Asian Banks Relatively Safe From CDO Contagion

Source : The Business Times, September 17, 2007

But they need to start building good business practices: expert

Small impact: Mr Dallara said that Asian investors have little exposure to sub-prime debt, are not facing a credit crunch and are backed by strong fundamentals

Financial contagion to Asian banks from the ongoing credit crunch emanating from the troubled US mortgage finance market is likely to be minimal, said Charles Dallara, managing director of the Institute of International Finance (IIF), a global association of financial services institutions based in Washington DC.

Speaking at a luncheon address to the IIF Asian CEO Summit last Friday, Mr Dallara pointed out that Asian banks have not been leaders in developing the collateralised debt obligations (CDOs) and other asset-backed instruments that have come under the most pressure.

Asian investors, including banks, are also at relatively early stages in investing in these instruments and therefore do not have a lot of exposure to them. Nor do Asian banks face the funding constraints currently affecting US and European banks.

Increasing defaults on US sub-prime mortgages in recent weeks have led to very tight liquidity conditions in the US and Europe. But this has not yet spread to Asia, although there has been some increased volatility in regional equity markets.

Mr Dallara pointed out that Asia's relative immunity might also stem from Asian economies being underpinned by strong fundamentals: the IIF forecasts that the region's economies (outside China and India) will grow at a healthy 5.1 per cent this year and 5.4 per cent in 2008.

In addition, Asia will be the biggest beneficiary of private capital flows to emerging markets, which the IIF projects will hit a record US$600 billion in 2007 and then US$570 billion the following year. Asian central banks also have record levels of reserves.

Talking about the strains in the global financial markets and what lies ahead, Mr Dallara said that funding in the commercial paper markets remains tight, although it has eased slightly of late. 'There's a huge amount of paper that needs to be rolled over,' he said. 'A lot of this is asset-backed, but not a lot is sub-prime.'

However, markets are cautious, he said. For many investors right now, 'the risk of getting into something they don't want is much greater than the benefits of higher returns'.

Earnings reports from US banks over the next few weeks will be crucial, he added. And markets will be watching what banks will reveal about valuations and/or losses in their loan portfolios. The more they reveal, the more reassured markets will be.

Down the road, Mr Dallara said that banks will need to take a 'hard look at some of their business practices'. He said that it is better for banks to be proactive about this and lead the process rather than wait for regulators to act, because that could mean fewer market-friendly regulations.

In particular, he said, banks should move to develop best practices in the following areas:

* Valuation practices: as far as possible, investment instruments should be 'marked to market'.

* Transparency: many investors have problems determining their exposures to CDOs, and the contents of CDOs.

* Credit ratings: credit assessments have been inadequate, especially in fixed income markets.

* Risk measurement and management: risk assessment has tended to happen in 'silos'. For example, while banks have a lot of expertise in credit risk, liquidity risk and market risks, there is little understanding of how risks migrate from one 'silo' to others. In reality, higher credit risk in the sub-prime sector quickly led to more liquidity risk.

Mr Dallara said that in future there would also be tighter official regulations over sub-prime lending as well as more oversight covering institutions such as mortgage lenders, many of whom operated outside the regulatory net. Financial institutions are also likely to face more lawsuits from investors, he said.