International

An important factor at play in the financial markets during the past year has been the ongoing offloading of risk positions in financial instruments and leverage reduction among financial institutions. Increasing numbers of investment positions that require a high degree of borrowed capital have become untenable or unprofitable. This is because investors are demanding increasingly higher liquidity and other risk premiums, and the money market has dried up. This has consequences for the banks, as well as for other financial institutions, such as hedge funds. To illustrate the impact of leverage, the formula outlined below shows what happens when the required return on borrowed capital rises (i.e. the financing costs): the return on equity capital then declines by a factor that depends on the ratio of debt to equity. As long as the return on assets is higher than the required return on debt, an institution can crank up the return on its equity capital by operating on the basis of a high debt-to-equity ratio.

Offloading positions pushing prices down

Considerable leverage (D/E) can, however, have the opposite effect, if the financing costs rise sharply. This induces financial institutions to lower the risks on their balance sheets and decrease the debt ratio, by reducing debts and/or raising additional equity capital. Another way to improve the risk position and raise liquidity is by selling assets. However, when numerous market participants are trying to do the same thing at the same time, and in some cases are forced to do so, severe downward price pressure can be the result. This was especially evident during the past year in the sharp fall in prices of US mortgage backed securities. In other markets, too, we see the consequences of more cautious behaviour by the financial institutions. Banks have started to reduce proprietary trading activities and are less generous in financing hedge funds. There has also been a sharp fall in the popularity of what is known as carry trades, as a result of the volatility of currency exchange rates and dwindling interest rate spreads. With a carry-trade, investors are borrowing in the currency of a country where interest rates are low, and lending or buying assets in the currency of a country with high interest rates. The Japanese yen is an extreme example of this. Because of the drop in carry trades, the yen reached a value of 93 against the dollar in late October - its highest level in over thirteen years. The recent developments in the financial markets of a number of emerging economies, particularly in Europe, where we have seen a sharp sell-off, are another example of the consequences of risk reduction among market participants.

• Despite large-scale write-offs, de-leveraging will still feature strongly
  in 2009

During the past year, financial institutions have reported heavy losses and write-offs. According to Bloomberg data, by 26 November 2008 the banks had written off and incurred losses of more than $713 billion on account of the credit crisis. At the same time they had raised capital worth $766 billion. While most of the losses have been recorded in the US, European banks have also embarked on a path of recapitalisation, albeit in many cases with government support in the form of direct capital injections. In its most recent Global Financial Stability Report, the IMF estimates total losses for the banking sector to reach $725-$820 billion ($1,400 billion for the financial sector as a whole). Based on current data for write-offs, it might therefore be assumed that the worst is over. Nonetheless, caution is advised and the de-leveraging process will continue to dominate the market in 2009, for the reasons outlined below.

Firstly, much uncertainty continues to surround the impact of hedge funds. It is generally more difficult to exit from a hedge fund than from regular investment funds, which slows down the process of de-leveraging. On account of their unique reward structure, hedge fund managers have greater incentives to close down their funds. This can put renewed downward pressure on the prices of certain assets, such as credit bonds. Secondly, it has become apparent that banks have significantly expanded their credit lines to nonfinancial corporations over the past couple of years. Because of deteriorating conditions in the capital markets the bank's clients have increasingly drawn on these facilities. So banks have - more or less - been forced to expand credit. At the same time, it has become very hard to convert loans into securities and sell these on to investors. The confidence in the credit quality and marketability (liquidity) of such paper has been severely damaged by the US subprime crisis, to the extent that a market in private-label securities still barely exists. So the banks need to shoulder more risks due to a deterioration in market conditions. The result is even more pressure on the banks to raise extra capital. A third factor is that in future, the supervisors will place greater emphasis on improving solvency ratios. This means that capital that has vanished as a result of the credit crisis will not only have to be replaced, but that additional capital will be required to raise solvency ratios to a structurally higher level in the long term.

Clearly in 2009 we will still have to contend with very volatile markets and downward price pressure in various market segments (even if this may mean a certain amount of undervaluation). And financial institutions will have to further reduce their risk positions as well as tighten the criteria for new lending. Inevitably, there will be a negative impact on the economy. At the same time, we acknowledge that governments are ready and willing to intervene with proactive measures in order to bring about a stabilisation of financial markets and the financial sector. However, it is questionable whether further massive capital injections will be politically feasible. It may require supplementary measures on the budgetary front to stabilise economies and to prevent a vicious circle between negative developments on financial markets and the rest of the economy. The call for coordinated action as expressed by the G20 in early November is a step in the right direction. Well-designed fiscal measures would be preferable to extreme monetary provisions. After all, overly relaxed monetary policy was one of the catalysts of the current financial crisis.