Very good.
Report by the Working Group of the Financial Stability Forum and the Committee on the Global Financial System
Exec summary:
This report explores the link between leverage and valuation in the light of the recent experience of market stress. Prior to the crisis, traditional balance sheet measures of leverage did not give an unambiguous signal of higher risk during the boom years of 2003–07. While balance sheet leverage increased at European banks and US investment banks, and for the household sector in many countries, there was not a widespread increase for other banks or the corporate sector.
Nevertheless, a break in the trend in leverage seems to have occurred around 2003–04 as leverage and risk started to build up in less visible ways, and this set the stage for the crisis:
• the leverage and risk embedded in structured credit products increased, making traditional measures of balance sheet leverage less meaningful;
• assets held in highly leveraged off-balance sheet vehicles increased dramatically;
• maturity mismatches, and exposure to funding liquidity risk, increased as off-balance sheet vehicles and some large financial institutions funded a growing amount of long-term assets with short-term liabilities in wholesale markets.
Since the crisis broke in mid-2007, part of this build-up of leverage and risk has reversed, at times with disruptive consequences.
Over a longer time period, and as a result of a range of market and regulatory developments, fair value measurement has come to be more widely used for financial reporting purposes. At the same time, mark-to-market valuation techniques have become more widely used for risk management purposes.
Although it was not well understood during the boom, it has now become clear that these two developments – the increase in leverage and risk during 2003–07 and the spread of market-sensitive valuation techniques – are related. While market practices related to market-sensitive valuation techniques have existed for some time, their growth appears to have created a risk to financial stability. In short, these market practices appear to have contributed to an increase in the procyclicality of leverage in the financial system.
This report discusses six market practices:
• Value-at-risk and other market-sensitive risk measures that did not capture “through-the-cycle” volatility.
• Triggers in debt or over-the-counter (OTC) derivative contracts that reduce a firm’s liquidity in times of stress when a trigger based on a market valuation or credit rating is breached.
• Strongly procyclical haircuts on financing transactions and initial margins on OTC derivatives, which have a similar effect of adding liquidity to the market in a boom and draining it in times of stress.
• Upfront recognition of profits on structured products where some risks were retained.
• Use of mark-to-market valuation practices even for assets where markets have become illiquid, thereby yielding valuations that seemed too low to some and highly uncertain to many, with adverse consequences for firms reporting such valuations.
• Carrying assets and their hedges at fair value as an alternative to hedge accounting.
The reports sets out a menu of policy options that could be considered to mitigate these procyclical mechanisms. These include quantitative limits on leverage, steps to support better measurement and pricing of risk through the cycle (in particular funding liquidity risk), and measures to mitigate procyclical effects that mark-to-market valuation may have on incentives and decision-making.
Looking ahead, the procyclical effects arising from the interplay between leverage and valuation need to be assessed from a macroprudential perspective. It appears desirable for regulators and supervisors to get a clear and comprehensive picture of aggregate leverage and liquidity and have the necessary tools to trigger enhanced surveillance if necessary. Suitably constructed leverage ratios may, both as indicators of potential excesses and safeguards against amplification mechanisms, play a role in a macroprudential framework. The proper pricing of funding liquidity risk in the system could be key in preventing a build-up of leverage and maturity mismatches in the future. Valuation and risk measurement methodologies, while keeping as close as possible to market inputs and best practices, should also avoid creating incentives for excessive risk-taking through underestimating the price of risk.