Financial Sector Assessment

Analysis of FSIs for Securities Markets12

Securities markets are a major component of the financial sector in many countries. The capitalization of equity and bond markets in many industrialized countries, with savings in securities investments now exceeding savings in deposits, dwarfs the aggregate assets of the banking system. Exposures of households, corporations, and financial institutions to securities markets have increased substantially through investments in primary and secondary markets and through trading of risk in financial markets.

Well-developed securities markets offer an alternative source of intermediation, thus enhancing efficiency in the financial sector through competition. Well-functioning secu­rities markets provide a mechanism for the efficient valuation of assets and diversification of risks, create liquidity in financial claims, and efficiently allocate risks. Those markets help reduce the cost of capital, thereby raising economy-wide savings and investment. They also foster market discipline by providing incentives to corporations and financial institutions to use sound management and governance practices.

The stability of securities markets can be monitored using a range of quantitative indicators measuring depth, tightness, and resilience of markets.13 Most quantitative indi­cators focus on market liquidity because of the important role that liquid securities play in the balance sheets of financial institutions. Chapter 2 discusses the FSIs that measure market tightness (bid-ask spreads) and depth (market turnover, measured by gross average daily value of securities traded relative to the stock). The analysis of securities markets’ FSIs focuses on trends in those key variables and their determinants, including institu­tional factors and market structure (for an example of this type of analysis, see Wong and Fung 2002). The analysis also tries to assess resiliency of the market, which refers either to the speed with which price fluctuations resulting from trades are dissipated or to the speed with which imbalances in order flows are adjusted. Although there is no consensus yet on the appropriate measure for resiliency, one approach is to examine the speed of the restoration of normal market conditions (such as the bid-ask spread and order volume) after large trades. For more on the robustness of market liquidity under conditions of stress, see the discussion in section 3.3.2 and in appendix D. For an alternative approach to measuring soundness using market volatility as a financial soundness indicator, see Morales and Schumacher (2003).

Qualitative information drawn from standards assessments and other sources can also help assess stability of securities markets and can help interpret FSIs. The financial market

infrastructure (trading systems, payment systems, clearing and settlement systems, cen­tral bank operations and other systemic liquidity arrangements, and government foreign exchange reserve and debt management practices) affects financial institutions’ access to funding on the liabilities side of their balance sheets, their ability to liquidate positions on the asset side, and their exposure to systemic and operational risk in the clearing and settlement system. This information can be derived from assessments of the Organization of Securities Commissions (IOSCO) objectives and principles (see also chapter 5), the Committee on Payment Settlement Systems (CPSS)-IOSCO recommendations for secu­rities settlement systems (see also chapter 11), the CPSS core principles (see also chapter 11), and other sources such as event studies of past disturbances.

Information on market microstructures and the diversity of funding sources can be used to assess how well financial institutions can maintain access to funding in a crisis. The robustness of market liquidity depends on market microstructure, including whether markets are based on over-the-counter (OTC) or are exchange-based. For OTC markets, information on features affecting the capacity of market makers to make markets—for example, the number and capitalization of market makers and the size of the positions they take—could be useful. For exchanges, information on the trading systems, price transparency, margining rules, and capital committed by the exchange to support trad­ing could be used. For electronic trading systems, an indicator of liquidity is the standard transaction size. Also relevant is the extent to which closely related assets are traded on the different types of markets, which can substitute for one another if one market loses liquidity.

Information on the operation of the payment systems, the clearing and settlement systems, and the safety nets is also useful for interpreting FSIs for securities markets, and it provides insights into access to liquidity in a crisis. Indicators of payment system function­ing include the relative size of intraday, inter-bank exposures and daylight overdrafts, the length of settlement lags, the scope of loss-sharing arrangements, the level of reliance on collateral, and the particular markets that have real time gross settlement. All those indi­cators provide information on the potential credit and settlement risks in the payment system. The safety net and the central banks’ providing of liquidity to markets influence the extent to which banks and other market intermediaries can continue to access market liquidity in a crisis. Central bank operating procedures are a key determinant of money market liquidity and of the liquidity of other markets in longer-term paper, where position taking by dealers is supported by access to money markets.