The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. Their main forms have been balance sheet expansion and risk premium compression through asset purchases and targeted lending, forward guidance in respect to future monetary policy, and changes to collateral rules. Future non-conventional policies could team up with fiscal expansion to create versions of “helicopter money”. Non-conventional policies have created new systemic risks, arising from [i] prolonged sedation of financial markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding. Read more
Basic Summaries on Systemic Risk
Systemic Risk I: Non-Conventional Monetary Policy
The Federal Reserve relied heavily on non-conventional monetary policy after the great financial crisis, purchasing treasuries and mortgage-backed securities in excess of a quarter of concurrent GDP. In conjunction with various forms of forward guidance it compressed both term and credit risk premiums by unprecedented margins. The Federal Reserve has also been the first large central bank to begin reversing ultra-easy monetary policy. The initial focus is on a normalization of interest rates, while any reduction of the Fed’s huge balance sheet is more uncertain and a matter for the further future. The prime focus remains on downside or deflationary risks for the economy, while considering the inconvenient side effects for the global economy. The latter include growing addiction to cheap funding and challenges to the business model of financial institutions. Read more
The European Central Bank runs one of the most complex monetary policy regimes in the world. Since the euro area sovereign crisis its operating framework has extended well beyond regular liquidity supply and now includes [i] long-term full-allotment and targeted lending operations, [ii] large-scale asset purchases, [iii] active and comprehensive collateral policies, [iv] flexible forward guidance on policy operations and [v] a contingent facility to intervene in government bond markets in case of sovereign debt crises. Read more.
Systemic Risk II: Government Finances
Public debt ratios in the developed world remain stuck at 200-year record highs, even with a mature global expansion and negative real interest rates. This poses a lingering systemic threat to the global financial system for at least three reasons. First, governments’ capacity to stabilize financial and economic cycles has been compromised, which matters greatly in a highly leveraged world that has grown used to public backstops. Second, many countries have taken recourse to mild forms of “financial repression”, which puts pressure on the financial position of savers and related institutions, such as pension funds. Third, future political changes in the direction of populist fiscal expansion can raise the spectres of old-fashioned inflationary monetization or even forms of debt restructuring. Read more.
Systemic Risk III: Financial System
The great financial crisis revealed vulnerabilities of the regulated banking system’s capital structure, liquidity reserves and resolution regimes. This has given rise to an unprecedented expansion and tightening of regulatory rules that include a massive increase in minimum capital ratios, mandatory minimum leverage ratios, new compulsory liquidity ratios and new resolution regimes. The new rules may have unintended consequences, however, including tighter bank lending conditions and more regulatory arbitrage. Read more.
Shadow banking means financial intermediation outside the reach of standard regulation. Shadow banks engage in term, credit and liquidity transformation similar to regulated banks and function principally to channel institutional cash pools to the funding of asset holdings. This makes them an essential part of financial markets. Often this intermediation takes place in a complex multi-institutional setting. The special vulnerability of the shadow banking system arises from its dependence on collateral (asset) value and the absence of a safety net in form of central bank backstops. Read more.
Emerging markets have greatly increased in importance since the 1990s. In particular, local-currency bonds and foreign-currency corporate debt have expanded rapidly. Emerging economies and political systems are now highly dependent on global financial conditions and their feedback onto developed markets is powerful. A particular concern is China, due to its size and aggressive use of financial repression to sustain high levels of leverage and investment. The expected decline in China’s medium-term growth will put the sustainability of private debt, corporate earnings and property prices to a test. Read more.