Managing Global Finance and Risk

• Author: Garry J. Schinasi, Burkhard Drees, and William Lee
• Position: Chief of the Capital Markets and Financial Studies Division in the IMF's Research Department/Senior Economist in the Capital Markets and Financial Studies Division in the IMF's Research Department/Deputy Division Chief in the Capital Markets and Financial Studies Division in the IMF's Research Department

The turbulence that swept through financial markets in the fall of 1998 was a wake-up call. It revealed that risk-management practices and supervisory and regulatory frameworks did not fully take account of the changing nature of private financial risk-taking, market dynamics, and systemic risk.

Russia's unilateral debt restructuring in August 1998 and the subsequent ruble devaluation sent shock waves through mature financial markets. Many investors experienced dramatic losses. One of the world's largest hedge funds, Long-Term Capital Management (LTCM), found itself near collapse in September 1998-setting off a chain reaction of further losses for financial market participants. Even though the U.S. authorities facilitated a private rescue of the fund, markets continued to be uneasy, causing a pullback in lending and raising the specter of a credit crunch.

The turbulence uncovered weaknesses in the international financial system and called into question the adequacy of existing defenses against systemic risk in light of changes that have transformed the world of finance. First, market discipline may have been undermined by the existence of financial safety nets such as deposit insurance and lenders of last resort, and many financial institutions may now be considered too important to fail. Second, modern risk-management practices-such as marking to market, margin calls, dynamic hedging, and frequent portfolio rebalancing to meet internal and regulatory capital requirements-allow institutions to make rapid adjustments in response to new information and reappraisals of risk. When such adjustments are made by large institutions with international operations, spillovers may occur between seemingly unrelated markets. Third, the growing use of off-balance-sheet transactions has made it easier for institutions to leverage their capital positions. During economic booms, the ability to leverage may encourage institutions to undertake activities that turn out to be unprofitable and unsustainable once markets change direction-as was the case with LTCM-and high leverage levels magnify the consequences of negative shocks.

Private financial institutions and public policymakers face a complex challenge. They must find ways to limit and manage risk taking and curb the buildup of financial excesses that can lead to the virulent market dynamics witnessed last fall, but without sacrificing the efficiency-enhancing potential of innovative financial instruments and techniques. Of paramount importance in averting future turbulence and crises are improvements in financial disclosure and transparency; greater awareness and better coordination of private, market, and regulatory incentive structures; a better understanding of the changing nature of systemic risk; and the reduction of moral hazard.

Financial disclosure and transparency

Adequate, timely disclosure by financial institutions and transparency of their risk profiles are fundamental for effective market discipline and regulatory and supervisory oversight. However, accurate information about risk exposures may be difficult to obtain in an environment in which risks can be unbundled, repackaged, and embedded in securities. Risk managers can estimate the capital at risk based on risk-management models and stress tests. Although this provides some understanding of a firm's exposure and how well the firm's portfolio might perform outside historically based scenarios of market stress and turbulence, it may not be sufficient. The financial industry has begun to develop techniques for more accurately estimating potential future exposure and assessing the possible impact of systemic disturbances on capital at risk.

A financial institution's external stakeholders-investors, depositors, creditors, and counterparties-are also challenged by the lack of transparency. Often, the only information available to them about risky off-balance-sheet activity is in footnotes in the firm's annual report.

The lack of transparency gives rise to systemic concerns related to the concentration of exposures within specific markets and linkages across markets. Without adequate information, it is difficult for officials to know where in the international...