Regulators’ fears suggest global financial system not as stable as hoped

Concerns about global financial stability are growing amid slowing growth, rising oil prices and war in Ukraine and Palestine
Reports released by a series of top economists and regulators suggest many vulnerabilities remain despite efforts to curb systemic risks

Andrew Sheng

Published: 8:30pm, 20 Oct 2023

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The annual meetings of the World Bank and the International Monetary Fund (IMF) took place this month in Marrakech, Morocco. These meetings came at a time when key reports on the global economic and financial health were published.

The outlook for global growth has slowed amid weakness in the Chinese and European economies. And in addition to Russia’s invasion of Ukraine, war has broken out in the Gaza Strip, driving oil prices above US$90 per barrel.

How strong is the global financial system? Earlier this year, the problems experienced by Silicon Valley Bank (SVB) and Credit Suisse highlighted that all was not well. However, swift action by the US Federal Reserve and the Swiss authorities stemmed losses in confidence.

Today, despite prospects of interest rates being “higher for longer”, stock prices in Europe and the United States are about 10 to 12 per cent higher than the beginning of the year, while overall financial conditions have not been as stringent since monetary policy has eased somewhat.

The IMF’s Global Financial Stability Report, released earlier this month, warned that there are still vulnerabilities out there. This is not difficult to see since global real estate values are several times that of GDP, so a decline in property prices would affect asset wealth several times over. History has shown that banks are vulnerable to fluctuations in real estate since it forms 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 significantly higher than in early 2022, we will see the impact of “higher for longer” rates on real estate, especially commercial real estate, over the coming months.

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What was interesting was that the IMF has highlighted the impact of climate change on bank assets. One of the biggest challenges for the financial system is how to increase the current investment and funding needs for climate action. With rising natural disasters and violent conflict, the risks are rising, whereas the credit risk premiums do not necessarily reflect the underlying risks.

The Financial Stability Board (FSB), created after the 2008 financial crisis to coordinate global financial stability, also released its annual report this month. The report says its basic framework and speedy action following the SVB and Credit Suisse crises averted greater trouble, but vulnerabilities in the global financial system continue to be elevated, including major changes in the nature of the risks.

The FSB also highlighted climate-related vulnerabilities, as well as cyber risks. It is spending more time on monitoring the cryptocurrency market.

The key structural issue over global financial stability is that the world’s financial system comprised roughly US$486.6 trillion at the end of 2021, of which nonbank financial institutions (NBFIs) accounted for US$239.3 trillion, or 49.2 per cent of total financial assets. In other words, the world is roughly divided into half banking system assets, which are tightly regulated, and half NBFIs, which are lightly regulated. The FSB has tried to regulate NBFIs but was repulsed by powerful fund managers.

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The FSB’s real fear is that even though the banking system is tightly regulated, regulatory arbitrage could ensure that risks slip into the NBFI area. The run on money market funds during the 2013 “taper tantrum”, for example, underline central banks’ concern that problems in one sector could quickly spread to the banking system through contagion.

The Centre for Financial Stability, a non-profit think tank, has also just issued two important reports, one on bank supervision and regulation after SVB’s collapse, and one on the role of monetary and fiscal policies in the recent bank failures. Authored by a group of experts including former Federal Deposit Insurance Corporation chair Sheila Bair and economist Charles Goodhart, the team highlighted how groupthink and blind spots enabled SVB, Signature Bank and First Republic to fail.

Essentially, financial regulators failed to take into consideration the impact of rising interest rates on financial stability. Of course, all regulators would like to blame bank management for their lack of risk management. However, alert and experienced bank supervisors would have picked up the vulnerabilities of each failed bank, since the stock market was already signalling the weaknesses in SVB as early as November 2021.

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In hindsight, the extremely loose fiscal and monetary policies during the Covid-19 pandemic 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. So when the Fed raised interest rates rapidly, these banks became vulnerable.

In every crisis, there are elephants in the room which no one wants to mention. What worries me more about central bank monetary policy and financial stability is the way in which central banks have expanded their “safety net” wider and wider, including using their balance sheets to buy all kinds of assets.

For example, the Fed’s Bank Term Funding Programme is a lender-of-last-resort facility. It was created in March after SVB’s failure to lend to other banks that had big unrealised losses on their holdings of government bonds and were at risk of large-scale withdrawals of deposits.

The facility allows banks to exchange assets such as US Treasuries for cash at their full-face amount, regardless of the current market value. This means any losses will in the end be borne by the Fed, a bailout in effect if not in name.

Andrew Sheng is a former central banker who writes on global issues from an Asian perspective