This article first appeared in City A.M. on Wednesday 7th February 2018.
Brexit has been the centrepiece of the City’s agenda this week, with two planned Brexit Select Committee meetings alongside Michel Barnier’s visit to the UK.
Despite the fractures Brexit has caused within the government, there seems to be more coherent understanding in the Square Mile on the future shape of regulatory architecture.
Any future deal seems most likely to treat financial services based on existing equivalence rules for non-EU countries rather than a more ambitious deal.
While perhaps sub-optimal, regulators are ruling out any retreat from current standards. Sam Woods, deputy governor at the Bank of England, weighed in over the weekend, pledging to “maintain standards of resilience in the financial sector at least as high as those we have today”.
With the Brexit deadline just over a year away, banks are in the process of implementing relocation plans, preparing for the worst-case no-deal scenario, and exploring business opportunities that fall through the cracks between Brexit planning and ring-fencing.
But while Brexit still dominates much of the City’s immediate thinking, issues beyond the EU are starting to register more prominently.
The end of ultra-loose monetary policy, the proliferation of cyber security concerns and technology risks, the competitive threat from fintech, big tech, and incumbent giants from adjacent industries are all very much on the agenda.
The stock market sell-off that saw steep falls in most major indices is a powerful case in point. On Monday, the S&P 500 and the Dow Jones indices both dropped by about four per cent by the market close. The catalyst for this significant market correction is concern over rising inflation, as western economies experience a “synchronised upturn” and their labour markets have less slack to absorb additional demand without needing to increase prices.
This triggers market fear that a decade of cheap money – characterised by near-zero interest rates and quantitative easing programmes – is ending once and for all. The expectations of interest rate rises pushes up bond yields, triggering a repricing of equity prices as an investment substitute. Higher interest rates also mean that a higher discount rates will be used when making equity valuations.
Even though it is widely expected that western central banks will embark on monetary policy normalisation in a gradual, well-announced manner, an eight-year bull run in stock markets is probably ripe for any trigger to spur a market correction.
Indeed, the fact that the S&P 500 had reached new highs earlier this year while the VIX index, a measure of market volatility, remained at historic lows last month, 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 the symptoms of the hangover from a prolonged era of ultra-loose monetary policy continue. The abundance of cheap money has also led to a misallocation of resources, as forbearance has allowed zombie companies to be kept alive, while low rates have lowered the price of borrowing and contributed to an increase in debt.
Several regulators, including the European Central Bank and the Bank of England, called out repricing of risk premia and debt sustainability as some of the key risks to financial stability in the year ahead. The European Banking Authority further assumed the most adverse conditions yet in its 2018 stress testing scenario based on the materialisation of these risks.
Cyber risk is another systemic threat to financial stability identified by multiple regulators.
Mass data breaches and intentional manipulation of online platforms challenged the digital economy in 2017. In 2018, cyber security will become the undercurrent across technology, business and political concerns.
The financial industry is particularly vulnerable. Professional cyber criminals are after high-value targets such as banks, while state-sponsored activities are now adding to the growing array of cyber crimes. The banking system is ill-prepared to cope with these new threats and cyber crimes.
So while Brexit grabs the headlines, keep a close eye on the global issues currently playing out that will shape the financial industry’s risk agenda in the years to come.
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