Taking a global perspective is vital to learn lessons from financial market turbulence and find the right approach to move forward in the future, says Jaime Caruana.

Global financial markets have endured an important test – a test that will take some time to fully resolve. Most view this episode as the first true test of the financially innovative structured credit products that have proliferated in recent years – but this is also a meaningful test of the resiliency of emerging markets.

Financial globalisation and new product innovation has extended to a diverse set of countries outside the mature market core, enabling more sustained economic growth and enhanced financial stability. Surprising many has been the degree to which emerging markets have been able to distance themselves from what has become a major dislocation in mature financial markets. The lessons that we take from the episode will likely have significant effects on those countries in the epicentre of the event and on emerging market countries. It will be important to consider the lessons with a global perspective in mind.

Old and new

This episode of market turbulence has its roots in the US subprime mortgage market, where such mortgages were packaged into complex structured credit products and purchased by a broad range of investors. The ensuing difficulties have brought to light new and old elements.

The new element is that much of the uncertainty has revolved around the inability to value highly complex structured credit instruments; uncertainty that was heightened following the multiple-notch downgrades of these securities by ratings agencies, leading investors to question these ratings. The more traditional elements have been a classic lowering of credit standards during a period of benign conditions and a maturity mismatch in the funding of the loans.

However, there is a new twist: the maturity mismatch was not on the balance sheets of traditional providers of credit – that is, banks – but in off-balance sheet conduits and special investment vehicles (SIVs), where in some cases structured credit products constructed from loans were funded with asset-backed commercial paper.

Given its centre stage in the episode, a rethinking of some of the incentives in the ‘originate-and-distribute’ model for loan securitisation is warranted. However, it would be a mistake to view securitisation, per se, as flawed. This is an instance in which the sophistication of the securitised products grew more rapidly than the ability of markets and participants to keep up with the new products and structures. Market practices will need to change, but to some extent, some of the issues arising from this episode may be self-correcting.

Investors are reportedly beginning to insist that originators or securitisers assume more responsibility for some of the loans they originate or package and that more ratings information be made available from rating agencies. That said, the episode raises other issues that may require some supervisory or regulatory adjustments. Here again, it will be important not to rush to regulate.

Moving forward on regulations that are already in the pipeline or at an early stage of implementation, such as Basel II, may help. The more comprehensive, risk-based approach of Basel II could have made a positive difference had it been in place some years ago. Its emphasis on transparency in pillar three is a move in the right direction.

Addressing risks

In the area of liquidity management, the latest events give financial institutions an incentive to attain proposed best practices and make their funding strategies more robust. But given the potential systemic implications of poor liquidity management by individual institutions, supervisors or central bankers should continue the dialogue with the industry to better address systemic liquidity risks. Financial stability should also enter the debate.

Going forward, it will be particularly important to draw the right lessons. Policymakers now face a delicate balancing act. They must establish robust frameworks that encourage investors to maintain high credit standards and strengthen risk management systems, but must also avoid inhibiting beneficial financial innovations. At the same time, to keep market contagion and spillovers at bay, it will be important that investors differentiate across products and markets. Reinforcing the good financial practices and economic policies that emerging market countries have put into place and addressing existing areas of fragility should aid global financial stability and minimise the fallout from the episode.

Jaime Caruana is head of the IMF’s monetary and capital markets department.

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