APR 08 World Economic and Financial Surveys G l o b a l F i n a n c i a l S t a b i l i t y R e Global Financial Stability Report p o r t Containing Systemic Risks and Restoring Financial Soundness 08 R P A IMF Global Financial Stability Report, April 2008 I N T E R N A T I O N A L M O N E T A R Y F U N D World Economic and Financial Surveys Global Financial Stability Report Containing Systemic Risks and Restoring Financial Soundness April 2008 International Monetary Fund Washington DC © 2008 International Monetary Fund Production: IMF Multimedia Services Division Cover: Jorge Salazar Figures: Theodore F. Peters, Jr., Jeffrey Rydberg, Andrew Sylvester Typesetting: Julio Prego ISBN 978-1-58906-720-2 ISSN 0258-7440 Price: US$57.00 (US$54.00 to full-time faculty members and students at universities and colleges) Please send orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Tel.: (202) 623-7430 Fax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org CONTENTS Preface vii Executive Summary ix Chapter 1. Assessing Risks to Global Financial Stability 1 Global Financial Stability Map 1 Credit Deterioration—How Deep and Widespread? 4 Systemic Risks Have Risen Sharply 10 Will Emerging Markets Remain Resilient? 23 Credit Squeeze or Credit Crunch? 32 Immediate Policy Challenges 36 Annex 1.1. Global Financial Stability Map: Construction and Methodology 40 Annex 1.2. Methodology for Calculating Global Losses and Bank Exposures 46 References 53 Chapter 2. Structured Finance: Issues of Valuation and Disclosure 54 Valuation and Disclosure of Complex Structured Finance Products 55 The Role of Off-Balance-Sheet Entities 69 Conclusions and Outlook 80 Annex 2.1. The World According to GAAP 83 References 84 Chapter 3. Market and Funding Illiquidity: When Private Risk Becomes Public 86 The Nature of Market Liquidity Risks 87 Funding Liquidity Risks 87 Market and Funding Liquidity Dynamics 93 Liquidity Dynamics Since July 2007: An Empirical Investigation 95 The Role of Central Banks During Periods of Market and Funding Illiquidity 98 Central Banks’ Response to Liquidity Strains Since July 2007: An Empirical Investigation 102 Recommendations to Enhance Liquidity Risk Management 104 Conclusion 109 Annex 3.1. Liquidity Dynamics Since Summer 2007 109 References 115 Glossary 118 Annex: Summing Up by the Acting Chair 125 Statistical Appendix 129 iiiiii CONTENTS Boxes 1.1 Outlook for U.S. High-Yield Corporate Debt Markets and Default Rates 14 1.2 Do Sovereign Wealth Funds Have a Volatility-Absorbing Market Impact? 20 1.3 The Rise in Balance Sheet Leverage of Global Banks 31 1.4 Quantitative Financial Stability Modeling 41 1.5 Banking Stability Index 48 2.1 Structured Finance: What Is It and How Did It Get So Large? 56 2.2 When Is a AAA not a AAA? (Part 1: The ABCs of MBSs and CDOs) 59 2.3 When Is a AAA not a AAA? (Part 2: Actual versus Market-Implied Mortgage-Backed Security Ratings) 61 2.4 When Is a AAA not a AAA? (Part 3: Collateralized Debt Obligation Rating Dynamics) 63 2.5 Conduits, SIVs and SIV-Lites 70 2.6 Consolidation of Structured Investment Vehicles: An Illustrative Example of Issues That Arise 73 3.1 The Determinants of Market Liquidity 88 3.2 Liquidity-Adjusted Value-at-Risk: At the Forefront of Market Liquidity Risk Management? 89 3.3 Standard Ways to Measure and Control Bank Liquidity Risks 90 3.4 Institute of International Finance Principles of Liquidity Risk Management 92 3.5 Central Bank Counterparties 102 3.6 Liquidity Regulation and the Basel Process 107 Tables 1.1 Estimates of Financial Sector Potential Losses as of March 2008 12 1.2 Typical “Haircut” or Initial Margin 23 1.3 Macro and Financial Indicators in Selected Emerging Market Countries 24 1.4 Changes in Risks and Conditions Since the October 2007 Global Financial Stability Report 40 1.5 Losses by Asset Class as of March 2008 51 1.6 Global Bank Losses as of March 2008 52 2.1 Accounting for Securities Held as Financial Assets 65 2.2 U.S. Subprime Exposures and Losses 78 2.3 Market Participants in Credit Derivatives, 2004 and 2006 79 3.1 Impact of Central Bank Interventions on LIBOR-OIS Spreads 115 Figures 1.1 Global Financial Stability Map 2 1.2 Mortgage Delinquencies by Vintage Year 6 1.3 U.S. Mortgage-Related Securities Prices 7 1.4 U.S. and European House Price Changes 7 1.5 U.S. and UK Nonconforming Delinquencies by Mortgage Vintage Year 8 1.6 Commercial Mortgage Borrowing and Real Estate Prices 8 1.7 CMBX Spreads 9 1.8 Charge-Off Rates for U.S. Consumer Loans 9 1.9 Credit Card Charge-Off Rates versus Credit Card Asset-Backed Spreads on Securities 10 1.10 LCDX Prices and Spreads 10 1.11 U.S. Leveraged Buyout Loans: Credit Quality Indicators 11 iv CONTENTS 1.12 C omparison of Financial Crises 13 1.13 E xpected Bank Losses as of March 2008 13 1.14 F inancial Guarantors 17 1.15 S ystemic Bank Default Risk 18 1.16 S ecuritization Volume in the European Union (EU-15) 19 1.17 B ank Equity Price Changes and Balance Sheet Leverage 19 1.18 U .S. Funding Market Liquidity 23 1.19 E uro Area Funding Market Liquidity 23 1.20 D ecomposing Interbank Spreads 25 1.21 External Position of Emerging Markets by Region vis-à-vis BIS Reporting Banks 26 1.22 S elected European Banks: Dependence on Wholesale Funding as of March 2008 26 1.23 C entral and Eastern Europe: Growth in Private Credit and House Prices, 2002–06 27 1.24 B altic States, Bulgaria, and Romania: Credit to Households by Type 27 1.25 B altic States’ 5-Year Credit Default Swap Spreads and Romanian Leu 28 1.26 E merging Markets: Private Sector External Bond Issuance 29 1.27 C arry-Trade Index and Currency Volatility 30 1.28 H eat Map: Developments in Systemic Asset Classes 33 1.29 S preads Across Credit: Historical Highs, Lows, and Current Levels 33 1.30 U .S. Private Sector Net Debt Issuance by Sector 34 1.31 G -3 Bank Lending Conditions 35 1.32 U .S. Private Sector Borrowing 35 1.33 I mpulse Response of U.S. GDP to Credit Shocks 36 1.34 G lobal Financial Stability Map: Monetary and Financial Conditions 42 1.35 G lobal Financial Stability Map: Risk Appetite Conditions 43 1.36 G lobal Financial Stability Map: Macroeconomic Risks 44 1.37 G lobal Financial Stability Map: Emerging Market Risks 45 1.38 G lobal Financial Stability Map: Credit Risks 46 1.39 G lobal Financial Stability Map: Market and Liquidity Risks 47 2.1 Selected U.S.-Based Financial Institutions: Change in Level 3 and 2 Assets 66 2.2 Writedowns of Selected Financial Institutions: October 15, 2007–February 14, 2008 68 2.3 Timelines for Implementation of Basel II Framework 75 2.4 Market Participants in Credit Derivatives, 2006 79 2.5 Structured Credit Products by Market Participants 80 2.6 Financial Guaranty Industry Insured Portfolio Distribution, 2006 81 3.1 Commercial Banks: Deposit-to-Asset Ratios 91 3.2 Aggregate Bank Credit Default Swap Rate and Selected Spreads 95 3.3 United States: Selected Money Market Spreads 95 3.4 United States: S&P 500 Stock Market Returns and Aggregate Credit Default Swap Rate 96 3.5 On-the-Run/Off-the-Run Five-Year U.S. Treasury Note Spread 96 3.6 U.S. Model: Selected Implied Correlations from Dynamic Conditional Correlation GARCH Specifi cation 97 3.7 Advanced Economies Model: Selected Implied Correlations from Dynamic Conditional Correlation GARCH Specifi cation 98 3.8 Three-Month LIBOR to Overnight Index Swap Spreads 99 3.9 Central Bank Key Policy and Overnight Money Market Rates 99 v CONTENTS 3.10 European Central Bank’s Liquidity Provision and Reserve Holdings 100 3.11 Euro Area: Selected European Central Bank Policy Actions and Term Funding Stress 103 3.12 United States: Selected Federal Reserve Policy Actions and Term Funding Stress 104 3.13 U.S. Model: Implied Correlations from Dynamic Conditional Correlation GARCH Specifi cation 112 3.14 Advanced Economies Model: Implied Correlations from Dynamic Conditional Correlation GARCH Specifi cation 113 3.15 Emerging Markets Model: Implied Correlations from Dynamic Conditional Correlation GARCH Specifi cation 114 The following symbols have been used throughout this volume: . . . to indicate that data are not available; — to indicate that the fi gure is zero or less than half the fi nal digit shown, or that the item does not exist; – between years or months (for example, 1997–99 or January–June) to indicate the years or months covered, including the beginning and ending years or months; / between years (for example, 1998/99) to indicate a fi scal or fi nancial year. “Billion” means a thousand million; “trillion” means a thousand billion. “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to !/4 of 1 percentage point). “n.a.” means not applicable. Minor discrepancies between constituent fi gures and totals are due to rounding. As used in this volume the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis. vi PREFACE The Global Financial Stability Report (GFSR) assesses key issues in global fi nancial market develop- ments with a view to identifying systemic vulnerabilities. By calling attention to fault lines in the global fi nancial system, the report generally seeks to play a role in preventing crises and, when they do occur, helping to mitigate their effects and offer policy advice, thereby contributing to global fi nancial stabil- ity and to sustained economic growth of the IMF’s member countries. The analysis in this report has been coordinated in the Monetary and Capital Markets (MCM) Department under the general direction of Jaime Caruana, Counsellor and Director. The project has been directed by MCM staff Peter Dattels and Laura Kodres, Division Chiefs; and Brenda González- Hermosillo and L. Effi e Psalida, Deputy Division Chiefs. It has benefi ted from comments and sugges- tions from Jonathan Fiechter and Christopher Towe, both Deputy Directors, and Mahmood Pradhan, Assistant Director. Primary contributors to this report also include Sergei Antoshin, Sean Craig, Phil de Imus, K ristian Hartelius, Heiko Hesse, John Kiff, Ulrich Klueh, Rebecca McCaughrin, Paul Mills, Ken Miyajima, Michael Moore, Christopher Morris, Mustafa Saiyid, Kenneth Sullivan, and Christopher Walker. Other contributors include Kristian Flyvholm, Marina Moretti, Miguel Segoviano, Tao Sun, and Ian Tower. Nathaniel Frank provided empirical modeling support. Martin Edmonds, Oksana Khadarina, Yoon Sook Kim, Narayan Suryakumar, and Kalin Tintchev provided analytical support. Caroline Bagworth, Shannon Bui, Christy Gray, and Aster Teklemariam were responsible for word processing. David Ein- horn of the External Relations Department edited the manuscript and coordinated production of the publication. This particular issue draws, in part, on a series of discussions with accountancies, banks, securities fi rms, asset management companies, hedge funds, auditors, credit rating agencies, fi nancial consul- tants, and academic researchers, as well as regulatory and other public authorities in major fi nancial centers and countries. The report refl ects information available up to March 21, 2008. The report benefi ted from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on March 26, 2008. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the Executive Directors, their national authorities, or the IMF. vviiii EXECUTIVE SUMMARY T he events of the past six months have facing policymakers is to take immediate steps demonstrated the fragility of the global to mitigate the risks of an even more wrenching fi nancial system and raised fundamental adjustment, including by preparing contingency questions about the effectiveness of the and other remediation plans, while also address- response by private and public sector institu- ing the seeds of the present turmoil. tions. While events are still unfolding, the April 2008 Global Financial Stability Report (GFSR) Chapter 1—Assessing Risks to Global assesses the vulnerabilities that the system is fac- Financial Stability ing and offers tentative conclusions and policy lessons. Some key themes that emerge from this Chapter 1 documents how the crisis is spread- analysis include: ing beyond the U.S. subprime market—namely to (cid:129) There was a collective failure to appreciate the prime residential and commercial real estate the extent of leverage taken on by a wide markets, consumer credit, and the low- to high- range of institutions—banks, monoline insur- grade corporate credit markets. The United States ers, government-sponsored entities, hedge remains the epicenter, as the U.S. subprime mar- funds—and the associated risks of a disorderly ket was the origin of weakened credit standards unwinding. and was the fi rst to experience the complications (cid:129) Private sector risk management, disclosure, arising from the associated structured credit financial sector supervision, and regulation all products. But fi nancial institutions in other coun- lagged behind the rapid innovation and shifts tries have also been affected, refl ecting the same in business models, leaving scope for exces- overly benign global fi nancial conditions and— to sive risk-taking, weak underwriting, maturity varying degrees— weaknesses in risk management mismatches, and asset price inflation. systems and prudential supervision. Industrialized (cid:129) The transfer of risks off bank balance sheets countries with infl ated house price levels relative was overestimated. As risks have materialized, to fundamentals or stretched corporate or house- this has placed enormous pressures back on hold balance sheets are also at risk. the balance sheets of banks. Emerging market countries have been broadly (cid:129) Notwithstanding unprecedented interven- resilient, so far. However, some remain vulner- tion by major central banks, financial mar- able to a credit pullback, especially in those kets remain under considerable strain, now cases where domestic credit growth has been compounded by a more worrisome macroeco- fueled from external funding sources and large nomic environment, weakly capitalized institu- current account defi cits need to be fi nanced. tions, and broad-based deleveraging. Debt markets, particularly for external corporate In sum, the global fi nancial system has debt, have felt the impact of the turbulence in undoubtedly come under increasing strains advanced countries and costs of funding have since the October 2007 GFSR, and risks to risen and further shocks to investors’ risk appe- fi nancial stability remain elevated. The systemic tite for emerging market assets cannot be ruled concerns are exacerbated by a deterioration of out if fi nancial conditions worsen. credit quality, a drop in valuations of structured Losses stemming from credit deterioration credit products, and a lack of market liquid- and forced sales, as well as reduced earnings ity accompanying a broad deleveraging in the growth, have signifi cantly tested the balance fi nancial system. The critical challenge now sheets of both banks and nonbank fi nancial iixx