The Basel Committee will soon introduce new supervisory initiatives on liquidity-risk management.
Readers watching closely the developments in global financial markets will have noticed the improvements in credit markets since the middle of March. Although credit concerns remain, the sentiment seems to have calmed down considerably from the near panic in early March. The introduction of the Term Securities Lending Facility by the Federal Reserve and the rescue of Bear Stearns have probably succeeded in turning sentiment around. Lower policy rates in the US and expectations that they may be kept low for a while have also had some tranquillising effect. The spreads of credit default swaps (CDS) for banks in Europe and America have narrowed considerably, with the premiums roughly halving: the CDS premium for US banks (five-year on-the-run mid-spread), for example, narrowed from its peak of over 170 basis points to just above 80 within a few weeks. Corporate bond spreads have also narrowed, although they are still at historically high levels.
One certainly hopes that this improvement, which has been reflected in the latest performance of the equity markets, can continue. Time will tell. Meanwhile, however, there is no lack of risks in other areas. The housing market in the US, where it all started, is crucial. We in Hong Kong have a lot of experience in housing-market adjustments and we know how debilitating they can be. When residential property prices are on a clear downward trend, few people want to buy; so that, despite a sharp fall in housing starts, and therefore the prospective supply, and lower mortgage rates, the demand simply remains low. This, together with the increase in negative-equity mortgages and foreclosures, reinforces the downward pressure on property prices. They may even overshoot, as we saw in the first half of 2003 in Hong Kong, before they finally rebound. The threat to financial stability in the meantime is real, particularly if the rates of household and corporate savings are low, affecting their staying power as they repair their balance sheets, and if the financial institutions do not have much capital cushion.
This is perhaps why, in contrast to the improvements in credit markets, money-market conditions have remained tight, particularly in Europe and the US, where spreads have continued to widen to near the peaks seen in August and December last year. This divergence in money and credit-market conditions is a strange phenomenon not seen previously, perhaps suggesting that financial institutions now have less confidence about lending to each other in the interbank market than lending to or holding obligations of the non-bank sector. What makes this even stranger is the fact that the central banks have been very forthcoming in providing liquidity assistance to the financial system, specifically to financial institutions, moral hazard notwithstanding. The actions by the Federal Reserve, the European Central Bank and the Bank of England are well documented. And there have been indications that these are being formalised into a more durable framework for the provision of liquidity. For example, the special liquidity scheme of the Bank of England announced on 21 April makes it possible for banks to swap illiquid assets (or rather, liquid assets that have become illiquid when the financial system is under stress) for liquid ones.
As I mentioned in my Viewpoint article on 10 April, liquidity-risk management is of crucial importance to the stability of financial institutions and of the financial system. The financial turmoil in the developed markets illustrates how securitisation may present complex challenges for managing liquidity risk. It is not clear whether, as a result of the recent market events, securitisation will continue to be perceived by financial institutions as a reliable means of making illiquid financial assets liquid, especially during times of market stress. It would be a pity if there were to be a permanent roll-back of securitisation, because it is not securitisation that is the crux of the problem but the erosion of credit standards that crept in. Unfortunately, more than half a year into the financial turmoil, the securitisation market in the developed economies, particularly for mortgages, is still pretty sick, necessitating the continuation of central-bank assistance and the possibility of such assistance becoming permanent. In any case, perhaps there is a need to have a standing and reliable facility for making illiquid assets liquid, however this is organised and whether or not the public sector is involved. Once again, the example of the Hong Kong Mortgage Corporation as a provider of liquidity for conforming mortgages comes to mind.
As far as new supervisory initiatives on the management of liquidity risk are concerned, the Working Group on Liquidity of the Basel Committee on Banking Supervision is according urgent priority to updating the Committee’s publication in 2000 concerning sound practices for liquidity-risk management and supervision. I would encourage financial institutions interested in the latest thinking and the areas of focus of the Working Group to study the paper issued by the Basel Committee in February and prepare themselves for the possible changes. There are likely to be concrete proposals for higher liquidity-risk-management standards soon.
Joseph Yam
8 May 2008
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