Market behaviour during good times

inSight

21 Feb 2008

Market behaviour during good times

When times are good, make sure you don’t drop your guard.

As financial turmoil rages in the developed markets, many have been trying to identify the underlying causes. There are indeed many candidates, including questionable underwriting standards in the US sub-prime mortgage sector, credit-risk transfer leading to erosion of credit standards, poor risk management by financial institutions, lapses on the part of the rating agencies, regulatory arbitrage and gaps in financial supervision. But there are also some general causes that may help explain the current situation, and which we should be alert to.

There are at least two general causes. One is financial innovation and the risks that it brings. I have written about this before (for example, in the Viewpoint article of 27 September 2007) and I shall come back to it again in future. The other one is that good times often encourage imprudent behaviour, as market participants get carried away for one reason or another.

The developed economies, in particular the US, have been on a sustained trend of expansion with relatively low inflation since the events of 11 September 2001. The financial markets have been performing well, with (until recently) declining volatility encouraged by interest rates being kept fairly low. The global macroeconomic environment and monetary and financial conditions have been unusually benign for a rather long period. This has led to higher appetites for risk, a search for yield and rising leverage among financial institutions, investors and borrowers.

In fact, for nine months before 9/11, the Fed Funds Target Rate had been cut successively from 6.5% to 3.5%. The Fed then continued with further cuts, lowering the rate to 1% in mid-2003 where it stayed for about a year before concerns over the possibility of rising inflation caused the Fed to start increasing the rate by 25 percentage points each time the Federal Open Market Committee met until the third quarter of 2006 when the rate reached 5.25%. So the Fed Funds Target Rate was below 2% for about three years (and below what is considered the normal level of 3.5% for about four years).

This sustained period of easy monetary conditions led to changes in the behaviour of participants in the financial markets. As the yield curve flattened considerably, turning negative at times, financial intermediaries, particularly banks that traditionally borrow short and lend long, were forced to explore other more profitable business activities. For example, banks began to look for more fee income and get more involved in (and take on more exposure to) the money and capital markets, rather than in deposit taking and lending.

The sustained low-interest-rate environment also encouraged investors and financial intermediaries to search for yield, leading to a significant compression of yield spreads that may not have adequately reflected the additional risks being taken. The reduction of volatility, measured by the historical performance of financial markets over the period, also lowered the perception of risk. This encouraged an increase in risk appetites and, at the same time, a general decrease in attention to the possibility that potential volatility could differ considerably from the actual observed volatility.

There was also an increase in leveraging, by investors to boost absolute return and by financial intermediaries to improve profitability, exposing both to greater market and liquidity risks and increasing the probability of disorderly unwinding. Borrowers were also encouraged by the low interest rates and sustained economic expansion to run their businesses with higher leverage and therefore greater dependence on credit, making them more vulnerable to a sudden tightening of credit conditions.

Good times are therefore when we should look for structural weaknesses in our financial system. Prevention is obviously better than cure. This is precisely why, with the help of a consultant, we are conducting a review of how we in the HKMA can best discharge our responsibilities for promoting the safety and stability of Hong Kong's banking system. We have also been spending a lot of time looking critically at the whole spectrum of work in which we are engaged as the institution responsible for the monetary system and the various aspects of the financial system of Hong Kong.

Joseph Yam
21 February 2008

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