15 January 2008

IMF Intensifies Work on Subprime Fallout

Following the recent subprime mortgage crisis in the United States and the resulting global market turmoil, the IMF has recalibrated its work program and launched a number of initiatives with the aim of developing policy proposals both to deal with the present crisis and to improve the Fund's capacity to spot potential trouble spots.

The crisis, which erupted in mid-2007, has had far-reaching and still evolving consequences (See "Subprime: Tentacles of a Crisis"). The shock has forced significant writedowns at some of the world's largest financial institutions and required, in some cases, significant capital injections from existing and new shareholders, including sovereign wealth funds.

Central banks have responded by lowering policy interest rates and by amending the terms of their usual lending facilities to provide much-needed liquidity to interbank markets. Financial regulators too are re-examining the extent to which existing prudential norms and regulations may need to be amended.

Notwithstanding these responses, the impact of the crisis is likely to be protracted and most forecasters—including the IMF—have scaled back their estimates of growth for this year. The IMF will announce its latest estimates for global growth and an update of its views on financial markets on January 25.

The IMF will provide an updated and in-depth look into the state of financial markets worldwide in its next Global Financial Stability Report (GFSR) in early April, building on the Fund's policy prescriptions contained in its October GFSR.

Focusing on member countries

To better understand the complex interactions between financial markets, the IMF has ramped up its work, both in-house and with its member countries and other international institutions, to analyze the causes of the crisis, its spillovers to the world economy, and the possible policy responses.

The IMF's first priority is to help its member countries address their economic and financial vulnerabilities in this new, volatile environment, even if these vulnerabilities are not directly related to the subprime crisis.

At the bilateral level, the preparation and delivery of country assessments and updates under the joint IMF-World Bank Financial Sector Assessment Program (FSAPs) to member countries, which was already on the rise, was stepped up further following the crisis, as national authorities are becoming more aware—sometimes painfully so—of the critical linkages between the financial sector and the macroeconomy.

In addition, the financial sector component of regular annual consultations with IMF members has also been stepped up, and more effort has gone into analyzing regional implications.

New generation of analytical tools

The IMF's Monetary and Capital Markets Department (MCM) has also speeded up the development of tools to test for vulnerabilities and for the risk of contagion, and to probe the resilience of the financial system at the national and the global level.

A new generation of stress tests and macrofinancial risk modeling is being gradually rolled out that aims to capture the highly complex interactions between the macroeconomy and financial markets, second-round effects of shocks, liquidity risks, and the possible impact of "extreme events"—exactly the elements that have been at the heart of the recent crisis. The related article on Quantitative Financial Stability Modeling describes the different directions along which this work is developing.

The emphasis is on creating practical, user-friendly tools that can be used easily by IMF teams and country authorities to assess and monitor risks. The related article on the Risk Measures Project is a good example of this approach.

Five key areas for further investigation

In addition to these activities, last October the IMF's policy-guidance body, the International Monetary and Financial Committee, asked the Fund to investigate the implications of the subprime meltdown. In response, the IMF's MCM Department set up five working groups, each focusing on an area related to the recent crisis:

• risk management practices related to complex financial products, including in the biggest financial institutions;

• treatment of complex products by rating agencies and their impact on investor behavior;

• basic principles of prudential oversight for regulated financial entities;

• valuation and accounting for off-balance-sheet instruments; and

• liquidity management.

In this effort, the IMF is working in close cooperation with national authorities, supervisors, international standard setters, the Financial Stability Forum, and the private sector, among others. The Fund's analysis will feed into ongoing work by a number of international and national bodies to identify information gaps and make policy recommendations, including on risk management practices, valuation models, financial regulation, and supervisory practice. Here's what the five working groups are looking at:

1) Risk management. The working group will evaluate risk management practices from the perspective of both buy-side investors (pensions, insurance companies, asset and money managers, and hedge funds) and sell-side institutions (investment banks and commercial banks). The immediate focus is on the risk management practices at the largest global financial institutions and best practice examples relevant for policymakers; structural influences on risk management practices, such as regulatory, capital, and accounting guidelines; lessons learned by risk managers from the recent market turmoil; and what new risk management tools may be needed, if any, in the broader market to help address current and potential new challenges.

2) Role of credit rating agencies. Is there a conflict of interest for rating agencies that are paid to rate complex structured products, yet often actively consult with issuers on the specific structures required to achieve a desired rating? This working group is examining whether this potential conflict of interest may have contributed to excessively high ratings for structured products—particularly those associated with subprime mortgages.

This group is also looking at the potential benefits of differentiated rating scales that highlight composite risks and different dynamic risk characteristics inherent in many structured products not found in ordinary debt securities.

3) Basic principles of prudential oversight. A third group is working with other international bodies to develop principles and operational advice to better align supervisory structures with financial stability objectives, including arrangements for coordinated actions among agencies responsible for liquidity provision, supervisory oversight, and bank resolution. Among other topics, the group is focusing on implications for capital adequacy frameworks, minimum underwriting and disclosure standards, and deposit insurance systems.

4) Valuation and accounting. Are the prevailing accounting and valuation processes for sparsely traded and complex products destabilizing? As market liquidity declined in mid- 2007 amid concerns about the exposure of structured products to U.S. nonprime mortgage-related asset-back securities, market participants found it increasingly difficult to value these products. Many used pricing models that relied on historical patterns that were no longer relevant, causing the models to break down. This working group is examining issues related to the valuation and accounting of structured products, including how the process has been handled by major financial institutions. See related article on valuation.

5) Liquidity management. The recent market turmoil presented major challenges to a number of advanced-country central banks, notably the ECB, the U.S. Federal Reserve, and the Bank of England. It illustrated shortfalls in the ability of central banks to respond effectively and provide needed liquidity in the face of a major loss of confidence in asset markets and market participants. This working group is examining how the world's major central banks addressed these shortcomings and whether there are additional lessons to be learned.

As the related article on central bank response to the recent turmoil explains, several factors had a bearing on the effectiveness of the central banks' response to the liquidity crisis, in particular the range of collateral they were prepared to accept, the ability to interact directly with a large number of counterparties, and the extent to which reserves are remunerated. Needless to say, this experience also highlighted the need for closer coordination of their activities in turbulent times.

© Graham Bishop