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RESERVE BANK OF AUSTRALIA

Financial Stability Review – March 2008

The Global Financial Environment

The past six months have been the most difficult for much of the global financial system for many years. The system is having to deal simultaneously with a significant repricing of risk, a marked rise in uncertainty about the economic outlook and the strength of financial institutions, and an unwinding of some of the leverage that was built up during the preceding boom. The catalyst for the adjustment was deteriorating credit conditions in the US sub-prime mortgage market, but the effects have become pervasive since the turmoil began.

At the heart of the current adjustment is a repricing of many financial assets. This repricing stems from at least two inter-related factors. The first is an increase in risk aversion, with investors requiring more compensation for holding an asset with a given risk of default. And the second is that many assets are now simply seen to be more risky. These changes in attitude have led to very large declines in the prices of many financial assets, particularly structured credit products with exposure to US sub-prime mortgages. In some cases, the price declines have been exacerbated by the sale of assets required to unwind leveraged structures.

These price declines have come after a number of years in which there were concerns about the underpricing of risk and, in particular, the apparent willingness of investors to invest in highly leveraged structures. Clearly some adjustment in prices and the terms under which finance was available was required. Such changes, however, rarely occur smoothly, particularly after a long boom in both the real economy and the financial sector. Perhaps not surprisingly, the global financial system has moved quickly from a situation in which risk aversion was very low to one in which it is very high, and from one in which assets appeared to be priced for ‘perfection’, to one in which pricing often appears to be based on quite pessimistic scenarios. The changes have led investors to question a number of aspects of the financial system, including the sustainable level of spreads on a whole range of financial assets, and the long-term viability of a variety of financial structures and business models that had become commonplace over recent years.

There is a high degree of uncertainty in the current global environment that is serving to prolong the adjustment process. This has at least three inter-related dimensions. The first is the uncertainty about the health of financial institutions, mainly banks, but also, more recently, bond insurers. The second is uncertainty about the performance of various structured credit products, given their complex nature. And the third main source of uncertainty relates to the economic outlook, and particularly the prospects for the housing market in the United States.

Banks’ Liquidity and Funding Conditions

As noted in the previous Review, one of the main areas of concern in the initial phases of the turmoil related to banks’ liquidity, as banks were called upon to honour lines of credit they had offered to a range of structures that were having difficulty rolling over their existing liabilities. The need to provide this credit stemmed from problems in the asset-backed commercial paper (ABCP) market, which came under intense pressure early in the turmoil as investors shunned commercial paper backed by sub-prime mortgages, and eventually all types of ABCP. From a peak of about US$1.2 trillion last August, the value of ABCP outstanding in the United States fell by nearly 40 per cent, to a low of about US$750  billion in December, before stabilising in recent months (Graph 1). Spreads between 30-day ABCP and overnight indexed swap (OIS) rates in the United States, which had typically been very close to zero, reached 200 basis points at one point in December 2007, but have subsequently declined to around 70 basis points.

The dislocation in the ABCP market has resulted in a period of significant adjustment for the vehicles that are most reliant on this market for their funding, particularly conduits and structured investment vehicles (SIVs), which had been set up by some banks to finance assets off their balance sheets. Some of these vehicles had to draw on the back-up liquidity lines they had arranged with banks, while others were forced to sell assets to repay maturing ABCP. SIVs came under the most pressure as many did not have liquidity lines with banks, and some of them have defaulted. In an effort to avoid a ‘fire sale’ of assets, a consortium of international banks began working on plans in late 2007 to establish a large fund to support the SIVs. These plans eventually broke down however, with some of the sponsoring banks instead winding these vehicles down, including by bringing them on to their own balance sheets.

As noted in the previous Review, the concerns over the extent to which the banks ’ commitments would be drawn down, in addition to growing uncertainty about the likely scale and distribution of sub-prime related credit losses, contributed to banks hoarding liquidity, which led to a significant tightening of conditions in inter-bank and short-term money markets in August. This was most evident in the sharp widening of spreads between 3-month LIBOR and risk-free interest rates in a number of countries (Graph 2). Central banks responded to these tensions by injecting liquidity into their banking systems and, in some cases, broadening the range of assets they accepted in their market operations. In September, the US Federal Reserve also embarked on a series of interest rate cuts, which has so far seen the Federal funds rate reduced by a cumulative 3 percentage points, to its lowest level since early 2005.

While these actions saw inter-bank spreads fall partially back in September and October, they widened sharply again late in the year, following news of large credit write-downs by a number of global banks and increasing anxiety about banks’ year-end funding requirements. These renewed tensions prompted further liquidity injections, including a co-ordinated operation by a number of central banks. The US Federal Reserve, the European Central Bank and the Swiss National Bank also put in place reciprocal swap agreements, mainly to assist European banks experiencing difficulty accessing US dollar liquidity, while the Federal Reserve introduced a ‘term auction facility’ to provide liquidity against a wider range of collateral and to a broader range of counterparties than in its usual operations.

Together with the passing of year-end funding pressures, the various central bank operations contributed to a narrowing of inter-bank spreads in late December and January, but spreads have remained volatile and moved higher again in the period since, though generally not to the same extent as in the earlier episodes. Since mid March, the 3-month LIBOR to OIS spreads in the United States and Europe have fluctuated in a range of about 60 to 90 basis points, compared to an average of around 10 basis points in the period prior to August 2007. The persistent strains are prompting ongoing efforts by major central banks to supply liquidity, including through the introduction of new facilities, and through the expansion of existing facilities, making funds available to a wider range of market participants, for longer periods, and against a broader range of assets.

With liquidity pressures still evident in short-term funding markets, many longer-term funding markets are also experiencing difficulties. Issuance of residential mortgage-backed securities (RMBS) has declined sharply since the turmoil began, and spreads have widened significantly. In the United States, only US$67 billion of non-agency RMBS was issued in the fourth quarter of 2007, compared with a quarterly average of about US$200 billion over the past couple of years (Graph 3). Issuance of sub-prime RMBS has fallen particularly sharply, by about 90 per cent over the year to the December quarter 2007. The strains in RMBS markets have also been evident in a number of other countries, including Australia (see The Australian Financial System chapter). The markets for more complex structured credit products, such as collateralised debt obligations (CDOs), have also been under considerable pressure due to widespread investor distrust of these instruments. In the fourth quarter of 2007, there was just US$60 billion of CDOs issued in the United States, down from US$250 billion a year earlier. The decline in issuance has been particularly pronounced for structured finance CDOs, which includes CDOs composed of RMBS, other asset-backed securities, or other CDOs. Banks’ issuance of bonds in their own names has also declined since the turbulence began, though generally not to the same extent as structured products. Overall, spreads on all debt instruments have widened considerably, resulting in a sharp rise in the cost of funding for banks, which is being passed on to many borrowers.

The funding requirements of some banks are being added to by the difficulty they are having on-selling some of the leveraged buyout-related loans they had made last year; currently, banks are estimated to be sitting on about US$150–200 billion of such loans. Together with the general increase in credit spreads, this has prompted some banks to begin taking haircuts on these loans in order to sell them.

It was in this environment of tighter funding conditions that emerged last August that the UK bank Northern Rock became concerned about its liquidity position due to its relatively heavy reliance on wholesale funding markets, particularly securitisation. As a result, Northern Rock approached the Bank of England regarding emergency liquidity assistance in early September 2007. Despite there being no immediate solvency concerns, news that the bank had sought assistance from the Bank of England triggered a run on retail deposits, which was only halted when the UK Government provided a guarantee on Northern Rock’s deposits. In the ensuing months, the UK authorities sought a private buyer for the stricken bank, but with these attempts having failed, Northern Rock was brought under public ownership in February this year.

In mid March, the ongoing pressures also took their toll on a US investment bank, Bear Stearns, which suffered a significant deterioration in its liquidity position when growing solvency concerns precipitated a sharp withdrawal of funds. This prompted an injection of liquidity by the US Federal Reserve, through JPMorgan Chase, with JPMorgan Chase subsequently announcing its acquisition of Bear Stearns.

Credit Write-downs and Capital

While liquidity was one of the initial concerns, as the turmoil has continued, attention has also focused on underlying credit quality, particularly as some financial institutions began announcing substantial write-downs on their holdings of various structured credit instruments.

From the start of the current episode, it was widely recognised that the adjustment process would be aided by institutions being as transparent as possible about their sub-prime related credit exposures. A number of US and European institutions moved quickly in this regard, reporting significant write-downs in their third-quarter 2007 results. However, confidence has not been helped by some of these same institutions reporting further write-downs in their fourth-quarter results and subsequent earnings updates. The multiple announcements have created concerns that bad news is likely to be followed by further bad news, and the various announcements have not always revealed sufficient information for investors to assess whether the new valuations fully reflect current market conditions. The resulting uncertainty about the scale and distribution of further losses is hindering a return of confidence to the market. One development that would be likely to help confidence would be institutions announcing write-backs to previously announced valuation losses, but this still seems some way off.

In total, since the onset of the turmoil, the major global financial institutions have reported cumulative write-downs of about US$190 billion on their holdings of various credit instruments. In some cases, these write-downs have resulted in the banks recording overall losses in the most recent reporting period, and some have had their credit ratings downgraded. While the worst affected institutions have been the large global investment banks – for example, Merrill Lynch, Citigroup, and UBS have reported around US$70 billion of write-downs between them – a number of mid-tier banks in the United States, Europe and Japan, have also reported significant write-downs. In the United States, the write-downs have driven a significant reduction in the return on assets of deposit-taking institutions, to an annualised rate of about 0.2 per cent in the fourth quarter of 2007, compared with an average of about 1.2 per cent over the preceding decade. While this fall has been concentrated among the larger institutions, the average return on assets for smaller US banks also fell, by about one third in the fourth quarter of 2007 compared with the average of the past few years, consistent with a more generalised weakening of bank profitability. Elsewhere, the banking systems in most other major economies have remained quite profitable.

One positive aspect of the recent experience is that when banks have recorded very large losses, they have been able to raise new capital, albeit at a significant cost, leading to a substantial dilution of the interests of the existing shareholders. These capital raisings, including significant injections from Asian and Middle Eastern sovereign wealth funds, have allowed banks reporting losses to maintain, and in some cases increase, their capital ratios. Without these injections, the global financial system would have been in a much more difficult position. Notwithstanding this, there remains a risk that further large write-downs could make a substantial dent in banks’ capital. In some cases, capital ratios are also being strained by the banks bringing back on balance sheet assets formerly held in off-balance sheet vehicles, and by increased demand for funding from a range of businesses, some of which have been shut out of the capital markets. While most banking systems, in aggregate, remain reasonably well capitalised by the standards of the past, further deterioration in the economic outlook could put pressure on banks’ capital ratios, increasing the probability of a further tightening in the availability of finance. Furthermore, it is not clear to what extent sovereign wealth funds would be as forthcoming with additional capital if further significant losses were announced.

Reflecting the various difficulties being faced by banks, bank share prices have fallen considerably in all of the major economies (Graph 4). Prices are generally down around 30–40 per cent from their levels in mid 2007, compared with falls in overall markets over this period of about 15–25 per cent. The uncertainty about the health of banks has also contributed to a very sharp increase in their credit default swap premia, with banks in the United States among the worst affected (Graph 5).

While the health of banks has been the focus of much attention, another factor weighing on confidence recently has been the prospects for US ‘monoline’ bond insurers. As discussed in more detail in Box A, in recent years, these insurers have moved beyond their original business of insuring mainly municipal debt, to insuring structured credit products. With this insurance often taking the form of credit default swaps (CDS), these companies have recorded large mark-to-market losses, which has prompted credit rating agencies to either downgrade, or consider downgrading them. While some have been able to raise new capital, the general consensus in the market is that the industry is under-capitalised, which is prompting various ‘rescue’ efforts.

The downgrade of a monoline insurer raises the prospect of significant mark-to-market losses for investors, with banks estimated to have hedged about US$125 billion of their holdings of sub-prime related CDOs by entering into CDS with monolines. These contracts are subject to significant counterparty risk, because whereas collateral is normally posted by participants in over-the-counter CDS transactions, typically no collateral was posted if a monoline was the counterparty. Concerns over the health of monolines have led some banks to begin raising provisions or writing off their insurance exposures to these companies.

Another way banks may be affected by the downgrade of a monoline insurer is through the back-up liquidity lines they have provided to investment vehicles that had funded the purchase of long-term insured municipal bonds by issuing bonds able to be put back with the issuer on demand. (This is analogous to the maturity mismatch risk being faced by conduits and SIVs.) If the downgrade of a monoline creates funding difficulties for these vehicles, they may be forced to draw on their back-up liquidity lines, placing further pressure on banks’ liquidity.

US Mortgage and Housing Markets

As noted in the previous Review, it was the deterioration of conditions in the US sub-prime mortgage market that was the initial catalyst for the recent adjustment. As was widely expected, problems in this market have continued to worsen over the past six months. According to data from the Mortgage Bankers Association, by number of loans, the 30-day arrears rate on US sub-prime adjustable-rate mortgages rose from 17 per cent in June 2007 to 20 per cent in December 2007, which is about 5 percentage points above the peak of the previous cycle in 2002 (Graph 6). The equivalent arrears rate for fixed-rate sub-prime mortgages also picked up fairly sharply over the second half of 2007, to about 14 per cent, after being more contained during the preceding couple of years. While sub-prime mortgages represent about 13 per cent of all US housing loans outstanding, they accounted for more than half of the loans entering foreclosure in the fourth quarter of 2007. While much of the attention has been on the sub-prime market, the 30-day arrears rate on prime mortgages has also increased, though at about 3¼ per cent in December 2007, it is low relative to that on sub-prime loans. The increase in delinquency rates on US mortgages has contributed to a sharp rise in the number of foreclosures, which was up around 60 per cent over the year to the December quarter 2007.

Much of the increase in US mortgage defaults has been due to borrowers being unable to meet the higher loan repayments after their rates reset following the expiration of introductory discount periods, though this problem has been alleviated somewhat by the relaxation of US monetary policy. Recent falls in house prices have also contributed to mortgage defaults as many borrowers that took out loans with little or no downpayment now have negative equity. According to the S&P/Case-Shiller index, average house prices in the 20 large US cities covered by the index have fallen by about 10 per cent from their peak in mid 2006, with the pace of decline accelerating in the second half of 2007 (Graph 7).

In response to the problems in the US sub-prime mortgage market, a number of initiatives have either been introduced, or are being considered, to assist distressed borrowers. These include temporary freezes on interest rates for borrowers subject to resets and possible changes to bankruptcy laws to allow mortgages to be reduced to the market value of the house.

Lenders in the United States have tightened the availability of mortgage credit in response to the more difficult financial environment. The loan officer survey conducted by the US Federal Reserve in January 2008 showed the highest proportion of US banks tightening their lending standards for residential mortgages since the survey began in 1990 (Graph 8). This was most evident for sub-prime and other non-traditional mortgages, but even for prime mortgages, standards were reportedly tightened by more than half of the respondent banks over the three months to January 2008. The tightening of lending standards has been evident in a slowing of mortgage credit growth in the United States. From a peak of around 14 per cent in the first half of 2006, year-ended growth in mortgage credit in the United States slowed to about 7  per cent in December 2007.

A major factor determining how conditions in the US mortgage markets play out in the near future is likely to be the performance of the US housing market. The larger is the decline in house prices, the greater will be the number of foreclosures, and the larger will be the losses on RMBS and the structured instruments that have been developed based on these securities. The central scenario for many involves a further modest decline in house prices, with prices stabilising later in the year. In contrast, a more pessimistic scenario is one in which house prices continue to fall, leading to further difficulties for the financial system, which, in turn, lead to a significant reduction in credit supply, contributing to further downward pressure on house prices. The result could then be a self-reinforcing cycle, with increasing losses and very weak outcomes. Of course, it is possible that the US Federal Reserve would respond to such a weak scenario by further easing monetary policy.

The current market pricing of various mortgage-related structured credit instruments appears to be consistent with a very pessimistic scenario. For example, as discussed in more detail in Box B, the prices of the ABX.HE indices of credit default swaps on US sub-prime RMBS have declined significantly over the past year or so, even the prices of those indices that reference the highest-rated tranches. Current prices imply losses on the underlying RMBS – including AAA-rated tranches – many times greater than historical experience. While many financial institutions have used these indices to value their holdings of a wide variety of sub-prime related credit instruments, a number of market participants have questioned whether the large price falls accurately reflect the likely losses on the underlying mortgages.

Impact on Non-financial Businesses

Concern about the impact of the turmoil on non-financial businesses has primarily focused on the possibility of reduced availability of credit as well as the general uncertainty and pessimism regarding the macroeconomic outlook. Banks’ losses and funding difficulties have raised concerns about the emergence of a broad-based ‘credit crunch’, even though there is little sign as yet of slower growth in business credit in most major economies. While some tightening of lending standards is a welcome development given the problems that arose from lax lending standards in the sub-prime mortgage market, there is a risk that lending standards could swing too far in the opposite direction, restricting the availability of credit to creditworthy borrowers and thereby exacerbating any economic slowdown.

As with banks, non-financial companies in many countries have been affected by the tighter conditions in wholesale funding markets, including in Australia (see the chapter on Household and Business Balance Sheets ). Corporate bond issuance has fallen since the turmoil began, especially among lower-rated issuers, and spreads on corporate bonds of all ratings have widened to their highest levels since earlier this decade (Graph 9). For lower-rated companies in the United States, the rise in spreads has exceeded the reduction in government bond yields associated with the easing of monetary policy, resulting in an overall increase in the cost of debt. Similarly, spreads on CDS for both investment grade and sub-investment grade companies in the United States and Europe have risen sharply over the past six months, though the increases in spreads have tended to be smaller for non-financial companies than for equivalently rated financial institutions.

As businesses have faced difficulty tapping capital markets they have been turning to banks, placing additional pressure on banks’ liquidity and capital. Reflecting this, growth in business credit, which had already been quite strong in most major countries in recent years, tended to strengthen further in the second half of 2007 (Graph 10). While this has seen a generalised increase in business sector gearing, gearing is still low by historical standards in most major economies, and interest-servicing ratios are also generally lower than a decade ago. One exception is the United Kingdom, where business gearing and interest-servicing ratios have risen markedly in recent years, to above long-run averages.

The less receptive funding environment and tighter lending standards are likely to have a larger impact on companies that are more highly geared and/or reliant on short-term financing. Consistent with this, the value of leveraged buyouts (LBOs) fell sharply in the second half of 2007 (Graph 11). The difficulties in the LBO market have also been evident in the spreads on CDS indices referencing leveraged (high-yield) loans, which have nearly tripled since the middle of 2007.

Commercial property markets have also been showing some signs of weakness in a number of countries, particularly the United Kingdom and United States. Delinquency rates on commercial property loans in the United States rose over the course of 2007 and banks have been reporting tighter lending standards on these loans. Heightened concerns have been reflected in the deteriorating performance of indices that track CDS on US commercial mortgage-backed securities, even though there have been relatively few actual defaults on these securities. The Household and Business Balance Sheets chapter discusses developments in the Australian commercial property market.

So far, the higher cost of debt and weaker economic conditions have resulted in only a slight increase in Moody’s global speculative-grade corporate default rate from the 25-year low reached late last year. However, the rating agency is projecting a sharp increase in defaults, to over 5 per cent, over the next two years as the global economy slows and refinancing becomes more difficult, though this would still be well below the earlier cyclical peaks in this series in 2002 and 1991.

In addition to the poor credit outlook, strains have also been evident in weak equity markets, to a large extent reflecting the deterioration in the economic outlook in the United States and the associated downward revisions to company earnings (Graph 12). As noted earlier, financial institutions have accounted for a lot of the weakness in share prices, though even excluding financial stocks, share markets are noticeably below their earlier peaks. In the major industrialised countries, the broad share market indices have fallen by about 15–25 per cent since October 2007, with a particularly sharp sell-off experienced in the second half of January, and are now generally below their levels at the beginning of 2007. As with most other financial assets, measures of volatility in equity markets are elevated.

Macroeconomic Outlook

The adjustment in the global financial system is occurring after a number of years in which the world economy has grown faster than trend, although, as noted in the most recent Statement on Monetary Policy, the adjustment is prompting a weakening in the growth outlook. Reflecting this, Consensus forecasts of world GDP growth in 2008 have been revised down since the previous Review, to 4.2 per cent, with the Reserve Bank’s forecast for world growth somewhat weaker than this. While growth in the major developed economies is expected to slow to well below its average rate, the overall growth outlook is being underpinned by more favourable conditions in many developing economies, particularly China, India and the smaller east Asian economies, which are continuing to grow strongly.

In response to concerns about slower economic growth and the impact of the credit market turmoil, several central banks have eased monetary policy in the past six months, most notably the US Federal Reserve, with financial markets currently pricing in lower interest rates in the euro area, United Kingdom and the United States (Graph 13).

International Regulatory Response

The ongoing adjustments are attracting close attention from various national and international regulatory and supervisory bodies. This work is attempting to both diagnose the weaknesses that contributed to the recent events and formulate appropriate policy responses. A main co-ordinating body is a working group established by the Financial Stability Forum and comprising representatives from various national authorities, the chairs of international supervisory, regulatory and central bank bodies and representatives from the Bank for International Settlements and International Monetary Fund. This group issued an interim report in early February, with a final report due in April.

Views on the underlying causes of the turmoil and on the factors that amplified its effect have tended to coalesce around a few main areas. At a fundamental level, the episode can be seen to be the outcome of a prolonged period of unusually benign macroeconomic conditions and low interest rates that bred a perception that risk was low. The combination of solid economic growth and low interest rates supported rising asset prices, a willingness of investors to seek higher-yielding assets, and a preparedness to borrow to purchase both real and financial assets. At the same time, financial institutions engaged in ever more complex financial engineering to create the higher-yielding products that investors were seeking. Although these products had never been tested in a downturn, investors were apparently willing to buy them on the assumption that the benign conditions of recent years could continue.

A number of specific weaknesses also played a role in the build-up of exposures, including the following:

  • poor underwriting and some fraudulent practices in the US sub-prime mortgage market;
  • deficiencies in financial institutions’ risk management practices, particularly in relation to liquidity risks;
  • a lack of transparency and disclosure of risks in relation to complex structured credit products that contributed to shortcomings in the modelling and valuation of these instruments;
  • poor investor due diligence, including over-reliance on credit rating agencies and poor understanding of the nature of ratings;
  • poor performance of credit rating agencies in relation to assessing and disclosing the risks associated with structured credit instruments; and
  • various incentive distortions, including the incentives in the Basel I capital framework that appear to have encouraged some financial institutions to securitise assets for capital relief. There were also weak incentives for parties in the originate-and-distribute model to properly assess and monitor the creditworthiness of the nd borrowers.

While there is a range of policy responses being considered, attention has tended to focus on four main areas.

One of these is the shortcomings in the originate-and-distribute model, and in particular how to overcome the incentive problems that can arise when those originating loans do not bear the consequences of poor underwriting standards. Up until recently, one argument was that pressure from the investor side was sufficient, as investors would limit funding to originators with either poor disclosures or poor underwriting practices. Recent events, however, have largely discredited this argument. Many investors simply relied on the credit rating agencies to evaluate complex instruments and, in an environment in which risk was perceived to be low, investors were attracted to the modestly higher yield offered by these securities. This inadequate due diligence created an environment in which originators were able to easily package and distribute loans via securitisation, having only a weak incentive to assess and monitor the creditworthiness of the underlying borrowers.

The policy responses under discussion have focused on the need to improve the transparency of the securitisation market and the accountability of participants. There is a broad consensus that more information needs to be provided to investors, including about the underwriting standards for the underlying assets, and the performance of the assets after they have been originated. Already, there are signs that data providers are mobilising to address some of these gaps. In addition, there have been calls for greater standardisation and reduced complexity of structures, thereby making it easier for investors to assess risk, rather than to rely on credit rating agencies. Proposals to better align the incentives of credit originators have mostly centred on requiring them to retain some financial exposure to the products they securitise.

A second area of focus is the role of credit rating agencies. Here the concerns have mainly related to perceived inadequacies in the ratings of structured credit instruments and the (not unrelated) potential for conflicts of interest to arise from the fact that rating agencies are remunerated by the issuers of the securities they rate.

One of the problems highlighted by recent events is that many investors appeared to view a AAA rating assigned to a CDO the same as a AAA rating assigned to a conventional corporate bond, whereas the former was significantly more risky than the latter. Indeed, one interpretation of recent events is that some of the financial engineering over recent years was to take advantage of this misunderstanding, rather than to tailor products to the precise risk preferences of particular investors. There is now considerable pressure on rating agencies to provide greater disclosure about the assumptions and approach underlying their rating of structured credit instruments. The rating agencies themselves have taken some steps in this regard and have proposed introducing different rating scales for structured credit products than those used for conventional bonds, and possibly including an assessment of non-default factors such as liquidity risk. To help address the potential for conflicts of interest, there have also been suggestions that agencies should be prohibited from giving advice on the design of structured products they also rate.

A third area receiving close attention is the liquidity management of private banks and the supervisory approach towards liquidity risk management. It is now widely recognised that, over recent years, too little attention had been paid to liquidity risk, by both banks and supervisors, with much of the focus instead being on capital with the introduction of the Basel II capital framework. The recent turmoil has re-emphasised the importance of liquidity as a key determinant of the resilience of the banking system, and has also highlighted the linkages between funding liquidity risks and market liquidity risks. Some of the areas where there appears to be scope for improvement include: liquidity stress testing practices, to incorporate the implications of wider market disturbances, rather than just firm-specific disturbances; the management of liquidity risks arising from off-balance sheet activities and contingent commitments; and the information provided to supervisors and the market in relation to banks’ liquidity risks.

A fourth area being examined is liquidity provision by central banks. A number of central banks have changed the way that they conduct their market operations in an effort to ease persistent strains in their domestic money markets. Within the central banking community, there is an ongoing examination of a number of issues, including: the assets that the central bank is prepared to lend against; with whom it is prepared to deal; on what terms liquidity should be made available; and to what extent the arrangements for day-to-day liquidity operations can also be used for emergency liquidity assistance. On a related issue, in light of the United Kingdom’s experience with Northern Rock, policymakers in a range of countries are reconsidering their crisis management arrangements for dealing with a distressed financial institution (see the chapter on Developments in the Financial System Infrastructure for a discussion of these issues in Australia’s context).