The financial sector in the advanced industrial countries

The strong overall performance of financial firms in advanced industrial countries continued during the year under review. Banks benefited from another year of a generally benign credit environment and strong retail business. Once again, investment banks registered record profits driven by growth in capital markets activities and a boom in private equity. Investor inflows into hedge funds were moderate by past years' standards, in response to the declining rates of return registered by the funds. Hedge funds are, however, increasingly integrated in the international financial system as a result of requirements placed on them by a broadening range of investors, and of intensified pressure for enhanced disclosure or compliance with more detailed regulatory requirements. The balance sheets of life insurance companies strengthened, while the property and casualty sector continued to recover from a costly 2005 without major problems.

Current profits add to already healthy capital cushions, suggesting that financial firms are well placed to withstand the likely sources of strain over the near term, and financial systems should be able to deal with idiosyncratic episodes of stress. Banks are generally in a stronger position today than they were at a similar point of previous cycles. The major potential sources of vulnerability are indirect and linked to the business cycle. The implications of past risk-taking related to property investments and to the leveraged financing boom will depend critically on the future path of interest rates and overall economic conditions.

Financial globalisation has been a major structural trend with important implications for the organisation of banking firms, the nature of their business strategies and their risk profiles. Cross-border mergers and increased exposures outside home markets have created a network of international capital flows which offer profit and diversification opportunities. At the same time, these strategies carry risks that relate to the performance of both individual institutions and national economies. As a result, the internationalisation of banking also has implications for prudential policy, as regards both the design of the institutional structures and the calibration of policy instruments.