Bank for International Settlement releases September ’07 Quarterly Review

September 3 - The Bank for International Settlement (BIS) Quarterly Review released is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial activity. The second part presents five special feature articles: the first on evidence of carry trade activity; another on the covered bond market; a third on global and regional financial integration in emerging markets; a fourth on securitisation in Latin America; and a fifth on corporate financial restructuring in Asia.

Overview: credit retrenchment triggers liquidity squeeze
Concerns about exposures to US mortgages cast a dark shadow over global financial markets during the period from end-May to late August 2007, with deepening losses on mortgage-related products spilling over to markets for other risky assets.1 As uncertainty about the extent and distribution of these losses spread through the financial system, investors fled to safe havens and liquidity demand surged. This caused a pronounced squeeze across major financial markets, prompting central banks around the globe to inject large amounts of liquidity.

Triggered by declining confidence in the valuation of mortgage-related and structured credit products, spreads rose sharply across the credit universe, increasingly affecting higher-rated products and assets other than credit. The price of credit risk, a measure of investor appetite for credit market exposures, jumped upwards, suggesting that a large part of the ongoing repricing was due to changes in investor sentiment towards risk. Government bond yields plunged as investors fled risky assets and turned to the relative safety of government securities.

The downward pressure on bond yields also seemed to partially reflect a reassessment of risks to the growth outlook in the light of the deteriorating situation in the US housing market, and heightened fears of a credit crunch in the wake of the turmoil in credit markets.
Apart from the impact on bond yields, the combination of flight to safety flows and surging liquidity demand was evident from a sizeable drop in Treasury bill rates that occurred while interbank money market rates rose considerably.

Equity markets sold off under the weight of mounting losses from the repricing of credit risk, with housing-related and financial sector stocks underperforming the wider market. In line with sharply reduced appetite for risk, estimates of implied equity market risk tolerance dropped significantly. Foreign exchange markets also saw sharp increases in volatility, as carry trades were rapidly unwound. Emerging market equities and bonds, however, proved relatively resilient through most of the period, reflecting broadly favourable economic conditions.

Highlights of international banking and financial market activity
The latest BIS statistics on activity in exchange-traded derivatives markets, for the second quarter of 2007 (which predates the most recent episode of market turbulence), indicate that the combined turnover of interest rate, equity index and currency contracts increased only marginally from the first quarter. While rising valuations lifted turnover in derivatives on stock indices, this barely offset slightly weaker activity in the much larger interest rate segment. A modest increase in turnover on foreign exchange contracts masked rapid growth in derivatives on the Brazilian real (34%) and Canadian dollar (26%).

In the international debt securities market, issuance expanded significantly in the second quarter of 2007, fuelled by advances in both dollar- and yen-denominated securities. Private non-bank financial institutions accounted for nearly one half of global net issuance. Net issuance from the emerging economies of Latin America, Asia and Europe was strong; however, consistent with the secular shift towards non-government debt in emerging markets, borrowing by sovereigns remained subdued. Throughout the emerging markets, there was a surge in borrowing in currencies other than the US dollar, euro, sterling and yen.

In the international banking market, total cross-border claims expanded by $2.2 trillion in the first quarter of 2007, driving the annual growth rate to over 20% for the first time since 1987. The volume of net flows through the international banking system was extraordinary, with the largest net transfer of funds during the quarter being from residents of the United Kingdom to those of the United States, largely offset for the United States by net outflows to Caribbean offshore centres, Switzerland and the euro area. In emerging markets, substantial net inflows were registered for the first time in four years.

The surge in claims in the first quarter of 2007 was also evident in the BIS consolidated banking statistics, which track international banking activity from the creditor’s perspective. BIS reporting banks’ total foreign claims on an ultimate risk (UR) basis reached $25 trillion in the first quarter, up from $17 trillion two years ago. Along with greater credit, banks continued to extend guarantees and credit commitments to borrowers in emerging Europe; by contrast, reporting banks’ exposure to Latin America continued to decline on a relative basis.