Why the IMF Is Still Needed
At a time of great turmoil in the financial markets, what is the IMF’s analytical record?
The ongoing relevance of the IMF is coming under increasing scrutiny. In this Globalist Document, we present a March 2007 speech given by IMF Managing Director Rodrigo de Rato. At a time of great turmoil in the financial markets, it shows that the institution has its eyes on the ball.
I would mostly like to focus on a development which is of longer-term significance — the shift of financial risks from the banking and financial sectors to individuals and families.
The International Monetary Fund has been taking the lead in identifying strengths and vulnerabilities in the financial sector for many years, including through the launch of the Financial Sector Assessment Program in the late 1990s.
In our monitoring of the global economy, we are devoting more attention to the linkages between the financial sector and real economy.
Notwithstanding a global economy which is essentially strong and stable, we have seen considerable financial market turbulence lately. I believe that this reflects a reappraisal of risk in some important areas — economic risks in the United States, currency risks relating to the Yen carry trade — and more recently, risks in the U.S. mortgage market.
All have given rise to concern among investors. This concern is not in itself a bad thing. The most dangerous time in financial markets is when no one believes that they can lose. Recent movements in markets, despite their costs, will at least help to reduce any such complacency.
It is important that both investors and policymakers remain aware of economic and financial market risks. Among economic risks, oil supplies and prices remain vulnerable to geopolitical events.
There is also the risk, which may still be insufficiently appreciated, of a disorderly adjustment of global payments imbalances. The risks of this are relatively low, but the costs would be high.
There are also some developments in the financial markets which could have implications for the global economy. Let me mention a few of them:
• The first is now well-known: The problems in sub-prime mortgage markets in the United States and the risk that these could impact other markets or affect other sectors of the U.S. economy.
• Another development which I see as a source of risk is the recent increase in large private equity buyouts financed by a rising proportion of debt. The risk from a financial stability perspective is that if some of these deals were to turn sour, this may trigger a reappraisal of risk which would curtail market access more broadly for lower-rated corporate borrowers. This could adversely affect investment and growth prospects.
In responding to the economic and financial risks I have talked about, the International Monetary Fund can take the lead in some areas — especially in identifying and warning about key economic and financial risks. But leadership is also needed from other public sector agencies around the world, and from the private sector.
Such leadership will be very important in addressing the consequences of another development. This is the transfer of financial risks from financial institutions to a broad base of individuals.
Of course, there is a sense in which individuals have always been at risk, since as citizens and members of society their fortunes rise and fall with the economy.
But individuals are increasingly taking on financial risks much more directly. There are several ways in which this is happening:
• First, borrowing by individuals and households is much higher than in the past. Household financial obligations have grown with it. In the United States, they hit a record high of 19.4% of disposable income in the fourth quarter of 2006, despite the historically low interest-rate environment.
• Second, the role of banks has changed. Many banks no longer hold the bulk of the risk on the loans they make. Instead, banks transfer and diversify credit risks to other banks, insurance companies, mutual funds and hedge funds. A related development is the rapid growth of securitization of assets of all kinds: from mortgages to credit card loans, from corporate loans to aircraft leases.
• Third, the role of the financial intermediaries that are taking on the credit risk has changed. Where insurance companies and pension funds once held the risks themselves, the rise of non-guaranteed insurance savings products and the demise of defined benefit pension plans mean that individuals and households are becoming the ultimate holders of risk in the system in a much more direct way than in the past.
Weighing the situation
Each of these developments carries both benefits and risks. Let me take each in turn.
The broadening of credit brings with it opportunities that reach many more people than in the past. Many more people can finance a house, consumer durable purchases, a vacation, a business school education. This widens economic opportunities and makes it possible for individuals to balance their consumption better over the course of their lives.
The downside is that people sometimes take on too much debt. A recent movie, “Maxed Out,” graphically depicts the problem of credit card users being encouraged to take on substantial debt — and then penalized with late fees and other charges.
And the distress of financial markets in the face of the troubles in the sub-prime mortgage sector has its counterpart in hundreds of thousands of stories of individual distress.
A report by the Mortgage Bankers Association revealed that over one half percent of all home loans entered foreclosure in the fourth quarter of 2006, the highest in the 37-year history of the association’s survey. These developments suggest a need to take a fresh look at lenders’ underwriting standards and to educate borrowers in the risks that they are taking.
Turning to the position of savers, the changing role of banks has altered significantly the risks that other institutions and individuals face. The growth of markets in credit risk transfer instruments, and the structured credit products that go along with them, have allowed banks to make loans and then transfer and diversify the associated credit risk to other institutions.
The need to get a better picture of what is going on in these markets is increased because risks do not stay with financial intermediaries. Instead, there is a further shift in risk from insurers and pension funds to individuals and families.
In particular, the shift from defined benefit to defined contribution pension plans has placed more responsibility on households to manage investment portfolios and related risks.
Such schemes allow individuals more flexibility, but the price they pay is absorbing market and other credit risks and also longevity risk more directly.
Individuals now absorb risks as shareholders, investors in mutual funds, savers in non-guaranteed insurance savings products and members of defined contribution pension schemes.
One implication of this is that regulators and supervisors need to take the new reality and the new vulnerability of savers into account.
Another implication of the shift in the location of risk is that individuals and families need to take more responsibility for managing financial risks themselves. Therefore, they need to be educated consumers for financial information. Evidence from all around the world suggests that this is not happening at the moment.
Let me give a few examples:
• Only 30% of those surveyed in the United Kingdom can correctly calculate simple interest rates, and only 44% reported a basic knowledge of pensions in 2004.
• Nearly half of workers in the United States who have no savings still report themselves confident that they will have enough for retirement.
• A majority of French households consider themselves to be ill-equipped to choose an investment strategy.
• About two-thirds of Dutch households are unable to provide any estimate of their pension income on retirement.
In these circumstances, it is unfortunate that while consumers are more in need of financial advice than ever before, they remain reluctant to pay for it directly.
Perhaps this is because when it comes to financial advice, consumers doubt the impartiality of the advisors. Such doubts may be justified. Some financial advisors are paid to maximize sales or to push certain products.
However, there are actions that can be taken, and leadership is needed from all of the major players — governments, the private sector and regulatory authorities. Governments can encourage the teaching of financial literacy in schools and provide counseling for low-income groups.
They can also promote default options in pension schemes, which would give people a simple and reasonably conservative option for saving for retirement, while giving people who want to save at different rates or take more risks the option of doing so.
The private sector can provide more targeted products with transparent fee structures. Regulatory authorities can help to promote simple, easily understood investment products and menus which meet the needs of less sophisticated investors.
Also, as neutral — and hopefully trusted — sources of advice on financial matters, regulators can coordinate the efforts of other parties and can publicize the best sources of advice on financial planning.
The message is not that change should be resisted, but that all parties — governments, regulators, market participants and individuals — need to adapt to change.
They need to pay attention to the new risks in the financial system, and to the fact that more of these risks are falling directly on individuals and families. I am confident that if sufficient attention is paid to this issue, there is sufficient ingenuity to meet these challenges.
Editor’s note: Adapted from the author’s speech, Responding to Shifts in Financial Risk: The Need for Leadership, at the Wharton School, University of Pennsylvania, on March 23, 2007.