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October is the month for the Annual Meetings of the World Bank/IMF, held this year in Marrakesh in Morocco. It is also the time when key reports on global economic and financial health are published. Essentially, the growth outlook overall has slowed, with weaknesses in the Chinese and European economies, and as war has broken out in Gaza on top of Ukraine, oil prices are again on the up with Brent crude topping $90 per barrel. How strong is the global financial system? Earlier this year, the problems of Silicon Valley Bank (SVB) and Credit Suisse highlighted that all was not too well.
But swift action by the Fed and the Swiss authorities stemmed the loss in confidence. Today, despite prospects of interest rates being “higher for longer”, stock prices in Europe and the United States are about 10-12 per cent higher than at the beginning of the year, whilst overall financial conditions have not been as stringent since monetary policy has eased somewhat.
The IMF’s Global Financial Stability Report October 2023 warned that there are still vulnerabilities out there. This is not difficult to see since global real estate values are roughly three times GDP, so that a 10 per cent decline in real estate prices would affect asset wealth by 30 per cent of GDP. History has shown that banks are vulnerable to real estate prices since these comprise the bulk of collateral for bank credit. According to the IMF, “in the advanced economies, real house prices fell 8.4 per cent in the first quarter of 2023, whereas emerging markets saw a smaller decline of about 2.4 per cent.” With interest rates nearly 500 basis points higher than 2021, the lagged impact of “higher for longer” rates on real estate, especially commercial real estate, will surface over the coming months. The IMF has highlighted an even longer perspective by warning of the impact of climate warming on bank assets.
One of the biggest challenges for the financial system is how to provide funding for the current investment needs for climate action from roughly $2 trillion to $4 trillion annually. With rising natural disasters and violent conflict, the risks are rising, whereas current credit risk premia do not properly reflect the underlying risks. The Financial Stability Board (FSB), created post-2008 to coordinate global financial stability, also released its Annual Report this month. FSB thinks that its basic framework and speedy action in March 2023 arising from SVB and Credit Suisse averted greater trouble, but vulnerabilities in the global financial system remain elevated, aggravated by major changes in the nature of risks.
The FSB highlighted climate-related vulnerabilities, as well as cyber-risks. It is also spending more time on the cryptoasset market. The key structural issue over global financial stability is that the global financial system comprises roughly $486.6 trillion at the end of 2021, of which non-bank financial institutions (NBFIs) account for $239.3 trillion or 49.1 per cent of total financial assets. The financial world is roughly divided into half banking system assets, which are tightly regulated, and half NBFIs, which are lightly regulated. The FSB tried hard in the post-2008 crisis to regulate NBFIs and was repulsed by very powerful fund managers. FSB’s real fear is that sooner or later, regulatory arbitrage would shift system risks into the under-monitored NBFI area with hidden leverage.
The runs on money market funds in periods of tight liquidity, for example, are nightmares where central banks fear that problems in an underregulated sector can quickly spread through contagion to the banking system. The Center for Financial Stability, a non-profit think tank, has also just issued two important reports on “Supervision and Regulation after Silicon Valley Bank”, as well as “The Role of Monetary and Fiscal Policies in Recent Bank Failures”.
Authored by a group of authoritative experts, such as Sheila Bair, former Chairman of Federal Deposit Insurance Corporation (FDIC) and LSE Professor Charles Goodhart, the team highlighted how groupthink and blind spots enabled SVB, Signature Bank and First Republic to fail. Essentially, the financial regulators failed to take into consideration the impact of rising interest rates on financial stability. All regulators naturally like to blame bank managements for their lack of risk management.
But alert and experienced bank supervisors would have picked up the vulnerabilities of each failed bank, since the stock market was already signaling the weaknesses in SVB as early as November 2021. In hindsight, the extremely loose fiscal and monetary policies during the Covid period created conditions whereby the failed banks were running risks by buying long-term treasuries that had low credit risk, but high duration and interest rate risks. When the Fed raised rates rapidly, these banks keeled over.
In every crisis, there are elephants in the room which no one wants to talk about. What worries me more about central bank monetary policy and financial stability (coined macroprudential policies) is the way in which central banks have expanded their “safety net” wider and wider, including using their balance sheet to buy all kinds of assets. For example, the Fed’s Bank Term Funding Program (BTFP) is a lender of last resort facility created after the SVB failure in March 2023, to lend to other banks that had big unrealized losses on their holdings of government bonds and were consequently vulnerable to large-scale deposit withdrawals.
The facility allows banks to exchange assets such as U.S. Treasuries for cash at their fullface amount, regardless of their current market value. In essence, the crisis was resolved through the Fed underwriting mark-to-market losses from banks onto its books. In essence, the global financial system looks stable, because central banks have expanded their balance sheets to $44 trillion or 9.1 per cent of global financial assets, shifting more and more government and private debt onto their books, and some are already showing losses on a markedto-market basis.
If reserve currency governments continue to run unsustainable fiscal deficits, funded ultimately by unsustainable debt, propped up by central banks, who will ultimately pay for the losses? We are socializing private risks onto public books. The investor market is complacent about financial risks, because they are still picking up pennies before a coming roller-coaster. They assume that central banks will forever bail them out. When government fiscal discipline does not exist, and central bankers do not take away the punch bowl, expect forthcoming financial instability or inflation, or both.
(The writer, a former Central banker, writes on global affairs from an Asian perspective.) Special to ANN.