Tobias Adrian, International Monetary Fund
The Current Global Financial Stability Assessment
Although financial conditions are easy in every major region of the world, the economy is facing “a bumpy road ahead”. This is the punchline of Tobias Adrian’s Working Lunch talk. Adrian, who is an IMFS Research Fellow, is Director of the Monetary and Capital Markets Department of the International Monetary Fund (IMF) and Financial Counsellor to Christine Lagarde.
As a result of easy financial conditions persisting for many years, a lot of risk has been building up, Adrian who is also responsible for the IMF’s Global Financial Stability Report (GFSR) explained. This report assesses the key risks facing the global financial system. Whereas one year into the future conditions still look good, Adrian emphasized that the situation is totally different for a three-year horizon: “In the medium-term we see a lot of risk”. In comparison with the year 2000, those medium-term estimates for global GDP growth are even at a lower range.
According to Adrian, there are various aspects of underlying vulnerabilities. First of all, the global equity rally has pushed valuations higher worldwide. Markets are not pricing in a significant likelihood of sharply higher inflation.
Regarding credit quality, Adrian warned that underwriting standards keep deteriorating. The demand for risky assets has compressed credit spreads. On the other hand, the global reach for yields has driven investor flows to private equity funds. “The leveraged loans market is at an all-time high, private equity funds are important players,” he pointed out. As a consequence of the weakening credit quality, the nonbank investor base is growing.
With regard to emerging markets and low-income countries, Adrian cited the situation in China, which accounts for a considerable proportion of the 400 percent increase in total financial assets to GDP. In contrast to this, China has only five big banks and some small and medium-sized banks. This in turn has led to a very large shadow banking sector in China where a lot of risk is embedded, similar to the Chinese insurance sector, which he also considers very risky.
According to Adrian, another important source of vulnerability lies in the banking sector. Although banks are much safer than before the global financial crisis, having a higher level of liquidity, they end up pooling a lot of assets in US dollar, Adrian warned. Therefore, “we urge regulators to also look at the currency level”.
In Adrian’s view, the risky situation is intensified by the political environment. “Trust in political institutions is eroding around the world, which generates a lot of risk.” In this case, neither historical data nor models help. “We don’t know where this will end up,” Adrian concluded.
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Stephen L. Schwarcz, Professor of Law & Business, Duke University School of Law
Central Clearing of Financial Contracts: Theory and Regulatory Implications
Modern financial regulation requires that derivatives contracts be cleared and settled through central counterparties, such as clearing houses affiliated with derivatives and commodities exchanges, in order to try to reduce systemic risk. In his Working Lunch, Stephen Schwarcz, Professor of Law at Duke University, examined whether regulators should also require the central clearing of non-derivative financial contracts.
In the aftermath of the financial crisis, the Financial Stability Board (FSB) felt that derivatives were inherently risky, given that fact they are debt and volatile. Therefore, by concentrating it on a CCP, the overall systemic risk should be reduced. However, as Schwarcz pointed out, the net counterparty exposure on non-derivative financial contracts greatly exceeds that on derivatives contracts. He raised the question whether derivatives were truly riskier than other types of financial contracts.
As he further pointed out, CCP often started out as special purpose entities (SPE). As they have expanded their tasks, Schwarcz claimed they should be ringfenced as a way to protect other clearing members against the accumulated risk. However, according to Schwarcz, it is very hard to formulate specific laws to achieve this. Typically, regulators don’t direct major financial institutions how to control their risk. He came to the conclusion that even the multi-lateral netting of non-derivative financial contracts does not systematically reduce risk.
Robert Kaplan, President of the Federal Reserve Bank of Dallas
A Discussion of U.S. Macroeconomic Trends and Their Implications for U.S. Monetary Policy
For Robert Kaplan, President of the Federal Reserve Bank of Dallas, technology-enabled disruption is one of the major economic trends, which will shape the future. However, in his opinion the recent drop at the stock market is likely to be a healthy correction instead of the beginning of a new crisis. In his talk at the IMFS Working Lunch, Kaplan shared his insights on macroeconomic trends in the United States, comparing it to the economic development in Germany with Volker Wieland as his interview partner.
With regard to the emergence of dominant technology companies in the United States, such as Google or Amazon, Kaplan pointed out the importance of soft factors. “Apart from investment, you need an ecosystem for such companies”, referring to infrastructure, education and universities. These conditions were abundant in California as well as in the Boston area. However, “passion is the rocket fuel for innovation, not money”, Kaplan concluded. In this context, he also emphasized the importance of education and life-long training. “In the US, we’re lagging behind in helping people getting trained for middle-skill jobs”.
In his opinion, technology-enabled disruption is one of the permanent economic developments in the US, together with the slowing workforce growth and rising government debt. As for the demographic development, Kaplan said that 50 per cent of the workforce growth in the last twenty years was due to immigrants and their children. “This is also a way to grow faster than debt”, he said. He expects the demographic situation to limit the way the central bank will apply fiscal policy in the future. Since September 2015, Kaplan heads the Dallas Fed. He is a non-voting member of the Fed’s policy committee.
Regarding the implications for monetary policy, Kaplan told the audience that higher wages in the United States will not necessarily lead to faster inflation. Although the United States were nearly at full-employment – one of the goals forming the Fed’s mandate – Kaplan was not convinced that this would translate into higher prices because businesses had much less pricing power due to technological advances. According to Kaplan, the Fed should continue to tighten monetary policy. “If you have significant enough overshoot of full employment, history shows that usually other excesses and imbalances build up”, he warned.