09 January 2009

OECD Financial Market Trends - January 2009

This edition focuses on the causes and policy issues raised by the financial market crisis, and contains articles on ageing, pensions and financial markets, as well as on institutional investors’ assets.

This edition focuses on the causes and policy issues raised by the financial market crisis. It also contains articles on ageing, pensions and financial markets, as well as new statistical releases on household wealth and institutional investors’ assets.

 

Part I: Current Issues in Financial Markets: Financial Turmoil

The Current Financial Crisis: Causes and Policy Issues

This article summarises the causes of the current crisis as set out in a major research article for the Reserve Bank of Australia conference in July 2008, and some of the policy discussion that emerged from it in and around that conference. The business model of banking changed, mixing credit with equity culture, and when combined with complex interactions from incentives emanating from macro policies, changes in regulations, taxation, and corporate governance, the current crisis became the inevitable result. The paper points to the need for far-reaching reform for a more sustainable situation in the future.

Full article

 

Lessons from the Financial Market Turmoil: Challenges Ahead of the Financial Industry and Policy Makers

This financial crisis, ending a period of search for yield and increased risk-taking, has triggered various policy responses, ranging from more ad-hoc measures initially to more structured and co-ordinated financial sector rescue actions as the crisis evolved. Lessons drawn so far should help to devise longer-term, more encompassing and more consistent policies. Various reforms are being proposed by the financial industry as well as by official authorities and international standard-setting bodies, many of which arrive at similar conclusions regarding the causes of and remedies for the crisis. Shortcomings in risk management, including compensation schemes, governance structures, liquidity and counterparty risk, need to be addressed. Enhancing transparency by improving disclosure, valuation and ratings should help to restore market confidence. Further regulatory reforms, striking a balance between stability and growth, are needed, but should be assessed with respect to their efficiency and effectiveness. Reform areas should cover cross-border regulation for banking and finance, capital requirements, the institutional scope of regulation and financial safety nets. Financial crisis mechanisms as well as multilateral global surveillance should be reinforced to make the financial system more resilient, sound and efficient.

Full article

 

Financial Crisis: Deposit Insurance and Related Financial Safety Net Aspects

Government provision of a financial safety net for banks and other financial institutions has been a key element of the policy response to the current financial crisis. In the process, the design of many safety net elements, such as deposit insurance, has been redrawn in many jurisdictions. In particular, governments extended existing guarantees and introduced new ones. While these measures did not address the root causes of the lack of confidence, they were nevertheless helpful in avoiding a further accelerated loss of confidence, thus buying valuable time. But they are not costless. First, like any guarantee, deposit insurance coverage gives rise to moral hazard, especially if the coverage is unlimited. Clearly, in the midst of a crisis, one should not be overly concerned with moral hazard, as the immediate task is to restore confidence, and guarantees can be helpful in that respect. Nonetheless, to keep market discipline operational, it is important to specify when the extra deposit insurance will end, and this timeline needs to be credible. Second, the co-existence of different levels of protection could give rise to unfair competitive advantages, vis-à-vis other forms of savings or vis-à-vis other deposit-taking institutions that do not enjoy the guarantee. Third, to make a guarantee credible it is important to specify the manner in which it will be provided. There is the possibility that the capacity of some governments to provide for the guarantee that they have announced or implied in announcements may be questioned. Looking ahead, a sharper policy focus will have to be placed on “exit strategies”, especially where unlimited guarantees have been extended. In this context, the fundamental question remains whether government guarantees can be a one-off proposition. There may be a general perception that, once extended in one crisis, a government guarantee will always be available during crisis situations.

Full article

 

Resolutions of Weak Institutions: Lessons Learned from Previous Crises

The present financial crisis may be added to a growing list of episodes worldwide in which financial sector problems have become systemic in nature. Many OECD countries have been affected, either directly or through the transmission of problems cross-border. Most financial crises share a number of common elements. For instance, financial innovation has often played a role in distress episodes, in many cases, having much to do with their idiosyncratic aspects. For example, structured credit products and the latest incarnation of the originate-and-distribute model of intermediation have been at the epicentre of the current crisis. It differs from other crisis episodes in having a sub-component of the residential mortgage sector as its trigger, while previous crises have more often been prompted by problems in the commercial mortgage market and with corporate clients. It shares with other crises of the past few decades a significant accumulation of debt and assets in an environment characterised by very low risk premia and high concentrations of risk. Policymakers in many jurisdictions have faced these types of problems. In most cases, authorities have adopted an overriding objective to ensure that the underlying disturbance is contained and that public confidence in the system as a whole is preserved. There is no optimal blueprint for how to achieve this goal, but a number of key lessons emerge from specific crises and from the measures introduced to resolve them.

Full article

 

Part II: Pensions, Ageing and Financial Markets

Ageing and the Payout Phase of Pensions, Annuities and Financial Markets

This paper reviews the impact of ageing on private pensions, in particular on the payout phase, assesses the part that annuities can play in financing retirement, and examines the role of financial markets in facilitating the allocation of assets accumulated in defined contribution pension plans. A comprehensive set of recommendations for consideration is provided at the end of the paper.

 

Challenges for Financial Intermediaries Offering Asset Decumulation Products

The present article focuses on issues related to asset decumulation. In discussing these issues, a key proposition is that financial institutions are most willing and able to offer decumulation products with fixed payment promises to the extent they are able to invest in financial assets that allow them to hedge a considerable part of the risks associated with the payment promises they extend. Indeed, what is sometimes overlooked in discussions about shifts from asset accumulation to decumulation is that the decumulation phase also involves investment challenges, especially if specific patterns of payouts such as regular payouts of fixed amounts are aimed at. Many writers have argued for some time now that pension fund managers will have difficulty implementing asset-liability matching because there are insufficient quantities of suitable assets. As it turns out, the shortfall in hedging instruments extends to more than just the “toxic” tail of longevity risk, as is commonly being argued. The analysis in this article shows that hedging interest rate risk is also not as straightforward as one may think.

 

Revisiting the Asset Meltdown Hypothesis

The present article focuses on the so-called “asset meltdown hypothesis”, which postulates a direct link between demographic developments and the level of asset prices. In particular, proponents of this hypothesis argue, when baby boomers start entering retirement they will become net sellers of financial assets to finance retirement consumption. As subsequent generations are smaller in numbers, other things equal, this would put downward pressure on financial asset prices. Revisiting this hypothesis, there is some support for a link between demographics and financial asset prices, although the link may not be strong. A number of mitigating factors exist, so that “other things” will not be equal. A major question in this context is to what extent demographic developments and their implications for other variables affecting financial asset prices are already reflected in financial asset prices and how fast any additional pressures on financial asset prices will play themselves out. Demographic developments such as the ageing of baby boomers are slow moving and relatively easy to predict, so that one would expect forward-looking and efficient financial markets to price these developments well before they actually occur. The adjustment is likely to be gradual, while any rapid demographically-induced asset meltdown appears to be highly unlikely. Having said that, such an outcome cannot be completely ruled out. For sure, at this point in time it is difficult to conceive of any specific demographic developments that may have the potential to trigger strong financial market reactions. But the recent crisis has been a reminder that markets are prone to occasional turmoil and triggering events are difficult, if not impossible, to foresee.

 

Pension Fund Governance: Challenges and Potential Solutions

Good governance is increasingly recognised as an important aspect of an efficient private pension system, enhancing investment performance and benefit security. Yet, despite regulatory and industry initiatives, governance weaknesses persist across OECD and non-OECD countries. This paper highlights the main governance challenges faced by policymakers (particularly with trust-based pension systems), and draws on recent policy initiatives to propose possible solutions to strengthen governance arrangements.
The paper suggests that some of the more serious cases of governance failures could be solved through a more balanced representation of stakeholders in the governing body, higher levels of expertise (which may be achieved via training or the use of independent trustees) and the implementation of codes of conduct addressing conflicts of interest. The absence of governance arrangements for defined contribution style pension plans also needs to be addressed, potentially via management committees, increased fiduciary responsibility for relevant parties or via a strengthened role for pension supervisory authorities. Consolidation of the pension industry in some countries may also be required to achieve economies of scale and reduce costs, which in turn would allow pension funds to dedicate more resources to strengthening their internal governance.

 

Part III: Debt Management, Bond Markets and Financial Statistics

Secondary Market Liquidity in Domestic Debt Markets: Key Policy Conclusions

The Tenth OECD/World Bank/IMF Annual Global Bond Market Forum highlighted that liquidity is a complex concept with different dimensions – micro liquidity vs. macro liquidity, market liquidity vs. funding liquidity, endogenous vs. exogenous liquidity, and so on. Relative liquidity (including ‘liquidity freezes or squeezes’) can best be explained by focusing on the market’s institutional structure, in particular the architecture of electronic trading platforms, the importance of OTC trading, the nature and width of the investor base, disclosure requirements, valuation methods, the role of primary dealers including market-making requirements or conventions, tax factors, and the role of issuers of government bonds and other fixed-income instruments in primary and secondary markets. The rapidly changing investor base with sizable growth in assets under management and a decline in their home bias, also has significant implications for liquidity. Emerging markets facing liquidity management challenges from capital inflows is largely symptomatic of the lack of broader and deep domestic capital markets. Indeed, the current turmoil in mature credit markets has highlighted that EM policymakers and market participants should aim to foster a strong institutional structure for local currency bond markets.

 

Households' Wealth Composition Across OECD Countries and Financial Risks Borne by Households

The first section of this article presents a combined analysis of households’ financial and non-financial balance sheets across OECD countries over the period 1995-2006, based on two OECD data collections – financial balance sheet accounts and households’ financial and non-financial assets. The scope of the study mainly covers households’ gross wealth (financial, dwellings and land) and therefore does not include debt. The second section, based on the OECD households’ financial and non-financial assets database, analyses financial risks borne by households investing their savings either in investment fund shares, in life insurance reserves or in pension schemes, and how these allocations have changed and developed over time in various OECD countries.

 

Recent Trends in Institutional Investors Statistics

Data to measure and analyse the increasing role of institutional investors in capital markets has been collected and published by the OECD for a number of years. This dataset is now integrated in the framework of the OECD Financial Accounts. This article presents an overview of institutional investors’ assets, their components and their development in the aggregate and by country

 

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