With international markets still reeling from the “sub-prime meltdown” and investors already bracing for the next financial quake, it’s good to know that some of the world’s economic shepherds are well aware of the wolves on the horizon, however unprepared they might be to fight back. Unlike their more political and rhetorical peers, enlightened stewardship from the IMF and its sister organizations may be the global macro-economy’s only hope against the coming valuation storm, as risk quietly shifts from sophisticated financial institutions into the hands of the unsuspecting Everyman…
“Responding to Shifts in Financial Risk: the Need for Leadership”
Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund
March 23, 2007
1. We have seen a period of turbulence in the financial markets over the last few weeks, and I will talk a little about the implications of that. I will suggest that there are some developments in the global economy and in world financial markets that should reassure us, and some that should give us cause for concern. But today I would mostly like to focus on a development which is of longer-term significance: the shift of financial risks from the banking and financial sectors to individuals and families. I will also propose some steps that should be taken to respond to this shift in risk.
2. First, let me say a few words about the changing role of the International Monetary Fund in assessing financial risks. Our member countries face new opportunities and new risks from financial globalization, and the Fund is adapting to help them meet these challenges. We are intensifying our efforts to integrate our financial sector work, including on capital and financial markets, into our economic analysis. The increased importance of financial markets for growth and development for all countries is a major feature of the new world of globalization. It is of particular importance for emerging market countries, which have a lot to gain from financial integration but may also become more vulnerable in integrated global markets.
3. The Fund has been taking the lead in identifying strengths and vulnerabilities in the financial sector for many years, including through the launch of the Financial Sector Assessment Program in the late 1990’s. Now we are advancing this work further. In our monitoring of individual countries’ economies, we are enhancing the analysis of financial sector vulnerabilities and ensuring that this is reflected in our macroeconomic analysis and policy advice. In our monitoring of the global economy, we are devoting more attention to the linkages between the financial sector and real economy.
4. What does this analysis tell us about the current state of the global economy and the situation in financial markets? First, the economic fundamentals are good. The world has already seen several years of strong growth, and we in the International Monetary Fund expect that global growth will once again be close to 5 percent in 2007. This would be the strongest five-year span for the global economy since the late 1960s. In the United States, the speed of the expansion has eased—largely reflecting the slowdown in the housing market. But in the euro area growth momentum looks solid, and Japan’s economy seems to have regained its footing. China and India continue to be engines of growth, and many other emerging market and developing countries are enjoying a continuation of the strong growth of recent years.
5. Notwithstanding a global economy which is essentially strong and stable, we have seen considerable financial market turbulence lately. I believe that this reflects a reappraisal of risk in some important areas—economic risks in the United States; currency risks relating to the Yen carry trade, and more recently risks in the U.S. mortgage market. All have given rise to concern among investors. This concern is not in itself a bad thing. The most dangerous time in financial markets is when no-one believes that they can lose. Recent movements in markets, despite their costs, will at least help to reduce any such complacency.
6. It is important that both investors and policymakers remain aware of economic and financial market risks. Among economic risks, oil supplies and prices remain vulnerable to geopolitical events. There is also the risk, which may still be insufficiently appreciated, of a disorderly adjustment of global payments imbalances. The risks of this are relatively low, but the costs would be high.
7. There are also some developments in the financial markets which could have implications for the global economy. Let me mention three of them.
• The first is now well known: the problems in sub-prime mortgage markets in the United States and the risk that these could impact other markets or affect other sectors of the U.S. economy.
• A second development which I see as a source of risk is the recent increase in large private equity buyouts financed by a rising proportion of debt. The risk from a financial stability perspective is that if some of these deals were to turn sour, this may trigger a reappraisal of risk which would curtail market access more broadly for lower-rated corporate borrowers. This could adversely affect investment and growth prospects.
• A third development is the very substantial flows of capital into emerging markets, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa. To the extent that such inflows reflect a reallocation of capital to productive investments they are welcome. But they also expose the countries concerned to an abrupt reversal of flows if investors suddenly become more risk averse.
In considering all of these risks, I would urge investors to exercise due diligence, regulators to remain vigilant and policymakers to keep in mind the potential for spillovers between markets, and from financial markets to economies.
8. Before leaving the subject of economic risks, let me mention one more, which I believe need to be taken more seriously by the public and by policy makers. This is the rise in protectionist sentiment. This has many manifestations. There is the doctrine of national champions in Europe. There are legislative proposals that aim to protect some industries through tariffs or other protectionist measures in the United States and elsewhere. Politicians and business people need to be more forceful in reminding the public of the benefits of trade. For example, studies indicate that trade liberalization, including trade deals under the GATT and the WTO, have lifted annual U.S. incomes by as much as US$750 billion. Indirect gains arising from investment and similar reforms have been of a similar magnitude. Moreover, U.S. firms engaged in trade tend to be more productive, have higher employment growth, and pay higher wages than domestically oriented firms.
9. I am concerned that if the world does not quickly move forward on trade, it risks moving backward, to the narrow nationalism that characterized the depression era. It is very important to bring the Doha Round to a conclusion that delivers ambitious reforms. In the United States, given the delays of the past year, completing the Doha Round will almost certainly require that Congress grant an extension of the U.S. administration’s fast track negotiating authority. Such an extension could be accompanied by measures to help those adversely affected by structural changes in the economy, while strengthening the economy’s adaptability. For example, trade adjustment assistance can both protect workers and facilitate their movement to growing industries. The terms of an extension of fast track are a matter for the U.S. Congress. But the results of the Congress’s decision will be important not only for the United States but also for the rest of the world. I hope Congress will move quickly on this issue.
10. In responding to the economic and financial risks I have talked about, the Fund can take the lead in some areas—especially in identifying and warning about key economic and financial risks. But leadership is also needed from other public sector agencies around the world, and from the private sector.
11. Such leadership will be very important in addressing the consequences of another development, which I would like to talk about in the remainder of my remarks. This is the transfer of financial risks from financial institutions to a broad base of individuals. Of course, there is a sense in which individuals have always been at risk, since as citizens and members of society their fortunes rise and fall with the economy. But individuals are increasingly taking on financial risks much more directly. There are several ways in which this is happening.
• First, borrowing by individuals and households is much higher than in the past. Household financial obligations have grown with it. In the United States, they hit a record high of 19.4 percent of disposable income in the fourth quarter of 2006, despite the historically low interest-rate environment.
• Second, the role of banks has changed. Many banks no longer hold the bulk of the risk on the loans they make. Instead, banks transfer and diversify credit risks to other banks, insurance companies, mutual funds and hedge funds. A related development is the rapid growth of securitization of assets of all kinds: from mortgages to credit card loans, from corporate loans to aircraft leases.
• Third, the role of the financial intermediaries that are taking on the credit risk has changed. Where insurance companies and pension funds once held the risks themselves, the rise of non-guaranteed insurance savings products and the demise of defined benefit pension plans mean that individuals and households are becoming the ultimate holders of risk in the system in a much more direct way than in the past.
Each of these developments carries both benefits and risks. Let me take each in turn.
12. The broadening of credit brings with it opportunities that reach many more people than in the past. Many more people can finance a house, consumer durable purchases, a vacation, a business school education. This widens economic opportunities, and makes it possible for individuals to balance their consumption better over the course of their lives. The downside is that people sometimes take on too much debt. A recent movie, “Maxed Out” directed by a former Wharton student, graphically depicts the problem of credit card users being encouraged to take on substantial debt and then penalized with late fees and other charges. And the distress of financial markets in the face of the troubles in the sub-prime mortgage sector has its counterpart in hundreds of thousands of stories of individual distress. A report issued last week by the Mortgage Bankers Association revealed that over one half percent of all home loans entered foreclosure in the fourth quarter of 2006, the highest in the 37 year history of the association’s survey. These developments suggest a need to take a fresh look at lenders’ underwriting standards and to educate borrowers in the risks that they are taking.
13. Turning to the position of savers, the changing role of banks has changed significantly the risks that other institutions and individuals face. The growth of markets in credit risk transfer instruments, and the structured credit products that go along with them, has allowed banks to make loans and then transfer and diversify the associated credit risk to other institutions.
14. Loan securitization—the issuance of securities backed by loans—has similar effects on the transfer of risk. Issuance of loan securities has expanded from around $0.5 trillion in 2000 to $2.75 trillion in 2006; and it has become far more geographically widespread (from Mexico to Australia, and from Korea to Russia). This is transforming how banks in many parts of the world do business. Banks’ willingness to lend and the rate at which they do so is increasingly being driven by the price they will receive for the loan when they sell it to the securities market. And much of the risk from these loans is now dispersed to other investors.
15. Both of these developments can be seen as enhancing financial stability, because bondholders, pension funds, life insurers, and hedge funds all have less exposure to short-term liquidity pressures and a greater ability to share losses with investors. But there are also some downsides. The first is lack of transparency. We know credit risk is being transferred, but it is often not clear who it is being transferred to, or whether the ultimate holders of these risks fully understand them and can manage them prudently. The second is that we do not know how well liquidity in credit risk transfer or securitized loan markets will hold up if the credit cycle turns down sharply and defaults become more common.
16. The need to get a better picture of what is going on in these markets is increased because risks do not stay with financial intermediaries. Instead, there is a further shift in risk from insurers and pension funds to individuals and families. In particular, the shift from defined benefit to defined contribution pension plans has placed more responsibility on households to manage investment portfolios and related risks. Such schemes allow individuals more flexibility, but the price they pay is absorbing market and other credit risks and also longevity risk more directly. Individuals now absorb risks as shareholders, investors in mutual funds, savers in non-guaranteed insurance savings products, and members of defined contribution pension schemes.
17. One implication of this is that regulators and supervisors need to take the new reality and the new vulnerability of savers into account. Regulatory and accounting reforms have helped to improve pension and insurance industry transparency, thereby reducing default risks. But they have also encouraged risk transfer to other investors, including hedge funds. There are now estimated to be more than 9,500 hedge funds—fourteen times more than in 1990. The investor base of hedge funds has also broadened, with about 30 percent of investment in them now coming from pension funds. Close attention will need to be paid to these changes. At present, the focus for supervisors should be on making the supervision of hedge funds’ regulated counterparties more effective. But as the structure of markets changes, supervisors may need to adapt the framework of supervision to improve investor protection and reduce systemic risks and vulnerabilities. It will also be important to monitor developments in the global hedge fund industry from an international and multilateral perspective.
18. Another implication of the shift in the location of risk is that individuals and families need to take more responsibility for managing financial risks themselves. Therefore, they need to be educated consumers for financial information. Evidence from all around the world suggests that this is not happening at the moment. Let me give a few examples:
• Only 30 per cent of those surveyed in the United Kingdom can correctly calculate simple interest rates, and only 44 per cent reported a basic knowledge of pensions in 2004;
• 47 per cent of workers in the United States who have no savings still report themselves confident that they will have enough for retirement.
• A majority of French households consider themselves to be ill-equipped to choose an investment strategy;
• 65 per cent of Dutch households are unable to provide any estimate of their pension income on retirement;
Let me put this in a more personal way. You are students and graduates of one of the top business schools in the United States. How confident are you of your own ability to forecast your pension and insurance needs, and to work out the steps you need to take to meet them?
19. In these circumstances, it is unfortunate that while consumers are more in need of financial advice than ever before, they remain reluctant to pay for it directly. Perhaps this is because when it comes to financial advice, consumers doubt the impartiality of the advisors. Such doubts may be justified. Some financial advisors are paid to maximize sales or to push certain products.
20. However, there are actions that can be taken, and leadership is needed from all of the major players—governments, the private sector and regulatory authorities. Governments can encourage the teaching of financial literacy in schools and provide counseling for low-income groups. They can also promote default options in pension schemes, which would give people a simple and reasonably conservative option for saving for retirement, while giving people who want to save at different rates or take more risks the option of doing so. The private sector can provide more targeted products with transparent fee structures. Regulatory authorities can help to promote simple, easily understood investment products and menus which meet the needs of less sophisticated investors. Also, as neutral—and hopefully trusted—sources of advice on financial matters, regulators can coordinate the efforts of other parties and can publicize the best sources of advice on financial planning.
21. There have been success stories. For example, the Swedish authorities educated households about their new system of personal pension plans, so that only a small percentage said that they did not understand it. The U.K. Financial Services Authority has coordinated and publicized both government and private firms’ efforts to better educate financially the British public, in order to fulfill the formal objective given to it by Parliament. But with an increased burden of risks falling on individuals, such efforts are needed elsewhere too.
22. I have spoken today about some of the changes in financial markets, and discussed some of their benefits and the risks that come with them. The message I want to leave you with is not that change should be resisted, but that all parties—governments, regulators, market participants and individuals—need to adapt to change. They need to pay attention to the new risks in the financial system, and to the fact that more of these risks are falling directly on individuals and families. I am confident that if sufficient attention is paid to this issue, there is sufficient ingenuity to meet these challenges.