MAS Official Casts Light On Two Market Risks

Source : The Business Times, October 24, 2007

Deputy MD also calls on banks to update their stress test scenarios

THE recent credit crisis has put the spotlight on off-balance-sheet exposures and regulatory liquidity requirements, said Ong Chong Tee, the Monetary Authority of Singapore's (MAS) deputy managing director.

Both financial institutions and regulators have to give more attention to off- balance-sheet exposures. - Ong Chong Tee

Two financial innovations most often cited as the culprits which caused the credit markets to seize up - risky assets packaged into collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) - are held as off-balance-sheet items by financial institutions.

This has led to no transparency on their holdings.

Mr Ong said SIVs allow banks to gain exposure to risky assets such as US sub-prime mortgages which were the initial trigger for the crisis through contingent arrangements that minimise capital charges. As off-balance-sheet items, banks did not have to set aside capital for these assets.

'CDOs and SIVs therefore helped to spread the exposures and losses from sub-prime. But they also did something else - they made the financial system a lot more opaque and a lot harder to determine who owns what risks,' he said.

Mr Ong was speaking at a derivatives conference yesterday.

Related Link - http://tinyurl.com/37w83k
Mr Ong's speech

'In mid-August, when the Libor (London interbank offer rate) market was malfunctioning, I had asked a senior banker why banks are not lending to each other. His reply was simple - uncertainty. As we know, the flip side to that uncertainty is the fall in confidence.'

'Banks are uncertain about their own balance sheets and they are uncertain about other banks' balance sheets. At the crux of this uncertainty is their inability to value their own derivatives positions and to estimate the probability that their contingent liabilities may be called,' said Mr Ong.

The recent crisis has surfaced many issues that regulators and financial institutions will need to give attention to so that financial innovation can continue on solid foundations of robust risk assessment and management, he said.

Mr Ong highlighted two issues.

'First, it is clear that both financial institutions and regulators have to give more attention to off-balance-sheet exposures, whether they arise from contingent liquidity lines, implicit or explicit credit enhancement and support, or exposures that could come back on balance sheet for reputation considerations,' he said.

Second, the recent events highlighted the importance of liquidity risk management and regulation, said Mr Ong.

'In the past months, we have seen a stark demonstration and perhaps timely reminder, that market liquidity risk and funding liquidity risk can be interlinked. Liquidity evaporated across a range of credit markets and wholesale money markets, and where it was still available, spreads had shot up considerably,' said Mr Ong.

'These events reinforced the fundamental importance of regulatory liquidity requirements, alongside regulatory capital or solvency requirements.'

Mr Ong called on banks to update their stress test scenarios with elements of the recent events and simulate the impact not just on capital but also on their liquidity positions.