African Reserve
Bank, at the 48th Association of Collective Investment (ACI) world
conference, Cape Town
13 March 2009
Central banks and financial stability: Some lessons for the future
Introduction
Honoured Association of Collective Investment (ACI) members
Organisers
Moderators
Guests
Ladies and gentlemen
Thank you for the invitation to speak at this illustrious event. It is
indeed a privilege and a rare opportunity to share some ideas about the state
of the global financial system with market practitioners from across the world.
It is difficult in the current circumstances to give an optimistic address.
Nevertheless, I will try to avoid to paint too dismal and depressing a
picture and instead will focus on things that we can learn from our recent
experiences, to contribute towards a better future.
The mood in the global economy has changed from almost over exuberance to
the
depths of a recession in less than two years. We are certainly
experiencing
unprecedented events and the actions taken to restore stability and trust in
the global financial system are surpassing previous ones. Judging from the
programme of your conference, we expect that these issues will be discussed in
greater detail over the next two days. This presentation will also make,
towards the end, some comments about the state of the South African banking
sector.
It remains difficult to understand how various role players, including
supervisors, central banks, rating agencies, multilateral agencies,
governments, risk managers and highly competent private sector participants,
failed to fully comprehend these developments that, with hindsight, were bound
to bring us at some time to this point.
Yet, the important thing is not to apportion blame, but to try and
understand how we can avoid repeating the same mistakes. There are many lessons
to be learnt, and we are of the view that these lessons can be valuable not
only from the point of view of supervisors and policy makers, but also that of
traders, bankers and other financial market participants. Clearly, as the
situation is still unfolding, one can at best only talk of âpreliminary
lessonsâ.
Lesson number one: The sum of perfectly rational individual decisions
doesnât equal a perfectly rational market
With hindsight, it is clear that, although individual institutions hedged,
transferred and managed their risk exposures in very sophisticated ways, at a
systemic level a point is reached at which it becomes impossible to fully
diversify or transfer risk. The global financial system is a finite entity, and
although risk can be passed around, it does not disappear. We had probably
underestimated the inter-linkages of financial systems across the globe, and
the extent to which globalisation had created a complicated network of circuits
for the contagion of financial risk.
The lesson to take forward is that we should never lose sight of the
systemic implications of individual institutions, transactions and events.
Financial stability is a systemic concept, and it will play a much bigger role
in future and should be taken much more seriously than was the case during the
exuberant years prior to 2008.
Issues such as macro prudential analysis and supervision, crisis
preparedness and stress testing of the financial system are likely to feature
much more strongly in our collective endeavours for years to come.
Lesson number two: If something seems too good to last, it probably is the
current crisis resulted from a specific combination of a number of causes
For years, liquidity in global financial markets was mispriced, and
therefore generally taken for granted. Interest rates were low, and huge
profits were locked in through carry trades where funding could be obtained at
a minimal cost in overnight markets, and invested in high yielding longer term
assets, be it emerging market financial assets, equities, securitised mortgage
loans or asset backed securities.
South Africa was a beneficiary of this trend: between 2004 and 2007, net
inflows recorded in the financial account of the balance of payments totalled
R391 billion. If the inflows that are included under âunrecorded transactionsâ
are added, this figure would be well over R500 billion. Compare this to a
combined net outflow of around R23 billion over the prior four years. The
advantages of these inflows were significant: they allowed the South African
Reserve Bank to restore a fragile foreign exchange reserves position to a more
healthy one, they helped the country to finance its current account deficit, to
build infrastructure, to boost economic growth and to increase employment.
Overall, they made the country slightly more resilient against the adverse
developments that we are currently experiencing.
However, we have been abruptly reminded that portfolio flows are fickle, and
cannot be relied upon as a source of external funding when the tide turns. Even
though South Africa still maintained a positive net balance on its financial
account for the first three quarters of 2008, there were significant net
outflows of portfolio investments as global investors were forced to
deleverage. In addition, funding in the international markets has become much
more expensive.
We have also been reminded that markets move in cycles, and the fallacy of
some people who advocated a âdecoupling of emerging marketsâ or that âthe
business cycle has been conqueredâ has been proven to have widely missed the
point. What is the lesson to be learnt? The lesson is that prolonged periods of
high asset growth that are not fully justified by trends in the real sector are
bound to correct. For example, how can house prices continue to grow at double
digit rates if economies grow by two to three percent per year? How can the
balance sheets of banks consistently grow four to five times faster than the
underlying economy? How can off balance sheet activities of banks consistently
outpace on balance sheet growth without signalling some sort of distortion? How
can profit targets and bonuses keep on rising year after year, while the
underlying real economy is still very much the same?
It is human nature to be more tolerant of continuous rises in asset prices
than of price declines. Perhaps we should be more careful in future: if growth
rates and price increases are not justified by developments in the underlying
activity in the real economy, asset bubbles develop, and the effects when such
bubbles burst can be very serious.
Lesson number three: The seeds of the next crisis are sown in the solutions
for the current one
Without having much choice, central banks and governments in (mainly) the
industrialised world have taken unprecedented actions in their attempts to
restore confidence in the financial system. These actions included significant
liquidity injections, lowering of collateral requirements, asset swaps, longer
maturity refinancing operations, intervention in foreign exchange markets,
co-operation among central banks in their market operations, monetary
accommodation, quantitative or credit easing, capital injections into banks and
other financial institutions, substantial fiscal stimulus packages and, in some
cases, nationalisation of banks. Looking at the instruments available to banks
and governments, there really are only a few that have not been used in one way
or another during this crisis.
Actions being implemented now may be the lifeline for the world financial
system, but we are also well aware that they may, inherently, have negative
consequences over the long term. The major central banks will have to plan
their exit strategies well.
Governments will have to manoeuvre themselves out of their heavy
indebtedness, the potential crowding out of the private sector would have to be
addressed and some reasonable limits to moral hazard will have to be restored.
In a recent speech, Jeffrey Lacker, President of the Federal Reserve Bank of
Richmond, noted that âthe striking feature of central bank lending and other
government financial support during the current turmoil is the extent to which
it has extended well beyond the boundaries that previously were understood to
constrain such lendingâ, and that âthe scope of the financial safety net
ultimately must be rolled backâ. Although inflation is currently not an issue
that many people are worried about, we all know that the measures currently
taken are potentially inflationary, and at some point this will have to be
attended to.
As one of our colleagues has remarked when âthe house is on fire, we need
all the fire engines on the scene, the mopping up operations will come
laterâ.
Lesson number four: Every good party needs a strong bouncer
In financial markets, the bouncers are the supervisors. Looking at previous
issues of the International Monetery Fund (IMFs) global financial stability
report, the Bank for International Settlements (BIS) quarterly reports, and
various individual central banksâ financial stability reports, it is evident
that many of the causes of the financial crisis had been noted, but that they
had not been acted upon.
As pointed out by our colleague Jean-Claude Trichet2 in his capacity as
chairman of the global economy meetings of central bank governors at the BIS
meetings that we also attend on a regular basis several policy makers had
indicated to market participants that they needed to prepare for a significant
correction. With hindsight, there were clear danger signs that supervisors
could possibly have countered more decisively.
To list but a few of these warnings, excessive leverage through
securitisation and re-securitisation, excessive dependence on short term
wholesale funding, a complete under-estimation and under-pricing of risk, in
particular liquidity risk, skewed incentive structures, an over-reliance on
mathematical and statistical risk models without a proper understanding of
their assumptions, dynamics and constraints, a blind reliance on credit ratings
without properly analysing and understanding their methodologies and caveats,
and a proliferation of financial innovation that resulted in complex products
that were not well understood by those selling or buying them.
However, supervisors and advocates of financial stability seemed powerless
to address these issues while the party was still going on. Only weeks before
being nationalised, Northern rock reported record profits and was hailed for
its innovative business model and financial strength, including capital
adequacy. It is very difficult for supervisors to spoil the fun while
everything is going so well.
Yet, if supervisors and financial stability functions in central banks have
to take on the role of bouncers, they have to have muscle! Much attention is
currently given in international forums to strengthening supervisory and
regulatory frameworks and to giving more legal powers to financial stability
practitioners. For example, some of the recommendations that have been made by
the financial stability forum are to strengthen the prudential framework for
banks, including with regard to capital, liquidity, risk management and market
infrastructure, to strengthen the framework for transparency and valuation,
changing the role and uses of credit ratings, and enhancing the responsiveness
of authorities to risks and cooperation in dealing with weak banks.
Other issues being addressed in various forums are ways in which the
pro-cyclicality of financial regulations could be reduced, how areas of
regulatory arbitrage could be eliminated, and how cross border supervisory and
crisis resolution frameworks could be strengthened, for example through
supervisory colleges.
Lesson number five: Common sense should prevail
A comment was recently made that perhaps one good thing about the current
crisis is that engineering students will in future actually do what they have
been trained for: to be engineers. In the past decade or so, the financial
world has been taken over by mathematicians, statisticians, engineers and
scientists. These professionals have made breakthroughs in the development of
sophisticated risk management and valuation techniques, which contributed
vastly to financial innovation and the development of new products. But we have
probably over-relied on these models.
After all, engineering is a different field from banking, finance and
business
management, and in many instances a great divide was created between the
business acumen of boards of directors of banks, and the models on which the
banksâ operations were based. While financial and risk modelling should
continue to play an important role in future, it should be better balanced by
basic business common sense, which should challenge the underlying assumptions
of such models and attempt to understand their inherent limitations and
constraints.
Some comments on the South African banking system
We would like to conclude this address as promised earlier, by making some
comments on the South African banking system, and why it appears to have
weathered the storm relatively well up to now. To date, South Africaâs banking
system has remained largely shielded from the direct effects of the global
financial market crisis, although our banks have been somewhat affected by the
general re-pricing of risk and increases in funding costs. South African banks
have very limited direct exposure to the troubled toxic securitised debt market
in the US, partly owing to prudential restrictions on the type of assets and on
the extent to which domestic banks are allowed to invest offshore. In addition,
securitisation activities of our banks have been moderate and prudent.
As a result, the high leveraging observed in some other jurisdictions has
not been evident in the South African banking sector and our banks have
continued to follow a fairly traditional banking model. Even more
significantly, South African banks are predominantly funded by domestic
deposits, and not through internationally held structured products. As at the
end of December 2008, the total foreign currency denominated deposits of banks
amounted to R78,3 billion, and other foreign currency denominated funding to
R86,7 billion, together comprising 6,7% of banksâ combined total funding
liabilities of R2,4 trillion. Even of this relatively small amount, only a
portion is provided by non-residents.
South African banks are well capitalised, with an overall capital adequacy
ratio of 13,0% of risk weighted assets under the Basel II measurement, as at
the end of December 2008, which is 3,5% points above the minimum requirement
of
9,5%. Even on the basis of capital to total un-weighted assets, they are not
highly leveraged. Also noteworthy is that Tier one capital adequacy stood at
10,2%. This high level of capitalisation makes the banking sector more
resilient to economic shocks. Although some deterioration in asset quality has
been observed over recent months (for example, impaired advances to gross loans
and advances increased to 3,8% by December 2008), this was more attributable to
the tightening of domestic monetary policy and slowing growth than to the
global financial crisis.
These trends are not out of line with what would be expected in the current
stage of the domestic economic cycle, and impaired loans are adequately
provided for. The foreclosure procedures in South Africa are also different
from those in the United State (US), for example, allowing banks to recover a
greater portion of their non-performing loans.
In this environment, the South African Reserve Bank (SARB) will continue to
focus its monetary policy decisions based on the inflation outlook, within the
context of its inflation targeting framework whilst taking full cognisance of
the global collective efforts to avoid a deep recession. An improved inflation
outlook, against a backdrop of slowing domestic and global growth, allowed the
monetary policy committee of the SARB to reduce the policy rate by 150 basis
points since December 2008, to 10,5%.
The SARB continued to drain significant amounts of liquidity on a net basis
in order to maintain a shortage in the money market as part of our monetary
policy implementation framework. The domestic interbank market continued to
operate, with no anomalies observed in either the volumes or rates of interbank
funding. In general, financial market stability continues to be observed in
South Africa.
Far from being complacent, however, we are monitoring the situation closely.
Crisis preparedness is a key consideration for the South African Reserve Bank.
In fact, in partnership with the World Bank we are hosting a regional crisis
preparedness simulation test for the South African Development Community (SADC)
region next week, to be facilitated by the Toronto Centre.
We are also very conscious of the potential impact of the global economic
slowdown on our own economy, and are starting to feel the painful effects of
this through job losses, rising insolvencies and lower volumes of exports. In
this regard, fiscal and monetary policies have to play a much more central
role.
Conclusion
There is a G-20 meeting of ministers of finance and central bank governors
taking place in the United Kingdom on Saturday, 14 March 2009. Many issues
similar to those you might discuss here are also on the G-20 agenda. Hopefully,
the G-20 conclusions will assist in taking us forward. Time is of the
essence.
I wish you well in your deliberations.
Thank you very much.
Issued by: South African Reserve Bank
13 March 2009
Source: South African Reserve Bank (http://www.reservebank.co.za)
