26 March 2008

Bank of Japan issues report on financial turmoil

The BoJ issued its second financial market report summarizing among others the facors behind the financial turmoil during the second half of 2007. The rise in delinquency rates on U.S. subprime mortgages, which comprise merely a small portion of underlying assets of various securitized products, affected global financial markets substantially, the report states.

First, unexpected losses on subprime-related securitized products raised strong concerns about the most important functioning of financial markets, i.e., about whether risks had been properly priced under the originate-and-distribute model of financial intermediation. Since the credit risks of various underlying assets were spread among a wide group of investors in the originate-and-distribute model, investors started to reassess risks of securitized products overall.

Second, the increase in mark-to-market losses on securitized products caused many investors to want to sell but few to buy, leading to a mutually reinforcing deterioration in market and funding liquidity. The deterioration in liquidity decreased the risk appetite of investors further and affected credit markets overall as well as stock markets.

Third, the disruption in securitization markets forced banks to face a reintermediation of risks which they had seemingly transferred off their balance sheets. U.S. and European banks experiencing an involuntary expansion of balance sheets were then confronted with a rise in funding costs, reflecting heightened concerns about counterparty risk in money markets.

Finally, concerns mounted that the tightening of bank lending might adversely affect the macroeconomy, raising uncertainty about the outlook for the U.S. economy and leading to an increase in the volatility of asset prices and a further deterioration in market liquidity.

The significant deterioration in market liquidity has made it difficult for investors to reevaluate financial assets adequately. Adjustments in securitization markets and credit markets overall have intensified further. Therefore, developments in global financial markets and their effect on the global economy warrant careful attention.

Press release

Full report

© Bank of Japan