Systemic Aspects of Recent Turbulence in Mature Markets

• Author: Garry Schinasi
• Position: Chief of the Capital Markets and Financial Studies Division in the IMF's Research Department

The recent turbulence in mature financial markets appeared out of proportion to the events that triggered it. This experience suggests that both private and public financial institutions should display a much greater awareness of potential financial vulnerabilities and disruptions.

UP UNTIL July 1998, the mature financial markets in Europe and the United States had largely avoided the spillovers from the Asian crisis and remained buoyant. Government bond yields continued to decline and prices in equity markets rose steadily. In mid-July, equity markets began to decline on poor corporate earnings reports and concerns over slowing U.S. economic growth. Interest rate spreads between high- and low-quality borrowers also began to widen in mature markets. This was followed in late August 1998 by a dramatic widening of spreads and severe turbulence in mature financial markets, driven by Russia's unilateral restructuring of GKOs (treasury bills), the withdrawal from other emerging markets, and the near collapse in mid-September 1998 of the highly leveraged hedge fund, Long-Term Capital Management (LTCM).

Dynamic adjustments in emerging markets necessarily entailed adjustments in mature markets, reflecting the latter's important role in financing and leveraging investments in Russia and other emerging markets. But such adjustments would normally be expected to occur relatively smoothly and without the kind of severe financial turbulence that occurred in September and October 1998 in some of the deepest and most liquid markets in the world.

However, the resulting financial turbulence in mature markets appeared out of proportion to the events that triggered it. The Russian restructuring led to large losses, changed perceptions of default and convertibility risk, and affected the balance of risks and returns in international portfolios. Because of the new financial calculus that resulted, internationally active financial institutions appear to have engaged in a wholesale reassessment and repricing of financial risk, accompanied by a rapid rebalancing and deleveraging of international portfolios, accented by risk avoidance, market illiquidity, and extreme price movements. Despite the apparent concentration of turbulence in U.S. markets, internationally active European and Japanese financial institutions were involved in similar leveraged risk taking, in some cases on a very large scale. The negative impact on asset values during the most turbulent subperiod-mid-September through mid-October-was severe enough to trigger fears of significant negative spillover effects on world economic growth.

This severe turbulence raises issues concerning private risk and portfolio management, banking supervision, financial market surveillance, and the operation of the international financial system. The key issue is how very large leveraged positions could build up across a large number of financial institutions to the point where systemic risk was raised to extraordinary levels.

Several features of international financial markets help explain why there was a reassessment and rebalancing of mature market portfolios, but do not explain the severity of mature market turbulence.

* Russia's unilateral debt restructuring challenged investor assumptions about sovereign risk and international support.

* Mature markets financed a significant share of emerging market exposures.

* Many diverse institutions-not only hedge funds-had similar risk exposures and became vulnerable to a widening of interest rate spreads.

* Risk-management models did not prevent vulnerabilities from building up, and portfolio management worsened their unwinding.

* A disorderly unwinding and deleveraging, if it had been allowed to continue to build momentum, would have posed systemic risks in international financial markets.

Impact of the Russian crisis

Why did the Russian crisis create more turbulence in mature markets than the Asian crisis? Despite the uniqueness of Russia and the prevailing perception that Russia was "too big to fail," for many market participants Russia's unilateral restructuring was a sudden and defining event, unlike the Asian crisis, which developed more slowly. It challenged fundamental assumptions about...