Financial markets

Financial Market Trends No.93, November 2007


Please find below an overview of each of the articles published in the November 2007 issue of Financial Market Trends:

Highlights of Recent Trends in Financial Markets

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Structured Products: Implications for Financial Markets

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The paper looks at financial market innovation and how it has led to the rapid growth of structured products. It explores the mechanisms that come into play as assets inside these products (mortgages, credit card receivables, etc.) suffer losses. The potential size of such losses is currently concerning financial markets, and the paper looks at various ways to quantify the issues and where, going forward, pressures are most likely to arise. The problem is seen mainly as a stock adjustment issue (related to inventories of assets etc.) that is going to require time to set right. Time could well be more important than the cost of capital. The idea of a super fund to buy up unwanted assets should be seen in this context. The paper goes on to look at financial market implications, including the credit supply process, spreads, and the dollar.

Selected Questions Regarding Hedge Funds

There has been rapid growth in the share of assets under control of hedge funds over the past decade and, as a result, these entities have now become firmly entrenched in the universe of investment vehicles and, in turn, have themselves become important investors. Against this background, the OECD Committee on Financial Markets (CMF) discussed specific issues related to these entities on several occasions as part of its market surveillance activity. The present article provides a summary of selected aspects of recent CMF discussions related to hedge funds, focusing in particular on the responses to a questionnaire on hedge funds that was circulated prior to the CMF meeting in May 2007 to inform the discussion at that meeting. These various discussions suggested that a consensus is emerging that the most efficient way to address any policy concerns related to the activity of hedge funds is to focus on hedge fund investors and counterparties rather than on these entities themselves. Only a minority of countries are considering policy actions in a variety of areas, but many respondents seem to underline the need for public authorities to continue monitoring developments regarding hedge funds.

Institutional Investors and Corporate Governance in Latin America: Challenges, Promising Practices and Recommendations

This report addresses the issue of how some institutional investors in Latin America have been working to encourage better corporate governance in the companies in which they invest, and what further policy initiatives and practices may be desirable to enhance their role as a force for better governance in the region. It provides a brief overview of 1) consensus recommendations on the role of institutional investors as active and informed owners agreed by the Latin American Roundtable on Corporate Governance and in the OECD Principles of Corporate Governance; 2) the Latin American context, including market characteristics and the size and make-up of the institutional investor sector in each of the participating countries; 3) country legal and regulatory frameworks impacting on how Latin American institutional investors behave; 4) challenges and promising practices identified in separately developed country reports focusing on experience in Argentina, Brazil, Chile, Colombia, Mexico and Peru; 5) issues for further recommendations; and 6) conclusions.

Collective Pension Funds: International Evidence and Implications for China’s Enterprise Annuities Reform

Collective pension funds (CPFs) – occupational pension funds that cover the employees of more than one employer (enterprise) – have been operating in OECD countries for decades. Generally speaking, there are two models, i.e. closed pension funds, with membership restricted to a particular industry or group of industries, and open pension funds, open to all types of companies. The governance structure of such funds also operates in two ways – via an internal model (with trustees appointed by employers and employees) and an external model (with professional, commercial trustees). In this report, we first describe and analyse how CPFs are operated in selected OECD countries and non-OECD economies. Then, we review occupational pensions (or Enterprise Annuities – EA – in Chinese terminology) in general and CPFs in particular. Given the problems holding back the development of EA plans among small and medium-sized enterprises (SMEs) in China, and bearing in mind both China’s specific situations and international best practices, we propose a number of policy recommendations to promote the development of CPFs covering the SME sector. Our practical policy recommendations include: 1) industry funds with more open membership; 2) establishment of new purpose-built industry funds; 3) establishment of new regional EA administration centres acting as independent pension councils (trustees) for open pension funds; 4) in parallel to these policy initiatives in China, commercial trustees should be encouraged to establish CPFs targeting the SME sector.

Indian Financial System Reform: Selected Issues

India’s financial sector has become much more diversified, with capital markets playing an increasingly important role. These markets have been substantially deregulated and, recent changes notwithstanding, many restrictions on capital flows have been eased, especially with respect to equity inflows. As well, the health of the public banks, which initially had very weak balance sheets, has been restored. While India’s regulatory, supervisory and financial policy authorities have made progress, they are likely to face challenges related to several aspects characterising the country’s financial system, including its banking sector and its capital markets. Banks remain subject to government imposed constraints on their lending portfolios and the banking sector is still dominated by public institutions. Although the Indian government has intensified its efforts to develop corporate bond markets, the latter remain relatively underdeveloped. Equity markets, which have evolved considerably, have recently been characterised by substantial price increases, in part reflecting large foreign inflows. This development raises the question of sustainability of valuations under changing global monetary liquidity conditions and risk aversion. Different policy responses have been considered by Indian authorities. Representatives from these authorities expressed a reluctance to interfere with the market process. However, the recent decisions by policy authorities suggest that during the course of the ongoing deliberations by policy authorities, these considerations have been outweighed by concerns about the consequences of failing to constrain inflows. The decision by authorities to disallow issuance of “participatory notes” by foreign institutional investors has to be seen in this context.

Public Debt Management and the Evolving Market for (Ultra-)Long Government Bonds

The demand for long-dated bonds has increased, driven by stricter asset-liability matching regulations governing pension funds, new international accounting standards, as well as new risk-based regulations for insurance companies. In several countries, pension funds and insurance companies are important investors in long-dated bonds. Projections of rapidly ageing and longer-living populations in most OECD countries indicate that the demand for ultra-long paper is poised to grow further.

Governments in several OECD countries have responded to that demand, by starting or re-introducing the issuance of very long (20 to 30 years) and ultra-long (30 years and longer) bonds, provided that the issuance of those bonds is consistent with the cost-risk objectives of the minimisation of borrowing cost subject to a preferred level of risk. Consequently, there has been an increase in the supply of (ultra-)long bonds as a percentage of total bonds outstanding in many markets. An important consideration for issuers is that pension funds and insurance companies are to an important degree buy-and-hold investors. This may lead to illiquid markets in long-dated paper when the ongoing supply of (ultra-)long government bonds remains below a certain critical level, resulting in higher government borrowing costs than paper issued in liquid markets.   From a medium-term strategic issuers’ perspective, a liquid market in (ultra-)long bonds requires substantial and regular issues by government debt managers.

Changes in regulatory standards and the adoption of new international reporting standards have increased the focus on liability-driven investing by pension funds. The study concludes that it is likely that there will be some re-allocation of the assets of many pension funds and insurance companies toward (ultra-)long bonds. However, views differ as to the pace and magnitude of such a re-allocation.


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