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Melbourne APEC Finance Quarterly Issue 5, December 2008 |
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Welcome to the newsletter of the Melbourne APEC Finance Centre. In our 5th edition we reflect on the ever deepening impacts the credit crunch is having on financial services industries. KPMG’s Andrew Dickinson comments on Basel II, and how the banking industry will need to review their practices; ANZ’s Tony Morriss demonstrates that the extreme volatility of the AUD really is "unprecedented", and Vanguard Investments' MD, Jeremy Duffield assesses the challenges facing the Funds Management industry going forward. In addition, our MAFC Director, Ken Waller provides readers with a synopsis of the recent roundtable discussions held with Chinese Bankers about the prevailing crisis and impacts on our respective countries.
THE CREDIT CRUNCH ONE YEAR ON - WHAT DOES IT MEAN FOR BASEL II AND BANK RISK MANAGEMENTAndrew Dickinson is Partner Financial Services at KPMG
Given the number of banks failing and needing capital injections from their respective governments one could reasonably ask whether Basel II is fundamentally broken and whether it is correct to base a capital regime on banks' own assessments of risk. Was Basel II calibrated correctly to start with and how can the world prevent this happening again in the medium to long term? What may have started simply as a liquidity issue has now very much become a capital one and the need for capital as a means of restoring confidence has become important. Review of the rating agencies Subject to a lot of criticism from industry bodies over the past year for their perceived role in the credit crunch, liquidity crisis and anything else that can realistically be blamed on them, the rating agencies have come under intense scrutiny and review. They have been subject to detailed review by International Organisation of Securities Commissions (IOSCO) and the Financial Stability Forum (FSF) during the year. The US Securities and Exchange Commission (SEC) has additionally carried out an in depth review of the rating agencies’ practices and recently published its report. There have been various proposals put forward as to how to improve the workings of the market in ratings, particularly with respect to the structured products market, but it is probably fair to say that the rating agencies might count themselves fairly fortunate at the moment. At first glance, none of the proposals appear particularly damaging to the agencies, especially to their business models, although the SEC does propose cutting back dramatically on the use of reference to ratings in regulatory rules. Liquidity, liquidity, where for art thou liquidity This has been a perennial feature of any discussion on Banking and Basel over the past year, because liquidity risk was not explicitly covered in Basel II. Arguably Pillar 2 would, and probably should, have covered liquidity risk, and many supervisory bodies have issued guidance and principles on liquidity risk over the past decade. However, there is nothing like a crisis for bringing such matters to everyone’s attention and ultimately capital is not the best lever to use for liquidity management anyway. The challenges of implementing Basel had taken eyes away from business as usual, to which liquidity management supervision in banks should be central. Basel Committee for Banking Supervision (BCBS) has provided some guidance. Although I am sure many people would agree that the guidance is a timely reminder for the industry, there is little that is particularly new in it; it’s certainly not ‘rocket science’! Indeed that is one of the fundamental problems with liquidity risk – liquidity risk has been described as being synonymous with confidence and it is very hard to apply models to confidence. However, for many institutions more effort will be necessary in particular with regard to the following areas:
The old chestnut of pro-cyclicality of the Basel models During the development of the Basel Accord there was a lot of talk about whether Basel would be pro-cyclical, and lots of earnest academic analysis and debate. Whilst the BCBS responded by making adjustments to dampen the impact of the cycle, and Pillar 2 should also serve to make banks adopt a longer time horizon view to capital and financial management, unless firms have pure ‘Through the Cycle’ rating models, ratings grade migrations are likely to introduce an element of volatility into the capital requirements. What is now extremely interesting is that less than one year after the Advanced Internal Ratings Based (AIRB) approach was first adopted there is now the first real test of what an economic downturn may do for capital requirements. As the effects of the liquidity crisis and credit crunch flow through from the financial system to the ‘real’ economy, how cyclical do banks models turn out to be; how will Basel react in a downturn; and what will happen to banks’ behaviour and the regulators response? It is not clear how appropriate the core Pillar 1 credit risk approach set out in Basel has been in recent months. One fundamental question being asked by many in the industry is whether it was a mistake to start with the same eight percent capital ratio from Basel I. Were banks really adequately capitalised in the past on an overall basis, given the need for massive capital injections over the past year? In light of the changes to market conditions, and the speed with which we appear to be entering recessionary downturn conditions, firms should consider:
What will happen to securitisation? With industry commentators and politicians clamouring for change, the EU has taken the lead in adopting key changes to tighten up its implementation of Basel in the Capital Requirements Directive. The changes that are more substantial generally relate to securitisation and include:
Although many in the industry would accept that something should be done with respect to structured products, and it is worth bearing in mind that whilst the securitisation rules had moved the most over the seven year gestation period of Basel, one can’t help feeling that further change is likely when the full Basel and FSF recommendations flow through. Conclusion What the past year has shown us is that a complex world requires more complex rules and principles, but that a more complex Accord does not ‘fix’ inherent problems and disasters in the making in the real world. The banking world continues to get ever more complex. Other issues not even considered above include the mark to market debate, the ramifications of carbon trading issues, the continued pressure on remuneration methods and the long-term impact that significant capital investment in banks by sovereign wealth funds will have. Even in the current climate it is hard to argue with the fundamentals of Basel II, but further questions remain over the overall level of capital, calibration and matters such as pro-cyclicality. These will therefore continue to occupy us over the coming months. Basel II may not be fundamentally broken but it is very much bruised and needs some urgent reviews to restore confidence in internal models and risk-based capital mechanisms.
HARD LANDING - FALL OF THE AUSTRALIAN DOLLARTony Morriss is Senior Currency Strategist at ANZ
The AUD has seen a period of unprecedented volatility that has coincided with huge disruptions across markets in recent months. AUD/USD fell by 38 cents over a two-and-a-half month period from a high around 0.9850 in mid August to a low near 0.6000 at the end of October. Compare this with the average annual trading range of the AUD since the float of the AUD in December 1983 of less than 12 cents. On two days in October, the AUD traded a range wider than seven cents. So it is both the size of the direction of the move and the level of intraday volatility that are both beyond recent experience. The scale of the sell off can be seen in Figure 1 below. Figure 1: AUD since the float
Source: ANZ and Bloomberg What drove this volatility? The AUD threatened to break above parity against the USD in July with good reason: Commodity prices were surging to multi-year highs (oil was nearing USD150 a barrel) while contract prices of iron ore and coal were being set at 100-200 percent above year-ago levels, the Reserve Bank of Australia (RBA) was raising rates towards the highest level in the OECD (above seven percent), and finally, Fed rate cuts and weaker economic data in the US had seen the USD hit new record lows. Investors were buying AUD to reflect a bullish view on Chinese economic growth. All of these factors went into reverse from the end of July. It is the speed and extent of the sell-off that is without precedent. There were major sell-off following the float (current account crisis) and the Asia crisis in 1997, but nothing compared with the straight line recent collapse. Is it unjustified? While the AUD appears to have been singled out for special treatment to be the second worst performer of all currencies in the three months to the end of October (behind the Icelandic Krona), movements in other markets suggest the AUD was probably the most liquid market to reflect big changes in direction in views about global growth, risk assets, commodities and the outlook for China.
Firstly, the speed and intensity of movements in key financial markets have been without precedent. Figure 2 below is a measure of implied volatility in the US S&P500 stock market. Current volatility is worse than during the 1997 Asian currency crisis, the 1998 LTCM/Russia debt crisis and the 9/11 disaster in 2001. This provides some context to the AUD’s value as a measure of risk aversion. Figure 2: Extreme volatility the S&P500 implied volatility VIX index
Source: ANZ and Bloomberg And if the collapse in shipping costs represented in the Baltic Dry Shipping Index (below) is any guide, then the AUD’s sell-off does reflect a massive change in dynamics around the commodity outlook, especially for bulk commodities such as coal and iron ore which account for around 25 percent of Australia’s exports. Figure 3: AUD/USD and Baltic Dry Shipping Index
Source: ANZ and Bloomberg The BIS estimated prior to the onset of this crisis that AUD/USD was the 4th most heavily trade currency pair in the world. This liquidity across all time zones has proven to be attractive for those investors looking to hedge existing positions or take a view on future movements. The close correlation between movements in the AUD and stock market moves can be seen in the inverse relationship between the S&P VIX index and AUD/JPY in Figure 4 below. Figure 4: AUD/JPY and the S&P500 Implied Volatility index
Source: ANZ and Bloomberg The highlights how the AUD appears to have been singled out for special treatment as a hedge against investments in other markets. In some interesting remarks, RBA Governor Glenn Stevens said the following on October 21: “The Australian dollar fell particularly sharply, in part because of the changes in interest rate expectations and commodity prices, and partly because its relatively liquid market sees it used by many managers as a device to change quickly their exposures to some other currencies and commodity-based strategies.” What is hard to explain is why the AUD would have fallen so sharply considering still relatively robust growth in the Australian economy. Figure 5 below shows the extent to which the AUD has fallen more than can be justified by movements in rate differentials. However, these differentials do not appear to be a key driver in markets at present and the global credit crisis highlighted that possible funding issues for those countries with current account deficits can leave those currencies vulnerable. Figure 5: AUD sell-off not justified by rate differentials
Source: ANZ A weaker currency will help to insulate the Australian economy from softer global growth – a so called “automatic stabiliser.” But there is little doubt that the size of recent currency moves and related volatility will cause some dislocation in trade flows, so all would welcome a return to more stable conditions in coming months. As for the direction, the long-term average level of the AUD since the float – around 0.7200 seen in Figure 1 – is a useful guide to where the AUD will trade in coming months. As a simple guide, the AUD often trades below this level during times of slower global growth (with weak commodity prices) and above it when world growth is strong. As we are looking at a period of protracted slower growth around the world, the AUD is likely to remain below this level over 2009. We think there is a risk of a move towards the mid-0.50s level as growth weakens further.
MUTUAL FUNDS - BALANCING RISK AND TRUSTJeremy Duffield is Managing Director of Vanguard Investments Australia
Now a year into the Global Financial Crisis (GFC), mutual funds industries worldwide have been impacted in both obvious and unexpected ways. The obvious direct effects have been through the dramatic falls in share markets in funds industries which have been heavily equity oriented. US, UK, Japanese, Australian and many Asian fund industries have been very heavily weighted to common stocks in their asset allocations. While the industry in much of Europe has been more weighted towards fixed income, it nevertheless, has not been immune to the declines. Year on Year Development of Major Mutual Fund Markets (assets under management, USD billions)
Source: Cerulli Edge Global Edition, September 2008; 2008 figures for China and Australia as of end June. Previous commonplace assumptions have been seriously challenged The more unexpected impacts have been through a spiralling crisis of confidence, as sustained market shocks have fed contagion and market failure. The once commonplace and sanguine assumptions about the liquidity and trading spreads of securities have been seriously challenged. There have been major events in mutual funds industries throughout the world, where fund management companies have struggled to deliver on expectations – their own and those of their clients. Few asset classes, if any, remain unaffected: equities and currencies, commodities and real estate and of course credit spreads have been afflicted, providing little respite for investors seeking a safe haven. An end to Money Market Funds’ resilience to credit cycles The trials of money market funds in the US illustrate the reverberations of the credit crisis. A number of funds have been caught with exposure to collateralised debt obligations and in significant number of cases managers have stepped in to shore up assets. In even more extreme cases, a few money market funds – after the demise of Lehman Brothers – were unable to maintain the one dollar per share net asset value and investors could only redeem at a discount. Thus ended a long record of money fund resilience to credit cycles. The US Government finally intervened to offer an emergency fund insurance program. In other markets, some funds have been unable to meet redemption requests and have suspended redemptions, undermining one of the basic promises of the funds industry: liquidity. For instance, in Australia, most mortgage funds have been forced to freeze their assets as investors redeemed units in a “flight to safety.” Structural problems in some parts of the wider funds management industry have also been exposed. For example, highly leveraged Real Estate Investment Trusts have fallen sharply and have failed to deliver to their investors’ expectations. Many hedge funds, too, have “blown up” and investors have finally acquired a more appropriate scepticism about the lack of transparency and high costs in the hedge fund sector, and are retreating. How will Industries Recover? Developed Industries vs. Developing Industries While well-developed fund markets have suffered from market declines and structural problems in securities markets, they are reasonably well placed to weather the storm. Such industries can be expected to see this as a severe but temporary setback. Many investors have experienced stock market declines before and have some appreciation for the cyclicality and long-term nature of investing. And further, the dominant role played by retirement savings programs in the industries – e.g. IRA and 401k plans in the US, superannuation in Australia – supports a long-term view and the long-term prospect for these industries. In developing economies, mutual funds sectors were expected to develop rapidly; high growth projections were underpinned by populations with rising incomes that were discovering mutual fund investing for the first time. For example, the Chinese mutual fund business had grown dramatically from about $45 billion in mid-2004 to $485 billion by mid 2007, before the stock market fell by some 70 percent. The Chinese mutual fund industry stood at assets of $250 billion in October 2008. Mutual fund markets in other developing countries have seen a similar, if less pronounced, pattern of strong growth followed by rapid decline. Not only have assets declined with the equities market but net cash inflows have gone from strongly positive to negative, as investors have headed for the perceived safety of bank deposits. Fledgling markets may flag The setback for developing markets may be quite severe. Investors disappointed with the early experience of mutual fund investing may take a while to return. Firms with a fledgling presence in the industry – perhaps with a reliance on one asset class – may be unable to sustain a long-term commitment to building the required brand and service capability. Investor education efforts may flag as firms and regulators lack the resources to continue programs to introduce investors to mutual funds. This may particularly be the case for developing economies that lack retirement savings programs. The severity of the current investment climate is a significant setback for industries which have not yet had the chance to develop asset-class diversification, nor a foundation in retirement planning, nor indeed their identity with investors. In more developed markets it’s about re-establishing trust Developed market mutual fund industries can expect to recover from the GFC eventually. The question is how successfully they will do so and whether the GFC will have fundamentally changed the market structure. It is conceivable that the problems of this experience will call into question the very model of the industry. The presumption has been that securities markets are of sufficient depth and liquidity, transparency, tolerable volatility, and that funds can function well as a substitute for raising capital through entities acting as principals (i.e. banks). Recent events appear to undermine this record. The US financial system failed in two critical tasks: those of risk management and capital allocation. And funds, which previously had represented an efficient way to raise and allocate capital, in some cases failed in their inherent understanding of the risks they bought into. Trust in the securities markets and the funds themselves must be restored for funds to regain their position in the intermediation of finance. The lessons and challenges There are many lessons for mutual fund industry participants and regulators in the current crisis. The industry’s foundation must be built on investor trust and that has been sorely tested by securities market results and some industry practices. Securities markets will always have risk and uncertainty. The challenge continues to be to build a mutual funds industry best suited to reward investors for taking those risks – and to reinstate investor trust.
CHINESE BANKERS DISCUSS ECONOMIC WOES WITH AUSTRALIAN COUNTERPARTSKen Waller is Director of the Melbourne APEC Finance Centre at Monash University
A roundtable meeting convened by MAFC in early October in Melbourne, under the auspices of the Australian Leadership Awards Program and financed by Ausaid, provided an opportunity for finance specialists representing policy, regulatory, academic and business from China and Australia to exchange views on the effects of global financial crisis on economic prospects and on financial systems in both countries. Discussions focused on economic adjustments necessitated by the crisis and on the impacts of liquidity constraints, credit, market and operational management issues for banks and regulators in handling risk and governance arrangements in the circumstances now confronting financial markets and systems. While exposure of Australian and Chinese banks to the sub-prime crisis was limited, all markets were impacted by the higher cost of funds and tightening liquidity. The shock to confidence globally is major. Financial turbulence has revealed shortcomings in credit and operational risk management practices that are not necessarily new or unknown risks, but rather they reflect long-standing lessons that should not have been forgotten by market practitioners. From saving to consumption Growth in China in 2008 is expected to be around two percentage points lower than in 2007. The fall in external demand for China’s exports arising from the global slow down will require a switch in growth via domestic investment and consumption if China is to maintain strong growth momentum. (Since the roundtable, China has announced a major domestic stimulus package). Changing China’s growth pattern is a major structural issue requiring some lowering of the savings rate in favour of consumption. Concerns about the recent rise in inflation in China persist although these are likely to have eased with the rapid fall in global energy prices. High food prices in China are part of the reason for a firming in monetary policy earlier in the year. While China’s financial sector was not initially affected by the sub-prime crisis, the yuan exchange rate has been subject to marked fluctuations after rapid appreciation earlier in the year. Changing sentiment arising from uncertainty as to how reserves have accumulated in light of a sharp fall in the trade account and the possible sharp withdrawal of reserves has seriously impacted on China’s equity market with values falling to a seven year low. The international crisis poses real concerns for the management of China’s foreign exchange reserves. China’s monetary authorities have a deep interest in USD stability over the period ahead and China will be concerned to be involved in international discussions on changes to the international payments and supervisory systems as a consequence of the fall out of the crisis. Separation of powers China’s banks are preparing for a slow down in domestic activity. Provisions for bad debts are being increased and there is more detailed monitoring of credit markets, particularly for lending in the real estate sector and to small and medium sized enterprises. Disclosure requirements have been tightened and financial innovation may well be placed on hold. In the period ahead, China is likely to continue to maintain the principle that there be a fundamental separation in the financial system between banking and capital market activities. There is concern with developments in western banking systems that activities of securitisation, origination and distribution have led to the elimination of firewalls between banks and capital markets. In Australia, financial system turbulence has led to higher funding costs, extremely limited activity in securitisation markets, a fall in equity markets and increased volatility, several high profile corporate failures and financial asset write downs. Growth is slowing. While banks did not have material exposure to the sub-prime crisis some non-bank institutions outside the formal banking system were seriously impacted. The situation has demanded close monitoring of financial institutions and the provision of system liquidity support. The government and regulators have introduced a range of measures to improve resilience to future financial sector shocks. Australia is implementing a number of recommendations made by the Financial Stability Forum’s report in April which focused on enhancing market resilience. Measures include in relation to liquidity and risk management, transparency and valuation, the role of credit rating agencies, cross-border regulatory coordination, dealing with stress in financial systems and flexibility in domestic market operations. International organisations are also proposing new measures for financial system supervisors. For example, under Basel ll enhanced capital requirements, banks are required to increase capital to cover exposure on trading books to structured financial products and to reduce risks in over the counter derivatives. The code of conduct for credit rating agencies is being revised. East Asia at the table The IMF and the World Bank are reviewing progress on the implementation of the FSF recommendations. Of particular concern to China is that its voice and those of other Asian economies be better reflected in any new international standards and processes that emerge in the aftermath of the current crisis. There is concern that Asia has been on the sidelines previously in the development of regulatory codes and practices, many of which have failed. Also of concern is the absence of an Asian regional credit rating system and the need to a credible regional rating system. Regulatory agencies in both China and Australia are closely involved in coordinating national approaches to enhanced financial system regulation and this has become more pronounced as a direct consequence of the impact of the global financial crisis. Exchanges between the regulators of both countries are increasingly occurring and highly regarded and seen by regulators on both sides as particularly important in ensuring smooth financial relationships between Australia and China.
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