Address by Mr TT Mboweni, Governor of the South African Reserve Bank, at the Gordon Institute of Business Science on 28 May 2008 1 introduction The global financial landscape has changed dramatically over the past twelve months, with global financial markets experiencing a financial crisis of note in the history of the world economy. The impact has been severe, with some of the world’s largest and most credible financial institutions reporting large consecutive quarterly losses. By the end of March 2008, the market capitalisation of banks globally had declined by USD720 billion. These developments prompted the former US Fed Chairperson, Mr Alan Greenspan, to remark that "the current financial crisis in the US is likely to be judged as the most wrenching since the end of the Second World War." Financial market asset prices have also echoed these extremely distressed circumstances and volatile conditions, in some instances requiring unconventional responses by central banks and other international institutions. Recent events again put into full perspective the crucial role of central banks in times of turmoil. In particular, the dual responsibility of central banks to implement monetary policy as well as contributing to financial stability has become much more challenging. 2 Causes of the crisis The financial market turmoil, which started around July 2007, was initially triggered by huge losses on US sub-prime loans, disclosures of delinquencies and foreclosures by households, as well as a number of major hedge funds which reported substantial losses. Exceptionally benign macroeconomic and financial market conditions between 2004 and mid-2007, as reflected by robust economic growth and low inflation and interest rates, however, fostered an underlying search for yield over recent years. At the same time, decades of vigorous financial innovation facilitated a deepening of capital markets, easier access to credit by households and enterprises through a variety of new and complex instruments. In recent years, however, financial innovation has been increasingly associated with complacency in risk management. In particular, the lack of transparency of these complex products may have made it easier for investors to underestimate the risks they take on, as well as the under-pricing of risk in some key asset markets. In addition, with prudential regulation sometimes lagging behind financial innovation, some institutions may not have been sufficiently transparent about their exposures to complex structured financial products on and off their balance sheets. In these circumstances it is not surprising that the most recent Triennial Survey of the BIS showed that the credit derivatives market has witnessed substantial growth, from USD118 billion in 1998 to USD52 trillion in 2007. The main participants in credit derivatives, comprising about 80 per cent of the total market, are banks and hedge funds. The announcement of losses by hedge funds exposed to US sub-prime mortgages in mid-July 2007 triggered the reappraisal of asset prices, and excessive market volatility with a general flight to quality or less riskier assets. Credit risk evolved into liquidity risk and banks struggled to obtain funding as interbank liquidity dried up, causing sharp increases in money-market rates in the major financial centres of the world. 3. How deep and widespread? What began as a fairly contained deterioration in portions of the US sub-prime market has evolved into severe dislocations in broader credit and funding markets that now pose risks to the global macroeconomic outlook. In April 2008, the International Monetary Fund (IMF) estimated that declining US house prices and rising delinquencies on mortgage payments could lead to aggregate losses related to the residential mortgage market and related securities of about USD565 billion, including the expected deterioration of prime loans. Adding other categories of loans originated and securities issued in the US related to commercial real estate, consumer credit market
