As I joined the annual meeting of the IMF & World Bank in Washington DC last month, I felt a sense of dissonance. There was clearly no sense of crisis, hence no sense of urgency. Economic and financial indicators look sequententially better and extraordinary monetary stimulus may soon be pared back. Banks and regulators catalogued the series of measures taken over the past decade that should’ve rendered the financial system more robust. At the same time, there was nervousness about a relapse or worse, brought about by a cocktail of incomplete reforms, continuing imbalances, tech disruption, political uncertainty and
divergent positions on global interaction.
On that backdrop, the challenge of risk identification, assessment and sequencing of action becomes all the more daunting. To help us with that, I asked a few questions to Dr. Hyun-Song Shin, whom I met just after his panel on “Systemic Risk and Macroprudential Stress Testing”.
Dr. Hyun-Song Shin is a member of the Executive Committee, Chief Economic Advisor and Head of Research at BIS. Prior to that, he was a Professor of Economics at Princeton and Professor of Finance at London School of Economics (LSE). In 2010, he served as Senior Adviser to the Korean president, formulating stability policy and developing the G20 agenda during Korea's presidency.
How does your notion of the “global banking glut” relate to current account imbalances? Isn’t it current account imbalances that lead to the risk of financial crises?
Not always. In the case of the subprime crisis, an important feature of capital flows was the ”round-tripping”, where European banks borrowed dollars short-term from US money market funds, and then sent it back to the US by purchasing subprime mortgage securities. But since the outflows to Europe were matched by the inflows from Europe, the changes in net flows were negligible, so that these flows were virtually invisible to someone who looked only at the current account balance. European banks had claims of $856 billion on US borrowers in 2002, but this grew to over $2 trillion by 2007. This increase coincided with the rapid growth of the asset-backed securities (ABS) issuer sector, which grew to well over $2 trillion by 2007. Subprime securitisation depended heavily on the activity of European banks. Some of the short-term dollar funding came from US money market funds, but a substantial amount came from the currency swap market, where European banks borrowed dollars by pledging other currencies (euros, for instance) as collateral.
Tell me more about FX swaps. How large are the exposures?
As you know very well from your former career as a banker, an FX swap is similar to other collateralised borrowing arrangements in that the borrower posts collateral. However, the accounting convention deems FX swaps not to be debt, as the collateral is cash. Recently at the BIS, we have put a number on the size of this “missing debt”. Of the $58 trillion of FX swaps and related exposures, 90% is denominated in dollars and an estimated $13–14 trillion is owed by non-banks outside the US. For comparison, world GDP is about $75 trillion, and global trade $21 trillion. Most of the swaps are short-term. Around three quarters have maturities of less than one year, and that of the typical transaction is much shorter.
What are the risks? If they are collateralised, they should not pose any credit risk.
You’re right about the credit risk. Since cash is the collateral, risk of loss on the part of the lender is minimal. But that is not the only risk. The main problem is the maturity mismatch, as long-term commitments may be funded by short-term swaps. If there is another deleveraging of the global banks, as we saw during 2008, we may see a similar funding squeeze. And since most of the FX swaps are in US dollars, there may be a short squeeze on dollar funding as we saw during 2008.
What can policymakers do to mitigate these kinds of risks? Shouldn’t advanced economies also adopt macroprudential tools, just as emerging market economies have done? Have we all become more Asian in that respect?
It’s true that economists’ views on regulation has changed quite a lot since the crisis. Regulation, by its nature, is an interference in the workings of the economy, but the intention is to counter other distortions. This is a variant of the “second best” argument. Adding a distortion (regulation) results in a better outcome if it mitigates other, more serious, distortions that make the financial system vulnerable to much worse outcomes.
Very few people would say that we should abolish financial regulation in the domestic context, but things get much more contentious and difficult in the international context, especially when discussion turns to capital controls to deal with boom-bust cycles. Unlike for domestic financial regulation, the frictionless economy still exerts a powerful hold as the benchmark to aim for in the international context.
My sense is that the contrast is due to an outdated and misleading framing of the questions that makes us blind to some vulnerabilities, and too quick to condemn solutions. Actually, a proper framing of the issues puts the domestic and international dimension on a more equal footing. But emphasis on controls at the border is equally misplaced; it confuses outward symptoms and underlying causes. It perpetuates the flawed framing of the questions.
What is the proper framing, then? How should we approach the problem of global financial stability?
The global economy is not just a group of islands, but a set of nodes connected by a dense network of financial claims. The image is of a matrix, not a collection of islands. The lesson is to distinguish underlying causes from outward symptoms. Yes, the 2008 financial crisis was in large part a cross-border phenomenon, but focusing on capital flows confuses the symptoms (capital flows) from the underlying causes (excess leverage and funding risk). If the problem is excessive bank leverage and funding risk, then address these risks directly with traditional microprudential, or regulatory tools. Applying these microprudential tools with macroprudential intent, or the intent to work on the whole financial system, is what makes them part of a macroprudential framework.
What about exchange rates? Where do they fit into your story?
Exchange rates affect the economy not only through a trade channel but also through a financial channel. The financial channel goes in the opposite direction to the trade channel. A stronger currency goes hand-in-hand with a lending boom and buoyant investment activity on the back of strong capital inflows. The effect is particularly marked for emerging market economies, as we witnessed during the boom in the immediate post-crisis years. Unfortunately for them, the financial channel also works in reverse, as the recent period of dollar strength and growth slowdown has shown.
What is the mechanism, exactly?
The financial channel of exchange rates operates through valuation changes on balance sheets. For instance, a weaker dollar flatters the balance sheet of dollar borrowers whose liabilities fall relative to assets. From the standpoint of creditors, the stronger credit position of the borrowers creates spare capacity for credit extension even with a fixed exposure limit, for instance through a Value-at-Risk (VaR) constraint. The spare lending capacity is filled through an expansion in the supply of dollar credit.
There are knock-on effects of the risk-taking channel on the government’s fiscal position, too. When credit supply expands, so does the set of investment projects, raising economic activity and improving the fiscal position. If corporate dollar borrowing is done through state-owned enterprises, as is the case for the oil and gas sector in many EMEs, then the fiscal impact may be even more direct through the dividends that are paid into government coffers.
Moving to BIS banking regulation. The banks say regulation is too tight, and this hurts lending to the real economy. Do you agree?
Banks are intermediaries. They borrow from other lenders, combine the borrowed funds with their own funds, and then lend the combined total to ultimate borrowers. Bank capital refers to the bank’s own funds. The more capital a bank has, the more own funds it has to lend out. But bank capital plays a more important role than this for overall lending. As well as lending out its own funds, a bank with plentiful own funds is able to borrow more from its creditors, and on much better terms than if the bank is poorly capitalised. So, if the objective is to unlock bank lending to the real economy, ensuring that banks have enough capital to support their lending activity is vital.
It is also true that bank capital is a loss-absorbing buffer in the sense that the bank’s own funds can absorb losses from lending activity without imposing losses on the creditors to the banks. But solvent banks can sometimes be reluctant to lend, and weakly capitalised banks may seek to improve solvency metrics such as their ratio of capital to risk-weighted assets by cutting back on lending. If a bank’s solvency metric is expressed as a ratio, there may even be some apparent tension between the policy objective of unlocking bank lending and the supervisory imperative of ensuring the soundness of individual banks.
But this tension between the monetary policy objective and the supervisory imperative is more apparent than real; both the macro objective of unlocking bank lending and the supervisory objective of sound banks are better served if banks have more capital. In general, sound banks lend more, and do so in a sustainable way over the cycle.
We are at a juncture when the major central banks are either normalising monetary policy or will do so in the near future. What are the risks now?
Experience has taught us that bond markets can move abruptly and “overreact” relative to the benchmark where the long-dated yield is the average of expected future policy rates. The possible “snap-back” in bond markets is something we should be looking out for.
Here, monetary policy communication is an important element. We often hear the argument that the market is pricing in this or that action of the central bank, and that any deviation would upset the market. This type of argument neglects how market participants have become conditioned to the manner in which they interact with the central bank. Jeremy Stein put it well in his last speech as a Fed Governor. The more the central bank whispers in order not to upset markets, the more market participants lean in to hear better.
Predictability and gradualism may not be a virtue if market participants take them as a commitment not to pull the rug from under their feet while they build up leverage and risk-taking positions. Tobias Adrian and I argued in our 2008 Jackson Hole paper that predictability and gradualism may have been enabling factors in the build-up of leverage before the Great Financial Crisis.
Dr. Shin - Thank you so much for your time.
Lutfey Siddiqi CFA
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