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SOURCE: International Monetary Fund/Rich Clabaugh–STAFF |
Amid recession jitters, world's financial system vulnerable
Despite regulations, global markets are at risk.
from the November 28, 2007 edition
Page 2 of 3
Either way, the current financial challenges have a strong element of déjà vu. During good times, credit comes easily and rising home prices help to minimize loan defaults by consumers. As the cycle peaks and then cools, banks begin to tighten credit, and some lenders get burned by a surge in delinquencies. That story has been repeated again in this new millennium.
But new forces have played important roles in this year's credit turmoil. Some economists say these forces also mean that at some point – not necessarily now – the financial industry could be hammered by an even bigger crisis, with more firms collapsing altogether.
These new forces include:
Complex investments. Financial firms wield ever more sophisticated financial tools. The so-called derivative security that IKB held, for example, was of a type that surged to popularity just in the past few years.
New institutions. Players such as hedge funds and buyout firms – known as private equity – represent a large and rising share of overall investment money. Hedge funds have done fairly well this year, but some were big buyers of investments tied to mortgage loans. Significantly, they are less regulated than traditional public companies – and less transparent, which means they're not monitored closely by regulators or central bankers.
Leverage. The growing use of debt, or leverage, by financial players magnifies the first two forces. An era of easy money has enabled more risk-taking built on borrowed funds. That can accentuate both the ups and downs of a cycle, raising the prospect of "fire sales" to cover losses during downturns.
Globalization. Linkage among nations is as important a trend in finance as in mining or manufacturing. Often, this means that "best practices" are spreading to more nations, and that large banks have spread their risks across a wider range of nations. But it also raises the possibility of worldwide ripple effects from financial shocks.
What all this means is that things can go very well for a long time and then, possibly, go very wrong.
"People can borrow greater amounts at cheaper rates than ever before, invest … and share risks with strangers from across the globe," Raghuram Rajan, a University of Chicago economist, wrote in a 2005 research paper titled "Has Financial Development Made the World Riskier?"
He agreed that financial innovation has bequeathed enormous benefits, but he explored the negative side effects. His conclusion: More participants in the economy are able to absorb risks today, yet "the financial risks that are being created by the system are indeed greater."
The risk of a catastrophic meltdown – involving the collapse of many Wall Street firms – remains very small, he concludes.
In fact, the world economy now has some shock absorbers that didn't exist before, economists say. Businesses have grown better at managing inventories. Central banks, by many accounts, have grown better at handling crises. And although emerging-nation markets remain the most volatile, many now have large currency reserves that they lacked during the so-called Asian contagion, a financial crisis in the late 1990s.
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