. Further measures concerning liquidity were announced in December 2007 and in March and September 2008.

The first institution-specific measure was taken in March 2008, when the authorities became concerned that the failure of Bear Stearns could generate a widespread firesale of financial assets, with very serious flow-on implications for other financial institutions. In response, they assisted with the sale of Bear Stearns to JPMorgan Chase, with the Federal Reserve providing liquidity assistance and, importantly, purchasing (via a special purpose vehicle) close to US$30 billion of Bear Stearns’ most illiquid assets. The Federal Reserve also introduced the Primary Dealer Credit Facility, which provided, for the first time, liquidity to primary dealers, including investment banks. In September 2008, the eligible collateral for this new facility was broadened and the continued operation of the facility extended to January 2009.

In July and August, the authorities then became very concerned about the growing loss of confidence in Fannie Mae and Freddie Mac, the government sponsored housing enterprises. Even though these entities were privately owned, the implicit government support that had existed for many years had allowed them to borrow at lower rates than their financial position would have otherwise allowed. The GSEs’ management had used this ability to build large, highly leveraged balance sheets, so that by mid 2008, they had exposures to around 45 per cent of the outstanding stock of US residential mortgage assets, both directly and through guarantees and securitisation. While most of the mortgages they have exposures to are prime mortgages with loan-to-valuation ratios less than 80 per cent, the GSEs also have sizeable exposures to riskier sub-prime, Alt-A and high loan-to-valuation ratio mortgages written at the peak of the housing boom.

As concerns about the solvency of the two agencies increased due to expectations of further losses from their exposure to the US housing market, confidence in them deteriorated significantly, with their share prices falling by around 90 per cent from mid-2007 to early September. Given the deteriorating situation and the important role that these entities play in the US housing market and in many investors’ bond portfolios, the US Government stepped in with a rescue package in early September, with the package having the following four key elements: (i) Fannie Mae and Freddie Mac have been placed in conservatorship, under the control of the Federal Housing Finance Agency which will work to return them to a sound condition; (ii) the US Treasury has been issued with US$1 billion of senior preferred stock in each entity and has been granted the authority to inject additional capital into each entity of up to US$100 billion, while it can exercise warrants to acquire an equity interest of almost 80 per cent; (iii) the US Treasury has been granted the authority to purchase GSE mortgage-backed securities in the open market, with the size and timing to be determined by market conditions; and (iv) a new, short-term secured credit facility has been created for these agencies.

In the case of AIG, the authorities again judged that, in the prevailing circumstances, its failure could have destabilised the financial system, particularly given its size and complexity. Under the rescue package, the Federal Reserve Bank of New York will lend AIG up to $US85 billion, secured by AIG's assets, at an interest rate of 3-month LIBOR plus 850 basis points. In addition, the US Government will be granted an equity interest of almost 80 per cent in the company, substantially diluting the interests of existing shareholders.

On 19 September, the US authorities announced several major initiatives intended to provide a comprehensive approach to relieving the stresses in financial institutions and markets. First, in an effort to free banks' balance sheets of highly illiquid troubled assets, the US Treasury proposed that the government purchase up to US$700 billion of residential and commercial mortgage-related assets, comprising loans and mortgage-backed securities, from certain financial institutions. To qualify for the program, assets must have been originated or issued on or before 17 September 2008 and participating financial institutions must have significant operations in the United States. It is intended that the assets will be managed by private entities, under the direction of the Treasury, and may be sold off or held to maturity.

Second, in response to concerns that redemptions from money market mutual funds were causing severe strains, the US Treasury announced that it will draw on US$50 billion available through the Exchange Stabilization Fund (created in the 1930s) to temporarily insure the holdings of any money market mutual funds, at both the retail and institutional levels, that pay a fee to participate in the program. The intention is to ease investor concerns of losses on investments in these funds, thereby stemming the flow of redemptions.

In addition to these measures, the US Treasury announced two further actions to provide more support for housing finance. In particular, Fannie Mae and Freddie Mac will increase their purchases of mortgage backed securities, and the Treasury will expand its own program of MBS purchases.

Finally, on 22 September, the US Federal Reserve announced that the two remaining large investment banks, Goldman Sachs and Morgan Stanley, will become bank holding companies. To assist during the transition to their new structure, the Federal Reserve will grant their broker-dealer subsidiaries immediate access to the Primary Credit Facility for depository institutions. (Access to the Primary Dealer Credit Facility for investment banks was granted in March.)

Funding Conditions

The ongoing waves of concern about the health of the banking system in the United States has caused credit spreads in money markets to remain elevated, with these spreads rising and falling on the ebb and flow of news. Conditions in longer-term funding markets also remain difficult, primarily reflecting concerns about the capital strength of counterparties. Not surprisingly, in this environment, many banks around the world have tightened their lending standards and are seeking to preserve and strengthen their liquidity.

Spreads in short-term money markets rose significantly around the time of Bear Stearns’ problems but then declined over the following months, only to again increase sharply in mid September, following the Lehman Brothers bankruptcy (Graph 8). In the United States, the spread between the 3-month LIBOR rate and the OIS rate rose to as high as 140 basis points in mid September, compared with an average of around 10 basis points in the first half of 2007. Throughout the past year, conditions in short-term money-markets have been assisted by the domestic market operations of central banks and, in particular, by the willingness of central banks to take illiquid assets under repo and, in exchange, provide the banking system with assets that have more favourable liquidity characteristics. In the United States, for example, the Federal Reserve's holdings of US Treasuries have declined from around $740 billion in early January 2008 to $480 billion in September 2008, and correspondingly the holdings of other, less liquid, assets have increased.

In mid September, many financial markets experienced very strained conditions, as investors became much less willing to take counterparty risk. Bid-ask spreads increased in many markets and trading conditions were very difficult. One illustration of the extreme conditions that prevailed at the time was that the interest rate on 3-month Treasury bills in the United States fell almost to zero for a short time, as investors sought assets with very high credit quality and very high liquidity. In part, this reflected the difficulties in the money-market mutual fund sector, with large redemptions from many funds as investors became concerned about the capital value of their investments.

Over the past year, credit premia on longer-term bank debt have increased by substantially more than those on short-term debt, reflecting the heightened levels of uncertainty about the medium term. These spreads have also tended to exhibit the same cycles as for short-term securities, with the spreads to US Treasuries on 5-year bonds issued in the United States by AA-rated banks currently around 370 basis points, compared with 70 basis points prior to the turmoil. Of particular significance for the US housing market, spreads between yields on GSE senior debt and US Treasuries increased substantially from mid 2007 and especially from early April to early September this year (Graph 9). Under the plan announced by the US authorities in September, payments to all debt holders including holders of subordinated bonds, will be honoured (although dividend payments to existing shareholders have been suspended) and spreads have consequently fallen sharply.

Conditions in markets for asset-backed commercial paper remain very difficult. In the United States, issuance of asset-backed commercial paper remains low with the amount outstanding relatively unchanged over 2008 at around US$760 billion, well down on the August 2007 peak of around US$1,200 billion. Similarly, CDO issuance has been virtually non-existent, falling by 93 per cent in the United States in the first half of 2008, compared with the equivalent period a year earlier, while issuance in Europe is down by 65 per cent over the same period (Graph 10). Non-agency securitisation funding has also declined significantly with just US$39 billion of non-agency debt having been issued in the year to June, compared with US$470 billion during the same period in 2007. Reflecting investors’ current lack of appetite for structured products, issuance of financial intermediaries’ conventional bonds has held up better although, as noted above, the spreads on these bonds have risen substantially. Similar trends are evident in other countries, with structured market issuance extremely limited but moderate levels of issuance of conventional bonds; in Europe, issuance of securitisations fell sharply in the first quarter of 2008.

The difficult environment facing many financial institutions has contributed to a marked tightening in the conditions under which credit is provided to many borrowers. Most banks cite the deteriorating economic conditions as the main reason for this tightening, although an increased share of banks in the United States and Europe also cite concerns about their capital positions.

Loan officers’ surveys in a range of countries show an unprecedented tightening in lending standards for residential mortgages, after standards were eased over the middle years of this decade (Graph 11). The tightening has been particularly pronounced for riskier loans with, for example, almost 90 per cent of the surveyed US banks engaging in sub-prime mortgage lending reporting a tightening in lending standards in the three months to July 2008. Nearly two thirds of banks originating riskier loans report that they expect further tightening over the rest of 2008/09.

Lending conditions have also tightened significantly for business borrowers, particularly for those with highly leveraged balance sheets and/or significant exposures to commercial property markets (Graph 12). Risk margins have increased, covenants have been tightened, and the maximum size of credit lines has been reduced.

In terms of the demand for credit, higher interest spreads and the heightened uncertainty have significantly reduced the appetite of many businesses and households for debt. This, combined with the tightening in credit supply, has resulted in a significant moderation in credit growth. Over 2008 to date, annualised housing credit growth in both the United States and the United Kingdom has fallen significantly to low single digit figures (Table 3). The rate of growth of business credit in the United States and United Kingdom has also declined, after growing strongly in preceding years. This is espite business credit being boosted, to varying degrees, by the re-intermediation of off-balance sheet business in response to the financial market turmoil.

Given the general increase in uncertainty and risk aversion, businesses raising funds in capital markets have also faced more difficult conditions than for some years. Issuance of short-term debt has held up reasonably well but issuance of longer-term debt, especially sub-investment-grade debt, has declined substantially; US investment-grade corporate bond issuance in the year to June was more than 10 per cent lower than in the same period of 2007, while issuance of riskier debt was two thirds lower. At the same time, the spreads demanded by investors have risen sharply, up by 270 basis points for investment-grade debt, and 550 basis points for sub-investment-grade debt, since mid 2007 (Graph 13). However, for AAA-rated debt, the rise in spreads over the period has been broadly offset by the fall in yields on US Treasuries.

Among specific corporate debt markets, the ‘leveraged loan’ market (used to finance leveraged buyout transactions) and the ‘cov-lite’ market (for loans with fewer or less stringent covenants than typical corporate loans) have been particularly affected. These markets flourished in the mid 2000s amid high leveraged buyout (LBO) activity and increased investor appetite for risk, but the value of announced and completed LBO deals fell to less than US$50 billion in the second quarter of 2008. This compares with a peak of over US$400 billion in the June quarter of 2007, but is broadly in line with the average for 2002 to 2005 (Graph 14). Elsewhere, tighter financing conditions in commercial mortgage-backed securities markets (and in the supply of credit from banks) have reinforced pressure on commercial property market prices in some countries, with share prices in this sector typically underperforming broader indices.

Global Macroeconomic Outlook

As discussed above, the moderation in credit growth, and heightened investor uncertainty, are weighing on many asset values. Clearly, developments in housing markets – particularly i the United States – will continue to be a key factor in macro-financial developments. While the estimated size of the nation-wide fall in US house prices since their peak is sensitive to the measurement methodology used – ranging from 6 per cent according to the Office of Federal Housing Enterprise Oversight to 19 per cent according to the Case-Shiller index – there is no doubt that nationwide house prices have been weak, with the states of California, Nevada and Florida experiencing particularly large falls. This weakness, and the associated rise in foreclosures, has reduced banks' willingness to lend and has dampened private consumption. House price weakness is also a concern in a number of other countries: UK house prices have fallen by 13 per cent since their peak in August 2007 while prices in Spain and France have recently stopped rising after a number of years of rapid growth (Graph 15).

Despite the considerable financial headwinds in the developed countries, global economic activity held up reasonably well in the first half of 2008. In particular, the US economy continued to expand during this period, reflecting strength in business investment, the fiscal stimulus and strong exports due, in part, to the depreciation of the US dollar. Most commentators, though, expect little, if any, growth over the rest of 2008. More generally, expectations for the advanced economies as a whole are for only modest growth during 2008 and 2009. While these outcomes will weigh on growth in the rest of the world, most forecasters still expect global growth to remain reasonably strong in 2009, although notably lower than that seen in recent years.

To date, business activity globally has held up reasonably well in the face of difficulties in the financial system, although some companies have had increased difficulty servicing debt and, in particular, refinancing maturing debt. Consistent with this, and the associated weakness in general economic activity, rating agencies’ expectations of default on speculative-grade debt have increased significantly, although reflecting the generally healthy state of business balance sheets in many countries, the expected default rate is currently lower than that after the dot-com boom or the recession of the early 1990s (Graph 16).

In emerging markets, banking systems have been relatively unaffected by the credit market turmoil but capital markets have come under pressure: equity prices have fallen; spreads have increased; and external corporate debt issuance in the first half of 2008 was less than half of that in the first half of 2007. Another challenge for many emerging market economies is rising inflation. In particular, some have experienced a significant increase in inflation (albeit less so for core, than headline, inflation) which left unchecked has the potential to undermine growth and external confidence and be a source of financial instability (Graph 17).

Regulatory Responses

The events of the past year have highlighted a number of difficult questions facing policymakers regarding the future regulation of the financial system.

In the United States, a critical issue is the future role of the GSEs. Over the past decade or so, Fannie Mae and Freddie Mac were allowed to reach a size that made it very difficult for the government to do anything other than to effectively guarantee their liabilities when they got into difficulties. Looking forward, ways will need to be found either to reduce the systemic importance of these institutions and/or to bring them under much closer and stronger public-sector oversight. The current reform plan goes some way in this direction, allowing for some modest expansion of the GSEs’ balance sheets up to end 2009, but then requiring a contraction of at least 10 per cent per annum over a number of years.

A more general issue facing the authorities in both the United States and elsewhere is how to limit the probability that the current actions to prevent financial instability sow the seeds for even more risk taking in the future. Here, policymakers face a difficult balancing act, with a number of the recent support efforts leading to significant losses to the shareholders of the affected institutions, but with bond holders being less affected (except in the case of Lehman Brothers)

At the international level, much of the ongoing work examining the causes of the recent turmoil and possible policy responses is being coordinated by the Financial Stability Forum (FSF). In April 2008, the FSF released an extensive report, Enhancing Market and Institutional Resilience, identifying a number of weaknesses in financial systems that had underpinned the build up of risk over the past decade as well as areas where regulatory action needs to be considered. These areas include:

the strengthening of prudential oversight of capital and liquidity and, in particular, improving the regulatory arrangements that apply to off-balance sheet exposures, securitisation activities and other contingent liquidity risks;
increasing the transparency of banks' balance sheets and re-examining how fair value approaches to valuation should be applied when markets are illiquid and/or the only transactions taking place are by distressed sellers;
re-examining the role and uses of credit ratings by both financial institutions and regulators, as well as addressing the conflicts of interest that can arise within these agencies;
the strengthening of authorities’ responsiveness to risk, including via improved cooperation; and
improved crisis management arrangements, both for domestic and internationally operating financial institutions.

Initiatives are underway at both the domestic and international level to implement the FSF's specific recommendations (see chapter on Developments in the Financial System Infrastructure or a discussion of the Australian authorities’ response). For example, the new Basel II capital regime has introduced capital requirements on 364-day renewable liquidity facilities; these facilities, which underpinned many of the structured finance transactions over recent years, previously had no capital requirements. In addition, the Basel Committee on Banking Supervision has published proposals to increase the capital requirements on structured finance products held in trading books and is revising its Principles for Sound Liquidity Risk Management. Regulators are also examining ways to reduce risks in the infrastructure supporting trading in over-the-counter (OTC) derivatives. In the United States, for example, the Federal Reserve, together with the private sector, has agreed to an agenda to improve the infrastructure for OTC derivatives, which includes the use of a central counterparty for CDS trades.

On transparency, FSF members have written to internationally active financial institutions in their respective countries to encourage them to comply with best practice disclosures, particularly in relation to asset-backed securities, special purpose entities and leveraged finance. Some institutions have used at least parts of this template in their recent mid-year earnings releases. The US Securities and Exchange Commission (SEC) has also written to selected financial firms asking them to consider disclosing a list of items associated with off-balance-sheet entities. In a similar vein, the American Securitisation Forum (ASF) – a private-sector organisation – has released a proposal to standardise disclosure about RMBS to ensure that a uniform set of information is available to all market participants. The ASF expects to finalise the disclosure package before the end of 2008, for implementation in 2009.

In May, the International Organization of Securities Commissions (IOSCO) revised its Code of Conduct for credit rating agencies. Among other things, the Code: prohibits the agencies from making recommendations regarding the design of structured finance products; requires the agencies to adopt reasonable measures so that the information they use is of sufficient quality to support a credible rating; and requires the agencies to differentiate ratings of structured finance products from other ratings. While the three major credit rating agencies have noted poor industry feedback on the last of these requirements, two of the agencies have indicated a willingness to move in this direction. The US SEC is reforming its regulation of rating agencies by broadly following the revisions to the IOSCO Code of Conduct, as well as making additional changes, including reducing references to credit ratings in official rules and requirements. The European Commission, together with the Committee of European Securities Regulators and the European Securities Markets Expert Group, is intending to propose a European registration and external oversight environment for credit rating agencies, similar to that in the United States.

On strengthening the authorities’ responsiveness to risks, one means is through improving information exchange, including across borders. In order to foster this, the FSF has formed a group of key supervisors to develop the protocols needed to establish supervisory colleges for each of the major global financial institutions. The colleges will be chaired by the home supervisor and comprise a small number of host supervisors of activities that are fundamental to the soundness of these financial institutions.

A more general issue identified by the FSF is the inherent pro-cyclicality of the financial system. This reflects the fact that while the specifics of the current turmoil are unique, its origins lay in the preceding boom in the financial sector of the economy, as have almost all previous episodes of financial turmoil. The FSF is currently examining longer-term policy responses that might help deal with these cycles. Issues under consideration include: the remuneration arrangements in financial institutions; the accounting rules for illiquid assets; the case for monetary policy to lean against financial booms; and the tightening up of various prudential requirements during a boom so that financial institutions build up their capital buffers in good times, and are allowed to run these buffers down in bad times.