Standard Chartered Bank, Chairman
Bank of America, Corporate Treasurer
European Systemic Risk Board, Head of the ESRB Secretariat
Luiz Awazu Pereira da Silva
Bank for International Settlements, Deputy General Manager
Office of Financial Research, U.S. Department of Treasury, Deputy Director
1. Averting the risk of global fragmentation
1.1 The global economy in an uncertain environment
The Chair stated that the session deals with emerging risks in global and European financial markets, and that this may be a very relevant discussion, because of the complexity of the current times. Decision making in the context of so much uncertainty, including geopolitical uncertainty, economic uncertainty, and regulatory uncertainty, is not easy. Growth numbers from 2016 indicate that the year saw the lowest global growth since the global financial crisis. However, in the short term, growth is increasing in the United States. European growth is solid; no ‘hard landing’ is envisaged in China, and emerging markets in general are expected to perform better, so forecasts for global growth this year and next are increasingly positive. However, on a deeper level, a number of issues are still not right. Total factor productivity growth still remains very low, lower than in the pre crisis period, and a lot of debt remains, both on the public and the private side.
Many banks still struggle to adapt their business models to the new post crisis economic, regulatory and political realities. Most importantly, there are many concerns about whether the world is going to enter a phase of de globalisation, both of trade and finance, which would be very risky for a global economy. Despite this, however, financial markets are generally doing very well.
A representative of the public sector agreed that that phenomenon is ‘a bit paradoxical’. Better indicators are being seen in the areas of activity, inflation pick up, core, and equity prices. However, there is a disconnect between this optimism and the very high level of political uncertainty. Political risk has been mispriced.
1.2. Threats to trade, financial integration and international cooperation are increasing
According to this speaker, this disconnect includes issues like the complexity of Brexit, but most importantly, the potential consequences of a rise in protectionism and populism, and the trade tensions that might result. This is occurring in a difficult context, wherein there has been some rejection of trade and financial integration, and international cooperation. All of these have been very successful in creating growth in the global economy. Many emerging markets have tried protectionism and populism before, but it has never led to a positive outcome.
This speaker added that trade tensions could lead to ruptures to global value chains, for instance impacting large global corporations and retailers. This could have consequences for consumption and then investment eventually halting the recovery that is beginning to occur. There would be sudden stops of foreign direct investment and some deterioration of trade flows, which would affect financial stability, both globally and locally. There is a need to not be complacent about the current positive indicators.
In the area of financial sector risk, there is a different type of complacency: people tend to forget crises too quickly, and to think that removing regulation might boost creditor markets. Prudence remains necessary; good progress was made following the crisis on many aspects of the regulatory framework – capital, liquidity, and leverage – and these elements need to be implemented with a reasonable, positive mindset. Many studies from many international institutions for example the BIS have shown that stronger and better capitalised banks are the ones that benefit credit markets. There is a need to finalise regulatory reforms, and ensure that a robust, healthy financial sector is the best contributor to the real economy.
2. Adapting the business models of banks in the current uncertain economic and regulatory environment is challenging
A leader of the industry considered that their institution has spent the last few years implementing new regulation, and has learned a lot as a result. It welcomes the regulation much of which has been valuable. For example, the advent of stress testing, scenario planning and resolution planning have been significant positive developments and are important tools for treasurers. Also the increase in business involvement in properly managing risks, and escalation up to the board and back down through the organisation, has been incredibly positive.
The view taken by this speaker is that there is a need to bring the process of regulatory change to a conclusion, but it appears that it will continue. This is a challenge as the speaker’s institution works for its shareholders, investors, staff, and customers. In doing so, it needs to build optimisation routines, and optimising returns for banks in the present environment, with all of the complexity that has been created by regulation, is difficult... Overall, good progress has been made in the area of regulation, but work on supporting the business strategy remains to be done, as well as being able to support that business strategy with optimisation models that prove that the decisions that are made are the right decisions for stakeholders. They would like to reach the end of the regulatory change process.
Although it is still quite early, it appears, according to him that the current global forces are trending away from consistency and towards divergence. This speaker noted that they are operating in around 40 countries, and it is difficult to keep up to date with 40 varying regulatory regimes at the same time. Although banks are told to simplify their business models and structures, the regulators, central banks, and regulation creates increased complexity and cost in the system, which ultimately also affects returns and makes optimisation exercises more difficult.
3. US financial stability issues
A representative of a public authority explained that risks to the US are in the moderate or medium range, and has identified four broad categories. These are risks from low long term interest rates, and the risk taking behaviour that this encourages; risks that emanate from other countries and transmit to the US, particularly political and financial stresses originating in Europe; risks that exist in financial institutions, especially growing cyber security risks and the stability implications of these, which stem from the interconnectedness of financial firms; and finally data gaps. Without good data, it is hard to fully assess the risks that exist.
In relation to the risks from low long term interest rates, this representative of the public sector stated that when the Federal Reserve began its tightening phase, it was stricking the extent to which the media, press, and business analysts were talking as if the era of low interest rates had come to an end, and there was no longer any need to worry about these risks. At the present time, the Federal Funds Rate stands at 0.75% to 1%, and even with three tightenings over the course of 2017, it would only stand at 1.5% to 1.75%. That would be a historically low rate for any point in time, and certainly for this point in the business cycle. US long term rates also remain very low, and the term premium on the 10 year treasury is ‘almost non existent’. Although it is assumed that this will change as tightening continues, this official did not perceive much of an increase in that term premium during the last tightening cycle, and does not expect that it will necessarily increase this time, either.
As financial systems have become more globally interconnected, which will inevitably continue in the future, every time that political or financial stress occurs somewhere in the world, people seek safety through US treasuries. This has pushed down interest rates at the long end in the US, and the same thing has happened in this instance. This has benefited the US as the US did not need to take its policy rates into a negative range but it has also encouraged risk taking activity.
Although there has been discussion of the potential market reaction to a reduction in the asset holdings on the Federal Reserve’s balance sheet, the Federal Reserve has only been following the steps it outlined when it first started tightening. It has been very clear that it was going to raise the policy rate first and taper the balance sheet later, and that it probably will taper by no longer reinvesting the earnings and instead leting maturing bonds roll off the balance sheet gradually. From public data on the distribution by maturity of the Federal Reserve’s holdings, it is clear that not a lot will mature in the near term. Tightening will be a very gradual process, and the speaker does not expect it to have enough of an impact to offset the global pressures that encourage a ‘flight into treasuries’.
4. The structural vulnerabilities in several banking systems of the EU
The Chair noted that for many years, the European Union has succeeded in stabilising the economy and growing further, and has made significant steps towards banking union, but there remain a number of ‘hotspots’ for financial stability in the EU.
A representative of the public sector stated that Mahmood Pradhan’s statement the previous day had contained a lot of the points that they wanted to make. There is not much space for policy response in Europe in the event that things get worse, although this varies from country to country. Although Europe has returned to growth, the problem is ultimately not cyclical, although the cycle has made things worse. Some of the problems that Europe is confronted with are deeply structural, including the profitability of the banking sector in a situation where Europe is bank based. There are problems with banks’ business models, to which bankers do not know how to respond. Issues of asset quality will take a long time to solve; stock problems of this magnitude cannot be addressed very easily. Stakeholders, private and public, should act sooner rather than later.
The speaker noted that if Eurofi had been meeting in August 1913, a year before the beginning of the First World War, participants would have thought they were still living in the Belle Époque, when the world was completely globalised. De globalisation took only a few months, and regimes that had existed for centuries were destroyed in the course of months. The lesson of this is that disruption exists historically, which is a fact that, to a certain extent, has been forgotten. Although European integration has led some to believe that history is linear, and things will always go in the direction of closer cooperation worldwide, in actuality history does not have a direction, and uncertainty is endemic.
The damage to trade integration is real, but the problem goes deeper: the sense of mutual trust among people and social groups is coming into question in our polities, which is something that no financial institution can really address. The decision makers in the room will need to consider how they can have dialogue with a society that is changing.
The Chair observed that this speaker had spoken about asset quality problems – the pockets of non performing loans that exist within some EU banking systems – and structural issues related to banks’ struggles to regain profitability. However, one issue that is being widely debated is the excess capacity of the banking systems in the EU, which presents a formidable problem. This problem is similar to those that many economies faced in the 1970s and 1980s, related to traditional sectors like shipping and steel, which led to very significant industrial restructuring processes, high public expenditure, and large numbers of people losing their jobs. The Chair asked whether there is a plan to deal with the structural issues in the European banking system, particularly regarding excess capacity and the need to restructure, consolidate, and exit institutions.
The public authority representative replied that there is not a single plan for whether certain banks do or do not have a future, but there are rules and operational institutions. It is clear that banks that are continuatively not able to raise capital will need to be resolved at some stage. Banking is not the stable source of employment that it used to be until the 1990s; the number of banks will need to be reduced.
5. Will a sudden surge in yield to be a major risk?
A public authority representative stated that they are not expecting much of an increase in interest rates, but nevertheless, this is a risk. The search for yield in the US has led to elevated equity and commercial real estate prices, and a high – and rapidly growing – stock of US non financial corporate debt. Their institution has concerns about the risks that banks and insurers have taken on, and how mass investors might react to a surge in yields. Although there would be benefits from such a surge, including to retirees, their institution has been warning for some time about the duration risk that some institutions have taken on.
An industry representative added that it is hard to imagine rates increasing at a fast pace or to long run historical average levels without meaningful inflation. At the present time, a large number of structural factors are leading to low levels of inflation, including technology. Technology is having a major impact on jobs in the corporate sector: the entry level jobs that from the last few decades are disappearing. While structural shifts in energy and technology, e.g. robotics, will lead to significant job growth, it will likely be in different sectors and with different skill requirements. There is a lot more pressure on productivity in the economy in the sectors that used to support growth than is widely recognised which will likely persist until new sectors absorb and replace, which could cause rates to remain structurally low for some time.
Much attention is being paid to the last crisis, and what caused it. Through models, stress testing and infrastructure since the crisis, there is now very good capability to understand what will happen if rates, or property prices, increase or decrease. The industry representative feels that more focus should be paid to identifying the risks and understanding the shifts that would result in these variables changing.
Another panel member from the public sector added that it is necessary to manage expectations regarding markets in a very skilful manner; central banks have been doing this. However, monetary policy was never intended to be a substitute for productivity, or for growth enhancing policy, and these two processes need to occur simultaneously. Communication strategies need to be appropriate, which is happening in the US during their process of normalisation, but at the same time, conditions need to be created to enable the productivity and growth that will support an increase in activity.
6. Emerging economies need to adapt to a less supportive external environment
The Chair noted that there had not yet been much discussion of emerging markets. These could be significantly affected by headwinds coming from advanced economies; however, emerging markets have represented between 60% and 65% of global growth in the last few years, and have been a source of strength for the global economy.
A public authority representative stated that emerging markets will need to learn to operate in the new context, and will need to address some of their structural issues, including governance problems; a lot of them are doing so. Previously, because of the abundance of liquidity, many jurisdictions exhibited a tendency to get over indebted and benefit from very large inflows of easy money coming from advanced economies. This will need to be reversed in a way that does not create financial stress, or financial crisis. Emerging markets know from past crises how to deal with open economies, with what is called the ‘impossible trinity’. Now, they will need to learn how to disengage from this period of unconventional monetary policy and very easy money.
Summarising, the Chair stated that five themes had arisen from the panel session; the first is uncertainty. There has been an emphasis on political uncertainty, including geopolitical risk, but also the risk that politics might compromise the open, free trade and finance environment that has prevailed in the past. A potential de globalisation of free trade and finance would be a negative shock, and should be avoided; the ability of policy to address negative shocks is now much more limited than in the past, and political problems will need to be solved via political means.
The second theme is complacency, and if markets are too complacent, there may be a need to face the risk of market corrections.
The third theme is that many of the problems Europe faces are deeply embedded, requiring work that goes well beyond monetary policy, and achieving stronger growth will require a large number of structural reforms including on the financial side. Regarding the structural reforms in the banking area there will need to be coordination between the private sector, which ultimately takes the decisions, and the public sector, which needs to put together a ‘road map’; at present, there is not a clear road map in Europe.
The goal also needs to be a better global policy mix that allows for an exit, in a reasonable manner, from the very low interest rate environment.
The fourth issue is banks, which remain central to the concerns that exist. Many are experimenting with, or experiencing, very difficult transitions in their business models. There is now a three tier banking landscape: the first tier is the American banks that adapted best after the crisis, and were the first ones to accommodate their business models. The second is European banks, some of which are struggling, especially those located in very low growth economies, and the third is emerging market banks, which have continued to do better but still face some challenges.
The final issue is regulatory uncertainties. When the Chair was working in the public sector, they had thought that this issue was over emphasised, but they have changed his mind, particularly in the light of the changes brought in by the new administration in the US, which have introduced wholesale regulatory uncertainty. It is important that cooperation at the global level between different countries, which has been critical in making the financial system a safer place, is not undermined. There is a risk of endangering multilateralism, which would be a significant public bad news for the global economy, and the Chair expressed the hope that Basel continues to play its role of international coordination.