Financial crisis triggers first stress test

Customers queue to enter a branch of Northern Rock in Kingston, Surrey, September 17, 2007.

LONDON (Reuters) - The recent financial market turmoil, sparked by losses related to U.S. subprime mortgage securities, has imposed the first major stress test on the modern financial market system, Moody's Investors Service said.

A long overdue re-pricing of risk -- following five years of bullish sentiment and historically low credit spreads -- turned into financial panic due to untested financial innovation and a presumption of liquidity, which drives the highly leveraged system, the rating agency said in a report on Wednesday.

"The modern financial system over-relies on the presumption of liquidity; risk is increasingly difficult to localize; asset correlations increase in times of stress; and leverage changes the scale of market dynamics," Moody's said.

The 'weakest link' in the modern global financial system is that of confidence, with lessons to be learned from the latest financial crisis similar to those thrown up after the bailout of hedge fund Long-Term Capital Management in 1998, Moody's said.

Market psychology can change overnight, the agency warned.

Although central banks are able to help stabilize markets by injecting liquidity into the financial system, this summer's crisis has shown that it is far harder to buttress confidence in the broader non-bank financial system, it said.

The agency said one reason for that is that credit relationships are now more at arm's length.

Central banks are less able to influence the behaviour of significant market participants such as hedge funds, making it more difficult to reintroduce stability.

And the greater the loss of confidence, the harder it is to restore, and the greater the contagion throughout the market, Moody's said.

LIQUIDITY KEY TO STABILITY

The agency pointed to developments at British mortgage lender Northern Rock NRK.L, which last week said it had secured an emergency funding facility from the Bank of England due to problems raising short term funding in the wholesale market.

A loss of confidence has led customers to queue for days outside Northern Rock branches to withdraw savings, despite reassurances from the government that deposits are safe and that the company is solvent.

"Beyond providing 'liquidity' to deposit-taking institutions, the challenge is to ensure 'fluidity' throughout the system in order to ensure that systemically important non-bank financial institutions obtain vital irrigation," the agency said of the role of central banks.

In the face of a financial market disaster, central banks' longer-term objective of price stability will inevitably be subordinated to financial stability, it said.

The modern financial system is built on leverage, which is only possible with the presumption of liquidity, Moody's said.

"Panics remove that presumption, and it can only be restored by the authorities, who must ensure that systemically important bank and non-bank actors do not fail and trigger a systemic crisis."

TRANSPARENCY NEEDED

One of main consequences of this current crisis is likely to be greater pressure from both regulators and the market for more transparency of risky structured finance instruments.

Those include collateralised debt obligations and other structured investment vehicles, which have grown rapidly over the past few years and have plummeted in value.

"A way to look at the current crisis is to say that financial deepening and sophistication has outstripped the available information resources in the system, and when things turn sour, it aggravated the information assymetries," Moody's said.