29 January 2008

IMF urges policies to rebuild from subprime crisis

The IMF urged countries affected by the subprime meltdown to adopt policies to address both near-term stresses and longer-term financial stability, with the aim of reducing uncertainty and strengthening the soundness of financial institutions.

The IMF's Global Financial Stability Report Market Update, released on January 29, said that in the short run, the aim should be to rebuild counterparty confidence and the financial soundness of institutions and thus to ease ongoing liquidity tensions, allowing interbank markets to function normally again and intermediation to continue. To do so, the IMF called for early, consistent, and clear disclosure of exposures to losses in the subprime market and other securities and said supervisors and auditors had a key role to play.

IMF Monetary and Capital Markets Department Director Jaime Caruana said that although sources of the current strains are varied and complex, "market failures and weaknesses in oversight have contributed to these problems and they need to be corrected." Caruana told a January 29 news conference in Washington that such a correction requires not only macro policies but also policies in the financial stability area.

Major bank losses

The subprime crisis and subsequent market turmoil has forced major banks to declare losses worth billions of dollars in mortgage-related securities, but further writedowns by banks in different parts of the world are expected.

Overall, the Update noted that global financial market conditions have worsened since the publication of the IMF's last Global Financial Stability Report in October as the fallout from the crisis widened. Coordinated central bank operations, together with rate cuts, have helped ease liquidity tensions in the interbank market. However, strains persist and term premiums are likely to remain elevated for some time.

Term premiums reflect wider problems in the financial system such as valuation of complex products, credit deterioration, counterparty mistrust, and balance sheet pressures. Credit and market risks have continued to rise, and the global macroeconomic outlook looks less favorable (see "IMF see world growth slowing").

Addressing stability questions

The IMF assessment said the fact that systemically important institutions that have experienced weaker balance sheets are raising capital (some of which has come from sovereign wealth funds) and cutting dividends was a positive development.

Timely and consistent disclosure will also be key to removing uncertainty. Explaining methodologies and valuation assumptions are equally important. "On all of these issues, it is important to maintain a delicate balance so that actions do not exacerbate the cycle," the Update stated.

Longer run issues

This period of instability, characterized by a liquidity disruption in mature market banking systems raises issues for the private sector, central banks, and other financial supervisors and regulators in the longer run.

Credit rating agencies, for instance, can improve their methodologies, provide differentiated ratings (as suggested in the April 2006 GFSR) and give more information about the sensitivity of their ratings to the underlying assumptions.

The line between regulated and unregulated institutions is always a complex issue, but it has become evident that unregulated (or lightly regulated) financial institutions that originate mortgages and consumer credit products similar to those originated by regulated financial institutions should be subject to similar disclosures and consumer protection requirements, the Update said.

Central banks' role

The IMF said that the current period of instability—characterized by a mature market, banking system liquidity disruption—raises issues for central banks and other financial supervisors and regulators. "Central banks could usefully review the effectiveness of their tools to reduce market stress—and whether they work globally."

The Update said that central banks will need to continue to help manage the changing liquidity requirements in the money markets as long as needed to assure their smooth functioning to minimize the knock-on effects to the real economy. In this role, it will be very important that central banks maintain flexibility in adapting to the needs of the market—initiating and utilizing joint initiatives, such as the Term Auction Facility announced by the U.S. Federal Reserve, the European Central Bank, and the Swiss National Bank last December.

A convergence of practices for providing emergency liquidity across central banks could help alleviate the difficulties faced by central banks in communicating their actions and financial stability concerns. National and cross-border financial stability arrangements for information sharing and coordinated actions among the agencies responsible for supervisory oversight, the provision of liquidity, and bank resolution could be strengthened, the IMF said.

The IMF is assessing the different approaches taken by the major central banks in response to financial market turmoil sparked off by the subprime crisis, to help draw lessons for developing more effective liquidity management frameworks. The IMF believes that an examination of the different approaches followed by the European Central Bank, the U.S. Federal Reserve, and the Bank of England holds lessons that could be useful to all central bankers.

© International Monetary Fund