A Review of Financial Market Events in Autumn 1998

Following its March 1999 meeting, the Committee on the Global Financial System formed a working group, chaired by Karen Johnson of the Board of Governors of the Federal Reserve System, to examine the events surrounding the market stresses in many international financial markets in autumn 1998. The group was charged with putting these events in perspective, with special emphasis on understanding the suddenness of the deterioration in liquidity and elevation of risk spreads in a wide variety of markets, the proximate causes of the withdrawal from risk-taking, and the speed with which and extent to which markets subsequently recovered. The focus of the working group, therefore, was on developments across many markets in a relatively narrow time frame, as opposed to the more general investigation of market liquidity provided by an earlier report to the CGFS or the scrutiny of a narrow set of financial entities contained in the report of the US President's Working Group and the recommendations on industry practices of the Counterparty Risk Management Policy Group.¹

The working group assembled a large dataset on key financial prices in major international markets and attempted to characterise the degree to which price movements in the autumn were outsized and evidenced different correlations from those observed in relatively more tranquil times. (These data and some of the broad regularities among them are described in Annex 2.) It also searched contemporaneous accounts of the events to establish a time line of significant influences on markets (included as Table 1). Group members interviewed market participants in a number of international financial centres in June 1999 to learn about their actions regarding risk exposure and credit risk management. The group as a whole met with a half dozen market participants in Basel in early July to further that dialogue. Annex 1 summarises the insights gained from the interviews.

This is the report of the Working Group. Chapter 2 provides background on the episode of market stress in autumn 1998. The first part of Chapter 2 summarises the events of the period of market turmoil since mid-1997, noting the differences between the period July 1997 - July 1998 and the period July 1998 - early 1999. The second part examines the process of recovery in markets, which occurred rapidly as participants were encouraged by official action and emboldened by the profit opportunities offered in wide price spreads. Chapter 3 provides an analytic interpretation of the events of July-October 1998 and identifies important mechanisms that appeared to spread disruption across financial centres and amplified price dynamics. Some of those factors - such as an inadequate assessment of counterparty risks that permitted the excessive use of leverage, the failure to incorporate in risk management potential feedback effects of market liquidity on price setting, and the lack of information on aggregate positions - have already been identified as weaknesses in market structure in prior analyses of the events of last autumn by both the private sector and official institutions and have triggered a variety of responses and recommendations for additional changes. Other mechanisms - including a shrinking number of key market participants, the widespread emulation of certain financing, trading and risk management strategies, and compensation schemes encouraging a short-term focus in decision-making - are more entrenched in the structure of the financial industry and may still pose risks going forward. A diagram at the end of Chapter 3 summarises in schematic form the cycle of deterioration in market functioning as understood by the Working Group.

Chapter 4 examines the lasting imprint of last year's events. Risk spreads and many indicators of market liquidity have not returned to their levels of the summer preceding the storm, and indeed some have returned to their crisis levels. This may suggest that, on balance, market-makers and arbitrageurs have scaled back their activities somewhat and investors are more wary about the income prospects associated with a broad range of securities. To the extent that such risk spreads had been bid down to extremely low levels by historical standards in the period before the market pressures erupted, the subsequent net increase in those spreads may have made them now more consistent with fundamentals. Moreover, market participants appear to be taking steps to reduce their exposures to the recurrence of a widespread flight to quality, such as by using rates on private sector rather than government obligations as the benchmarks for pricing. But the net effect of these changes - both the reduced amount of capital devoted to enforcing arbitrage strategies and the shifting of hedging strategies - may have contributed to the recent widening of interest rate spreads, particularly on swaps, in many industrial countries in recent months.

Chapter 4 also draws some tentative lessons for policymakers from this experience. Foremost is the realisation that the first line of defence at a time of market stress is sound risk management by market participants, which in turn requires a regulatory and monetary policy environment ensuring that market discipline effectively governs credit decisions and risk-taking. Policymakers should also appreciate that the fallout from last year's financial market strains was less pronounced on real activity in the industrial countries because a healthy commercial banking system was able to act as a substitute means of intermediating funds. This helps to explain why in this episode the availability of credit to non-banks proved to be relatively more resilient in financial systems, such as those in the continental European countries, where banks play an important role, compared with those systems more oriented towards market-based financial intermediation. Thus, keeping depository institutions safe and sound must remain a priority. While some financial institutions were under severe stress at times, the events of last autumn were initially more a matter of a drying-up of market liquidity than a general withdrawal of credit availability. The subsequent dynamics, though, were complicated as the initial deterioration in market functioning that made participants less confident about price setting also subsequently induced credit strains as collateral values eroded and concerns about counterparties mounted.

Chapter 5 concludes with an outline of work still to be done. The group's efforts to describe the large dataset it collected only scratched the surface of potential empirical work. In addition, more sophisticated financial theory may be able to define more rigorously indicators of market stress, while continued contacts with market participants may make it possible to understand better the management of credit and market risks.

¹See BIS, Committee on the Global Financial System (1999), Market Liquidity: Research Results and Selected Policy Implications (the Shirakawa Report), the President's Working Group on Financial Markets (1999) Report on Hedge Funds and the Long-Term Capital Management Episode, and Counterpary Risk Management Policy Group (1999), Improving Counterparty Risk Management Practices (the Corrigan-Thieke Report).