Banking Soundness and Monetary Policy
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Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
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Author(s)
ANDREW SHENG

The paper by David Folkerts-Landau and Peter Garber surveys extremely well how derivatives can affect macroeconomic stability. The miscalculation of risks by market participants, possibly motivated by a desire to evade prudential regulations, can lead to potential systemic crises. The authors point out that a blind spot has emerged in the domestic and international surveillance of capital markets because of the emergence of a bewildering array of derivative products, putting whole financial systems at risk in dimensions that are not transparent to participants or regulators. They suggest that traditional data on bank exposures (such as gross or net positions) are inadequate in measuring such risks, and that regulators must focus on ensuring that financial institutions have good risk management systems in place. This implies that the regulators themselves must understand derivatives, their implications and exposures in the marketplace, as well as the dynamics of deregulation when domestic market participants get heavily involved in new financial products.

In recent years, the IMF and the BIS have begun to highlight some of the key issues relating to the emergence of derivatives in the global financial markets. Valuable work has been done through the pioneering work of Folkerts-Landau and his colleagues in the various issues of the IMF’s International Capital Markets. The BIS has added to the literature through its research, including the valuable Survey of Foreign Exchange and Derivatives Market Activity. What I propose to do is to review the key concerns over derivative markets raised by the authors and others, as well as some of the key characteristics of the derivative markets. I then offer some personal comments on the implications of such markets for central banks and conclude by reviewing what the Hong Kong Monetary Authority (HKMA) has done in the area of derivative markets.

Dark Side of High-Octane Derivatives

Henry Kaufman was one of the first to point out the structural changes in the global financial system that make it increasingly vulnerable to financial excesses: the decline of the banking sector relative to the securities market; the global trends toward market deregulation, the growth of derivatives, and the emergence of offshore hedge funds; and a new credit culture and infrastructure.1 Derivatives are considered dangerous because they add volatility to financial markets, they are not well understood (risks are opaque), and they are highly leveraged.

In addition, the authors argue that:2

  • derivatives can affect the magnitude and dynamics of a crisis;
  • dynamic hedging can exacerbate a crisis, as demonstrated in Europe’s exchange rate mechanism (ERM) and Mexican crises;
  • the growth of derivatives and their off-balance sheet accounting obscure market behavior, causing the authorities to misread the direction and causes of crisis and hence the appropriate response. Specifically, classical remedies such as interest rate tools may not work during speculative attacks.

I must confess that when I first read the 1994 paper by the authors, just before the outbreak of the Mexican and Barings crises, I had to undertake a crash course in derivatives to appreciate fully what they were saying. Since that time, both the Fisher Report and the Hannoun Report have addressed a number of fears raised by Kaufman.3 It may be useful to summarize this body of consensus.

In a derivative market that is new to many participants, it is right that market intermediaries should disclose the risk exposures and profiles of their trading activities to potential participants. To quote the Fisher Report, “Financial markets function most efficiently when market participants have sufficient information about risks and returns to make informed investment and trading decisions.” Market misinformation or uncertainties can cause major disruptions in its functioning, with potential systemic risks. Hence, the need to improve transparency.

Current accounting conventions do not provide sufficiently meaningful information at the transaction, institution, and market levels. The authors make the important point that derivative activities make balance of payments data less meaningful both in terms of magnitude of flows and timeliness. Because derivatives depend on complex models with critical assumptions about valuation, the participants must have good value-at-risks models and stress tests for proper risk management. This imposes heavy information costs on participants, as well as regulators, as each seeks to understand the risks involved.

The information disclosed should be meaningful and manageable for the participants. Such data should be comparable across products, institutions, and markets, as well as verifiable. The disclosure standards should have sufficient flexibility not to stifle further development of risk management concepts and disclosure practices. At the same time, it is understandable that derivative innovators want to preserve proprietary information to maintain their competitive advantage.

The Hannoun Report addressed specifically the macroeconomic and monetary policy issues raised by the growth of derivative markets and their implications for central banks. Under normal circumstances, derivative products promote better resource allocation and improve overall market efficiency. However, under conditions of stress, derivative products may add to market volatility and uncertainty. The Hannoun Report, however, was quite reassuring in suggesting that “developments in derivative markets are unlikely to have altered significantly the transmission channels of monetary policy or the efficacy of traditional monetary instruments.” They do provide central banks with new information, and with additional tools to conduct monetary policy. On the basis that derivatives are consequences, rather than causes, of instability, the report recommends that central banks should ensure that their policies do not contribute to uncertainty. The objective is to form stable non inflationary expectations through clear and continuing consistency in policies and policy formulation.

Derivative Markets: An Overview

Several key characteristics of derivative markets deserve greater attention. In April 1995, the BIS conducted a landmark survey involving 26 countries, covering roughly 90 percent of all active intermediaries in the derivative markets. The results were quite illuminating.

The 2,401 respondents reported a notional amount of outstanding OTC contracts at US$47.5 trillion, compared with US$8.2 trillion exchange-traded contracts outstanding at the end of March 1995. By comparison, the external liabilities of BIS-reporting banks were only US$9.2 trillion at the end of March 1996, and global wealth has been estimated at US$44 trillion.4 Although notional amounts are large, implying the (leveraged) right to buy and sell at highly significant levels, the net amount could be considerably smaller because there are substantial transactions offsetting each other.

The second feature is that the OTC market in derivatives is significantly larger than exchange-traded contracts. Ninety-eight percent of the OTC contracts were interest rate and foreign exchange products, reflecting the fact that interbank and foreign exchange markets are the largest OTC markets in the world. In April 1995, the daily average turnover, in notional amount, for the OTC contracts stood at US$880 billion versus US$570 billion for the exchange-traded contracts.5

Perhaps the most striking feature of the derivatives market is its high degree of concentration. Because of the skills base involved, the derivatives business is concentrated not only in mature markets, but mainly with a small number of financial intermediaries. In the United States, for example, 14 out of the 51 participants surveyed by the BIS accounted for over 90 percent of derivative market activities. This supports the findings by Moody’s that eight money center banks accounted for over 85 percent of total activity in the first quarter of 1994.6 Similarly, about 25 banks out of nearly 400 U.K. participants accounted for more than 90 percent of that country’s derivative market activity. In most markets surveyed, a handful of traders accounts for most of the action and therefore most of the risk.

The Emperor’s New Clothes

A derivative is the property right of a property right. The change in the value of the derivative with respect to the change in the value of the underlying asset is called the delta, δ. The second-order derivative with respect to the change in the underlying asset is called gamma, γ, and so forth. In essence, the financial sector is basically a derivative of the real economy. Put in such simple form, one can say, for example, that the central banks’ search for the transmission channel of money was a search for the δ of money relative to the behavior of the real economy. The benefits of derivatives are threefold: first, they allocate risks more efficiently; second, they generate useful information on market behavior; and third, they lower the transaction costs of trading in the underlying asset.

Derivative products are sold primarily on the basis that they distribute or hedge risks. Financial institutions are the major users of derivative instruments because they are risk intermediators. Put simply, derivatives enable the unbundling of property rights and risks to other parties. Derivatives were invented in order to split and trade property rights of lumpy assets: they subdivide asset specificity into manageable parts in the same way that money was invented to facilitate transactions. What has made markets more efficient, but unfortunately more volatile, is that property rights can be split almost indefinitely. A share is a derivative of the underlying assets of a company. A stock index is the second-order derivative of a basket of shares. A stock index option is the third-order derivative and so forth. As long as buyers can be found, derivatives can be created. As a cynic once said, “A derivative is a way to charge a client 400 basis points when you can normally charge him 40 basis points.”

Because derivatives generate information, they have a value whose correlation with the underlying asset is not necessarily stable. The higher the order of the derivative, the taller and more intertwined the credit pyramid of finance that can unwind if the underlying real economy suffers a serious reversal. Derivatives are supposed to distribute such risks.

This is where the concentration of derivative product players raises a fundamental question: to what extent have derivative risks been distributed outside the financial system? The market can price risks only if there is an acceptable way of measuring such risks. The Federal Reserve Board’s Bill Ryback used to comment that it is no good if a bank can quote the selling price of an option but cannot quote its buying price. My central bank instincts suggest that, in reality, the high degree of concentration of the derivative market, which makes the major players too big to fail, has transferred the systemic risks of these trades to the central banks as lenders of last resort.

The fact that derivatives have informational value also brings into mind one of the defects of the marketplace: “the fallacy of composition.” As seen in the ERM experience, the problem with the black-box models that price derivatives is that they are built on many assumptions of price stability, linearity, convexity, and the like. The trouble is that most of these assumptions are based on past trends and do not necessarily predict the future. Worse, their assumptions rest on central bank maintenance of price stability. When there are disjunctive shocks led by policy shifts or mistakes, those who are using these models find they are flying blind. This accounts for the Hannoun recommendation that the central banker must opt for policy consistency in derivative markets.

The informational content of derivative markets also underlines why the Folkerts-Landau and Garber paper suggests that we must “… focus on unregulated derivatives [which] can lead to systemic problems that can undermine macroeconomic policy through their use in circumventing the usual prudential regulation.” It raises the fundamental issue that not all of the major players are supervised by the central banks, and that not all of the regulatory or (information) disclosure standards are alike.

The derivative dilemma raises one important issue that must be addressed. Derivative markets can be efficient only if the underlying markets in real goods are efficient. Market participants will always try to bypass regulations or taxes through derivatives because the market will arbitrage out excessive rents in an unlevel playing field. If taxation or regulatory risks are high, the market will find a way around it. Differences in tax rates and regulations around the world will always create opportunities for derivative activity. The obvious solution is to reform the underlying distortions in economies that give rise to such activity.

I also agree with the authors’ thesis that traditional national income and monetary statistics no longer reflect the true behavior of global financial markets, making the interpretation and implementation of policy more difficult than ever. The traditional monetary and credit data that central banks collect no longer reveal the leverage in the system, because the leverage on options, warrants, and the like are provided by the capital market institutions, such as investment banks and funds that fall outside the statistics net. The degree of leverage and liability on derivatives is certainly not captured in balance of payments accounts as currently compiled.

Indeed, traditional value accounting principles cannot guide policymakers as to the degree of risks in the derivative market. Moreover, cash-based accounting in government budgets and accrual accounting in financial markets distort the quality of policy and market decisions, through leads, lags, errors, and omissions. Current difficulties in measuring productivity growth in the services sector reflect another dilemma in the quality of market information. The emergence of derivative markets blurs our vision and information, but neither do we have good information on the underlying assets. Improvements in the information content of both derivative and real asset markets should be policy priorities.

Where does all this lead? The authors are absolutely correct that regulators need to understand the derivatives market better. Regulators need to know and understand why bankers and their clients are behaving the way they are. Proper legal and accounting frameworks would help to make both the derivative and underlying markets more transparent.

Hong Kong’s Regulation of Derivatives

Having surveyed the issues, let me conclude by reviewing the HKMA’s approach to the emerging derivatives market. In conjunction with BIS’s global survey of derivatives, the HKMA conducted a derivatives survey on the size of Hong Kong’s derivatives market. From this, it emerged that Hong Kong currently has the seventh-largest derivatives center in the world. The HKMA has circulated guidelines on risk management of derivatives and is currently drafting policy guidelines on securities and derivatives trading for authorized institutions under the BIS’s proposals on the capital required to support market risks.

The HKMA derivatives survey, covering 379 participants, revealed that the notional amount of outstanding OTC contracts in Hong Kong at the end of March 1995 stood at US$1.5 trillion, compared with US$0.2 trillion ex change-traded contracts. On the other hand, the daily average turnover in the OTC market was only four times that in the exchange market. The daily average turnover for the OTC contracts stood at US$59.9 billion versus US$14.3 billion for the exchange-traded contracts in April 1995. As in the case of other markets, the top ten players accounted for 55 percent of the gross turnover and 58 percent of the outstanding amount.

Following the lessons of Barings, Procter & Gamble, and more recently, Sumitomo, regulators around the world have worked hard to develop an appropriate framework to manage derivative risks in their markets. The HKMA circulated guidelines on the risk management of derivatives in December 1994 and March 1996 to provide authorized institutions a framework on specific aspects of the risk management process for trading derivatives. These guidelines were based on direct observations, on weaknesses identified in the surveys and treasury visits conducted by HKMA since December 1994, and on recommendations from the Basle Committee and the Group of Thirty.

In essence, the guidelines concentrate on five specific areas:

  • (1) Risk management and corporate governance. It is vital for the board and senior management of financial institutions to “understand the nature of derivatives which they are supposed to be controlling.” It is their job to “ensure that the organization of the institution is conducive to managing risks.”
  • (2) Board and senior management oversight. Consistent with the above, “the board should approve written policies which define the overall [policy] framework within which derivatives activities should be conducted and the risks controlled.” This area also details the framework, giving requirements for the evaluation and approval of “new” products or activities, identifying the various types of risks, and requiring stress testing of positions.
  • (3) Identification and measurements of risk. The main types of risk are identified and defined for the attention of the institutions. “It is important that the institution understands clearly the nature of its relationship with the counterparty and the obligations which may flow from that.” Once these risks have been identified, the measurement process begins. All positions should be marked-to-market, and the probability of future losses assessed. The guidelines recommend that active dealers and active position takers should adopt the value-at-risk approach to manage their trading risks. Furthermore, institutions should conduct stress tests on a regular basis in order to evaluate the exposure under the worst-case market scenarios.
  • (4) Limiting risks. “A comprehensive set of limits should be put in place to control the different types of risks associated with derivatives and other traded instruments.” For example, market risk limits should be established for different levels of institutions and should take into account factors such as past performance of the trading unit and experience and expertise of the traders. The institution should establish separate limits for settlement risks. Each authorized institution should have independent risk control, that is, independent monitoring and control of the various risks in derivatives.
  • (5) Operational controls. Operational risk arises as a result of inadequate internal controls, human error, or management failure—hence, the importance of segregation of duties. A number of derivative losses, such as Barings, Daiwa, and Sumitomo, were due to a failure of basic internal controls. Policies and procedures should be established and documented to cover the internal controls and applied at various stages in the processing and monitoring of trades. Contingency plans should be reviewed and tested on a regular basis. Internal audits are an important part of the internal control process. The head of internal audit should, if necessary, have direct access to the board, audit committee, and the chief executive.

Concluding Remarks

I have tried to reduce what appears to be very complex issues into certain basic fundamentals. Derivatives are inherent features of property rights. It is the way financial markets are evolving. As the derivative markets get bigger, the systemic risks escalate. If I am correct, derivative markets reflect the distortions in the real economy. Therefore, the priority of central bankers remains the same. Take care of the fundamentals, and the market will take care of the rest. Our job is to help make the real economy, and by corollary the financial markets, work better.

Kaufman was right to call for greater international surveillance of financial markets and for better international harmonization of supervisory, regulatory, accounting, and trading standards and practices. This is already happening, though perhaps not as fast as some would like.

The author is grateful to Dorcas Kee, Economics Division of the Hong Kong Monetary Authority, for research assistance in the preparation of this paper. All opinions in this paper are those of the author and not necessarily those of the Hong Kong Monetary Authority.
1Henry Kaufman, “Structural Changes in the Financial Markets: Economic and Policy Significance,” Economic Review, Federal Reserve Bank of Kansas City, Vol. 79, No. 2 (1994).
2See also David Folkerts-Landau, and Peter M. Garber, “The Efficacy of Exchange Rate Management Methods in the Evolving Market for Exchange Rate Products,” in Proceedings of the Eleventh Pacific Basin Central Bank Conference on Monetary and Exchange Rate Management with International Capital Mobility (Hong Kong: Hong Kong Monetary Authority, October-November 1994).
3Bank for International Settlements, “Discussion Paper on Public Disclosure of Market and Credit Risks by Financial Intermediaries” (Basle: BIS, September 1994) [Fisher Report]; and Bank for International Settlements, “Macroeconomic and Monetary Policy Issues Raised by the Growth of Derivative Markets” (Basle: BIS, November 1994) [Hannoun Report].
4Roger G. Ibbotson, and Gary P. Brinson, Global Investing (New York: McGraw-Hill, 1993).
5Daily average turnover includes only interest rate and foreign exchange products.
6Moody’s Investor Service, “Derivatives Activities of U.S. Commercial Banks: The Risk and Reward Nexus” (New York; Moody’s, October 1994).

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