OUR WORK - Managing Risks, Sustaining Growth
International Financial Markets: Subprime Crisis 20
Asia: Resilient So Far But There Are Risks 23
Enhanced Surveillance and Supervision 24
Money Markets: Staying Vigilant 24
Business Continuity and Crisis Management 25
FATF Mutual Evaluation Exercise 2007/2008 26
AML/CFT Notice to SVF Holders 26
External Validation Performed Between Other Ministries' Internal Audit Departments and MAS 26
Box Story 2 - Audit Committee Guidance Committee 27
Risk Management Guidelines for Insurance Companies 28
Consumer Protection (Fair Trading) Act - Inclusion of Financial Products and Services 28
Corporate Governance of Listed Companies 28


International Financial Markets: Subprime Crisis

Following an extended period of low financial markets volatility and strong economic growth, the fairly sanguine environment was disrupted in early 2007 by equity market sell-offs, one of the initial signs that the rise in risk-taking activity could not continue indefinitely without some re-pricing. The second half of 2007 saw an even more serious disruption in financial markets as the US subprime mortgage crisis unfolded (Chart 4).

Delinquencies on some vintages of subprime US housing loans rose to levels which caused losses on mortgage-backed securities (MBS) to materialise (Chart 5). These and a series of rating downgrades by rating agencies meant that financial institutions had to post substantial writedowns on their holdings of these securities or instruments linked to them such as asset-backed securities collateralised debt obligations (ABS CDOs). The loss of confidence in this class of assets quickly developed into wider concerns over the valuation of complex structured credit products in general. This led to a sharp rise in risk premia, and worsened liquidity conditions throughout structured-credit markets, especially the wider ABS markets.

The heightened risk aversion arising from the subprime fallout caused money markets in the advanced economies to seize up. Short-term funding for investments in CDOs dried up, reflecting concerns over the quality of the assets underlying asset-backed commercial papers (ABCP). As a result, banks were forced to bail out the conduits and special investment vehicles that were set up by them to invest in CDOs and other complex products using funds raised through ABCPs. In such an environment, the uncertainty large international banks faced over liquidity needs and counterparty risks caused major interbank markets (Chart 6) to experience considerable strain. This prompted major central banks to inject liquidity into the banking system repeatedly.

While concerns about the liquidity positions of financial institutions dominated the early months of the crisis, solvency issues arising from large write-downs and uncertainties over the size of eventual losses became more dominant towards the end of 2007 and into 2008. Credit Default Swap (CDS) spreads for large international banks widened substantially towards the end of 2007 and again in March - when renewed concerns over banks' and broker-dealers' access to funding emerged. Over the same period, doubts emerged over the adequacy of major monoline insurers' capital relative to the losses they might incur on cover written for structured-finance products. Several had their credit ratings downgraded by rating agencies. These led to sizeable mark-to-market losses for banks, and also caused strains in the municipal bond markets. In response, major international banks raised capital from their shareholders and other investors including sovereign wealth funds.

As the credit crisis persisted, major central banks and regulators have in response taken a combination of targeted and concerted actions to stabilise the markets. These include the US Federal Reserve, the Bank of England, the European Central Bank, the Bank of Canada and the Swiss National Bank. They have introduced a wide range of facilities to inject liquidity into the financial system. The US Federal Reserve in particular has also eased monetary policy by cutting the target Federal Funds Rate by 3.25 percentage points, with the policy rate now at 2%.

These measures, along with timely actions to limit the possible effects arising from distressed financial institutions, have helped to stabilise the markets. Credit spreads have narrowed significantly, and activity across different credit markets has recovered somewhat as at end- May 2008 (Chart 4). These measures appear to have helped change perceptions of systemic risk and brought about a pause in the vicious cycle of deterioration in financial markets. At the current juncture, while there are concerns that economic fundamentals are shifting as GDP growth is expected to slow, of late, there are some encouraging signs. Indeed, corporations including investment-grade firms in the US and Europe have seen CDS spreads narrowing substantially in recent months after widening in end 2007 and the early part of 2008 (Chart 7). Interbank rates in these economies have also narrowed although they remain at an elevated level relative to where they were prior to August 2007.

However, despite the improved market sentiment, confidence is still fragile and further market volatility is likely, particularly as the real economy continues to weaken with adverse effects on the financial sector. While delinquency rates on US subprime mortgage loans have continued to rise, declining property prices have now put the prime and near-prime segments under pressure as well, with delinquency rates for these loans increasing. More recently, there have been concerns over commercial real estate loans and commercial mortgage-backed securities (CMBS) as well as the effects of rising oil prices on inflation and the broader economy in the US.

In April 2008, the Financial Stability Forum made a number of recommendations for enhancing the resilience of markets and financial institutions. These include strengthening authorities' responsiveness to risks and prudential oversight of capital, liquidity and risk management; enhancing transparency and valuation in structured products and offbalance sheet vehicles; changing the role and uses of credit ratings to improve the quality of the rating process; and increasing the robustness for dealing with stress in the financial system through enhancements of operational frameworks and strengthening of cooperation among authorities. MAS will continue to work closely with other central banks and regulators to implement the measures in the context of our financial system. We will conduct close monitoring of developments in financial markets and step up surveillance of financial institutions in Singapore.

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