Speakers of the session
Gaston GelosInternational Monetary Fund, Assistant Director & Chief, Monetary and Macroprudential Policies Division
Denis BeauBanque de France, First Deputy Governor
Francesco MazzaferroEuropean Systemic Risk Board, Head of the ESRB Secretariat
Fernando RestoyBank for International Settlements, Chairman, Financial Stability Institute
Sylvain BroyerS&P Global Ratings, Chief Economist EMEA
Tomo IshikawaMitsubishi UFJ Financial Group, Head of Global Regulatory Affairs
Objectives of the sessionTen years have passed since the onset of the worst financial crisis since the Great Depression. Since then, historically low, even negative, interest rates and unprecedentedly large central bank balance sheets have provided important support for the global economy. Persistently low interest rates facilitated notably a deleveraging in those countries and sectors that were at the epicenter of the crisis – in particular, households and banking sectors in major advanced economies.
The last financial crisis was activated by rapid leveraging, particularly in the US but current global leveraging is moving faster than during the pre-crisis period. Financial conditions are indeed easier than before the Great Financial Crisis (GFC) when many investors, households, corporations and sovereigns were caught out in the rain with no umbrella. But, lasting very low interest rates have triggered a continuous rise in the global stock of debt, private and public. The world is now 12 per cent of GDP deeper than the previous peak in 2019. Experience shows that in a cyclical upswing, it is wise to raise interest rates in order to create margins to reduce them when the next recession comes.
The most damaging consequence of the crisis has probably been the postponement of the implementation of pro-growth structural reforms. Accommodative financial conditions cannot boost long-run growth potential. Implementing growth-friendly structural reforms will become harder as monetary accommodation is withdrawn. And there is no denying that the room for manoeuvre in terms of monetary and fiscal policies is narrower today than 10 years ago. In addition, the continued growth of nonbank finance requires further efforts to properly monitor risks and react appropriately through regulation and supervision.
The objective of this exchange of views is to identify the main vulnerabilities that may still affect the resilience of the global and EU financial systems and to assess whether the post crisis regulatory reforms are able to mitigate them compared with the pre-crisis situation. The sustainability of sovereign debts will not be covered in the session since this will be discussed in another session of the Bucharest Seminar.
Points of discussionWhat are the main vulnerabilities in the financial sector at the EU and global levels in the context of the normalization of monetary and fiscal policies: e.g. level of indebtedness, increasing protectionism, asset bubbles, leverage or liquidity issues, cyber and other risks associated with technological innovation, weak bank profitability in the euro area hampering bank intermediation capacity …?
What are the financial stability risks that are emerging as a result of the growing of non-bank financing? What are the main activities/products/players concerned?
Are existing regulations and supervisory arrangements sufficient to mitigate these vulnerabilities? What additional elements may be needed at the global, EU and national levels?
Background of the session
Considerable progress has been achieved over the last decade in strengthening the resilience of the financial systemThe post crisis financial reforms not least Basel III and the implementation of macro prudential frameworks have bolstered the financial system. Banks are now better capitalised, more resilient and better able to cope with financial instability. Other reforms, such as minimum requirements for global systemically important banks’ (G‑SIBs) total loss-absorbing capacity, enhanced bank resolution regimes and the central clearing of all standardised derivatives contracts, are being implemented in parallel.
Given how much levels of debt have risen over the decade, risks ahead are materialPersistent low funding costs and the search for yield environment can lead to the mispricing of risks and encourage excessive risk taking.
Lasting very low interest rates have triggered a continuous rise in the global stock of debt, private and public, in relation to GDP. Global debt is at historic highs. Total nonfinancial sector debt—borrowings by governments, nonfinancial companies, and households—has expanded at a much faster pace than the growth rate of the economy. As a result, total nonfinancial debt in countries with systemically important financial sectors stands in 2017 at $167 trillion, or over 250 percent of aggregate GDP compared with $113 trillion (210 percent of GDP) in 2008. The world is now 12 percent of GDP deeper in debt than at the previous peak in 2009.
The continuous accumulation of debt is worrying for at least two reasons. First, the higher the debt, the more sensitive the economy and financial valuations are to higher interest rates. This, in turn, makes it more difficult to raise them, favouring further debt accumulation – a kind of “debt trap”. Second, higher debt – private and public – narrows the room for policy manoeuvre to address any downturn. Experience shows that in a cyclical upward episode, it is wise to raise interest rates in order to create margins in order to reduce them when the next recession comes.
High sovereign, corporate and household debt levels in many parts of the world could expose the financial system to market losses, rising credit defaults and increased rollover risk as monetary conditions tighten. Indeed, over extended corporations can experience difficulties to service their debt when growth slow down.
Looking ahead, a sharp tightening of global financial conditions could be trigged by a further escalation of trade tensions or by a sudden shift in risk sentiment caused by rising geopolitical risks or policy uncertainty in major economies (For example, uncertainty about fiscal policy in some highly indebted euro area countries could damage confidence in financial markets).
The toolkit needs to keep pace with new developments in the non-bank financing areaNon-bank institutional asset managers, ranging from investment management companies to pension funds and insurers have grown strongly over the past decade. Their total assets are estimated at nearly $ 160 trillion according to the BIS, exceeding those of banks worldwide.
Certain asset management products and activities may create potential financial stability risks particularly in the area of liquidity and redemption, leverage, operational functions, securities lending, and resolvability and transition planning. Many of these risks are now mitigated by funds legislation notably in the EU.
Strong demand for high yield debt has been accompanied by lower covenant protection for lenders/investorsOver the past decade, we have seen, in the current intense search for yield, both nationally and internationally, often reflecting excessive risk-taking by investors. This has dramatically compressed risk premia, including term premia and credit risk premia in corporate and EME sovereign yields.
In a recent speech A. Carstens explained that In the United States and Europe, the volume of high-yield bonds and leveraged lending has picked up in recent years, and leveraged loans tend to have fewer covenants. One driver of this surge is the revival of collateralised loan obligations, which have grown steadily in volume.
According to the Financial Stability Board, roughly $1,4 trillion in institutional leveraged loans, or loans purchased by institutional investors other than syndicate banks, was estimated to be outstanding globally as of October 2018. This outstanding amount of leveraged loans is even higher if the amount that syndicate banks retain on their balance sheets is taken into account. Available data suggest non-banks purchase the vast majority of leveraged loans in the primary market and therefore have greater exposure to potentially adverse market developments.
Improving macroprudential tools for reducing systemic risk where financial vulnerabilities are building upMacroprudential frameworks have become a key new element of the post-crisis financial reforms designed to ensure financial stability. The development of a macroprudential perspective and the creation of macroprudential authorities in many countries has contributed to a more holistic assessment of risks in the financial system, including the nonbank sector. This is important because the Great Financial Crisis (GFC) and previous crises have shown that vulnerabilities may build up across the system even though individual institutions may look stable on a standalone basis.
Macroprudential instruments in the EU are for the most part aimed at the banking sector, given the predominance of bank-based finance at the time that the initial response to the global financial crisis was designed.
But more must to be done: to better identify risks and calibrate the tools; to develop tools that target the non-bank sector; and to implement mechanisms to address cross-country leakages. To deal effectively with systemic risks stemming from asset management funds and other institutional investors, close cooperation among the various authorities involved is crucial: central banks, bank regulators, insurance regulators and securities regulators.