Published Date: 23 October 2007

Keynote Address By Mr. Ong Chong Tee, Deputy Managing Director, MAS, at International Swaps and Deriatives Association, Inc. Regional Conference 2007, Grand Hyatt Singapore, 23 October 2007

1   Mr Robert Pickel, ladies and gentlemen. Good morning and thank you for inviting me to this ISDA Regional Conference in Singapore. I had the privilege of speaking at this same conference in 2004, and some of you may recall that back then, the theme was on “Basel and Beyond”. Today, I would like to focus on something that probably epitomizes what you all do, this something called ‘financial innovation’.

2   Financial innovation has been described as the “bedrock of financial systems and lifeblood of efficient and responsive capital markets” [1]. One broad measure of the speed and extensiveness of financial innovation in the last decade can be seen from the remarkable growth in derivatives types and derivatives activities.  The Bank for International Settlement (BIS) began tracking OTC derivatives volumes from 1998. In 8 ½ years, the notional value of all OTC contracts has grown more than six-fold to US$415 trillion. The most impressive growth was seen in credit derivatives, which was negligible in ’98 that it did not warrant its own category then, but is now larger than equity and commodity derivatives combined. Behind these numbers is a trend where derivatives have become more complex, as well as embraced by a wider group of users. This spectacular growth, both in volume and pervasiveness, perhaps testify to the usefulness of derivatives, and by extension, the benefits they bring to the financial system and its participants. 

3   But there are also the views on the “darker side” of derivatives and more generally of financial innovation, as the recent credit market crisis revealed.  As monetary authorities, regulators and financial institutions continue to manage the fallout from the crisis, it may appear somewhat premature to look back at what happened, but nonetheless, allow me to use this occasion to reflect on some of the early lessons we can draw.

4   It may be useful to first, recap the background. The current credit crisis, at its core, represents a classic asset bubble. From 2000 through 2005, record US home price appreciation and aggressive cash-out refinancing resulted in abnormally low delinquencies across all mortgage products. This fueled strong growth in mortgages and investments into mortgage portfolios. In this environment, low underwriting standards were readily glossed over, even when pressures of rising interest rates and declining affordability started to hurt origination volumes.  As the housing market began to weaken in 2006, mortgages performance began to deteriorate rapidly – especially amongst sub-prime borrowers. Unable to pay these claims, most of the independent sub-prime originators went out of business. Other banks and investors who bought these loans also suffered losses.  Foreclosures rose, adding further pressure on house prices, which led to more delinquencies and so on.  If this has been the extent of the crisis, the damage would have been limited.  After all, the sub-prime segment is just US$1.4 trillion; making up only 15% of the total US mortgage market.  But that, as we all know, was not the end of the story.  

5   In July, the asset-backed commercial paper (ABCP) market seized up – not just in the US, but also much of Europe and Canada. This was followed by revelations of sub-prime related losses in banks; again, not confined to the US – but including financial institutions globally, although much less so in Asia. In early August, the Libor market and the swap market were also under stress.  Many central banks responded by injecting large amounts of funds into their respective banking systems. A number also expanded the usage of their discount windows. The Federal Reserve subsequently cut the discount rate by 50 basis points on August 17th followed by the Fed Funds Rate – also lowered by 50 basis points on September 18th. We are now all familiar with the problems that inflicted IKB and Northern Rock. So how and why did problems in a relatively small part of the US financial system have such widespread ramifications? Some have placed the blame squarely on the shoulders of financial innovation.

6   One characterization of this crisis is that it is akin to a “Minsky Moment” [2]. American economist Hyman Minsky’s model combines asset bubbles with credit cycles. In his view, periods of economic and financial stability will lead to a lowering of investors’ risk aversion and excess leverage. Investors start to borrow extensively and push asset prices excessively high. Financial innovation is an intractable component of this process.  

7   In this crisis, the two innovations that are often cited as the culprits that facilitated leveraging, are collateralized debt obligations (CDOs) and structured investment vehicles (SIVs). The former allow the credit risk of a portfolio of underlying exposures to be “tranched” into different segments, each with different risk and return characteristics. Thus, investors who could not invest in sub-prime and other risky assets can now do so by buying the senior tranches of CDOs.  The latter, SIVs, allow banks to gain exposure to these risky assets through contingent arrangements that minimize capital charges. CDOs and SIVs therefore helped to spread the exposures and losses from sub-prime. But they also did something else – they made the financial system a lot more opaque and a lot harder to determine who owns what risks. In mid-August, when the LIBOR market was mal-functioning, I had asked a senior banker why banks are not lending to each other. His reply was simple – uncertainty. As we know, the flip side to that uncertainty is the fall in confidence. Banks are uncertain about their own balance sheets and they are uncertain about other banks’ balance sheet. At the crux of this uncertainty is their inability to value their own derivatives positions and to estimate the probability that their contingent liabilities may be called. 

8   So the debate will continue, as to whether financial innovations are a boon or a bane. But in a sense, it will be academic, as the ‘DNA’ of financial markets is one of constant evolution and innovation, driven by competitive demands and profit pressures. In other words, the markets will continue to innovate; and problems that accompany financial innovations are perhaps a necessary outcome of risk discovery and risk re-calibration for sustainable growth. So what do all these mean in terms of the kind of responses to the prevailing financial stress?  Obviously, as ongoing developments in the major markets will suggest, the answer depends on one’s vantage point. Let me share some thoughts from my own perspectives.  As many of you are aware, the MAS has several distinct roles. We are a central bank – in charge of monetary policy and financial stability. We are also the financial regulator in Singapore. Finally, we also function as a market developer to work with financial institutions to facilitate a progressive and dynamic marketplace. 

9   First, perspectives as a central bank. A key objective of central banking is to ensure that the financial system functions smoothly. To the extent that CDOs and other innovations help spread credit risks over a wider investor base, the stability of the financial system is enhanced. I firmly believe that this still holds true.  Asian countries, which generally still have credit risks concentrated in the banking system, should continue to develop their capital markets. Nevertheless, this crisis does surface some interesting insights.  I will name three. Firstly, as the chain of risk distribution gets longer, some links become critically important to the system. A break of these critical links can potentially undermine the whole system.  Take for example, the use of collaterals for loans. Collaterals are typically valued in 2 ways: via mark-to-market, or mark-to-model using inputs from credit rating agencies.  Should one method fail, the other acts as a back-up. But if both fail, as is the case for the ABCP market, the market essentially breaks down. In maintaining financial stability, it has become ever more important for central banks to pay attention to the robustness of these critical links.

10   Secondly, the crisis also throws up the question of whether the instruments currently available for central banks to manage liquidity are adequate.  Most market operations and discount windows are very much designed for the core domestic banking system. As the financial system evolves, and capital markets take up a larger share of intermediation, these instruments may need to be broadened.  Thirdly, the crisis also showed how integrated the global financial system has become, than perhaps previously thought. A crisis in one market is now rapidly transmitted, through multiple channels to others.  In this regard, central banks may now need to consider instruments targeted not just their domestic markets but also foreign markets that their domestic institutions are operating in. A simple illustration would be the event in August, where a number of European banks had trouble obtaining US dollar funding when the CP market and the LIBOR ceased.  The FX swap market for Euro-Dollar was also dysfunctional.  Not surprisingly, the ECB decided on Euro- US dollar swap with the Fed, and then made available the dollars to European banks.        

11   Next, from the perspectives as a regulator. I do not think the recent events mean that financial regulators around the world will now view CDOs, or SIVs and conduits, with suspicion and distrust. Certainly, the underlying ‘technology’ behind these innovations will remain even if the CDO-squares and other complex derivatives may be put on the backburner. However, these derivatives have surfaced many issues that regulators and financial institutions alike will need to give attention to, so that financial innovation can continue on solid foundations of robust risk assessment and management. Some of these may have to be considered internationally, as a global effort, such as the role of ratings agencies in rating complex financial instruments; and accounting standards on consolidation of SPVs and mark-to-market and mark-to-model valuation of complex illiquid financial instruments. There are several issues that each supervisor will have to consider. I will briefly discuss two of these. First, it is clear that both financial institutions and regulators have to give more attention to off balance sheet exposures, whether they arise from contingent liquidity lines, implicit or explicit credit enhancement and support, or exposures that could come back on balance sheet for reputation considerations. Second, the recent events also highlighted the importance of liquidity risk management and regulation. In the past months, we have seen a stark demonstration and perhaps timely reminder, that market liquidity risk and funding liquidity risk can be interlinked. Liquidity evaporated across a range of credit markets and wholesale money markets, and where it was still available, spreads had shot up considerably. Banks reliant on securitization markets and wholesale funding have been particularly hard hit. These events reinforced the fundamental importance of regulatory liquidity requirements, alongside regulatory capital or solvency requirements. Financial institutions would do well to update their stress-test scenarios with elements of the recent events and simulate the impact not just on capital but also on their liquidity positions.  
12   Finally, let me add some brief points from the perspectives as a market developer. As I noted at the outset, financial innovation is a cornerstone to the development of the financial system. At its core, the primary purpose of the financial system is to allocate resources across entities, time and space. Financial innovations make this allocation more efficient by transcending impediments and behavioral distortions. Even the much maligned CDOs can serve a useful purpose, because they reduce the segmentation between credit markets. From this perspective, we should be open, if not even encourage, financial innovations that enhance and benefit the users and participants of the financial system. As Thomas Edison once said, “we shall have no better conditions in the future, if we are satisfied with all those which we have at present”.

13   The challenge then, is in the ability to harness the advantages of financial innovations while limiting its potential to destabilize the system. In addition to enhancing our central banking surveillance, monetary management and regulatory capacities, the MAS is also working closely with industry groups and partner institutions in two broad areas: (a) training of the financial talent pool in the new competencies to better understand and manage risks arising from new and more complex products; and (b) forging good industry practices and standards. I am pleased that associations like ISDA are playing an important role in surfacing issues, in standardizing legal documentation and so on. ISDA is also instrumental in championing for greater sharing of information and closer interaction among regulators, central banks, industry players and other trade associations.  Although credit derivatives transactions emerged in the late 80s or early 90s, a liquid market did not materialize until ISDA succeeded in standardizing documentation and providing legal certainty to these transactions.

14   To conclude, no one can really tell the complete extent of the recent financial market woes and how events will fully play out. Whatever the outcomes, one thing is sure - that the process of financial innovation will not be shackled. New products will emerge, and unfortunately, future crises cannot be ruled out either. Hopefully, the insights and lessons to be drawn from the recent market problems will not be forgotten.


[1] James Van Horne, Journal of Finance (1985)
[2] Hyman Minsky, Inflation, Recession and Economic Policy, 1982.