How healthy is the global fi­nan­cial sys­tem?

Financial Nigeria Magazine - - Contents - By Mo­hamed A. El-Erian Mo­hamed A. El-Erian, Chief Eco­nomic Ad­viser at Al­lianz, the cor­po­rate par­ent of PIMCO where he served as CEO and co-Chief In­vest­ment Of­fi­cer, was Chair­man of US Pres­i­dent Barack Obama’s Global De­vel­op­ment Coun­cil. Copy­right: Project

In re­cent weeks, pol­i­cy­mak­ers on both sides of the At­lantic have af­firmed that the fi­nan­cial sys­tem is sound and sta­ble. The US Fed­eral Re­serve an­nounced in June that all US banks passed its lat­est an­nual stress test. And Fed Chair Janet Yellen has now sug­gested that we might not ex­pe­ri­ence an­other fi­nan­cial cri­sis “in our life­times.”

At the same time, the Fi­nan­cial Sta­bil­ity Board (FSB) – which mon­i­tors reg­u­la­tory prac­tices around the world to en­sure that they meet glob­ally-agreed stan­dards – has de­clared, in a let­ter to G20 lead­ers, that “toxic forms of shadow bank­ing” are be­ing elim­i­nated.

In short, on­go­ing measures to but­tress the global fi­nan­cial sys­tem have un­doubt­edly paid off, es­pe­cially when it comes to strength­en­ing cap­i­tal cush­ions and cleaning up bal­ance sheets in im­por­tant parts of the bank­ing sys­tem. The lat­est as­sur­ances from pol­i­cy­mak­ers are com­fort­ing to those of us who worry that not enough has been done to re­duce sys­temic fi­nan­cial risk and to en­sure that banks serve the real econ­omy, rather than threaten its well­be­ing.

Yet it is too soon to give the fi­nan­cial sys­tem as a whole a clean bill of health. Ef­forts to shore up the bank­ing sec­tor in some parts of Europe are still lag­ging far be­hind. And, more im­por­tant, fi­nan­cial risks have con­tin­ued to mi­grate to non-bank ac­tiv­i­ties.

Af­ter ir­re­spon­si­ble risk-tak­ing al­most tipped the global econ­omy into a multi-year de­pres­sion in 2007-2008, reg­u­la­tors and cen­tral banks in ad­vanced economies launched a ma­jor ef­fort to strengthen their fi­nan­cial sys­tems. To that end, they fo­cused ini­tially on banks, which have since bol­stered their risk-ab­sorb­ing cap­i­tal cush­ions, cleansed murky bal­ance sheets, in­creased liq­uid­ity, en­hanced trans­parency, nar­rowed the scope of high­risk ac­tiv­i­ties, and partly re­aligned in­ter­nal in­cen­tives to dis­cour­age reck­less behaviour. More­over, the process for re­solv­ing fail­ing and failed banks has been im­proved.

In ad­di­tion to strength­en­ing the bank­ing sec­tor, pol­i­cy­mak­ers have also made progress to­ward stan­dard­iz­ing de­riv­a­tive mar­kets and mak­ing them more ro­bust and trans­par­ent, which also re­duces the risk of fu­ture tax­payer bailouts for ir­re­spon­si­ble in­sti­tu­tions. More­over, the sys­tem for pay­ments and set­tle­ment has been made safer, thereby low­er­ing the threat of a “sud­den stop” in eco­nomic ac­tiv­ity, like the one that oc­curred in the fourth quar­ter of 2008.

It has been en­cour­ag­ing to watch na­tional au­thor­i­ties co­or­di­nate their ef­forts un­der the aus­pices of the FSB. Bet­ter co­or­di­na­tion has re­duced the risk of reg­u­la­tory ar­bi­trage, and ad­dress the threat that banks will be, as for­mer Bank of Eng­land Gov­er­nor Mervyn King mem­o­rably put it, “in­ter­na­tional in life but na­tional in death.”

The United States and the United King­dom took the lead on re­form, and Europe has been catch­ing up. As­sum­ing that it does, as pol­i­cy­mak­ers there in­tend, Yellen’s as­sur­ance of a “much stronger” bank­ing sys­tem in the US will ap­ply to all of the other sys­tem­i­cally im­por­tant bank­ing ju­ris­dic­tions in the de­vel­oped world, too. And the FSB’s con­fi­dent as­ser­tion that “re­forms have ad­dressed the fault lines that caused the global fi­nan­cial cri­sis” will re­ceive more sup­port.

Still, it is too early to de­clare vic­tory. Al­though the FSB de­scribes the fi­nan­cial sys­tem as “safer, sim­pler and fairer,” it also ac­knowl­edges “nascent risks that, if left unchecked, could un­der­mine the G20’s ob­jec­tive for strong, sus­tain­able and bal­anced growth.”

As an ob­server and par­tic­i­pant in global cap­i­tal mar­kets, three of these risks stand out to me.

First, as more care­fully reg­u­lated banks have ceased cer­tain ac­tiv­i­ties, vol­un­tar­ily or oth­er­wise, they have been re­placed by non-banks that are not sub­ject to the same su­per­vi­sory and reg­u­la­tory stan­dards.

Se­cond, cer­tain seg­ments of the non­bank sys­tem are now in the grips of a “liq­uid­ity delu­sion,” in which some prod­ucts risk over-promis­ing the liq­uid­ity they can pro­vide for clients trans­act­ing in some ar­eas – such as high-yield and emerg­ing-mar­ket cor­po­rate bonds – that are par­tic­u­larly vul­ner­a­ble to mar­ket volatil­ity. And at the same time, ex­change­traded funds have pro­lif­er­ated, while fi­nan­cial in­ter­me­di­aries have shrunk rel­a­tive to big­ger and more com­plex end users.

Third, the fi­nan­cial sys­tem has yet to feel the full im­pact of tech­no­log­i­cal dis­rup­tions fu­elled by ad­vances in big data, ar­ti­fi­cial in­tel­li­gence, and mo­bil­ity, which al­ready are in the process of up­end­ing a grow­ing num­ber of other es­tab­lished sec­tors. And the fi­nan­cial-tech­nol­ogy (fin­tech) ac­tiv­i­ties that have ex­panded are in­ad­e­quately reg­u­lated, and have yet to be tested by a full mar­ket cy­cle.

To be sure, an­other sys­temic fi­nan­cial cri­sis that threat­ens growth and eco­nomic pros­per­ity world­wide likely won’t orig­i­nate in the bank­ing sys­tem. But it would be pre­ma­ture to as­sert that we have put all the risks con­fronting the fi­nan­cial sys­tem be­hind us.

Be­cause risks have mor­phed – and mi­grated out of the bank­ing sys­tem – reg­u­la­tors and su­per­vi­sors will have to step up their ef­forts and widen their fo­cus to see be­yond the banks. Af­ter all, as Greg Ip of the Wall Street Jour­nal pointed out in 2015, “Squeez­ing risk out of the econ­omy can be like press­ing on a wa­ter bed: the risk of­ten re-emerges else­where. So it goes with ef­forts to make the fi­nan­cial sys­tem safer since the fi­nan­cial cri­sis.”

Mo­hamed A. El-Erian

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