Have they really fixed financial instability?

Janet Yellen, in an unusually ebullient mood, suggested last month that there may not be a repeat of the Global Financial Crash (GFC) “in our lifetimes”. Given the extreme severity of the GFC, that is perhaps a fairly easy hurdle for the central bankers to clear. As a result of the co-ordinated efforts of Basel III and the Financial Stability Board under Mark Carney, the fault lines in the pre-2008 financial architecture have been largely repaired.

A more difficult question is whether the current phase of rising markets, which began in 2009, will end because financial asset prices implode under their own weight. There may not be a complete collapse of the entire financial system this time, but there could still be a very unpleasant bear market for investors to endure.

It is clear from the latest Fed minutes that “a few” members of the FOMC are more worried about the risk of financial instability than Chair Yellen, but even they seem reluctant to tighten monetary or prudential policy unless the Fed’s dual mandate, aimed at low inflation and maximum employment, is under threat.

While this is probably good news for asset prices in the near term, it is notable that the central banks are choosing to allow the remarkable build up in market risk, as evidenced in stretched asset valuations, to continue.

Recent central bank speeches and reports on financial stability [1] suggest that this can be tolerated because it is occurring without much associated growth in bank credit in the advanced economies, and because any setback to markets will not trigger an amplifying shock among banks and other financial institutions this time. Let’s hope they are right.

There is little room for debating that banks are vastly better capitalised, with much higher liquidity ratios than they were before the GFC. In the case of the Eurozone, large banks have been regulated for the first time in a unified structure controlled by the ECB. “Too big to fail” has been addressed, but not yet fully fixed. Steps have been taken to regulate and monitor over-the-counter derivative markets, though implementation has been painfully slow.

Shadow banking has been brought in from the shadows, with the liquidity mismatches in money market funds now largely solved (notably in the US). New potential problems, such as Fin Tech and the huge growth of the asset management industry, are under active consideration by global regulators.

In addition to these measures to increase the resilience of global financial architecture, the central banks have been working hard to design a new system of macro-prudential interventions that can be used instead of, or in addition to, higher interest rates to control the emergence of credit bubbles.

Capital and liquidity requirements can be increased if growth in bank credit is judged to be contributing to market excesses, notably in real estate. Direct controls over loan-to-value ratios can be imposed.

These prudential measures are still largely untested, and are fraught with difficulties, but they give policy makers many extra options that were not available before the GFC.

Regulators, like generals, are good at fighting the last war. The likelihood of another GFC developing out of a relatively small market shock, and then being amplified by a financial panic, has been greatly reduced.

The Federal Reserve is confident enough to have warned recently about potential problems in the markets for auto loans and student loans in the US, but then to have concluded that these problems will not become endemic to the entire system.

Similarly, the IMF has warned about excessive growth in credit to the US corporate sector, but the Fed thinks that most of the increase in credit is going to companies that have strong balance sheets and argues that the total outstanding amount of speculative-grade bonds and leveraged loans has edged down, especially in the oil sector. The Fed has also studied the provision of liquidity to the corporate bond market – an area of concern to investors – and has concluded that the market making function is adequately provided.

While the risk of a repeat of the GFC has been sharply reduced, there are clearly things to worry about. The BIS has been warning repeatedly about over-extended financial cycles in some of the smaller advanced economies, and in the emerging economies, including China. Their warnings before the GFC were perceptive, but overlooked.

Furthermore, there are signs that regulatory fatigue may be developing in those countries that were devastated by the GFC – especially in the US, where the Treasury Department under Steven Mnuchin seems determined to reverse a lot of the new regulatory controls over credit extension.

Richard Ramsden and colleagues at Goldman Sachs reckon that regulatory actions that can be taken without legislation in Congress could add up to $2 trillion to US banks’ capacity for credit extension in the next few years. Is this the right time of the economic cycle to be doing this?

Furthermore, while senior central bankers routinely say that “complacency must be avoided” and “we must be alert to new sources of risk”, these remarks tend to follow multiple pages of confident assertions that everything is fine. It is possible that this encourages risk taking in financial markets, which already seems elevated.

From where I sit, the main risk to financial stability at present stems not from financial architecture as such, but from the valuation of asset markets.

Term premia in government bond markets are abnormally low, and could rise sharply as monetary policy is normalised. Credit spreads are at all time lows in most markets. Equity risk premia, relative to bonds, are also at historical lows in many markets. Measures of volatility in financial markets, like the VIX, seem remarkably low, given the risk and uncertainty that is obvious in the global political system.

Central bankers acknowledge all of these issues, but they remain very reluctant to assign any specific role to financial stability in setting interest rates, and macro-prudential policy remains largely in the wings.

In the US, the dominant view in the Fed remains unchanged from the days of Chairmen Bernanke and Greenspan, who assigned no role to financial stability unless it threatened the attainment of the dual mandate on inflation and maximum employment. In the ECB, there is limited recognition of over-valued asset prices, and by far the main concern is to ensure that the banking sector is sufficiently robust to transmit the expansionary monetary impetus to the real economy [2].

Ironically, at the same time as the central banks have been assiduously fixing the plumbing of the financial system, they have been willing to allow market valuations to exceed historic norms by a wide distance. They seem to believe that the eventual outcome will not be too bad, provided that institutions are robust and provided that households and corporations are not exhibiting excessive amounts of borrowing, along with accompanying financial imbalances.

All of that seems true, at least in the US and the Eurozone. However, from an investor’s point of view, it is difficult to argue that the problem of financial stability has been “fixed” while danger continues to lurk in the shape of over-stretched asset pricing.



[1] Among recent central bank contributions, see remarks by Janet Yellen, Stanley Fischer, Mario Draghi, Mark Carney, Jaime Caruana and Claudio Borio. Among official financial stability reports, see those published recently by the BIS, the Federal Reserve, the ECB, the Bank of England and the IMF.

[2] A partial exception is the recognition from many FOMC members that the Fed needs to take into account wider “monetary conditions” in the US, implying that they may need to react to the behaviour of equity prices, credit spreads, the bond term premium and the dollar. When, as now, these wider monetary conditions are preventing the Fed from restraining the economy, even when interest rates are rising, that presents a prima facie case for increasing interest rates more rapidly. But even then, there would be no intent to target asset prices in themselves. Asset markets would simply be an intermediary step on the way to attaining the dual mandate.

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