Financial Markets Vulnerable To New Shocks
The world’s financial markets remain vulnerable to new shocks, not just in the credit markets but also, for example, in the equity or commercial property markets, according to The Bank of England
In its Semi-Annual Financial Stability Report, the BoE notes that the resilience of the UK and international financial system has been severely tested in the past few months. A gap between the information available to originators and end-investors, and leveraged position-taking by some investors, have magnified a rise in arrears on US subprime mortgages into a period of severe global market turmoil.
“Marked-to-market losses on assets linked to these mortgages have heightened uncertainty about the composition and value of all structured credit products. Leveraged loan markets have also been affected. The consequent loss of liquidity in these markets has left banks holding assets which they had expected to transfer off their balance sheets and facing obligations to off balance sheet vehicles whose normal commercial paper funding has dried up. ”
“This reintermediation of risks has led some banks to hoard liquidity to meet large, but uncertain, funding needs. In combination with increased counterparty risk, this has led to a sharp tightening in money markets, which has affected banks that are dependent on these markets for finance. In the United Kingdom, these pressures led Northern Rock to turn to the UK authorities for liquidity support.”
While it is too early to make a full assessment, the BoE says some lessons are already clear, including:
- The need for greater focus on liquidity management
- More rigorous stress testing
- Greater transparency in the composition and valuation of structured products
- Improved disclosure on institutions’ risk exposures, including to off balance sheet vehicles.
- Within the United Kingdom, crisis management tools also need to be strengthened.
Action in these areas and the continuing strong capital position of the UK banking system should anchor confidence as risk is repriced, the BoE says.
There have been signs of a recovery in some markets, though a return to earlier conditions would be undesirable as that involved an underpricing of risk.
The BoE expects a period of tighter credit conditions, especially for higher-risk borrowers. “And in the short run, the financial system in the advanced economies remains vulnerable to new shocks, whether in the credit markets which have been most affected to date or, for example, in the equity or commercial property markets.”
Financial Stability Report, October 2007, can be downloaded at no charge.
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