The Asian economies are not necessarily immune to the current turbulence in the US and European money markets.
Banks need capital to do business, and banking supervisors have laid down capital adequacy ratios (CAR) and other supervisory measures to ensure that the banks have enough capital to support the risks they take using depositors' money. These measures constrain the ability of the banks, particularly those with CAR near the regulatory minimum, to expand their business. It is therefore natural for the banks to try to do more business with less capital in an effort to make more profits for their shareholders.
One popular way of doing so is to securitise assets that would normally be booked on the balance sheets of the banks, through the creation of asset-backed securities (ABS) or, in the case of mortgages, mortgage-backed securities (MBS). This can be done by the banks themselves, or by so-called conduits or special investment vehicles (SIV) buying the assets from the banks, packaging and slicing them to suit the risk appetite of investors. The banks are then able to use the capital released to do other business, while at the same time earning fee income from continuing to service the securitised assets or underwriting the securities, and trading income from making a market in the securities. The securities issued by the conduits and SIVs to fund the purchase of assets from the banks may take different forms, such as the asset-backed commercial paper (ABCP). These are of short-term maturity and therefore not a stable source of funding, and so the banks provide, for a fee, the SIVs with back-up credit lines (these do not need to be supported by capital under Basel I) and credit enhancement support to help attain a high, possibly AAA, rating for the ABCP from the rating agencies.
Like a factory, the financial system of the developed market originates assets (such as mortgages); warehouses them; packages them, with or without slicing, creates ABS of all sorts, possibly mixing them with other financial assets and turning them into other forms such as collateralised debt obligations (CDO); and distributes them to investors including banks, pension funds and hedge funds all over the world. The financial system is so efficient at doing this that quite a lot of people take things for granted and few questions are asked. Why worry about the quality of these assets if they will be off-loaded to somebody else anyway? Let us get those conveyer belts moving more quickly, do more business, charge more fees for those back-up credit lines and credit enhancement support that require little or no capital, earn more income from trading the paper, and make more profits. Sub-prime mortgages? No problem. They will be off the balance sheet quickly. In any case, they are good assets, given ever-increasing property prices. If we do not do this, others will. The rating agencies are happy with the asset quality, aren't they? If not, they can be packaged with better assets and lumped into that big pool of diversified assets backing the issue of the next CDO. On and on it goes.
Until, as we saw earlier in the year, weakness in the housing market in the US led to a jump in the delinquency rate of sub-prime mortgages, leading to the following sequence of events:
- Downgrades of ratings of sub-prime-mortgage-backed securities
- Growing concern among investors about potential risk exposures
- Sharp widening of spreads in many structured products (MBS, ABS, CDO, ABCP)
- Disorderly re-pricing of risks
- Loss of confidence in the rating system of structured products
- Difficulty in pricing the structured products and depleted liquidity
- Conduits not able to roll over the ABCP and needing to draw on back-up credit lines from banks
- Assets underlying the structured products returning onto the balance sheets of banks – a process known as re-intermediation
- A marked rise in perceived risks faced by banks and loss of confidence in the interbank market
- Tightness remaining even when central banks provided liquidity support.
It is not clear when this turmoil in the money markets in the US and Europe will subside or whether monetary policy shifts may help. Interestingly, so far the contagious effects on emerging markets have been muted, presumably because financial innovation through securitisation has not taken hold as much as in the developed markets, given that the capital cushions of domestic banks in emerging markets in Asia, in excess of the regulatory requirements, are large. However, there is a risk that prolonged credit tightness may have adverse implications for the economy and asset prices in the developed markets, ultimately affecting the global economy.
Joseph Yam
4 October 2007
Click here for previous articles in this column.
Document in Word format
