This is the first in a series of insights from the 2018 World Economic Forum, Davos
The IMF kicked off this year’s World Economic Forum (WEF) on a cheerful note with its upgrades to global growth forecasts. The world economy is now expected to grow by 3.9% for both this year and next. All but six countries are expecting growth in the year ahead. “Global upturn” and “grand synchronisation” are now the buzzwords on the lips of policymakers, business leaders and global influencers as they gather in Davos this week.
And yet a dire warning for the financial sector was issued against this rosy backdrop. As a panel brought together bank CEOs, veteran central bankers and academics to discuss the next financial crisis, the sentiment was that the global financial system is as stretched today as it was at the dawn of the last crisis – but global financial regulators now have less policy wiggle room to respond to the threats. Of particular concern here was the hangover from the prolonged era of ultra-loose monetary policy, as central banks cut policy rates close to zero while injecting huge amounts of liquidity through quantitative easing to absorb the aftershocks of the financial crisis.
As we pointed out in our recent report, the abundance of cheap money has had its consequences. It has led to markets not pricing properly for risk. It has fed asset price inflation. Low rates have lowered the price of borrowing and contributed to an increase in debt. There has been a misallocation of resources, as forbearance has allowed zombie companies to be kept alive. The space for market correction is ample – and a sudden reversal of risk appetite is not unforeseeable.
Indeed, the very fact that the S&P 500 reached new highs while the VIX index, a measure of market volatility, remained at historic lows last week, even as the US federal government shut down, was an example of the decoupling between risks to market and the market’s response to risks.
But challenges to the financial system extend beyond interest rates and asset markets developments. The financial system itself is expanding to encompass not just banks, insurers and asset managers, but also FinTechs, BigTechs and, increasingly, incumbent giants from adjacent industries. The launch of Orange Bank, the financial services arm of the French Telecom company, is a case in point.
More non-bank players are undertaking banking activities and posing bank-like challenges to financial stability. This message was loud and clear in the Financial Stability Board (FSB) annual report published last week. As the FSB reflects upon the year just gone and plans for the year ahead, three supervisory priorities have become clear.
The first relates to the oversight of global systemically important insurers (G-SIIs) and structural vulnerabilities from asset management. In late 2016, nine G-SIIs were identified and will be subject to international standards of higher loss absorbency, enhanced group-wide supervision, and recovery and resolution planning. As for asset management, the FSB’s particular focuses will be on the mismatch between fund investments and redemption terms for open-ended fund units, the leverage within investment funds, and operational risk at asset managers in stressed conditions.
The second priority is on systemic risks associated with central counterparties (CCPs). Introduced to enhance standardisation and to mitigate systemic risk in financial markets, CCPs themselves now risk becoming a new, concentrated source of too-big-to-fail risk. This has led the FSB to highlight the need to understand the interdependencies between CCPs within the financial system and to develop CCP resolution planning.
The third and most prominent concern relates to the impact of FinTech on financial stability. Day-to-day technology use is posing macro-stability risks in the era of digital banking. A “decoupling” of innovations on the consumer-facing side of banking and the day-to-day operations on the institutional side creates ongoing vulnerabilities. The black-boxing of algorithms and the market concentration among technology providers pose stability risks to the financial system. Institutional interdependencies and risk correlations are central to financial crises and market crashes – and technology advancement accelerates the speed at which risks could spread across the financial system.
Cyber risk is perhaps the most notable form of systemic threat arising from technology use. The use of Cloud systems, and the reliance on technology in general, has allowed cyber-attacks to proliferate. Professional cyber criminals are after high-value targets such as banks while state-sponsored activities are now adding to the growing array of cybercrimes.
A 2017 study across seven countries pointed to a 27.4% year-on-year increase in the cost-per-company of responding to cyber-attacks (£11.7m), and the cost over the next five years of cybercrime to businesses is expected to be $8 trillion. In the World Economic Forum’s Global Risk Report this year, cyber is recognised as the third most likely threat to the global economy and the financial system – the last time cyber appeared among the top five risks was in 2012.
What is clear from the custodians of financial stability at WEF this year is that resilience now takes a much broader remit than making sure banks are meeting their capital requirements. The FSB is certainly scanning across the broader financial system to identify any form of undulation in these figures. A decade on from the global financial crisis, banks may be more capitalised, but preserving financial stability takes a lot more.
For more information contact:
Phone: +44 (0) 207 100 7575