Current account imbalances, household indebtedness, large leveraged transactions in the corporate sector as well as the growth in market complexity should all be sounding alarm bells, says Mario Draghi.

Financial crises are a bit like earthquakes: we know they are inevitable, we know what causes them, and we all know when one strikes. But we cannot predict with any certainty when or where and how violent it will be. Still, there are many things we can do beforehand to reduce the potential damage should one materialise.

A key function of the Financial Stability Forum (FSF), which brings together representatives of finance ministries, central banks, regulators, international institutions and expert groupings from around the world, is to focus on potential sources of weakness in international financial markets.

The global economy has been growing strongly and financial markets have been functioning well. But history shows that events can lead to sudden behavioural shifts by investors and institutions and cause problems across a broad spectrum of institutions and markets. When this happens, the potential for damage usually reflects accumulated macroeconomic or financial imbalances. It is not surprising therefore that policymakers and other observers are focused on several imbalances with the potential to affect the resilience of the financial system. Areas of concern include:

  • Global current account imbalances. Large current account deficits continue to be financed smoothly, but the existing pattern of current and capital account flows is not sustainable indefinitely. There is a small but genuine probability that the move to a more sustainable pattern might involve a disruptive shift in asset prices and capital flows.

 

  • Household indebtedness. Many industrial and emerging economies are seeing higher household indebtedness, much of it related to housing. There are, of course, important differences across countries. But increased household indebtedness heightens macroeconomic and financial sensitivity to shocks, both through the potential impact of softening housing markets on consumption and construction, and the direct exposure of lenders to any decline in household creditworthiness.

 

  • Large leveraged transactions in the corporate sector. Leveraged buyouts (LBOs) and acquisitions, many of them led by private equity firms, have become increasingly prominent in recent years. While aggregate corporate leverage remains at historically low levels, reflecting years of balance sheet repair, the LBO boom has raised risk concentrations for lenders, worsened the credit fundamentals of some companies taken private, and diminished the transparency of the corporate sector. A downturn in markets, including reduced investor appetite for credit risk, may find banks and other lenders exposed to these transactions in unexpected ways.

 

  • Growth of leverage and complexity in financial markets. Financial innovation, and the increased activity of hedge funds, have contributed to increased liquidity and improved price discovery in many financial markets, and increased the choices available to investors. But one consequence has been that financial systems have become more complex and, in some ways, more opaque, which makes tracking the sources of such risks, understanding where the pressure points might arise, and taking appropriate mitigating actions, more difficult.Inevitably innovation can run ahead of the ability to properly manage associated risks. Unless a significant shock occurs we will not know if these developments have raised the risk of unpredictable and damaging market dynamics.

 

Market functioning

Work is underway to address these areas of concern. For example, recent efforts to reduce confirmation backlogs and improve trading infrastructure in the credit derivatives market have reduced operational risks in it. These efforts represent a promising model for cooperation between the public and private sectors, in which market participants, through vehicles such as the Counterparty Risk Management Policy Group, identify areas where there is a need for collective action to improve market functioning, while public authorities, collaborating across borders, work to encourage, co-ordinate and monitor the private sector response.

Other issues that could fruitfully be addressed in this way include improvements in stress-testing, examining margining and collateral practices, extending current work on infrastructure to equity derivatives, promoting sound valuation procedures for illiquid instruments, and efforts to improve the transparency and risk management of hedge funds.

Mario Draghi is governor of the Central Bank of Italy and chairman of the Financial Stability Forum.

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