OECD Journal: Financial Market Trends

The paper revises our previous USD 300 bn estimate for mortgage related losses to a range of USD 350-420 bn. In doing this the paper explicitly rejects the previous approach based on implied defaults from ABX pricing, because these prices are affected by illiquidity and extreme volatility; they will likely lead to misleading estimates of losses. Instead it builds a proper default model approach and allows for recovery of collateral via house sales over time. The paper separates out the losses due to commercial banks in the US, and goes on to look at the implied deleveraging required to meet capital standards. It could take 6-12 months for banks to offset losses via earnings alone, depending on Fed rate cuts and the dividend policy of banks. Since even more capital than this is required if banks were to expand their balance sheets, the paper looks at possibilities for capital injections from groups like sovereign wealth funds; and it also looks at a novel plan for the use of public money with an RTC-style approach and the issue of zero coupon bonds. Finally the paper looks at the issues of moral hazard, the likely size of the impact in Europe and Asia and non-bank corporate leverage.

One specific aspect of financial safety nets that has been in the spotlight of late is deposit insurance. As events in markets are still unfolding, it is too soon to draw definitive conclusions regarding the effects of the crisis and the adequacy of financial safety nets, including deposit insurance arrangements. Nonetheless, preliminary suggestions for policy are emerging and the article singles out four areas for special attention. First, as regards coverage, deposit insurance systems with low levels of coverage and/or partial insurance may not be effective in preventing bank runs. Second, for an explicit deposit insurance system to be effective, depositors need to understand the extent of and limits to existing deposit protection schemes. Third, when different institutions are entrusted with responsibilities that are relevant in a crisis situation, ex ante arrangements delimiting the scope of the different responsibilities as well as the respective powers may not be sufficient to ensure co-ordination that is as close and smooth as needed. Fourth, the question as to whether a specific bankruptcy regime for banks is needed remains an important issue.

Traditionally, bond insurers have provided guarantees of payments on municipal bonds, where defaults have been very limited. But since the late 1990s they have become increasingly involved as guarantors of elements of various structured financial products: in particular, the credit enhancements provided by these entities have played an important role in making securities based on sub-prime loans attractive to a wide range of investors. It is this trend change in their activity that has become the focal point in concerns about the health of these entities that have grown during the financial turbulence. The note identifies three policy issues that arise in the context of the current challenges facing these entities and it draws some preliminary findings. First, while concerns regarding the potential financial stability implications of further downgrades and/or failures of some of these companies have ebbed somewhat from their peaks in early 2008, the situation still bears monitoring. Second, current developments raise questions regarding the role of financial guarantors in specific financial market segments. In this context, there appears to be a public interest in the continued availability of guarantees on payments on municipal bonds. Private solutions seem to be forthcoming. Third, transparency of the financial guarantee insurance sector is limited. In this context, the performance of credit rating agencies in providing guidance for investors regarding the quality of the guarantees provided by financial guarantors appears to have been uneven.

Sovereign Wealth Funds (SWFs) are pools of assets owned and managed directly or indirectly by governments to achieve national objectives. These funds have raised concerns about: i) financial stability; ii) corporate governance and iii) political interference and protectionism. At the same time governments have formed other large pools of capital to finance public pension systems, i.e. Public Pension Reserve Funds (PPRFs). SWFs are set up to diversify and improve the return on foreign exchange reserves or commodity revenue, and to shield the domestic economy from fluctuations in commodity prices. PPRFs are set up to contribute to financing pay-as-you-go pension plans. The total of SWF pools is estimated at around USD 2.6 trillion in 2006/7, and is getting bigger rapidly, owing to current exchange rate policies and oil prices. The total amount for PPRFs is even larger, around USD 4.4 trillion in 2006/7, if the US Trust Fund is included (USD 2.2 trillion if excluded). SWFs and PPRFs share some characteristics, hence give rise to similar concerns. However, their objectives, investment strategies, sources of funding and transparency requirements differ. There is concern about strategic and political objectives of SWFs, and their impact on exchange rates and asset prices. But SWFs also provide mechanisms for breaking up concentrations of portfolios that increase risk. Enhancing governance and transparency of SWFs is important, but such considerations have to be weighed against commercial objectives.

Many countries around the world are partly prefunding their otherwise pay-as-you-go (PAYG) financed social security systems by establishing or further developing existing public pension reserve funds (PPRFs). Most OECD countries have put in place internal and external governance mechanisms and investment controls to ensure the sound management of these funds and better isolate them from undue political influence. These structures and mechanisms are in line with OECD standards of good pension fund governance and investment management. In particular, the requirements of accountability, suitability and transparency are broadly met by these reserve funds. However, some specific details of the funds’ governance and investment management could be improved in a few countries, such as enhancing the expertise in the funds’ governing boards and constraining discretionary interventions by government. Such reforms will ultimately raise the long-term investment performance of the funds and the solvency of social security systems.

This paper provides a description of the risk sharing features of pension plan design in selected OECD and non-OECD countries and how they correspond with the funding rules applied to pension funds. In addition to leading to a better understanding of differences in funding rules across countries with developed pension fund systems, the study considers the trend towards risk-based regulation. While the document does not enter the debate over the application of riskbased quantitative funding requirements to pension funds (as under Basel II or Solvency II), it identifies the risk factors that should be evaluated and considered in a comprehensive risk-based regulatory approach, whether prescriptive or principles-based. The three main risk factors identified are the nature of risks and the guarantees offered under different plans designs, the extent to which benefits are conditional and can be adjusted, and the extent to which contributions may be raised to cover any funding gap. In addition, the strength of the guarantee or covenant from the sponsoring employer(s) and of insolvency guarantee arrangements should be carefully assessed when designing funding requirements.

The objective of this study is to analyse what the quantitative funding requirements for pension funds with defined benefit plans would be, if Solvency II (based on the QIS 3 methodology) would be applied. Also possible extensions of the Solvency II methodology that seem necessary in order to reflect the specifics of pension funds will be discussed.

The Ninth OECD/World Bank/IMF Annual Global Bond Market Forum held on 22-23 May 2007 in Paris, France, highlighted that there has been very sharp growth in the use of derivative instruments in both mature and emerging market countries. The use of derivative instruments is helping public debt managers in their portfolio management operations and in supporting market development. Several institutional and structural impediments, however, remain toward the more active use of derivative products. Most developed market debt managers use derivative instruments for debt management purposes, while this is the case for only a handful of emerging markets. Several emerging markets, though, are taking steps towards developing the legal environment necessary to support derivative markets, and are addressing the challenges posed by illiquidity of the underlying cash market, deficiencies in prudential regulation, and restrictions on market participation.