BIS Quarterly Review December 2014 – media briefing

Not to be released before 12:00 noon Central European Time on Sunday 7 December 2014
Please note that the Special Features present the views of the authors and not
necessarily those of the BIS. When referring to the articles in your reports, please
attribute them to the authors and not to the BIS.
BIS Quarterly Review December 2014 – media briefing
On-the-record remarks by Mr Claudio Borio, Head of the Monetary & Economic
Department, and Mr Hyun Shin, Economic Adviser & Head of Research, 05 December
Claudio Borio
Once again, the financial market scene was far from uneventful during recent
months. Volatility spiked in mid-October. Stock prices fell sharply and credit spreads
soared. US Treasuries were exceptionally volatile, at least intra-day – even more
than at the height of the Lehman crisis. And yet, just a few days later, the previous
apparent calm had returned. Volatility in most asset classes had sunk back down to
the depths of the previous two years. And as benchmark sovereign yields sagged
once more, the valuation of riskier assets recovered at least part of the lost ground.
So, what is going on?
It is too early to say what exactly triggered these sharp, if brief, price swings. As we
speak, researchers and market regulators in the United States and elsewhere are
sifting through tons of data to understand every market heartbeat during those
turbulent hours on October the 15th. That said, some preliminary reflections are in
order. No doubt, one-sided market positioning played a role, as participants were
wrong-footed. But is there more to it?
It is, of course, possible to draw comfort from recent events. Those who do so stress
the speed of the rebound. At the same time, a more sobering interpretation is also
possible. To my mind, these events underline the fragility – dare I say growing
fragility? – hidden beneath the markets’ buoyancy. Small pieces of news can
generate outsize effects. This, in turn, can amplify mood swings. And it would be
imprudent to ignore that markets did not fully stabilise by themselves. Once again, on
the heels of the turbulence, major central banks made soothing statements,
suggesting that they might delay normalisation in light of evolving macroeconomic
conditions. Recent events, if anything, have highlighted once more the degree to
which markets are relying on central banks: the markets’ buoyancy hinges on central
banks’ every word and deed.
The highly abnormal is becoming uncomfortably normal. Central banks and markets
have been pushing benchmark sovereign yields to extraordinary lows – unimaginable
just a few years back. Three-year government bond yields are well below zero in
Germany, around zero in Japan and below 1 per cent in the United States. Moreover,
estimates of term premia are pointing south again, with some evolving firmly in
negative territory. And as all this is happening, global growth – in inflation-adjusted
terms – is close to historical averages. There is something vaguely troubling when
the unthinkable becomes routine.
Looking ahead, two major developments in the period under review are likely to leave
a profound imprint on the financial and macroeconomic scene.
The first concerns exchange rates. As macroeconomic conditions have diverged
across the key currency areas, so have the actual and expected monetary policy
stance. The ECB and the Bank of Japan have loosened policy and indicated that
more easing may well be in the offing; by contrast, the Federal Reserve has stopped
purchasing assets and has been hinting at an interest rate hike at some point in
2015. This has already triggered sizeable exchange rate shifts. The US dollar has
appreciated relative to the euro and the yen as well as more generally.
The second concerns the sharp drop in the oil price, alongside a milder one in that of
other commodities. In fact, the 40 per cent fall since June 2014 is the third largest in
the last fifty years, exceeded only by that following the Lehmann default and the
breakdown of the OPEC cartel in 1985. Part of the drop reflects demand factors, not
least softening growth in China. But much of it reflects unexpected increases in
supply. This is surely good news for the global economy. That said, there are bound
to be winners and losers, and the drop may disproportionately affect some regions of
the world, possibly compounding domestic vulnerabilities.
These developments will be especially important for emerging market economies.
The spike in market volatility in October did not centre on these countries, unlike at
the time of the taper tantrum in May last year and the subsequent market tensions in
January. But the outsize role that commodities and international currencies play there
makes them particularly sensitive to the shifting conditions. Commodity exporters
could face tough challenges, especially those at the later stages of strong credit and
property price booms and those that have eagerly tapped equally eager foreign bond
investors for foreign currency financing. Should the US dollar – the dominant
international currency – continue its ascent, this could expose currency and funding
mismatches, by raising debt burdens. The corresponding tightening of financial
conditions could only worsen once interest rates in the United States normalise.
Unfortunately, there are few hard numbers about the size and location of currency
mismatches. What we do know is that these mismatches can be substantial and that
incentives have been in place for quite some time to incur them. For instance, postcrisis, international banks have continued to increase their cross-border loans to
emerging market economies, which amounted to $3.1 trillion in mid-2014, mainly in
US dollars. And total international debt securities issued by nationals from these
economies stood at $2.6 trillion, of which three quarters was in dollars. A box in the
Highlights chapter of the Quarterly Review seeks to cast further light on this question,
by considering the securities issuance activities of foreign subsidiaries of nonfinancial corporations from emerging markets.
Against this backdrop, the post-crisis surge in cross-border bank lending to China
has been extraordinary. Since end-2012, the amount outstanding, mostly loans, has
more than doubled, to $1.1 trillion at end-June this year, making China the seventh
largest borrower worldwide. And Chinese nationals have borrowed more than
$360 billion through international debt securities, from both bank and non-bank
sources. Contrary to prevailing wisdom, any vulnerabilities in China could have
significant effects abroad, also through purely financial channels.
Let me now pass on to Hyun Shin, who will go into more detail about the special
features in this issue.
Hyun Shin
Let me take over and discuss the special feature articles in this issue of the BIS
Quarterly Review.
In the first article, my colleagues Bob McCauley and Tracy Chan take on one of the
perennial questions in international finance: namely, why so much of the world’s
foreign exchange reserves are held in US dollar-denominated assets. More than 60%
are held in US dollars, and that share has barely budged since the Bretton Woods
era of fixed exchange rates to the dollar even though the share of US output in the
world economy has declined to less than one quarter of global output.
Bob and Tracy explore to what extent the high dollar share can be explained by a
concern by reserve managers to maintain a stable value of their foreign exchange
reserves in local currency terms. The idea is that a country holds its FX reserves in
dollars if the local currency moves closely with the dollar. Bob and Tracy introduce
the notion of a “dollar-zone” of countries whose currencies are relatively stable
against the dollar, and they show that a country’s weight in the dollar zone explains
about two thirds of the variation across countries in the dollar share of their reserve
In the second article, Adonis Antoniades and Nikola Tarashev revisit the issue of the
risks associated with securitisation, which received a lot of attention during the
financial crisis. The practice of bundling loans and then slicing and dicing the claims
into tranches of different seniorities received particular attention. It turned out that
the mezzanine and senior tranches were much more risky than investors had
bargained for.
With signs of the beginnings of a revival of securitisation discussed briefly in the
Overview chapter, the question of the true risk of securitised claims is back on the
agenda, and this piece is well timed.
Adonis and Nikola show that no matter how simple the underlying loans are, the
slicing and dicing of claims into tranches of differing seniorities introduces a so-called
“cliff effect” into the mezzanine tranche. The idea is that total losses on the
securitised piece are highly sensitive to measurement error in the default risk of the
underlying claims. Since we cannot banish uncertainty completely, such sensitivity to
small errors in measurement means that calculating the appropriate amount of
capital as a buffer against loss is subject to large uncertainty. The problem is even
more severe when the securitised assets are sliced and diced once again into further
securitised assets through the practice of “securitisations squared”, which was
prevalent before the crisis.
The uncertainty about the risk assessment of mezzanine tranches means that any
calculation of the prudent regulatory bank capital held for these tranches should be
significantly higher than that for the underlying asset pool. By how much higher
depends on the nature of this pool.
Nikola is the author of another special feature in this Quarterly Review, this time with
Rungporn Roengpitya of the Bank of Thailand and Kostas Tsatsaronis of the BIS.
They use bank balance sheet data and a technique called “statistical clustering” to
classify banks into broad categories that share similar summary features of their
balance sheets. Using this technique, they identify three distinct bank business
models: retail-funded commercial banks, wholesale-funded commercial banks, and
capital markets oriented, or trading, banks.
Armed with this classification, the authors then investigate how well these banks
performed according to a number of yardsticks. During last decade, they find that
retail-funded commercial banks displayed the lowest variation in its return on equity,
while the wholesale-funded commercial bank was the most cost-efficient.
But they also find that business models are not set in stone. Banks can and do shift
their business model over time. In the years before the crisis, they moved mostly
from a retail-funded towards a wholesale-funded business model. But the trend
reversed in the years after the crisis, with wholesale-funded banks coming to rely
more on deposits.
The final special feature continues the recent string of studies from the BIS
examining the issuance of debt securities by non-financial corporations
headquartered in emerging market economies. The box in the Highlights chapter that
Claudio mentioned a moment ago also belongs to this line of research.
I was involved in this latest special feature, and together with Stefan Avdjiev and
Michael Chui, we ask how a non-financial company can issue bonds offshore and
send the money back to headquarters, and how such transactions might show up in
the balance of payments. We dig deep into the balance of payments to find three
Some of the money shows up foreign direct investment, or FDI for short. We often
associate FDI with greenfield investment or the acquisition of domestic firms by
foreigners. But FDI also includes the loans made by an offshore subsidiary to its
parent. For a number of emerging economies, we find that such flows are quite
large. Far from being stable or “good” flows, such loans would have more in common
with hot money that could be withdrawn if foreign creditors demand their money
A second channel is trade credit between companies that arises from delays in
paying invoices. Trade credit is typically quite small, but we show that it is large for
some countries.
A third channel is cross-border deposits in the domestic banking system. We try to
capture such deposits by combining the balance of payments data with the BIS
international banking statistics. The BIS data cover only the loans made by banks,
and so any difference between the two series should give an indication of the activity
of non-banks. These two series tracked each other reasonably closely until the
financial crisis, but the gap between them has subsequently widened dramatically,
indicating a pickup in external loan and deposit financing by non-banks. There is
even reason to believe that this comparison understates non-financial deposits in
emerging market economies because of reporting issues in the balance of payments.