Quarterly Review, December 2008

Global financial crisis spurs unprecedented policy actions¹

The overview of the BIS Quarterly Review released today surveys the recent developments in the financial crisis and the unprecedented policy actions launched to address it.

Financial stability concerns took centre stage once again over the period between end-August and end-November. In the wake of the mid-September failure of Lehman Brothers, global financial markets seized up and entered a new and deeper state of crisis. As money market funds and other investors were forced to write off their Lehman-related investments, counterparty concerns mounted in the context of large-scale investment fund redemptions.

The resulting sell-off affected all but the safest assets and left key parts of the global financial system dysfunctional. With credit and money markets essentially frozen and equity prices plummeting, banks and other financial firms saw their access to funding eroded and their capital base shrink, owing to accumulating mark to market losses. Credit spreads rose to record levels, equity prices dived and volatilities soared across markets, indicating extreme financial market stress. Government bond yields declined as recession concerns and safe haven flows increasingly outweighed the impact of anticipated increases in fiscal deficits. At the same time, yield curves steepened from the front end, reflecting repeated downward adjustments in policy rates.

Emerging market assets also experienced broad-based price declines, as depressed levels of risk appetite and associated pressures in the industrialised world spilled over into emerging financial markets. With confidence in the continued viability of key parts of the international banking system plunging, the authorities in several countries embarked on an unprecedented wave of policy initiatives to arrest the ongoing collapse in asset prices and contain systemic risks.

Market developments over the period under review went through four more or less distinct stages. Stage one, which led into the Lehman bankruptcy in mid-September, was marked by the takeover by the US authorities of the government-sponsored housing finance agencies Fannie Mae and Freddie Mac. Stage two encompassed the immediate implications of the Lehman bankruptcy and the crisis of confidence it triggered. Stage three, starting in late September, was characterised by fast-paced and increasingly broad policy actions, as the response to the crisis evolved from case by case reactions to a more international, system-wide approach. In the fourth stage, from mid-October, pricing patterns were increasingly dominated by recession fears, while markets continued to struggle with the uncertainties surrounding the large number of newly announced policy initiatives.

Highlights of international banking and financial market activity

Trading on the international derivatives exchanges retreated in the third quarter of 2008. Total turnover based on notional amounts decreased to $542 trillion from $600 trillion in the second quarter. Most of the contraction took place in derivatives on short-term interest rates. Turnover declined slightly in derivatives on long-term interest rates. By contrast, it increased in derivatives on stock indices and foreign exchange. Turnover in derivatives on commodities, measured only in terms of the numbers of contracts, dropped although year-on-year growth remained quite high at 37%.

In the global over-the-counter (OTC) derivatives markets, notional amounts outstanding continued to expand in the first half of 2008. Notional amounts of all types of OTC contracts stood at $863.0 trillion at the end of June, 21% higher than six months before. By volume, credit default swap (CDS) contracts registered their first ever decline (-1%), compared with an average six-month growth rate for outstanding CDS contracts over the last three years of 45%. The fall was due largely to a significantly higher number of multilateral terminations of CDS contracts, as a result of the financial turbulence. Meanwhile, markets for interest rate and FX derivatives, as well as equity and commodity derivatives, recorded significant growth.

Borrowing in the international debt securities market lessened sharply in the third quarter of 2008 amid the continued turmoil in financial markets. Net issuance of bonds and notes decreased to $247 billion, down substantially from $1,086 billion in the second quarter. The decline was well in excess of normal seasonal patterns, and resulted in the lowest level of net issuance since the third quarter of 2005. Money market borrowing also stagnated, with net issuance falling into negative territory in the third quarter. By currency of denomination, the largest decrease in bond and note issuance came from the euro-denominated segment, followed by the dollar-denominated segment, while the breakdown by nationality of issuers indicates that the largest contraction in net issuance came from US borrowers, down from $308 billion in the second quarter to $46 billion in the third quarter.

Outstanding claims in the international banking market diminished sharply during the second quarter of 2008. BIS reporting banks' international claims fell by an unprecedented $1.1 trillion, with sizeable declines recorded across claims in most currencies of denomination. While a significant decrease in interbank claims (-$812 billion) accounted for most of that decline, international claims on non-banks also fell for the first time since 1998, mainly vis-à-vis the United States, the United Kingdom and Japan. At the same time, residents of emerging markets and many central banks around the world reduced their placements of funds with BIS reporting banks.

Special features

This issue of the BIS Quarterly Review presents four special features: developments in the repo market during the recent financial turmoil; commodity prices and inflation dynamics; bank health and lending to emerging markets; and mortgage contract characteristics and the incidence of negative equity.

Developments in repo markets during the financial turmoil

Repo markets are a vital source of secured financing for banks and financial institutions, and a key tool for the implementation of monetary policy. In their study of repo market developments during the financial turmoil, Peter Hördahl and Michael King of the BIS document that repo market activity became increasingly concentrated in the very shortest maturities and against the highest-quality collateral. While repo rates for US Treasury collateral fell relative to overnight index swap rates, comparable sovereign repo rates in the euro area and the United Kingdom rose. The authors conclude that the different dynamics across markets reflected, among other things, differences in the intensity of market disruptions and the extent of the scarcity of sovereign collateral.

Commodity prices and inflation dynamics

Commodity prices rose strongly in recent years until mid-2008, driving inflation up worldwide. Using a dataset for CPI inflation and its food and energy components that includes the major advanced and emerging economies, Stephen Cecchetti and Richhild Moessner of the BIS examine aspects of the impact of the rise in food and energy prices on headline inflation and its dynamics. The authors find that in recent years core inflation has not tended to revert to headline, which suggests that higher commodity prices have generally not spawned strong second-round effects on inflation.

Bank health and lending to emerging markets

Over the past decade, many emerging markets have increased their dependence on credit from foreign banks. However, the ongoing financial crisis may prompt banks to reassess their exposures to these economies. In their analysis of bank health and foreign bank credit to emerging markets, Patrick McGuire and Nikola Tarashev of the BIS find evidence of a clear longer-term link between measures of bank health and growth in foreign bank credit to emerging markets. Based on econometric analysis of data since the early 1990s, the authors show that deteriorations in bank health are associated with a decline in the growth of credit to emerging markets.

How many in negative equity? The role of mortgage contract characteristics

An important precondition for mortgage default is that the borrower currently have negative equity, that is, that the mortgage balance be higher than the value of the property. In her special feature on the role of mortgage contract characteristics, Luci Ellis of the Reserve Bank of Australia shows how sensitive the percentage of households in negative equity can be to different aspects of the mortgage contract. The author concludes that the recent large rise in mortgage delinquency and default rates in the United States, compared with the situation in other countries, can be partly explained by the fact that US mortgages were more likely to have characteristics that increased the incidence of negative equity.

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¹ The period covered in the Overview is from end-August to 28 November.