01 December 2011

IIF's Market Monitoring Group (MMG) released statement on crisis

MMG members broadly agreed that:

1. The recent severe strains in mature sovereign debt markets must be resolutely and urgently addressed. The November 30 decision by major central banks to provide coordinated liquidity support has been welcomed by financial markets. Furthermore, the steps taken by euro area leaders to strengthen economic/fiscal coordination, in particular enhancing the capacity and flexibility of the European Financial Stability Facility (EFSF), represent meaningful progress. Determined reform efforts made by the governments of Greece, Spain, Portugal, Ireland and Italy are also to be commended. However, much more remains to be done to restore investor confidence, specifically regarding the effective functioning of euro area debt markets. Without this, the very large funding needs of sovereign and bank borrowers in troubled euro area countries in 2012 would be at risk. The crucial role of the ECB in ensuring normal liquidity conditions in the euro area sovereign and financial debt markets cannot be overstated.
2. As these steps are being taken, urgent additional action by national euro area governments to ensure progress on key fiscal and structural reforms—including guarantees of bank borrowing—is needed as a cornerstone of resolution of the debt crisis. At the regional level, the process of establishing and operating a credible backstop for euro area sovereign debt markets is vital, and efforts to ensure that such facilities have sufficient magnitude—perhaps involving contributions from non-euro area countries—should continue. However, a sustained recovery in investor confidence will only be achieved by means of a permanent and comprehensive solution to the uncertainty surrounding the future of the euro area. Without underestimating the inherent challenges arising from domestic political considerations, decisive steps towards closer euro area economic and fiscal integration need to be taken now, with a clear roadmap for implementation. These steps should focus not only on fiscal discipline but on rebalancing growth within the euro area and on measures to improve the competitiveness of more vulnerable Member States. Without laying the foundation for more robust growth, planned and necessary fiscal consolidation—coupled with expected further deleveraging in banking sectors worldwide—could have serious consequences for the euro area and the health of the global economy.
3. It is imperative that the restructuring of private-sector holdings of Greek sovereign debt remain on a voluntary basis. The October 26/27 agreement in Brussels between representatives of private-sector investors and euro area Heads of State called for an unprecedented 50 per cent nominal reduction in the value of Greek government bonds in private-sector hands—roughly €100 billion, or 45 per cent of Greek GDP. The net present value losses on the part of private investors will need to be consistent with those implied by the October 27 agreement to be considered voluntary. The costs of involuntary debt restructuring—resulting in an effective sovereign default of a euro area country—in terms of financial contagion and a potential shutdown of market access for many euro area countries would far outweigh any marginal benefit of additional debt reduction.
4. The requirement imposed by the European Banking Authority (EBA) for significantly higher capital ratios compared to the announced Basel III timetable has greatly increased pressure for further deleveraging by banks—the resulting sales of bank assets, often at distressed prices, is adding to sovereign funding strains. Furthermore, the recent downgrading of the debt of global banks follows the severe strains in funding and capital raising markets; these strains in turn reflect concerns about a phasing out of implied state support, mark-to-market losses on sovereign debt exposure compounded by weaker global growth, and the cumulative impact of financial regulatory reform measures.
5. MMG members also discussed risks associated with the CDS market. To maintain confidence in this market, it is important to have sufficient transparency about the exposures of firms that have dealt in CDS contracts—net exposure may be contained, but gross exposures are also relevant. Moreover, given the current illiquidity of the CDS market and even cash markets for some Euro Area sovereigns, the requirement to mark-to-market banks’ holdings of sovereign debt including in “held to maturity” portfolios and loan books is damaging. Specifically, this adds a significant element of procyclicality in the financial system. Further work is needed by the industry to ensure that risk management standards in the CDS market remain robust.
6. MMG members also highlighted concerns regarding the failure of the US Budget “Super Committee” to reach agreement on measures to reduce the budget deficit. Broad across-the-board budget cuts, in lieu of targeted spending cuts and much-needed tax reform, could be a potentially significant drag on the US economy, with global implications. This could also undermine efforts to manage the US fiscal accounts according to national priorities. The perception of fiscal paralysis has eroded market confidence in policymakers’ commitment to maintaining US creditworthiness. Although market attention remains focused on Europe, the lack of progress on credible plans for medium-term US fiscal consolidation is another potential source of future systemic risk. It leaves the US and global economies vulnerable to significant event risk in the months ahead.
7. The MMG also engaged in a discussion of the risks associated with China’s financial sector. In particular, the discussion focused on the strong growth both in traditional bank lending and in “shadow bank” activities including off-balance sheet activities such as informal securitisation and bank-trust company relationships. The group does not see a near-term systemic risk in these areas, but underscored the need to monitor developments closely in the period ahead. Any move towards easier monetary policy in response to slowing economic growth would need to be accompanied by macro-prudential measures and continued financial sector reforms in order to address concerns about potential asset price bubbles and deterioration in credit quality.
8. The European Commission’s mid-November proposal to strengthen oversight of credit rating agencies has far-reaching implications for the industry and financial markets, some of which could have significant unintended consequences that could increase market risk. The impact of the Commission’s proposed measures could lead to changes in the structure of the industry, resulting in a limitation of the function of the rating agencies and the establishment of more control over the number, source and content of views on credit risk in the EU. Market participants look forward to continuing the dialogue with the European authorities on these issues through the coming legislative process.

 Press release

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